Why haven’t the significant financial and technological innovations of the past thirty years substantially decreased the cost of financial intermediation? What explains the ever-increasing complexity of financial products and markets? Why do so many investors hold actively managed mutual funds despite evidence that their costs typically exceed their benefits? How is it that real estate brokers remain able to charge such high fees despite the rise of the Internet and the increasing capacity of buyers and sellers to connect without their services? These are just a few of the questions that I address in a new article forthcoming in the University of Chicago Law Review and available here. The article, Intermediary Influence, shows that in the very process of serving as intermediaries, financial and other intermediaries develop expertise and acquire a range of other strategic advantages over regulators and the parties that they serve. Coupled with their greater capacity to organize to promote their collective interests, these advantages enable intermediaries to signficantly skew the processes through which market structures, laws, norms, and other institutional arrangements evolve. And, because transaction fees are revenue to the intermediaries to whom they are paid, we regularly see the adoption and entrenchment of relatively high-fee arrangements. Intermediary influence thus helps to explain an array of phenomena observable in the financial markets that are inconsistent with the standard assumption that institutions evolve to minimize transaction costs.
In this article and an earlier piece, Fee Effects, available here, I draw attention to unappreciated costs of the rise of intermediaries. Each recognizes that intermediaries function as a cornerstone of most modern economies, and with very good reason. Intermediaries can help parties to connect, transfer information, and otherwise overcome the many barriers to transacting far more efficiently than parties could do on their own. Nowhere is the value that intermediaries can provide more evident than in the financial markets, where intermediaries have long played a critical role helping to move capital from investors to productive undertakings. Nonetheless, precisely because they are so pervasive and so influential, it is time to consider whether our increasing reliance on intermediaries may have some drawbacks that get lost among the many benefits they provide. These two articles suggest that there are.
Fee Effects holds the amount of influence that intermediaries enjoy as static, and it then considers the ramifications of how they use that influence. Its primary contribution is to draw attention to the way that reliance on specialized intermediaries alters the total mix of transactions consummated. It further demonstrates that this shift does not just affect how the gains from trade are allocated; it reduces the social welfare created from the transactions that do get consummated.
Transaction fees operate as a friction, reducing the likelihood that a particular transaction will be consummated. That friction, however, often does not reduce the option set of possible transactions to just one. A firm seeking to raise capital, for example, may be able to engage in a number of very different transactions, from issuing new equity to obtaining a syndicated loan. Similarly, a shopper seeking a bottle of red wine to take to a party will likely face a wide range of acceptable options. In these circumstances, the person making the choice will often rely on the guidance of a specialized intermediary, be it an investment bank or a clerk at the wine shop, for help in choosing among possible alternatives. And, because transaction fees are revenue to the intermediary providing the guidance, the intermediary will have an incentive to use his influence to encourage the party to undertake the transaction that entails the highest transaction fees. As a result, transaction fees also act like a grease, increasing the probability that certain transactions will be consummated over others.
To be sure, there are a number of forces that limit intermediaries’ incentives to use their influence to maximize their short-term revenue. For example, many intermediaries rely on their reputation in order to attract customers, so they will consider how making a particular recommendation will influence their capacity to attract business in the future. The law, through fiduciary and other obligations, and competition from other intermediaries, similarly impose meaningful constraints on how intermediaries use their influence. Nonetheless, these constraints are imperfect. As a result, we see a shift in the total mix of transactions consummated toward those that entail relatively higher transaction fees. The paper explores the costs of this shift and some tools that might help to reduce those costs.
Intermediary Influence, in turn, considers the ramifications of intermediary influence in a dynamic environment where institutions evolve over time. The core claim is that intermediaries often exercise significant influence over the processes through which institutions evolve and they use this influence in self-serving ways. The result is the entrenchment and adoption of relatively high fee institutional arrangements, an outcome that runs directly contrary to the standard assumption that institutions evolve to minimize the associated transaction costs.
The article uses numerous examples from the financial markets to illustrate the positional and informational advantages that intermediaries often acquire from serving as intermediaries. It recognizes that these advantages are core to the cost savings that arise from reliance on specialized intermediaries, and thus are often to be encouraged. Nonetheless, they also enable intermediaries to exercise significant influence over the processes through which institutions evolve. Particularly when viewed in connection with collective action dynamics that often result in intermediaries deploying significant resources to entrench and protect favorable institutional arrangements, the article reveals that intermediary influence as a powerful and persistent market force.
Having revealed this underappreciated drawback of our reliance on specialized intermediaries, the article addresses the challenge of whether and how this cost can be reduced while still preserving the many benefits that arise from relying on specialized intermediaries. Building on Fee Effects, it suggests that a critical first step is for regulators and market participants to again “follow the fees” to better understand intermediary incentives and how they influence the processes through which institutions evolve. Examining legislative developments, rulemaking, and shifts in investor behavior over the last five years, the article suggests that one unexpected silver lining of the 2007-2009 financial crisis is that it seems to have had precisely this effect. Politicians, investors, and regulators all appear to be more skeptical of claims made by financial intermediaries and more willing to exercise independent judgment in making decisions that influence laws, market structures, and other institutional arrangements. The article also considers structural changes that may be warranted to help counteract intermediaries’ outsized influence over institutional evolution. The analysis suggests that there is no one-size-fits-all “solution” and intermediary influence is better viewed as a phenomenon to be understood and managed than a problem to solved, but it does identify a variety of context-sensitive reforms that may be worth pursuing.
Kathryn Judge is an Associate Professor of Law at Columbia Law School.