Theory of the Financial Firm Transactions Costs
If 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 Firms
A 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 Services
Transactions 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 Scope
Problem: 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 Settling
Many 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 the
Indian 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
Transaction
1. 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 Systems
FEDWIRE
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 Costs
Swap
Parties 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
U SA IN C
$15
$1.2
$1.2
$1.2
£1
£1
£1
£10
$15
B R IT PL C
£10
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.