Intermediation 1

1
Intermediation 1

• Spulber says that at least 1/4 of the US economy
  is intermediation. He divides this activity into
  4 components
• Retail Trade
• Wholesale Trade
• Finance Insurance
• Other (incl.. Advertising)
• An important question is why? Why is so much of
  our productive capacity dedicated to facilitating
  trade?

2
Intermediation 2

• Spulber identifies 4 areas of activity for
  intermediaries
• Price Setting Market Clearing
• Providing Liquidity Immediacy
• Coordinating Transactions - Matching Searching
• Guaranteeing and Monitoring

3
Price Setting Market Clearing

• A key question is the monopoly (pricing) power of
  the intermediary. Spulber assumes that the
  intermediary has monopoly power - but where does
  that come from?
• Under what conditions would buyers and sellers
  cut out the middleman?
• In the stock market, price setting means setting
  a bid-ask spread. Questions we will address
  include what determine the size and location of
  the spread.

4
Liquidity

• For an intermediary to provide immediacy and
  liquidity, it must have two things
• inventory on hand
• access to ready cash, or ability to readily short

5
Liquidity 2

• Intermediaries like Safeway, Desert Jaguar, and
  Amazon.com have a large inventory on hand.
  Maintaining inventory exposes the intermediary to
  price risk. If the intermediary is risk averse,
  then the bid-ask spread will be wider, the bigger
  is this price risk.
• Question What determines the extent of price
  risk?

6
Liquidity 3

• Providing liquidity does not necessarily involve
  taking on inventory.
• Think of the difference between a dealer and a
  consignee. (But consignment is not as common
  dealership.)
• This ties-in closely to the next point

7
Coordination

• Consider a Real Estate Broker. Perhaps the main
  value the broker provides is access to the
  Multiple Listing Service Book.
• Economics of matching services.
• We start with the idea that there are gains to
  trade. (These are usually obvious in say the
  housing market.) In a bargaining setting where
  all parties have equal bargaining strengths, how
  will the gains to trade be split? If the
  middleman is a dealer, then there are 2 separate
  transactions. In the first transaction, the
  middleman buys the good from the seller, and they
  split 1/2 of the total gains to trade equally.

8
Coordination 2

• In the second transaction, the middleman sells to
  the buyer, and they split the 1/2 of the total
  gains to trade equally.
• Of the total gains to trade, 1/4 would go to the
  seller, 1/2 to the middleman, and 1/4 to the
  buyer. (The solution to a bargaining problem,
  where the gains to trade are equally divided is
  known as the Nash Bargaining Solution.)
• Now contrast this to the split in the case where
  the middleman is a consignee. In this case,
  there is only one transaction, and the gains to
  trade would be split equally - each party
  receiving 1/3 of the total gains to trade.

9
Coordination 3

• The ability of an intermediary to extract rents -
  simply by bringing the buyer and seller together
  is a function of technology.
• How will the internet ultimately affect
• Real Estate Brokers?
• Rare Book Dealers?
• Employment agencies / headhunters?

10
Guaranteeing Monitoring

• We might add to these informational services, in
  general.
• Example of the pen buyer
• Bonding
• Deep pockets (Implicit guarantee)
• Reputational Capital

11
Monitoring

• Given their expertise, and large individual
  exposure, banks are in a position to monitor
  management on an on-going basis. Even for large,
  well-known companies, like Anheuser-Busch,
  shareholders may feel that the relationship with
  a bank may reduce agency costs. (The large
  exposure eliminates the free-rider problem of
  the capital markets.)

12
Relationships Discount Tire

• Discount Tire Company repairs tires for free. It
  is obvious that this is not a profitable
  transaction. So why do they do it? They hope to
  build relationships.
• What is a Relationship, how is it valued, and
  what does it have to do with Finance?
• In a transaction, the parties split the gains to
  trade according to their relative bargaining
  strengths.

13
Relationships (Contd.)

• In a relationship, the allocation of the gains to
  trade does not depend on these bargaining
  strengths. In fact, one of the parties may
  actually suffer a loss on the transaction. This
  is done because the parties believe that over
  time, there will be more value to be gained by a
  relationship.
• Why is this?
• What are the sources of this value?

14
Ethics

• In many cases, companies refer to policies that
  stress dynamic value as ethics. An example of
  this is the trading firm that always gives the
  customer the benefit of the doubt whenever there
  is inadequate documentation of the trade.

15
Reputation

• From Ron Chernows House of Morgan (p. 18)
• Joseph Morgan (Pierponts grandfather) had
  started the Aetna Fire Insurance Company.
  Joseph made his great windfall in December 1835,
  when a fire in the Wall Street area destroyed
  over six hundred buildings. As an Aetna founder,
  he insisted that the firm pay customers promptly
  and even bought up Aetna stakes from investors
  who hesitated to pay. Joseph Morgans quick
  action made the firms reputation on Wall Street
  and later enabled it to triple its premiums.

16
Reputation 2

• Reputation is similar to relationships. In fact,
  we can think of reputation as an attempt to
  develop many relationships at once. Companies
  may invest in building reputational capital.
  This asset pays off in terms of future monopoly
  profits.

17
Reputation 3

• An important aspect of intermediation is lending
  ones reputation. From The House of Morgan, (p.
  43)
• In 1879, the New York Central Rail Road had a
  large equity placement. In the largely
  unregulated Baronial Age 1838-1913, stock
  prospectuses were comically skimpy The credit
  and status of the company are so well known ,
  that it is scarcely necessary to make any public
  statement. With so little information about a
  company, the reputation of the sponsoring bank
  was critically important.

18
Reputation 4

• The lending of ones reputation is known as
  bonding. At least in the old days, bonding
  entailed an actual guarantee on the part of the
  intermediary. From HoM (p. 38)
• Under the Gentleman Bankers Code, bankers held
  themselves to be responsible for bonds they sold
  and felt obligated to intervene when things went
  awry.

19
Aggregating Bargaining Power

• Wal-Mart changed the nature of business in
  fundamental ways.
• It worked to develop a reputation for low price
  to generate large volume. Then it is in a
  position to play hard ball with its suppliers.
• We only want this in black and white, but we want
  you to sell it to us for this or well go
  elsewhere.

20
Wal-Martization

• Dell is an example of this Wal-Mart strategy. It
  intermediates between component manufacturers,
  like Intel, and computer buyers.
• Part of its success is its bargaining power with
  Intel due to its size.
• (Of course an implication of this is that the
  Intels must get bigger to develop comparable
  bargaining power.)

21
Wal-Martization

• This phenomenon is so pronounced that it affects
  the strategic planning of companies like
  Anheuser-Busch. Right now were big and our
  customers are small. We have all the bargaining
  power but Wal-Mart changes all that.