Ronald Coase, who died recently, was one of the most influential economic thinkers of the past century. He focused on how companies and markets really work, especially with barriers to free and open exchanges. His thinking started with the question, why do firms exist; why organize a company rather than working alone?
Indeed, Coase’s thoughts help explain much of the recent turmoil in the financial sector, especially with “shadow banking.”
To understand, let’s start with the traditional story from Adam Smith’s pin factory, which operated as follows. One person could dig ore out of the ground and sell it to someone with a wagon and a horse. That person would cart the ore to a port to sell to a ship owner. The ship owner would sail to some other port and sell the ore to a smelter. The smelter would sell steel to a person who manufactures wire, who then sells wire to someone who specializes in cutting wire to pin-like lengths. These pieces of wire would be sold to someone who sharpens one end to a point. This process could continue up to final delivery of pins to end-users.
This system looks highly efficient because at every step of production the participants would have constant market feedback, especially about prices. So why don’t independent contractors dominate all business?
Coase’s response was that the constant bargaining necessary under such a system increased transaction costs. Firms are designed to reduce these transaction costs by establishing relationships among owners of the factors of production. The pin factory example has lots of feedback but more transactions than necessary.
Integrating activities into a single firm depends on the size of the transaction costs that can be avoided and the extra cost of integration. Those costs include the possibility that managers will make mistakes because they lack market information about the pricing of inputs.
Now apply this to banking.
We usually think of the traditional financial system as a system of credit intermediation made up of banks, insurance companies and pension funds. On one side are savers who want to preserve their wealth and earn some income from it. On the other side are people who need credit, usually for their homes or businesses.
The credit intermediaries served as brokers of sorts between these two sides. In the mid-1940s, banks, insurance companies and pension funds were responsible for almost all of the credit intermediation.
The obvious question is why to have intermediaries at all rather than a method where credit is directly supplied from savers to borrowers? The answer is transaction costs. A potential borrower would have to find a multitude of savers; each saver would carefully review the borrowers’ credit worthiness; both parties would have to research the right price of the credit to be provided.
Borrowing would be a very expensive process. By organizing banks, we can avoid many of these costs. How has this evolved since today since a large portion (47 percent) of credit intermediation is conducted by what we call the shadow banking system?
The institutions of shadow banking: money market funds, REITs, mutual funds, etc., provide this service. From the Coase perspective, this transformation is the result of the decline in transaction costs for credit intermediation. Today so many types of credit instruments are readily available on markets that are easily accessible that there is vastly more information about prices at much lower cost.
Bundling of loans creates diversification that reduces the cost to savers of investigating each loan separately. The work of credit rating agencies appears to further reduce the cost of credit research. Price information is as easy as referencing a current table. The traditional banking firm became less important and shadow banking arose in its place. Shadow banking was the alternative available when the rewards for integrated banking shrank due to falling transaction costs.
The financial crisis can be seen as the sudden perception that transaction costs were actually higher, particularly the cost of price discovery of asset-backed securities. The initial results of this are well-known, a banking panic, illiquidity, several spectacular failures.
The result was consistent with Coase’s theory: higher transaction costs led to mergers, acquisitions and deeper integration. Companies with stronger positions gobbled up the less-stable companies.
The importance of the integrated firm came back with a vengeance.
Mark Sievers, president of Epsilon Financial Group, is a certified financial planner with a master’s in business administration from UC Berkeley. Contact him at firstname.lastname@example.org.