Transcript Value Creation: Economics, Agency Problems, and Credit Services

Value Creation: Economics,
Agency Problems, and Credit
Services
Week 4 – September 14, 2006
J. K. Dietrich - FBE 525 - Fall, 2006
Sources of Value in Financial
Services
 Where
does ultimate value come from?
 What problems must be solved?
 What services and can financial institutions
provide?
 What value is there for investors in financial
services?
 What determines amount of value extracted
by financial service firms?
J. K. Dietrich - FBE 525 - Fall, 2006
Value Creation in Theory
 Value
is addition to customers’ expected
utility
 Increased expected utility comes from
– Improvement in intertemporal consumption
– Exploitation of investment opportunities
– Risk management
 Apply
each in this discussion
J. K. Dietrich - FBE 525 - Fall, 2006
Inter-temporal Consumption and
Investment: Example
 Income
now $40,000 and in future $45,000
 Invest in tuition now and $30,000 future
income with schooling will be $85,000
 Interest rate 10%
 Draw tradeoffs
 What is current wealth under schooling and
no schooling
 How can financial services add value?
J. K. Dietrich - FBE 525 - Fall, 2006
Inter-temporal
Consumption/Investment
$96K
Consumption Later
$89K
I II III
($85K - $33K)/1.1 + $40K
$52K
$45K
$10K
J. K. Dietrich - FBE 525 - Fall, 2006
$40K
$80.9K $87.3K
Present Value of Consumption
Risks and Returns:
Sample Problem
 How
can diversification increase expected
utility?
 How can reducing equity stake increase
expected utility?
 How can financial service firm add value?
 What are sources of this value?
J. K. Dietrich - FBE 525 - Fall, 2006
Returns and Risk
0
J. K. Dietrich - FBE 525 - Fall, 2006
Variability of Future Returns
Principals and Agents
 Principals
are the beneficiaries of wealth, that is, it
is their expected utility that should be maximized
 Agents undertake activities that can benefit or
harm principals and their expected utility
 Examples: asset-management, credit, securities
trading
 Most financial services are covered by contracts
intended to minimize the conflict between
principals and agents
J. K. Dietrich - FBE 525 - Fall, 2006
Principal-Agent Problems
Price/Set Terms
Monitor/Control
Market/Inform
Produce/Deliver
Bear/Share Risk
Fund/Invest
t= -K
t=M
t=0
Adverse Selection
Select Contract
J. K. Dietrich - FBE 525 - Fall, 2006
Moral Hazard
Take Actions
Principal-Agent and Information
Asymmetry Problems
 Who
are principals? Who are agents?
 In previous examples, what are borrowers?
Financial institutions?
 What are sources of conflicts?
 Types of information
 How can you realize value in information?
J. K. Dietrich - FBE 525 - Fall, 2006
Financial Markets
 Economic
concepts and financial markets
– Marginal revenue and cost
– Substitutes and complements
 Problems in implementation
– Data
– Market definitions
 Examples of markets
J. K. Dietrich - FBE 525 - Fall, 2006
Pricing and Terms in Credit
 Revolving
credit and term loans
 Interest rates
 Balances
 Fees
 Conditions
 Real world implementation
J. K. Dietrich - FBE 525 - Fall, 2006
Resources to Provide Credit
 Types
of human resources
 Types of information
 Types of analytical competence
 Desired sales skills
 Sources of training/experience
J. K. Dietrich - FBE 525 - Fall, 2006
Activities in Credit
(and other financial services)
 Setting
Terms/Pricing
 Communicating/Marketing
 Producing/Delivering
 Controlling/Monitoring
 Funding/Investing
 Risk Bearing/Risk Shifting
J. K. Dietrich - FBE 525 - Fall, 2006
Market Power in Credit
(and Other Financial Services)
Marginal Cost of Funds
Cost of Funds
Rcompetitive
Marginal Return
Market Share with Market Power
J. K. Dietrich - FBE 525 - Fall, 2006
$ Loans
Market Power Requires a
Well Defined Market
 Geography
– Locally isolate markets (e.g. Illinois, etc.)
– Language, customs, legal environment
 No
substitutes, poor competition
– Ability to bear/share risks
– Competitors not interested
 Retail
markets
 Wholesale markets
J. K. Dietrich - FBE 525 - Fall, 2006
Combinations: Definitions
 Merger
= Shareholder approved joining of
activities of two firms
– Friendly
– Proxy contest
 Acquisition
= Buy stock without
shareholder or necessarily management
approval
– Friendly takeover
– Hostile takeover
J. K. Dietrich - FBE 525 - Fall, 2006
Types of Combinations
 Horizontal/Vertical/Conglomerate
– Norwest Bancorporation+Wells+First
Interstate, Chase+Chemical,
GoldmanSachs+SpearLeeds, many others
– B of A and Nationsbank acquire software firm
Meca for home banking
– Mellon Bank+Boston Company+Dreyfus
 Accounting
treatment
– Pooling and stock repurchases
– Purchase accounting
J. K. Dietrich - FBE 525 - Fall, 2006
Value in Mergers
 Synergies
=> (A+B) > A + B
 Revenue synergies
– Cross selling
– Market power
– Strategic alliances
 Cost
synergies
– Economies of scale and scope
– Vertical integration, tax savings, regulation
– Unused debt/borrowing capacity
J. K. Dietrich - FBE 525 - Fall, 2006
Possible Revenue Synergies
 Changing
market for deposits
– Reduced deposit demand
– Money market mutual funds
– New savings vehicles (IRAs and annuities)
 Changing
markets for credit
– Commercial paper and “junk bonds”
– Consumer credit and ABS
 Problems:
Bankers, investment bankers,
insurance agents, and brokers different
J. K. Dietrich - FBE 525 - Fall, 2006
Cost Synergies
 Larger
size or broader operations are used
to justify mergers
 Redundant investments (branches, systems)
 Economies of scale
– Difficult to measure with multiple outputs
 Economies
of scope
– Efficiencies depend on combination of outputs
 All
efficiencies depend on resource
flexibility
J. K. Dietrich - FBE 525 - Fall, 2006
Penetration of Financial Services
Marginal costs
Prices, Costs
Marginal costs
Marginal costs
Market Demand
J. K. Dietrich - FBE 525 - Fall, 2006
Analyzing Credit Markets:
Demand for Credit
 Determinants
of need for credit --
– investment in real assets
– liquidity
– restructuring
 Real
asset demand
 Other demands for credit
 Review Flow of Funds
J. K. Dietrich - FBE 525 - Fall, 2006
Term Setting and
Monitoring in Credit
 Terms
include both a range of covenants
and penalties/costs/sanctions
 Chan and Thakor analyze effects of
collateral surrendered with non-payment
 Diamond stresses value creation from
monitoring when a cost can be imposed on
borrower
 Important is effect on borrower incentives
J. K. Dietrich - FBE 525 - Fall, 2006
Pricing to Create Value
 Fees
on commitments vs compensating
balances
– Notion of a separating equilibrium
– Separation by different expected to costs of
borrowers of different types
Bad Credit Risk
Commitment Fee
J. K. Dietrich - FBE 525 - Fall, 2006
Good Credit Risk
Balances
Compensating Balance
Symmetry/Differences
Penalty vs. Collateral
 Penalty
costs borrower but does not provide
gain for lender
 Collateral costs borrower but does provide
gain to lender
 Both terms require monitoring to assure
value and existence of collateral or
satisfaction of other term
 Both require control procedures
J. K. Dietrich - FBE 525 - Fall, 2006
Loan Sales and Participations
 Principal-agent
problems with loan sales
– Payoffs to originator reduced
– Costs of non-compliance reduced
– Adverse selection in sales
 Sources
of value
– Diversification
– Comparative advantage in origination
– Cost of funds
J. K. Dietrich - FBE 525 - Fall, 2006
Resolving P-A Problems in
Loan Sales
 Recourse
 Guarantees
 Structuring
deal
– Equity-like portion
– Problems from regulators
 Real-world
examples
– CMOs (REMICs)
J. K. Dietrich - FBE 525 - Fall, 2006
Researching Market Size
 Regulatory
data
– Federal Deposit Insurance Corporation (FDIC)
– Federal Financial Institution Examination Council
(FFIEC)
– Annual Reports of regulators like Securities Exchange
Commission, Commodity Futures Trading Commission
 Industry
sources
– Annual Reports and Statistical Abstracts of industry
entities (e.g. New York Stock Exchange, Chicago Board
of Trade)
– Industry associations (e.g. Institute of Life Insurance,
Investment Company Institute, etc.)
J. K. Dietrich - FBE 525 - Fall, 2006
Next Week...
 Prepare
Chapter 9 for Thursday, September
28, 2006
 Chase case discussion also for Thursday,
September 28, 2006
 International Securities and Hambrecht
cases will be discussed on Saturday,
September 30, 2006 (starting at 12:30pm)
 Raise questions concerning project before
due date
J. K. Dietrich - FBE 525 - Fall, 2006