Transaction Costs and Efficiency in Inter-Mediation

By Bag, Dinabandhu | Journal of Services Research, April 1, 2013 | Go to article overview

Transaction Costs and Efficiency in Inter-Mediation


Bag, Dinabandhu, Journal of Services Research


Introduction

The business of lending depends upon the trust in the relationship between the borrowers and lenders and the size of the relationship depends upon the expected outcome (returns) of the transaction. Transaction costs of intermediation between the lenders and borrowers are a crucial challenge for both the lender and borrower. Hence, the presence of transaction costs lending decisions would not be taken with complete information about the credit-worthiness of potential borrowers. This situation of inadequate information regarding borrowers is also known as information asymmetry. In an increasingly competitive atmosphere, banks may not share information among themselves and this could worsen the problem of adverse selection, of moral hazard1 and the transaction costs in borrowing. The lack of trust associated with rising delinquency and credit losses impact the quality of lending. With the expansion in consumer lending and increased competition among banks, the necessity for sharing of information to reduce transactions costs is critical. Transaction costs have been amply discussed and demonstrated in the literature. Financial intermediaries incur numerous transaction costs that may include search costs, screening costs, training and counseling, credit education costs, monitoring and enforcement costs, to control possible opportunistic behavior of clients (moral hazard) and adverse selection (Gray, 1993). One can denote these types of transaction costs as information costs. Hence, information costs are defined as the cost incurred to ensure that borrowers adhere to terms of the loan. Therefore, information costs impact the operating costs in lending and determine the successful completion of a financial transaction (Cole, 1998). Monitoring activities are desired to enable lenders to obtain complete knowledge of the borrower. This study attempts to review previous work on transaction costs and also attempts to demonstrate the benefits of transaction theory usage on the borrower delinquency using test data on retail revolving assets for an Indian bank. The next section describes the literature on transaction costs.

Transaction Costs

The theory of transaction costs has been a very important driver in explaining the growth of the financial sector in the past few decades. Empirical research on financial intermediation has placed information costs at the center of total transaction costs incurred in conducting financial exchanges. Transactions costs make the presence of credit granting decisions costlier which means risk-averse lenders could deny sanctioning credit. Theoretical framework of transaction costs have been suitably discussed in the literature. There have been a number of previous researches on transaction costs and information sharing among lenders to improve the performance of credit markets (Campion, 2001, DeJanvry, 2003, Luoto et al, 2007, Miller, 2003, Vercamen, 1995, Cowan et al, 2003, McIntosh, 2009 and 2005, Japelli, 1993, etc). Transaction costs theory involves the design of efficient mechanisms for conducting economic transactions. The basic assumption is that economic transactions have potential costs associated with them where a transaction is the basic unit of analysis and is important in economizing transaction costs (Romano, 1992). Williamson (1985) states that transaction costs is the resultant friction that arises in undertaking transactions among exchange parties. The friction associated with transactions is mainly caused by opportunistic behavior that usually arises when two parties in an exchange fail to fulfill their obligations. The presence of collaterals can reduce transaction costs in such an exchange. Few theorists (Bardhan and Udry, 1999) placed emphasis on the acquisition of cost minimizing requirement such as lower reliance on collateral to reduce the incidence of opportunism. Other theorists have proposed the design of incentive mechanisms to discourage behavior that lead to diverging interests among exchange parties (Coase, 1991). …

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