As indicated in section 2.2.2, in modern monetary economies, credit is fundamentally different from credit in traditional economies, the reason being that, in a modern monetary economy, the desire to maximise profit for private use is regarded as legitimate and ethical (Kagan et. al., 1987, pp. 563–564).
The discussion on the nature of credit in modern monetary economies commences by describing finance as an academic discipline, moving to classification of loans and the dominating role of banks in credit provisioning, before the effect of globalisation of trade and credit on credit provisioning is highlighted. However, even as credit is advanced in order to make profit, there is still a social contract in this regard. In times of financial distress (such as the crisis of 2007/08 and its aftermath), governments invest in the financial viability of large banks to ensure the continuous supply of credit to citizens. There is evidence that the largest banks (who also receive the highest state investment) disregard this social contract, which is a reason for fundamental rethinking of the financial system (Baradaran, 2013, pp. 1283–1286).
This section was devoted to explaining the nature of credit in modern economies in order to identify the niche for private providers of asset-backed short-term finance.
44 2.2.3.1 Finance as a scientific discipline
Merton Miller (a Nobel laureate in Economy for his lifelong contribution to Finance) (Miller, 1991) assisted to lay the foundations for Finance in the 1950s (Miller, 1999, p. 95). He states that Finance deals with:
the cost of capital;
the funds a firm should use to acquire assets in a world where:
o the yields of those assets are uncertain; and
o capital sources can range from pure debt to full equity (Modigliani &
Miller, 1958, p, 261).
A more recent definition adds the investment of surplus funds and the sub-disciplines of private finance, corporate finance and public finance, focusing on respectively individuals, businesses and governments (Investopedia, 2017).
In 1958, Miller and Franco Modigliani, his colleague at the Carnegie Institute of Technology (currently Carnegie Mellon University), contributed the so-called Irrelevance Theory to the study of Finance, also called the Modigliani–Miller theorem;
the essence of this theorem is that, in a perfect market, the source of finance is irrelevant (Modigliani & Miller, 1958). In reality, according to Villamil, 2013, p. 2) only non-perfect markets exist, but it remains valid that the value of a firm is determined by the income stream it generates, and not by its capital structure.
In order to retain the largest possible portion of a firm’s income stream (either to reinvest or to appropriate), the irrelevancy theory (Modigliani & Miller, 1958) predicts that credit would be the capital source of choice, as it does not dilute ownership. The following citations confirm this prediction:
Denis and Mihov (2003) found that corporations in the United States of America overwhelmingly preferred credit to equity for external capital needs. They also found that companies with a high credit value prefer public borrowing, intermediate ones prefer banks and low credit-quality firms prefer non-bank borrowing.
According to Alexander (2013), corporate credit in Europe gradually follows the American example of preferring public borrowing to bank loans.
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The overview of finance draws attention to credit, as the preferred form of finance. In the next section, loans are classified.
2.2.3.2 Classification of loans
Loans may be classified according to different criteria. This section explains the distinction between secured and unsecured lending, which was relevant to this study.
The assumption that secured loans are per definition ‘safe loans’ is disproved.
Unsecured loans refer to a form of consumer lending, which the Federal Reserve Bank of Atlanta (2013) recommends should only be advanced to borrowers with an adequate net worth and ample liquidity. The Bank further recommends that unsecured debt should not exceed 1.5 times an applicant’s monthly net income, be limited to less than 10% of a borrower’s net worth, or 50% of the borrower’s unencumbered liquid assets, with terms limited to 12–18 months (Federal Reserve Bank of Atlanta, 2013, pp. 1–2).
Secured loans refer to any loan where an asset is offered as guarantee. In addition to mortgages on property, Song (2003) identifies pledges on deposits, inventory and equipment, as well as guarantees or ‘letters of comfort’ issued by the state, banks or other reputable institutions, where the value of security depends on its inherent quality, or the integrity of the guarantor.
Ibanez and Scheicher (2010) describe how, since the late 1950s, banks had started to securitise and sell household mortgages to investors. This gradually extending practice greatly accelerated after 2000. The incentives for originators of loans differed from those responsible for collecting payments, resulting in more risk-prone loans being created and ultimately the credit crisis of 2007/08 (Brunnermeier, 2008, p. 2;
Ibanez & Scheicher, 2010). While both Ibanez and Scheicher (2010) and Brunnermeier (2008) write from an American perspective, García-Herrero, Lis, and Santiago (2008) add a wider perspective by discussing the similar nature of the preceding Spanish housing boom and subsequent bust, which resulted in secured loans, which could not be redeemed.
The preceding section illustrated that both secured and unsecured lending require thorough investigation. In unsecured lending, borrowers have to be investigated individually, and in secured lending, this applies to the security offered, while the value
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of security depends on the quality of the underlying asset. Providers of asset-backed lending need to be aware of the fundamental requirements of exercising due diligence regarding the assets, which back their loans.
The primary focus of this study was private provisioning of asset-backed credit. These entrepreneurs operate in an environment currently dominated by banks, as indicated in section 2.2.3.1. Therefore, it was imperative to study the role of banks, as is reflected in section 2.2.3.3.
2.2.3.3 The role and income of banks
Banks have several roles to play in the functioning of financial systems.
Allen and Carletti (2010) state that, together with stock markets and bonds issued by the state and private firms, banks form the financial system. Banks share risk by diversifying and smoothing out fluctuations, although they can also be at the centre of financial crises and can help to spread the risk. In certain economies, bank officials have positions on other firm’s boards, which enable them to influence corporate governance. Banks help the economy to grow by supplying funds to firms, and they help overcome asymmetric information problems by forming long-term relationships with firms (Allen and Carletti, 2010).
Strahan (2010) sees the supply of liquidity to firms as the most important function of banks, which they perform by transforming liquid deposits into illiquid loans (Strahan, 2010). This ability, which can be described as pretending that long-term loans are safely covered by short-term deposits, is what King (2016, p. 96) describes as the
“alchemy of banking”, in other words, the ability to create gold from less valuable materials – an ability which King believes contributes significantly to the recurrence of banking crises.
Banks are also entities that act as the mediators between two parties in a financial transaction (Investopedia, 2017). Therefore, Choudry (2011, pp. 3–4) identifies the three income streams of banks, each related to a specific function (see section 2.2.3.4). These are interest income on lending activities, fees and commissions as a result of services, which are provided to customers, and trading income, which is generated through participation in financial markets.
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Accusations of excessive fees are made in the United States and the United Kingdom (Treanor, 2016; US Treasury, 2016), as shown in this paragraph. Regulatory authorities in the United Kingdom investigate ways to remove barriers from shifting bank accounts from the ‘Big Four banks’ (HSBC [Hong Kong and Shanghai Banking Corporation], Royal Bank of Scotland, Lloyds Bank Group and Barclays) to smaller banks, as these banks reportedly use exit barriers to trap consumers in accounts with excessive costs (Treanor, 2016). British regulatory authorities investigate claims that punitive charges for unplanned overdrafts (four times as costly as ‘payday loans’) burden vulnerable customers with excessive costs (Jones, 2016). In an advisory note to consumers, the treasury of the United States warned consumers to be aware of all charges and not to hesitate to switch between banks when excessive costs are charged (US Treasury, 2016). This is discussed in South African terms in section 3.2.3.3, also in relation to the present study.
2.2.3.4 The role of information and computer technology in banking
Domination by banks is partly retained by their being an adaptive industry, mainly driven by information and computer technology (ICT). In 1986, on the eve of the ICT explosion, Schmenner predicted fundamental changes in banking, resulting from the implementation of ICT. His prediction was that service companies, including banks, would have to choose between being ‘service factories’ or ‘service shops’. Service factories would have low interaction with customers. ICT would enable companies to produce standardised services on a large scale. Service shops, on the other hand, would be labour-intensive, meaningfully engaging with customers on the detail of their businesses (Schmenner, 1986). In 2013, the accuracy of Schmenner’s prediction was confirmed by Tinnilä. Some important results of the shift to ICT are discussed in the paragraphs that follow.
Riddiough (1997) explains how ICT enabled loan brokers to originate loans, pool these loans and then divide it into ‘packaged’ securities to be resold to investors.2 This
2 Riddiough (1997) refers to this kind of loan as ‘asset-backed lending’. It is important to distinguish between this concept and asset-backed lending as outlined in Chapter 1. The essential difference is that the detail of a loan and the asset backing it is central to the definition in this study, while Riddiough describes the opposite, where the detail gets lost when loans are pooled.
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innovation facilitated large capital mobilisation, but also led to a decline in lending standards, and ultimately the 2007/08 credit crisis (Brunnermeier, 2008, p. 2).
According to Gary Palmer, owner of Paragon Lending, as broadcast by CNBC Africa, use of ICT resulted in banks shifting their focus from secured to unsecured lending, based on consumer spending. Prospective borrowers were screened on monthly income and credit record, which credit bureaux verified by means of ICT (CNBC Africa, 2013).
The use of ICT in banks adds to operational risk, as new ways of defrauding customers are created. This is discussed in section 2.3.2.1.8.
The discussion above indicates that banks still have a dominating role in the credit industry, despite the challenges created by regulation and new competitors. The use of ICT resulted in the ability to process more credit agreements, but with less attention to detail. Emphasis on loan criteria shifted from security to credit record. Relevant to this study, was the emergence of small-scale credit providers, willing to investigate the detail of a security before reaching a loan decision. In the next section, the effect of globalised trade and credit on the nature of credit in modern, monetary economies is discussed.
2.2.3.5 Globalisation of trade and credit and the effect of financial crises Credit is part of the global financial system. Economic prosperity and crises alike could have grave consequences in countries far from the source of either prosperity or crisis.
Globalisation involves the social, cultural and economic spheres of life (Saloojee, 2014). However, only its effect on trade and credit was directly relevant to this study.
Globalisation is a term, which old neutrally refer to a process of progressive interaction between people from different parts of the world, which can be traced back to the empires of Greece and Rome. However, it also refers less neutrally to a process in which Western civilisation has been extending its domination globally. More recently, the so-called “Washington Consensus” in the 1980s brought accelerated globalisation by decreasing the role of the state in the economy and the tearing down of national borders, forming ever-increasing markets. This “neo-liberal globalisation” is criticised for marginalising working class people in industrialised countries as well as developing countries, in order to benefit the elites in industrialised countries (Saloojee, 2014).
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Brogan (1988, pp. 528–530) asserts that the general public only took notice of the global interconnectedness of trade and credit with the Great Depression starting in 1929. As the United States was the only solidly prosperous state after World War I, it supplied credit to the rest of the industrialised world. When economic disaster struck the United States in 1929, it instantly spread to all industrialised countries and commodity supplying regions (Brogan, 1988, pp. 528–530).
In the aftermath of World War II, economic devastation was so intense that globally co-ordinated reconstruction was necessary (Crafts & Toniolo, 1996). Just as post-war reconstruction seemed complete, the energy crisis of 1973–1974 occurred. In the winter of 1973–1974, the German Federal Republic imported the highest volume of oil in its history (Kepplinger & Roth, 1979). Nevertheless, the mass media were warning that an energy shortage might occur, whereupon the population became nervous and bought more crude oil products than ever before. As a consequence, short-term difficulties of supply from industrial producers seemed to confirm the warnings (Kepplinger & Roth, 1979).
In the context of recurring international crises, which inevitably seemed to be systemic, the importance of multi-national economic blocs increased. For instance, the Group of Ten (G-10) wealthiest member nations of the International Monetary Fund (IMF) often had to stand ready to lend, in order to prevent economic collapse somewhere in the world, which might prove to be globally contagious (Business dictionary, 2014).
The credit crisis of 2007–2008 demonstrated how the world’s growing dependence on oil had created a repeating pattern of banking, currency and energy-price crises. El-Gamal and Jaffe (2009) created a complex picture in which transfers of wealth to and from the Middle East resulted in a perfect storm of global asset and financial market bubbles,3 increased unrest, terrorism and geopolitical conflicts, and eventually rising costs of energy. They contend that only by addressing long-term energy policy challenges in the West, economic development challenges in the Middle East, and the
3 A financial bubble occurs when an economic cycle, equity prices, and/or the price of any kind of security, increases above the underlying value it represents. This is followed by a sudden decrease in prices, or market correction (Investopedia, 2015).
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investment horizons of financial market players, can policymakers ameliorate the forces that have been causing repeating global economic crises (El-Gamal & Jaffe, 2009).
Another interpretation of the financial crisis in 2007–2009 is that it is “a symptom of another, deeper, systemic crises of capitalism itself” (Esterhuysen et al., 2011, p. 271).
The ongoing decrease in the gross domestic product (GDP) rates in the West since the early 1970s created growing surplus capital that did not have sufficient profitable investment outlets in the real economy. The alternative was to place this surplus into the financial market, which became more profitable than productive capital investment, especially with subsequent deregulation. This phenomenon has led to recurrent financial bubbles (such as the Internet bubble of the early 2000s, and it is believed to be a deep cause of the financial crisis of 2007–2010 (Esterhuysen et al., 2011, p. 271).
This sub-section reflects the conclusion that the assets taken as security by asset-backed credit providers could decrease in value, due to international events. Even a private credit provider cannot ignore the global context in which it operates.
The section on the nature of credit in modern monetary economies reflected a discussion on finance as a scientific discipline in the modern monetary economy, as well as the classification of loans, the role of banks and the effect of an increasing globalising system of trade and credit. The present study presents a topic in the discipline of Corporate Finance, specifically regarding secured loans with a maturation time of at most twelve months (see Chapter 1). Banks still have a dominating role in the credit market, but ICT contributes to a trend towards larger-scale operations, with less emphasis on loans requiring detailed evaluation. This opens a niche for private credit providers, especially for liquidity-constrained, high net-worth customers.
Although evaluation of the assets offered for security is paramount, global trends need to be taken into account, to prevent disastrous devaluation of said security.