Glossary of Financial
and Economic Terms
(originally printed in “Financial Services and
Environmental Health”, Robert C. G. Varley, Environmental Health Project, USAID Global Health
Bureau, 1995. Edited and reproduced in
the Urban Age), October 1995 (Special Issue on Urban Finance)
asset Something with market or exchange value, is part of the wealth or property of the owner.
capital An imprecise word which is used in several different ways. In economics a capital good is one which is used in the process of production and which lasts beyond one accounting period (usually a year). It is only longevity which distinguishes such goods from raw materials or inputs. Consumer goods are used up in the period in which they are purchased. Another category of consumer durables mixes longevity with a focus on household consumption over time (eg a washing machine or latrine). Capital is also used in relation to finance where it seems to mean a large amount of money used for the purchase of assets. These assets can be of either long or short durability corresponding to the distinction between working and fixed capital. Capital is provided by the owners of an enterprise or by borrowing (debt) or more figuratively "other peoples money". Capital provided by the owners is known as equity or risk capital. The owners of equity capital have a claim on the net worth of the enterprise. This is the difference between assets and other liabilities. Often this number is not known since the value of assets can only be known when they are sold. The stock market attempts to value the assets of quoted companies. Accounts only provide historical prices actually paid.
capitalization A confusing term which originally meant the aggregate value of a company, measured by the value of all outstanding equity as shown by stock prices. More recently it has been used to describe the process of providing money capital to start up a productive enterprise or financial institution. Thus to say the government capitalized the new micro bank means it transferred money to new entity - this could be a gift, a loan at market rates, a subidized loan or equity (meaning the government in theory retains control and ownership of the net assets).
cash flow A widely used piece of financial jargon which is best understood in contrast to accounting terms such as sales and costs of production.. These are often imputed values rather than actual sums of money that have changed hands. For example businesses routinely include the value of sales for which they have not been paid by the customer as "accrued income". Similarly an item of capital equipment such as a computer may be bought at one time for cash but will yield its services over a five year period. The cost is spread over the five year period by allocating a part of the cost to each year. Cash flow is what makes of breaks a financial and any other business. When there is no cash to pay creditors then there can be serious consequences ranging from seizure of property, bankruptcy proceedings to a crisis of confidence by customers. A run on a bank occurs when depositors believe that the bank does not have the cash to pay them. This is invariably true as the cash that was deposited has been loaned out to credit customers. Cash flow is measured per unit of time as opposed to "Cash" which is a stock accumulated from all the previous periods' cash flows. When receipts for a period are more than outlays then cash flow is said to be positive.
collateral An asset belonging to a customer that is held by the lender as security in the event of default. The collateral may for instance be a title to a piece of land or certificate of ownership of a vehicle. Illiquid savings accounts can also serve as collateral. Collateral increases incentives to repay loans and uncollateralised loans are the exception rather than the rule in banking..
cost of funds (COF) The cost of money that a lender has to pay on the funds that are lent out to borrowers. For a bank the funds will generally come from deposits made by savers, retained profits or equity, and loans from other institutions or individuals. Each of these sources can have a different cost and the overall cost of funds is also referred to as the weighted cost of funds, the weights being the proportion deriving from each source. For realistic comparissons a value for equity should be imputed as this money could have been invested somewhere else and earnt a return. This alternative return is also referred to as the opportunity cost of capital.
cost-recovery An overused term which emphasizes that all entities must pay their way or get someone else to do it for them. The degree of cost recovery is the percentage of full costs that are paid by the user or benefactor of the goods or services supplied. Any shortfall must be met by a default on a debt or a subsidy/grant from some other internal or external source. Cost recovery is not an end in itself but as an empirical phenomenon low cost recovery is often associated with lax financial discipline and low economic efficiency.
covenants In this context promises made formally or informally to lenders by borrowers. A good covenant should be capable of being monitored and able to influence borrower behaviour.
credit Allowing the use of goods and services without immediate payment. Credit may be granted by retailers and finance houses (consumer credit), trade credit such as that given by manufacturers to wholesalers and retails and, bank credit which may either be for a fixed sum with corresponding fixed repayment schedules, or in the form of a variable line of credit or overdraft.
credit evaluation A formal process by which a bank or financial institution judges the creditworthiness of a customer and the inherent risks of activity that the bank is financing. In commercial banking this may involve sophisticated financial evaluation whilst in micro-finance such procedures would be prohibitively expensive.
credit products A term used by bankers to emphasize that different terms and conditions for loans are akin to the different attributes of products which appeal to different groups of consumers. Credit products are in turn marketed to different segments of the overall market for credit - eg mortgage loans for house purchase, trade credit for retailers. The major variables are the term or how long the loan can be held for, the rate of interest, the scheduling of installments and penalties and incentives built into the loan contract.
debt An amount of money or some other asset owed by one individual or organization to another.
debt capacity An imprecise term used to indicate the ability of a borrower to meet the obligations of the loan contract (service the loan). The usual method of calculation is to compare projected availability of cash to the value of loan installments.
default Failure to repay a loan on schedule. Countries can also default.
finance Another word with many meanings. It has commonly come to mean a source of money to pay for something, More broadly it is the provision of money when and where it is required. Finance may be required for consumption or for investment and may be long, medium or short term. The financing question is usually posed as "who will pay for this?". More correctly finance refers to the whole set of relationships that are defined by formal and informal contracts expressed in terms of monetary obligation. The many alternative ways in which money can channeled to the borrower and on what terms creates different incentives and behaviour. Thus in many countries money originating from the state and donors is often characterized as cold money with no particularly strong moral obligation to repay attached to it. On the other hand a loan from a relative or a neighbour to finance the same activity may be seen as warm money with a strong obligation and incentive to repay. In many contexts the path to development is for poor countries to develop their own mechanisms using their own resources in the form of savings and equity investment. It is only when financial markets have reached some basic level of maturity that external flows of capital can be efficiently utilised..
financial intermediary An institution which holds balances of money in order to make loans or other investments. Intermediaries act as go-betweens to parties who have excess funds which they want to invest and borrowers who are seeking capital or finance. In the absence of financial intermediaries individuals and businesses wanting to borrow would incur enormous costs in locating and negotiating with savers who had excess funds. By consolidating many different transactions intermediaries are able to provide essential services in terms of spreading risk, facilitating payments and transforming
financial markets The institutions, laws and practices which define the way in which the financial intermediaries in an economy (formal and informal), pass money and credit around a country's economy. The more mature the market the more specialized the niches that are served and the greater the options available. The process by which financial markets expand the scope of their intermediation is sometimes called financial deepening.
funds Another fancy word for money.
imprudent risk taking The idea of imprudent risk taking is closely related to the problem of moral hazard. In the context of financial institutions the incentives for imprudent risk taking are the major justification for prudential regulation. Imprudent risk taking arises from investment decisions made by the managers who control an institution which makes loans using creditors and depositors money. An appropriate level of risk will be one that balances the increased return from greater risk with the declining preferences of depositors/ creditors to take those risks. However the managers may stand to make a big return in terms of increased salaries and bonuses if an investment is successful but not to lose anything if it is not
Inflation-adjusted repayment scheme When inflation is high long term loans are a risky proposition for the lender as the real value of repayments will fall. While depositors will withdraw their money unless deposit rates are increased to compensate for inflation a fixed rate loan will provide to corresponding increase in income for the lender. While an inflation premium may be charged to cover this risk this can be very high. An alternative is for the loan agreement to allow the value of loan repayments to be linked to an index of prices or a reference interest rate such as that on short term government bills. In this way short term funds (such as liquid savings accounts) can finance long term loans without the problem of asset-liability mismatch.
intermediation costs When a loan is transacted both the borrower and lender incur an interest cost. For the borrower this is the rate paid on the loan while for the lender it is the cost of funds loaned out. The difference between these two is referred to as the spread. which is a measure of gross profit to the lender. This spread has to cover all the other non-interest or intermediation costs of making credit available. The costs to borrowers are usually not measured but are equally real and conceptually should be added to the rate paid. These costs are for such things as transport to the bank to make payments, time lost from work and time put into preparing the loan application. The intermediation costs incurred by the bank or financial intermediary are more easilly measured and must cover staff costs, buildings and services, a return on equity capital and loan losses. Any spread greater than the sum of these intermediation costs represents an abnormal return on capital and in competitive conditions will result in new entrants to the industry and a squeeze on spreads.
investments In economic parlance an investment is the amount by which the stock of capital goods of a firm or economy changes in a period of time. In everyday language it is the purchase of an asset or undertaking of a commitment which requires an initial sacrifice followed by subsequent benefits.
liquidity The ease with which an asset can be exchanged for money. In banking the assets are largely in the form of outstanding loans which are of course rather illiquid. Banks are usually required by law as well as prudence to maintain some percentage of their assets in liquid or near liquid form. The lower the liquidity of an asset the higher the interest rate required to induce to investors to acquire it. In everyday terms cash liquidity is needed for small unpredictable purchases which cannot be made by check or credit card. For a microentrepreneur liquidity is needed for the investment in materials and fixed assets required to take advantage of a business opportunity. Many of these opportunities are short term and unpredictable requiring an ongoing investment in working capital.
risk A decision is said
to involve risk when there is a range of uncertainty about the possible
outcomes. In modern corporate finance risk is closely identified with
measurable probabilities based on historic data. Keynes was among the first to
distinguish between risk, which is measurable, and uncertainty which is not. Uncertainty arise when there is no statistical basis for
quantifying risk - what is the probability of a war in
transparent loan terms Transparent loan terms are easy to understand and the information required to understand the underlying obligations and risks are easily accessible to all the parties involved in the credit transaction.