Debt

Debt is the state of owing something to another party. It is generally assumed to involve the transfer of financial assets, but in the barter economy the payment is executed in kind. It is important for both lender and borrower to reach an agreement about a deferred payment, and the lender is rewarded with an appropriate interest payment for forgoing current consumption. In the contemporary Islamic world, which has strong similarities with the stance of the medieval Catholic Church that condemned usury, debt repayment is replaced by profit sharing of co-investing parties. The orthodox religious thinking in certain parts of the world thus indicates that interest payment associated with debt leads to profit making without commensurate work effort and simultaneously causes the exploitation of those expected to pay it.

Nevertheless, debt has been an important market phenomenon throughout history. Expensive and prolonged wars had to be financed by extensive borrowing and this could eventually lead to bankruptcy. Private investors, such as the Rothschilds, supported the British government in war against Napoleon I, and one of the major roles of early central banks in the world was to provide public financing for the state. In contemporary economic flows it is evident that leverage, i.e., increased debt levels, lead to higher risk, but also to higher returns because of the difference between the (higher) investment return and (lower) cost of debt. The cost of debt financing is even lower because it is paid before tax, which implies lower after-tax cost of financing.

The notion of debt is not only essential at the micro-economic level. Governments issue so-called sovereign debt instruments (bonds) or accumulate various sorts of international loans for investment and consumption-related purposes and like companies are prone to default on debt if overexposed to the same. The best examples are Mexico and Brazil in 1982, the Russian Federation in 1998, and Argentina in 2001.

Small- and Medium-Scale Enterprises

At the micro level, companies borrow funds directly from financial markets or indirectly from financial intermediaries, such as commercial banks, savings institutions, credit unions, and finance companies. The scale and scope of lending instruments is different among lending institutions and are suited for particular market niches that occasionally include individual consumers (car financing provided by finance companies or personal loans from commercial banks). The involvement of a financial intermediary increases borrowing costs by a charged fee, which is potentially more disadvantageous with comparison to direct financing. However, small- and medium-scale enterprises (SMEs) would pay a significant premium to obtain funding from non-bank investors who do not have full insight in its business/credit rating. Accordingly, bank lending can be more attractive for SMEs, due to financial intermediaries' customer knowledge base and especially if debt is collateralized, i.e., supported by tangible assets that can be resold in the case of bankruptcy to retrieve extended funds.

[Page 477]Two-thirds of bank loans have maturities shorter than one year, and the modes of loan extension are diverse. Banks ask companies to sign promissory notes that may be secured with tangible assets. A series of promissory notes are issued as part of an informal line of credit indicating the maximum credit a bank will provide for the borrower during the year. When formalized, the line of credit becomes “revolving,” the committed sums are larger, lending periods turn generally longer than a year and loans are provided by a single bank or a syndicate of banks.

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