Theory of the Financial Firm - Transactions CostsIf you want to understand Financial Institutions (financial firms, you need to know what a firm is.

Question: What is a firm and why does it exist?

1. Coase (1937) - Nature of the Firm

• Classical Theory - The price mechanism of a purely competitive market works by itself - an invisible hand. A firm is a black box, an economic organism without internals that simply reacts to prices and price changes.

• Firms actually compete with markets where markets work primarily on the price mechanism and firms work internally by command.

• Markets (Firms) win out when the transaction costs of using the price mechanism (discovering the relevant prices and negotiating contracts) to organize production is low (high) - eg, hiring temp workers daily vs. permanent workers.

• Recently, firms focus more on “core competencies” and rely on markets to supply other needed services.

• Virtual firm -contracts every step in production - not a firm.

• A highly competitive economy exhibits fast changes in the organization of production as firms and markets reorganize in response to changing prices and transaction costs.

• Firm is a nexus of contracts where additional functions are added until it becomes cheaper to use markets.

2. Alchian and Demsetz (1972) - extends Coase

• In addition to transactions costs, team production helps explain the existence of firms.

• Team production is often more productive than individual self-directed production controlled through market prices.

• Teams are directed by a central owner who monitors team members’ productivity and sets pay to motivate members. Example: Canal barge pullers hire whippers.

• Owners receive the firm’s residual profit to motivate them organize production to be competitive with other firms and markets.

• Firms promote loyalty, culture, team players - for survival.

Economic Darwinism and Economic Evolution of FirmsA Basic Model of Economic Behavior of Individuals and Firms - Alchian (1950) and Hirshleifer (1980)

Assumptions

• Nonsatiation - unlimited wants (greed)

• Limited resources

• Competition results from the first two assumptions

• Variety in individuals and firms

Under these conditions, given the economic environment, the fittest firms (individuals) survive.

• Financial engineering - like bio-engineering.

Predictions Based on these Assumptions

1. Firms seek survival - positive profit - not necessarily maximum profit (natural selection).

2. Some firms imitate successful firms to survive (genetic heredity) or adapt to the environment.

3. Some firms innovate (mutate) as a means to survive.

4. The more saturated the environment, the more potential for large firms - less saturated implies more variety (entrepreneurs), changeability and growth.

5. Variety (even randomness) itself helps insure survival and can lead to better chances for economic survival and growth - Democratic freedom vs. Communist restrictions.

Many Financial Institutions Provide Transactions ServicesTransactions Cost Theory of the Financial Firm - Benston and Smith (1976)

• Old approach to financial institutions theory

- Banks as credit creators controlled by the Fed.

- Other financial intermediaries largely ignored.

• Their approach - Financial firms create specialized financial products whose sale price must exceed their cost - products typically involve transactions.

• Ex:Market Maker - provides market infrastructure-NYSE. Dealer - holds inventory -buys and sells - specialist. Mutual Fund - economies of scale in transactions.

• High transactions costs cause inefficiencies.

• Individuals save less.

• Save mostly in risk-free assets.

• Save only in low transactions cost assets.

• Successful financial firms offer good transactions services at low cost - e.g., Fidelity, Web Brokers.

• Good transactions services provide liquidity at low cost.

• Liquidity is the transformation of a savings asset into another desired commodity at the exact time, place and in the exact amounts demanded - Checks, Credit Cards, Flooz, Beenz, emailMoney.

• To provide liquidity, firms must invest customer savings in a way to earn enough return to be competitive but also manage risk.

• This requires expertise in gathering information on borrowers to transform a risky asset (loans) into a safe savings vehicle (deposits).

• Financial firms need sufficient equity capital to absorb loan mistakes.

• Financial firms do this at low cost by exploiting economies of scale and specialization in transactions and information gathering.

• Technology resources are important for low cost.

Problem: City Bank upgrades its computer equipment every 5 years. Its next upgrade is scheduled for two years from now at a $1,000,000 cost. Management is considering upgrading now because breakthrough software could generate significant savings. How much annual savings is required to justify the early upgrade if the cost of capital is 15 percent?

Answer: The equivalent annual cost of the 5 year replacement schedule is

Annual cost = $1,000,000/ [ 1/.15 - 1/ .15(1 + .15)5] or $1,000,000/[PVA.15,5] = $298,315.6

The savings needs to cover the present value of 2 years cost = $298,315[PVA.15,2] = $484,974

Economies of Scale and Scope• Economies of scale refers to the decline in the average cost of a single products’ production as a firm’s output increases.

• Economies of scope refers to the decline in the average cost of multiple products production as a firm increases the number of products it offers.

• To measure economies of scale/scope, use average cost

Average Cost = Total Cost/Size

where size = assets, deposits or loans

• Compare average costs before and after an increase in production of a single product (scale) or an increase in the number of products produced (scope).

Example: Economies of ScopeProblem: A commercial bank with $2 billion of assets and $200 million in costs has acquired an investment bank with assets of $40 million and expenses of $15 million. After the merger, the commercial bank has costs of $180 million and the investment bank has costs of $20 million. Does the merger provide positive economies of scale or scope?

Answer:

Average cost before merger = $215/$2,040 = 0.1054

Average cost after merger = $200/$2,040 = 0.098

Average costs have fallen after combining two different products so there are positive economies of scope.

(maybe look at financial statements for merging firms)

Clearing and SettlingMany financial firms are specialists at clearing and settling transactions.

• Clearing - processing payment instructions - clearing the way by confirming sale terms and resolving discrepancies.

• Settling - actual transfer of securities and funds.

•Technology is important in reducing transactions costs which leads to more efficient and cheaper financial system.

• More efficient markets - more frequent and speedy changes in institutions, markets and products in response to smaller changes in tastes, operating costs, regulations and taxes

• Sweden enacted large transactions taxes - 50% (85%) of stock (bond) trades moved to the London Exchange.

Financial firms reduce the cost and risk associated with transactions using the following mechanisms.

• Netting - end of day settlement with netting reduces transactions by 99% on CHIPS, Fedwire settles continuously.

Question: What is the potential risk of end-of-day settle?

- other competing mechanisms - options, swaps.

• Immobilize securities at depository - bearer bonds problem.

• Collateral - limits default risk.

• Delivery vs. payment - securities and funds transferred simultaneously - delays in deliver led to fraud at theIndian stock market - stocks fell 40% in response.

• Credit extension - until settlement (can buy then sell within settlement period) - Joseph Jett at Kidder.

• Finality of settlement depends upon

• legal validity and enforceability of transfers

• performance guarantees - AAA-rated subsidiaries

• Settlement mechanism

• Ebay’s system has problems because it doesn’t guarantee performance of traders - only rates traders.

•Potential solutions - performance bonds, loss sharing, restricted membership, trade limits, marking-to-market.

• Look at Ebay, Flooz and Beenz websites.

Exercise - Financial Transaction1. Offer to buy someone’s book with cash.

2. Offer to buy someone’s book with a check.

Question: Are you more willing to sell for one than for the other?

3. Now offer to sell some Disney Stock Certificates.

Question: How much are you willing to pay?

Question: Why might you be willing to pay more for the stock if a broker offered it?

Lower Transactions Costs Has Boosted Payment Volume

The U.S. Payment System

Backbone Transfer SystemsFEDWIRE CHIPS

Futures Clearinghouse& Depository

Stock Clearinghouse& Depository

FX, Bonds, etc Clearinghouse& Depository

Banks and Securities Firms

Customers

How a Swap is a Substitute for Transactions - Reducing CostsSwapParties to a swap exchange the risk associated with some asset or liability, without exchanging the asset itself.

EXAMPLE: • USA Inc. has a British subsidiary that produces profits of £1 million per year.

• BRIT PLC has an American subsidiary that produces profits of $1.2 million per year.

•USA Inc. and BRIT PLC both wish to eliminate exchange risk when repatriating profits from their subsidiaries.

One Method Used to Hedge Risk - Offsetting Loans• BRIT PLC makes a loan denominated in pounds to USA.• USA Inc. makes a loan denominated in dollars to BRIT.

TERMS OF THE LOAN:• Duration of 3 years.•BRIT PLC will pay 8% rate on the dollar-denominated

loan (the prevailing rate for $ loans).•USA Inc. will pay 10% on the pound-denominated loan

(the prevailing rate for £ loans).

•Assuming an exchange rate of 1.5 $/£, the face value of the loan is £10 million to BRIT and $15 million to USA.

• USA Inc. will pay £1 million each year.•BRIT PLC will pay $1.2 million each year

Cash Flows for the Offsetting Loans

BRIT PLC

USA INC

£10

$15£1

$1.2

£10

$15

$1.2

£1£1

$1.2

Question: Clearly this does the job, but why might this be an inefficient way to solve the problem?

Answer: Transactions costs and default risk.

• A potential alternative is to hedge the risk with forwards or futures but these are typically not available in liquid markets for more than a year or two in the future. Also, one transaction needs to be made to cover each year or quarter.

• In a swap, one agrees to pay (receive) the change in value in cash flows to the other party in the offsetting loan without actually trading the full face values or interest payments - reduces default risk. If exchange rates change, only the change in value is exchanged. If exchange rate stay constant, no transactions are necessary - reduces transactions cost.

Interest rate swaps save considerable transactions costs.

• A plain vanilla interest rate swap involves a holder of fixed rate debt exchanging interest rate payments with a holder of floating rate debt.

• Swap cost is a few basis points on the face value per year for bankers’ fees.

• The alternative to a swap is for the firms to buy back their debt and reissue new debt with the appropriate rate type (fixed or floating).

• Cost of buyback and reissue is from 4 to 8 percent of the face value.