Financial Frictions: No Country for Old Cost Accountants

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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)

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

Conclusion: “frictional effects” are complex phenomena

  • Nonlinear

  • Interact with each other

  • Dynamic

  • Interact with management strategies

  • Not generally amenable to cost-accounting approach

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