J. K. Dietrich - FBE 525 - Fall, 2006 Value Creation: Economics, Agency Problems, and Credit Services Week 4 – September 14, 2006

J. K. Dietrich - FBE 525 - Fall, 2006

Value Creation: Economics, Agency Problems, and Credit

Services

Week 4 – September 14, 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?


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


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?


Inter-temporal Consumption/Investment

Present Value of Consumption

Con

sum

ptio

n L

ater

$10K $40K $80.9K

$52K

$45K

$87.3K

($85K - $33K)/1.1 + $40KI II III

$96K

$89K


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?


Returns and Risk

Exp

ecte

d R

etur

ns

Variability of Future Returns0


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


Principal-Agent Problems

Fund/Invest

Produce/Deliver

Take ActionsSelect Contract

Monitor/Control

Market/Inform

Price/Set Terms

Bear/Share Risk

t=0 t=Mt= -K

Adverse Selection Moral Hazard


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?


Financial Markets

Economic concepts and financial markets

– Marginal revenue and cost

– Substitutes and complements Problems in implementation

– Data

– Market definitions Examples of markets


Pricing and Terms in Credit

Revolving credit and term loans Interest rates Balances Fees Conditions Real world implementation


Resources to Provide Credit

Types of human resources Types of information Types of analytical competence Desired sales skills Sources of training/experience


Activities in Credit(and other financial services)

Setting Terms/Pricing Communicating/Marketing Producing/Delivering Controlling/Monitoring Funding/Investing Risk Bearing/Risk Shifting


Market Power in Credit(and Other Financial Services)

Rcompetitive

$ Loans

Inte

rest

Rat

e

Cost of Funds

Marginal Return

Marginal Cost of Funds

Market Share with Market Power


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


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


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


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


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


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


Penetration of Financial ServicesMarginal costs

Marginal costs

Marginal costs

Market Demand

Pri

ces,

Cos

ts


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


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


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

Cos

t of

Bal

ance

s

Balances

Good Credit Risk

Bad Credit Risk

Commitment Fee

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


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


Resolving P-A Problems inLoan Sales

Recourse Guarantees Structuring deal

– Equity-like portion– Problems from regulators

Real-world examples– CMOs (REMICs)


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.)


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

Documents

J. K. Dietrich - FBE 525 - Fall, 2006 Value Creation: Economics, Agency Problems, and Credit Services Week 4 – September 14, 2006