At the very beginning of it, there are three facets of Trade that need to be studied - Saving, Investment and Lending. While we all know and have experienced the nitty-gritties of Savings, right from saving pocket money for weeks together to buy a gift for somebody or saving up on leisure time for a couple days to watch the Indo-Pak cricket match, Investment is a tad bit more complicated.
Why is investment needed in the first place ? Let us suppose that I am planning to start a shoe factory. However productive my idea is, I first need to lay my hands on some cash before I start making profit. This cash is called Capital and is an investment. Capital is of two types - Working Capital and Fixed Capital. I need to buy some land and set up my factory as well as buy the required machinery. This long term investment is called fixed capital and is done at the very beginning. Again, I need to pay my workers daily wages, buy raw material every week or month and also need to support a supply chain to sell my goods. These expenses, which vary according to demand and are like everyday expenses and are called Working Capital. The above was an example of Business Investment.There are, other forms of investment too, termed as Household investment. For instance, the fees I pay for my college are also an investment, the returns on which would start showing after I start earning my salary. Similarly, buying a car is also an investment, although not one that would give future returns. It would rather give me a service over a continuous period of time.
The two aspects that directly result from the above are Borrowing and Lending. Both Borrowers and Lenders gain from trade. A borrower like me would be able to start my factory and start earning good profit while a lender earn an interest on the money that he lends me. His other options would have been to either save up that money for years together or invest the money in some other form, but finding such a productive investment is a mammoth task in itself. So he gains from this trade too.
However, as with any system, there are basic problems involved with borrowing and lending. While buying goods from a shop by paying cash or bartering some other goods, called Cash trading ( exchange of value for value ) is fair and simple, Credit Trading ( involving exchange of value for a promise) is not as simple. My lender gives up some of his purchasing power to me and I give him a promise that I will return his money after a specific period of time. The problem is that I may not keep the promise because I can't predict the situation a few years down the line. That is, I may default. To have a detailed look at the problem and the costs involved, let us take the following example:
Suppose that I am a lender with huge amounts of cash. A company has approached me for a loan. The first thing that I, as an intelligent lender, would want to do is to gauge the risk in lending my money. So I would like to analyze the company's way of working, how well it is doing, how well it is predicted to do in the near future, etc. Since the company would always want to show itself in a positive light, I have to check the reliability of the information that I study. This is the first cost involved - The cost of acquiring and processing information.
Now, provided I decide to go ahead with the loan. I need to enter into a contract with the owner of the company to make sure that the whole process is overseen by law. Negotiating and drawing up the contract requires both time and fees ( legal, etc.). So the second cost is - The cost of negotiating and writing a contract.
Next, the type of contract I sign is also of paramount importance. ** There are two types of contracts in lending - Debt contract and Equity contract. ** An equity contract is one wherein if I lend an amount of say 10 lac to the company, I shall have a stake in the company's profits of, say 50%. This means that whatever profits the company makes, I am entitled to get 50% of it. However, the company is not entitled to give me back my 10 lacs. This implies a tax of 50% on the company's profits and hence, the management of the company might not work as hard as you would like them to and the profits could suffer. Also, the owner of the company might get himself a bigger office and make more expenses on perks, because each rupee spent on expenses will only cost him 50 paisa. There have been lots of cases in the global corporate world, where the CEO's of the companies, with themselves having a very low share in the company's profits, have indulged in extravagant expenses because of equity contracts.
On the other hand, a debt contract entitles the company to pay me a certain amount, say 50 lacs, after a fixed period, say 5 yrs and there is no "tax" on the profits. This will eliminate the problem of the owner not wanting to work hard because every rupee earned beyond 50 lacs is for him to keep. However, this might result in a conflict between myself and the owner of the company. The owner might go with a business strategy that maximizes his profit more than it favors my chances of getting the money back. Thus the third cost is - Incentive problems inherent in lending arrangements.
Fourth problem is that of monitoring the company. I, as a lender, would like to monitor the efforts of the owner in case I have signed an equity contract and also to have veto power on wasteful expenditures. In case of a debt contract, I might like to have a clause which states that until my loan is paid off, the company cannot undertake other loans. These are called loan covenants - which restrict the behavior of the borrower according to the lender's safeguarding of interest. This way, I might be restricting the company from venturing into something profitable. Also, I have to incur the cost of monitoring the compliance of these clauses periodically. Thus, the fourth cost is - The cost of establishing safeguards and monitoring borrower compliance.
Next problem is related to Liquidity. Liquid means capable of being turned into cash quickly without loss. Suppose that I need the money back because of an emergency, immediately after lending it to the company. That is, I would like the loan to be liquid while the company will need the funds to be committed for a long period of time. I might be willing to accept lower liquidity if promised a higher return, but that will be tougher for the owner of the company. Thus the fifth problem is - Conflicting interest over liquidity
The sixth problem is that I am currently feeling dizzy over how much of bhaat I have written in the past one hour. Phew!!! That was more than enough for one blogpost... Ciao
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