Financial Frictions: No Country for Old Cost Accountants
Financial Frictions: No Country
for Old Cost Accountants
John A. Major, ASA
Modigliani & Miller (1958)
taxes are neutral
capital markets are efficient
borrowing and lending are fair
financing decisions are uninformative
Leverage (gearing) doesn’t matter
Dividend policy doesn’t matter
Risk management doesn’t matter
What is a financial friction?
Something that violates M&M assumptions.
Explains why leverage, dividend policy, and r.m. do matter.
capital market restrictions
Why care about financial frictions?
Fair value of liabilities
Fair value accounting
Economic balance sheet
Consistent Embedded Value
Convergence: securitization / insuratization
CFO as risk manager
Modeling frictions is not just about estimating costs
pick a friction (e.g. agency cost of holding capital)
relate it to an underlying quantity (e.g., amount of surplus)
find or guess a cost rate or spread (e.g., 2%)
Voilà! We have our frictional cost.
Insert as a line item into valuation.
As you will see in the following example (working paper available)
makes no sense at all
(possible exception: double taxation)
1930 Cramér-Lundberg model
1957 de Finetti model
Typical solution is a “dividend barrier”
Model insurance company
Expected net profits = $0.5 above, -$0.25 below ratings boundary.
Can still make a profit under the boundary – with some luck
What is optimal dividend policy? What is market value of the firm?
But wait! Let’s make it more interesting…
modifies net cat losses
Attachment = $3 (41-yr RetPer), limit = $1 (110-yr RetPer).
Full cover Expected Loss = $0.016, r/i premium = $0.070
Purchase any fraction of cover
, 0-100%, paying prorata premium.
Applies to all cats, no reinstatement premium required.
What is optimal utilization
? What value does it add to the firm?
value added by XOL
If recapitalization is available
If costly, depends on cost
As cost is lowered from “infinite” to zero…
optimal capital level (div barrier) steadily moves down
value of the firm steadily increases
“go out of business” threshold
is pushed down and out
recapitalization is used everywhere under the ratings cliff (W=5)
XOL purchase at 8 ≤ W ≤ 10 is gradually zeroed out
XOL purchase comes in again at 5 ≤ W ≤ 6
XOL purchase zeroed out again as recapitalization is used above the ratings cliff
At zero cost, a version of Modigliani-Miller results
optimal capital at W = 7.5:
to dividend above
, recapitalize below
Conclusion: “frictional effects” are complex phenomena
Interact with each other
operate on probability distribution of
future earnings trajectories
Interact with management strategies
Not generally amenable to cost-accounting approach
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