Financial Frictions: No Country for Old Cost Accountants

Financial Frictions: No Country for Old Cost Accountants

• John A. Major, ASA

Modigliani & Miller (1958)

• If:

• taxes are neutral
• capital markets are efficient
• borrowing and lending are fair
• financing decisions are uninformative
• no bankruptcy cost

• Then:

• Leverage (gearing) doesn’t matter
• Dividend policy doesn’t matter
• Risk management doesn’t matter

• But:

• they do!

What is a financial friction?

• Something that violates M&M assumptions.

• Explains why leverage, dividend policy, and r.m. do matter.

• Examples:

• taxes
• transaction costs
• capital market restrictions
• agency problems
• bankruptcy costs
• customer credit sensitivity
• information asymmetry

Why care about financial frictions?

• Fair value of liabilities

• Fair value accounting

• Economic balance sheet

• Market Consistent Embedded Value

• Convergence: securitization / insuratization

• CFO as risk manager

Modeling frictions is not just about estimating costs

• Typical approach

• 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%)
• multiply
• Voilà! We have our frictional cost.
• Insert as a line item into valuation.

• As you will see in the following example (working paper available)

• this makes no sense at all
• (possible exception: double taxation)

1930 Cramér-Lundberg model

1957 de Finetti model

Optimal dividends

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…

• Available XOL program 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 U, 0-100%, paying prorata premium.

• Applies to all cats, no reinstatement premium required.

• What is optimal utilization U? What value does it add to the firm?

Shareholder 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
• no reinsurance

Conclusion: “frictional effects” are complex phenomena

• Nonlinear

• Interact with each other

• Dynamic

• operate on probability distribution of future earnings trajectories

• Interact with management strategies

• Not generally amenable to cost-accounting approach