The Role and Costs of Intermediaries in Financial Markets

In an important new article, Intermediary Influence, Columbia University Professor Kathryn Judge explores the persistence of high fees in the financial services sector, and attributes the costly phenomenon to political clout of financial intermediaries.  Through a series of examples from a cross section of settings such as real estate agents, stockbrokers, stock exchanges, and mutual funds, Professor Judges erects a singular framework to explain numerous examples of sustained pricing power. The unitary framework integrates concepts developed across different research fields, including transaction costs economics, agency theory, and regulatory capture.

Professor Judge’s impressive intellectual accomplishment is to unite disparate observations along with diverse approaches under the single heading of intermediary influence and to explain how it arises, how it is exercised, what some of the costs are, and how participants might respond. Professor Judge’s work carries considerable policy implications as well, including combating excesses by stoking competition and enhancing disclosure. 

In a solicited comment, I concur with Professor Judge’s analysis and conclusions and add the example of acquisition markets to her illustrations. As with her examples, the private equity industry commands considerable political influence that enables it to sustain lucrative fees that are often hidden. Likewise in accord with Professor Judge’s prescriptions, I contend that the excesses might be mitigated by a combination of stoking competition and enhancing disclosure.  To illustrate my point, consider two heavyweights in the acquisitions field: Berkshire Hathaway and Kohlberg Kravis Roberts. In my comment, I also pose four questions, and am delighted to surface them here for the sake of dialogue.

Scope and Uniqueness of the Puzzle. First, the gap between theory and reality does pose a puzzle to explain, but perhaps more modest than it seems. Intermediaries reduce search costs and match end users with providers. Professor Judge suggests that Internet technology should make searching and matching easier so that intermediary fees should fall. She sees the opposite in many financial sectors, suggesting that the puzzle is more pronounced there. Yet technology is not the only factor that influences the costs of searching and matching that intermediaries can neutralize.

Globalization and complexity may increase search costs and complicate matching as well. In many contemporary industrial settings besides finance, supply chains have fragmented and intermediaries have proliferated. Moreover, Internet technology may reduce some costs but raise others. For example, websites that help buyers compare prices promise consumer savings but are funded by referral fees that often skew results so that users need other sites to compare the comparisons. More broadly, problems with intermediary influence are not unique to the financial services sector but plague all markets, including those in which producers or manufacturers exert influence.

How to Isolate Influence? Second, Professor Judge’s examples of intermediaries suggest a degree of influence, but it can be difficult to isolate intermediary influence on laws or norms from the influence of other participants. For example, multiple intermediary sectors may each benefit from a particular outcome, and it is challenging to discern which exercises the relevant influence in shaping institutional arrangements. After fixed brokerage fees were replaced by competitive rates in 1975 (to give an instance that Judge presents prominently), stockbrokers steered customers toward mutual funds instead of individual stocks because mutual funds were more lucrative—an apparent exercise of stockbroker intermediary influence. But a number of concurrent influences might have contributed to the same effect, including advertising by the mutual fund industry as well as urging by academic proponents of modern portfolio theory’s directive for individuals to diversify and by management consultants who contended that mutual funds were superior to conglomerates as a means of achieving such diversification.

Who Really Gains?  Third, Professor Judge suggests that intermediary influence translates into economic gain for intermediaries, but her illustrations are instances of broader patterns in the economics of intermediaries that often benefit and sometimes cost end users. Take one general model of middlemen, particularly attractive to producers, where middlemen bundle delivery of a company’s product with their own expert services. The middleman may be both a salesman and a professional. Consider a dentist conducting a checkup who then recommends an implant, or an optometrist giving an eye exam along with a prescription for glasses. Patients ask physicians for advice based on trust, stressing the professional role more than the merchandising one.

By training and ethics, the doctor’s motivation is to provide the appropriate product; by economic incentive, it is to sell the most expensive good that is appropriate. In most cases, the patient’s and physician’s goals are aligned, although premium pricing often results and physicians exert influence on institutional arrangements to facilitate such exchanges. Manufacturers of dental implants and eyewear benefit, too, enhancing their pricing power while outfitting patients with desired necessities. This pattern parallels how mutual funds have benefited greatly from stockbroker influence.

Industry Structure and Causation. Finally, Judge implies that the influence of financial intermediaries often manifests itself in industry structure, particularly in oligopolistic features. Yet it is not always clear whether influence leads to oligopoly or oligopoly leads to influence. Oligopolies in many sectors result from products that deliver distinctive consumer benefits. Examples among financial intermediaries are auditors and debt-rating agencies, which provide test-based certifications of specialized information that investors cannot verify themselves. An oligopolistic structure can arise from requirements of professionalization and scale rather than industry influence.

As a broader category, consider producers of “modest essentials”—inputs that cost little in context but that are vital. Cheap machine tools used in aerospace manufacturing, enzymes added to food products such as yogurt, and industrial gases employed in processes such as steelmaking all represent a tiny fraction of the user’s production costs, but each is essential. Providers therefore command pricing power, with the result that the industry is dominated by large, reputable firms with oligopolistic industry structures. Though not exactly middlemen, these providers share something in common with financial intermediaries: when raising capital, both auditing and rating fees are small in context but are nevertheless an unavoidable prerequisite.

Oligopolistic intermediaries do tend to produce competition among rivals that is more benign than vigorous. Firms that possess oligopoly power, especially those that provide relatively uniform products, know that they will be competing for decades to come. The result is competitive behavior that promotes industry stability more than it leads to price wars among rivals. This is true not only of auditing and rating firms but also of suppliers of industrial gases and makers of other modest essentials. So the challenging question is whether intermediary influence causes institutional arrangements that create pricing power and high fees, or whether institutional arrangements cause such intermediary influence.

The preceding post comes to us from Lawrence A. Cunningham, professor at George Washington University and author, most recently, of Berkshire Beyond Buffett: The Enduring Value of Values. The post is based on his recent article, entitled “Berkshire versus KKR: Intermediary Influence and Competition” and available here.