Suppliers and Determinants of Loanable Funds Markets

Introduction to the Loanable Funds Market

The loanable funds market represents the aggregate savers and aggregate borrowers within a particular economy. In regard to capital markets, the providers of capital can come from a multitude of sources. Suppliers of loanable funds seek to defer current consumption in exchange for an adequate rate of return in the future. This rate of return is primarily dependent on the prevailing interest rates at the time. Likewise, those looking to utilize borrowed funds must also entice suppliers with an appropriate rate of return. It is the nature of capital markets to match these suppliers of loanable funds with those looking to use their funds in exchange for an adequate return. The suppliers of loanable funds are typically households, financial intermediaries, banks, foreign investors, governments, and even individuals using peer-to-peer lending.

Key Suppliers of Loanable Funds

Households supply funds through their ability to generate cash flow in excess of their immediate needs. This excess cash flow is typically allocated into various investment vehicles, including certificates of deposit, savings accounts, checking accounts, IRAs, and more. In certain instances, individuals can supply loanable funds to investors directly through peer-to-peer lending, where terms and conditions are negotiated on an individual basis. As a result, these loans are much riskier, as underwriting standards can vary by the individual supplying the capital. Default risk is also much higher, since many individual providers of loans are not diversified enough to weather a long and protracted market decline. In exchange for this added risk, individual suppliers of capital may often demand higher interest rates or fees.

Governments often generate income through taxes or by providing bonds to capital markets. Providers of loanable funds give governments capital in exchange for the promise to repay those bonds in the future. Municipal bonds are often particularly attractive to high-net-worth individuals because they carry tax advantages that other bonds may not offer. They also carry a higher perceived quality, as they are backed by the government's ability to levy taxes at the state and local level. Governments tend to generate excess cash through sound budgeting when revenues exceed expenditures, and these excess funds can then be invested in other asset classes.

Pensions and other institutions also provide loanable funds to the market. Pension funds are particularly powerful, as they often represent large constituencies in the market. They typically take a portion of funds generated in the labor market and use them to invest on behalf of large employee constituencies. Pension funds operate under strict investment mandates. Many can only invest in very high-quality assets, such as AAA-rated securities or equities included in a particular market index. Due to these restrictions, the investment universe of pensions and similar institutions can be limited. However, given their size, these institutions can provide large pools of capital where other market participants cannot.

Foreign investors tend to supply loanable funds when interest rates are higher in the United States than in their home countries. These investors look for markets that are liquid, efficient, and well-regulated. Asian foreign investors, in particular, have played a dominant role by providing capital to companies within the United States, in part because Asian countries tend to have high savings rates. These high savings rates allow foreign countries to supply loanable funds abroad in exchange for higher rates of return than could otherwise be found at home.

Japan is a classic example: the country has experienced approximately two decades of negligible growth, with interest rates near 0%. Japanese investors unable to earn an adequate return domestically look elsewhere to allocate their funds and benefit from higher interest rates available abroad. This practice is also known as the carry trade, in which an investor borrows in one currency — such as the Japanese yen — and lends it in another country with a higher interest rate, such as the United States. If executed properly, the foreign investor repays the loan and keeps the difference as profit. When done correctly, the carry trade can provide investors with excess risk-adjusted returns in exchange for supplying loanable funds to foreign countries. It is not without its risks, however: a sudden change in interest rates or exchange rates can cause the investor to lose money over the term of the loan.

Factors Influencing Corporate Access to Funds

The factors that influence the supply of funds available to a corporation include its credit rating, the industry in which it operates, its cash flow characteristics, its ability to service debt, its payment history, and the risk appetite of debt investors. As noted, some providers of loanable funds can only invest in securities that carry a certain credit rating. Most pension funds, for example, cannot invest in "junk bonds" or securities rated BBB or lower. Since pension funds represent a large pool of available capital, a corporation whose credit rating falls below that threshold will find its ability to obtain capital for future projects severely limited.

The industry in which a corporation operates can also have a disproportionate influence on its ability to obtain funds. New and highly speculative industries, sectors that are out of favor with investors, and broad investor sentiment can all restrict a corporation's access to loanable funds. Companies in new industries often lack a demonstrated performance record, making it difficult for investors to assess their future prospects. This has been the case with 3D printing companies, certain venture capital investments, and other early-stage technology firms. Because these companies lack history, their future development remains speculative, causing investors to either demand high rates and fees or decline to invest altogether.

Investor sentiment also plays a significant role. If sentiment toward a particular company is overwhelmingly negative, that company will find it harder to access capital markets. The retail industry has experienced this dynamic as numerous firms have entered bankruptcy, causing negative sentiment about the sector as a whole to impair even financially stronger retailers' ability to raise capital. Investors often apply a broad brush to an entire industry — a phenomenon that occurred in 2008, when all financial institutions, regardless of the strength of their balance sheets, were widely regarded as uninvestable.

Conclusion

The loanable funds market is shaped by a complex interplay of suppliers, borrower characteristics, macroeconomic conditions, and interest rate dynamics that together determine how capital flows through an economy. From households and pension funds to foreign investors engaged in carry trades, each type of supplier brings distinct motivations and constraints. Corporate access to these funds depends heavily on creditworthiness and investor sentiment, while broader supply and demand shifts are driven largely by prevailing and anticipated interest rates. Understanding the six determinants of nominal interest rates provides a framework for anticipating how these dynamics will evolve over time.

References

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