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 (Cont’d.) 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 Chernow’s House of Morgan (p. 18): [Joseph Morgan (Pierpont’s 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 Morgan’s quick action made the firm’s 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 one’s reputation. From The House of Morgan, (p. 43): [In 1879, the New York Central Rail Road had a large equity placement.] [I]n 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 one’s 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 Banker’s 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 we’ll 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 we’re big and our customers are small. We have all the bargaining power – but Wal-Mart changes all that.