Sources of Finance: Internal versus External

It ought not be surprising that borrowing can be difficult. In good times, households usually can obtain financing to purchase a house or car. But these loans are secured with collateral that is easy to resell. Even so, some measures suggest that it is currently more difficult than under “normal” conditions to obtain mortgage finance (see the Urban Institute’s Housing Credit Availability Index on page 16).

With firms, credit has been rising significantly in recent years—across advanced and emerging economies alike (see the BIS measures through 2017 here). Yet, commercial borrowers, especially small and medium sized enterprises, complain loudly when they feel that their ability to succeed is being hampered by overly cautious lenders. And, since lenders often find it difficult to both assess a business’s prospects and to monitor effort once a loan is made, aside from periods of euphoria borrowing can be quite difficult.

As we discuss in our primers on adverse selection and moral hazard, information asymmetries make external funding—either through equity or debt—expensive. And, while the entire financial system is designed to reduce these costs, they are still quite high….

Financing Intangible Capital

When most people think of investment, what comes to mind is the purchase of new equipment and structures. A restaurant might start with construction, and then fill its new building with tables, chairs, stoves, and the like. This is the world of tangible capital.

We still need buildings and machines (and restaurants). But, over the past few decades, the nature of business capital has changed. Much of what firms invest in today—especially the biggest and fastest growing ones—is intangible. This includes software, data, market analysis, scientific research and development (R&D), employee training, organizational design, development of intellectual and entertainment products, mineral exploration, and the like.

In this post, we discuss the implications of this shift for the structure of finance. Tangible capital can serve as collateral, providing lenders with some protection against default. As a result, firms with an abundance of physical assets can finance themselves readily by issuing debt. By contrast, a company that focuses on software development, employee training, or improving the efficiency of its organization, will find it more difficult and costly to borrow because the resulting assets cannot easily be re-sold. That means relying more on retained earnings or the issuance of equity....

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Money, Banking, and Financial Markets