Banks Finance/Insurance: Competition or Convergence
Banks Finance/Insurance: Competition or Convergence J. David Cummins, Temple University NYU Poly Capco Institute Inaugural Conference The Post-Crisis World of Finance June 16, 2011Copyright 2011 J. David Cummins, all rights reserved. Not to be used except for personal usewithout written permission.
Financial Services:Integration & Convergence Financial services integration is an event that combines two or more financial services organizations involved in manufacturing or distributing financial services Integration can lead to convergence of previously separate financial services firms and markets
Motivation For DiscussionDeregulation of financial services have set the stage for broad-based integration: g g Europe – EU Banking and Insurance Directives United States – Financial Services Modernization Act (Gramm-Leach-Bliley) (1999) Japan – “Big Bang” financial reforms
Motivation for Discussion Trends in financial services markets United States – 1990s to present Bank inroads into annuity markets Demutualization of major life insurers to compete more broadly in financial services Insurers providing investment banking services Is deregulation/consolidation economically beneficial?
Motivation for Discussion Trends i financial services markets T d in fi i l i k United States – 1990s to present Bank inroads into annuity markets y Demutualization of major life insurers to compete more broadly in financial services Insurers providing investment banking services I Insurers providing retail fi idi t il financial services i l i Europe: Widespread financial services sector consolidation Within-country, within-industry Within country within industry Within-country, cross-industry Cross-country, within-industry Cross-country, Cross-country cross-industry Is convergence economically beneficial?
European Union’s: 2nd Banking gCoordination Directive (1993) Single EU “Passport” – bank must be licensed in only 1 EU country to operate anywhere in EU y y p y Home country supervision – banks are regulated only by home country not host countries Harmonization of laws and regulations
European Union’s: Third GenerationInsurance Directives (1994) Single EU “Passport” – insurer must be licensed in only 1 EU country to operate anywhere i EU h in Home country supervision – insurers are regulated only by home country not host countries Insurance market deregulated ( g , for p g (e.g., pricing) g) except for solvency regulation
The Financial Services ModernizationAct (GA t (Gramm-Leach-Bliley) (GLB) 1999 L h Blil ) Most significant US financial services regulatory change since 1933 g Removed the remaining walls that fragmented the financial marketplace Permits banks, insurers, securities firms, and other financial institutions to affiliate under common ownership through Financial Holding Companies (FHCs)
Financial Holding Company Under GLB Financial Holding Company Insurance Mutual Fund Commercial Bank Investment Bank Group Company CInsurance AgencyI A Securities Agency S iti A Life I Lif Insurer P/L Insurer I
Financial Sector Integration Has deregulation led to the dominance of highly integrated financial intermediaries providing traditionally segregated products? Commercial banking Investment banking Insurance Securities d li S iti dealing Other financial services Will specialized firms survive and prosper?
Financial Sector Integration Even though the 1990s deregulation has facilitated integration, integration began much earlier Inactivities unaffected by regulatory restrictions Th Through earlier d h li deregulation l ti History of integration
Financial Sector Integration: 1970s Investment banks, brokers, & commercial banks Checkable money market funds – substitute for bank demand deposits p Expansion of commercial paper market – substitute for bank loans Asset-backed securities Move assets (e.g., mortgages) off-balance-sheet Adoption of “originate and distribute” model
Financial Sector Integration: 1970s Insurers vs. banks Insurers invest in privately p p y placed bonds – substitute for securities underwriting through investment banks IInsurers introduce single premium d f i d i l i deferred d annuities and GICs – substitute for bank CDs Insurers compete for commercial mortgages Insurers introduce mutual fund families Insurers introduce variable life and annuities
Financial Sector Integration: gDeregulation of 1980s & 1990s Regulatory restrictions Glass-Steagall Act of 1933 Separated commercial banking and investment banking Restricted inter-ownership between banks and insurance companies N ti National l B ki A t (NBA) of 1916 restricted Banking Act f ti t d commercial banks from selling insurance
Financial Sector Integration: gDeregulation of 1980s & 1990s Deregulation: Wholesale financial services In 1987 commercial banks permitted to engage in investment banking through “Section 20” subsidiaries 1987, I-banking limited to 5% of gross revenue 1996, I-banking 1996 I b ki permitted up t 25% of gross revenue itt d to f In1999, Gramm-Leach-Bliley Act removed all remaining restrictions and p g permits Financial Holding g Companies (FHCs) to engage in all types of financial services through subsidiaries
Financial Sector Integration: gDeregulation of 1980s & 1990s II Deregulation: Retail financial services National Banking Act interpreted to allow subs of g banks to sell insurance if headquartered in towns of < 5,000 population Office of Comptroller of Currency (OCC) deregulation 1985: OCC allowed banks to sell fixed-rate annuities 1990: OCC allowed banks to sell variable-rate annuities 1996: OCC actions upheld by U S Supreme Court U.S. Have banks succeeded in the insurance market?
Retail Integration: Bank Share of US gIndividual Annuity Premiums ($ billion) Year Total Bank Bank Share (%) 2000 184.9 31.0 16.8% 2001 179.3 179 3 38.3 38 3 21.4% 21 4% 2002 214.0 48.9 22.9% 2003 210.8 50.1 23.8% 2004 220.8 46.6 21.1% 2005 216.4 39.7 18.3% 2006 238.7 40.9 17.1% 2007 256.8 42.4 16.5% 2008 265.0 52.0 19.6% 2009 238.6 44.5 18.7%
Bank Share of US Annuity Premiums: yFixed vs. Variable45%40%35%30%25%20% Fixed15% Variable10% 5% 0%
US Bank Life Insurance Premiums $1,400 $1 400 2.5% 2 5% $1,200 2.0% $1,000Amount ($ millions) % of Total Market 1.5% $800 T t $600 1.0% $400 0.5% $200 $0 0.0% Amount % of Market
Research Findings: Market Value g Impact of Bank Sales of Annuities Carow (2000): Research questions: Did removal of entry barriers to bank sales of annuities destroy market value for insurers and increase value for banks? Sample: 89 banks and 44 insurers, 1984- 1996
Research Findings: Market Value g Impact of Bank Sales of Annuities II Results: OCC and court rulings destroyed value for life insurers ins rers on a erage b t had no effect on banks average but Insurers selling through brokers gain value, those using exclusive agents lose value g g Rationale: Entry barriers permitted insurers to earn excess profits Bank entry will lead to a competitive market, so banks will not gain value Brokerage insurers have more contracting flexibility and do not g g y have sunk costs in product distribution
Top 10 Writers of Fixed AnnuitiesSold By Banks Company 2009 premiums (millions) Western National Life $5,210 New York Life 5,194 AEGON/Transamerica 4,027 Pacific Life 2,319 Symetra Financial 2,093 Jackson National Life 1,142 MetLife 1,110 RiverSource Life Insurance 1,090 Lincoln Financial 1,034 Western Southern Western-Southern Financial 1,034
Largest Insurer Owned US Banks Insurer-Owned 2009 PremiumsCompany Bank (000s)ING Groep N.V. p ING Bank, , 90,293,933 , ,USAA Insurance USAA Federal Savings 37,922,355State Farm Mutual State Farm Bank 16,157,711Mutual of Omaha Mutual of Omaha Bank 4,109,578Nationwide Mutual Nationwide Bank 3,206,002Principal Financial Principal Bank 2,376,140Prudential Financial, Inc. Prudential Bank & Trust 1,785,822UNIFI Mutual HoldingCompany Acacia Federal Savings 1,387,290Allstate Corporation Allstate Bank 1,210,623American InternationalGroup, Inc. AIG Federal Savings Bank 1,127,943
Bancassurance Penetration: Europe Turkey PolandPortugalBelgium Spain p Life Italy Non-lifeGermany France UK 0 0.2 0.4 0.6 0.8 1
Retail Integration: Conclusions Banks have succeeded in annuities but not in life insurance But only about 20% of annuity market Banks mainly sell annuities manufactured by insurance companies Private label brands rather than through subs of financial holding companies Banks sell but do not manufacture
Retail Integration: Conclusions II Very limited penetration by US insurers into the retail banking market g Leader is ING – importing European model Bancassurance has been more successful in some European countries Mainly for life insurance Varies by country due to tax treatment and other factors
Financial Sector Integration: g1990s & 2000s Larger insurers engage in securitization and monetization of insurance risk Catastrophe bonds, options, and swaps Mortality bonds Life insurance embedded value securitizations Regulatory arbitrage securitizations, motivated by life insurance reserve regulations Assuming investment banking functions
Financial Sector Integration: g1990s & 2000s Insurers shift portfolios from conventional single issuer bonds into mortgage backed g g g and other asset backed securities Life insurers – 27% of bonds in ABS ABS = 180% of policyholders surplus Property-casualty insurers – 18% of bonds ABS = 31% of policyholders surplus f li h ld l Averages for 2009 – percentages much higher for many insurers
Life Insurer Asset Backed Securitiesas % of Surplus For 36% of life insurers ABS ≥ 100% of surplus. 100% 90% usPercent of Surplu 80% 70% 60% 50% 40% 30% 20% 10% 0% 0.0% 10.0% 20.0% 30.0% 40.0% Percent of Insurers
Is Integration the Dominant Model? Competing hypotheses Conglomeration hypothesis – firms can maximize value by operating a diversity of businesses to exploit cost and revenue scope p p economies Strategic focus hypothesis – firms maximize value by focusing on core businesses and core competencies
Why Diversification May Create y yShareholder Value Diversification across businesses reduces risk Reduce taxes (convex tax schedule argument) Increase debt capacity Reduce expected costs of financial distress Reduce cost of capital Economies of Scope: firm has excess capacity in resources and capabilities that are transferable across industries Reuse brand names and distribution channels Exploit financial and legal expertise Managerial scale economies
Why Diversification May DestroyShareholder Value Diversification creates agency problems Incentive benefits of stock options blunted for p divisional managers Increased span of control creates more opportunities for conflicts to develop Information asymmetries between central and divisional management Internal capital markets less efficient than external capital markets
Trends in Insurance Strategies: g1970s-1980s 1970s-1980s: Conglomeration ITT-Hartford:Communications & insurance AAmerican E i Express: All t types of fi f financial services i l i Sears: “Socks and stocks” Insurance Real estate Securities brokerage Retailing CIGNA – merger of Connecticut General (life) and INA (p p y (property-liability) y) AIG – all types of insurance worldwide
Trends in Insurance Strategies: 1990s 1990s: Return to strategic focus Sears spins off Allstate: 1995 ITT spins off Hartford: 1995 CIGNA sells property-casualty operations to ACE: 1999 Aetna sells property-casualty operations to Travelers Conversely, Travelers & Citicorp merge 1998 creating Citigroup
Trends in Insurance Strategies 2000s 2002: Citigroup spins of Travelers P&C citing failure of cross-selling personal lines P&C insurance to bank customers 2004: Travelers P&C merged with St. Paul Companies to form St. Paul Travelers More a focusing than diversifying merger 2005: Citigroup sells Travelers Life and g p Citigroup’s international insurance to Met Life “This transaction increases MetLife’s size and scale in our core products and markets ” CEO MetLife markets, CEO, MetLife.
Trends in Insurance Strategies 2000s September 2008: AIG is bailed out by US Government – $182 billion taxpayer commitment AIG had written $533 billion in CDS out of highly leveraged AIG Financial Products (year end 2007) Mainly to European banks using CDS for regulatory arbitrage Some AIG US insurance subsidiaries were heavily involved in asset lending p g g programs AIG also dependent on short-term financing through commercial paper
Trends in Insurance Strategies 2000s Bursting of the housing bubble and deterioration of MBS market led to Collateral calls from CDS counterparties Unwinding of asset lending positions, often from the same counterparties Inability to roll over AIG commercial paper Investment banking activities led to downfall of AIG
Integration and Interconnectedness Expansion of insurers into banking activities has created widespread inter- inter connectedness between financial firms Recent research provides statistical evidence of strong interconnectedness Bilio et al. (2010) – stock returns ( ) Acharya et al. (2010) – stock returns Cummins et al. (2011) – operational risk events
Interconnectedness: Evidence fromOperational Risk Events Basel II definition: “The risk of loss resulting from inadequate or failed internal processes, people, people and systems or from external events ” systems, events. In theory, operational risk is residual risk after accounting for other sources of risk g Market risk Credit risk I t Interest rate risk t t i k Exchange rate risk Systemic risk
Famous Operational Risk Events NASDAQ “Odd eighths” trading scandal (Christie and Schultz 1994) Barings Bank collapse (1995) – $1 3 billion loss due to $1.3 rogue trader (Nick Leeson) Daiwa Bank (1995) – $1.1 billion loss due to unauthorized bond trading (Toshihida Iguchi) Leading US securities brokers fined $1.4 billion (2002) – misleading research reports Prudential Insurance (US) fined $2 billion for sales abuses (1990s) State Farm Insurance loses $1.2 billion for breach of contract (1999)
Research Question Do operational risk events cause market value losses (spillovers) to non-announcing firms in ( p ) g the U.S. banking and insurance industries? Main Results Operational risk events have significant intra- and inter-industry spillover effects Negative impact on stock prices of non announcing firms non-announcing Spillover effects are information-based Informed, rather than indiscriminate, re-pricing of stocks
How Are Spillovers Generated? Arise if events cause investors to revise downward estimates of future cash flows for non-announcing firms Events p provide information on p previously unknown y risks to all institutions Events cause customers to be wary of financial institutions and disintermediate Events may induce greater regulatory scrutiny
Study Design: Spillover Effects Impact on non-announcing publicly traded banks and insurers around each event OpVar, CRSP, Compustat Non announcing Non-announcing firms Commercial banks: SIC 602, 6711 Investment banks: SIC 621, some 6282 Insurers: SIC 631 (life) and 633 (P-L) Large Events – exceeding $50 million
Hypotheses – Inter-industry effect: yp yEffect of insurance events on banks Commercial banks enter insurance, mid-1980s Annuities account for 2/3 of banks’ insurance premiums Premiums from life and P L insurance also growing rapidly P-L Commercial banks rather than investment banks have been th major players d i th b k ’ expansion i t b the j l during the banks’ i into the insurance market Thus, insurance events expect to have stronger impact on commercial banks than on investment banks
Hypotheses – Inter-industry effect: yp y Effect of bank events on insurers Competition with investment banks Securitiesissuance Commercial mortgages & mortgage backed bonds Mutual funds Competition with commercial banks Annuities,mutual funds, life insurance SPDAs, GICs Pension plan management No clear prediction on whether insurers respond more strongly to C bank events or I bank events C-bank I-bank
Inter-SectorInter Sector Effect: Banks 0.00%-0.10%-0.20%-0.30%-0.40% (-1,+1)-0.50% (-1,+5)-0.60% (-1,+10)-0.70%-0.80%-0.90% C-Banks on I-Banks I-Banks on C-Banks I-Banks events have strong effect on C-Banks. C-Bank effect on I-Banks dissipates rapidly.
Inter-Sector Effect:Bank Events on Insurers 0.00% -0.10% -0.20% -0.30% -0.40% (-1,+1) -0.50% (-1,+5) -0.60% (-1,+10) -0.70% -0.80% C-Bank Events on I-Bank Events on Insurers InsurersI-Bank events affect insurers more strongly than C-bank events.
Inter-Sector Effect:Insurance Events on Banks 0.00% -0.20% -0.40% -0.60% (-1,+1) -0.80% 0 80% (-1,+10) -1.00% (-1,+15) -1.20% -1.40% Insurer Events on Insurer Events on C-Banks I-Banks Insurer events have only weak effects on I-Banks. Insurer events affect C-banks as strongly as insurers.
Operational Risk Spillovers: Conclusions Investment bank events have strong effect on commercial banks C-bank to I-bank effects are much weaker I-bank events affect insurers more strongly gy than C-bank events – but both are significant Insurer events affect C-banks more strongly gy than I-banks
Integration: Conclusions Citigroup experience casts doubt on existence of synergies between banking and insurance – both life and non-life Support for strategic focus hypothesis AIG experience shows that insurers in investment banking can create systemic risk
Integration: Conclusions II Banks achieve gains in annuity markets As sellers rather than underwriters No widespread acquisitions of insurers by banks envisioned after GLB Insurers have made gains in wholesale financial services but not in retail banking More support for strategic focus than for conglomeration hypothesis
Integration: Conclusions III Deregulation and integration have provided opportunities for financial firms to Enternew markets Improve profitabililty p p y However, integration also increases interconnectedness and the probability of p y systemic events Has there been a net gain from deregulation and integration?