Irwin/McGraw-Hill 1 Product Diversification


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Irwin/McGraw-Hill 1 Product Diversification

  1. 1. Product Diversification Chapter 21 Financial Institutions Management, 3/e By Anthony Saunders
  2. 2. Introduction <ul><li>Universal FI structure in Germany, Switzerland and UK. </li></ul><ul><li>Recent Citicorp/Travelers merger. </li></ul><ul><li>Risks of product segmentation </li></ul><ul><ul><li>lack of diversification </li></ul></ul><ul><ul><li>exposure to nonbank competition </li></ul></ul><ul><ul><ul><li>especially MMMFs </li></ul></ul></ul>
  3. 3. Segmentation in U.S. Financial Services Industry <ul><li>Commercial and investment banking </li></ul><ul><ul><li>Glass-Steagall Act 1933 exemptions </li></ul></ul><ul><ul><ul><li>Underwriting Treasuries and municipal general obligation bonds; </li></ul></ul></ul><ul><ul><ul><li>Engage in private placements. </li></ul></ul></ul><ul><ul><li>1987 Federal Reserve Board allowed BHCs to establish Section 20 affiliates. </li></ul></ul><ul><ul><ul><li>Firewalls between banks and Section 20 affiliates. </li></ul></ul></ul>
  4. 4. Erosion of Glass-Steagall <ul><li>20 states allow state-chartered banks to engage in securities activities beyond those permitted by Glass-Steagall for national banks. </li></ul><ul><li>OCC ruling in 1996: </li></ul><ul><ul><li>permit national banks on a case-by-case basis to establish direct subsidiaries to undertake non-banking activities such as underwriting. </li></ul></ul>
  5. 5. Further Challenges to Glass-Steagall <ul><li>International Banking Act 1978 </li></ul><ul><ul><li>Foreign banks securities activities grandfathered. </li></ul></ul><ul><li>Investment banks increasing efforts to offer banking products. </li></ul><ul><ul><li>Cash management accounts </li></ul></ul><ul><ul><li>Deposit brokering </li></ul></ul>
  6. 6. Banking and Insurance <ul><li>1986: banks began selling annuities but traditionally banks prevented from entering insurance. </li></ul><ul><ul><li>Restricted to agency activities, offering credit-related products in small towns. </li></ul></ul><ul><ul><li>Garn-St. Germain Act specifies restrictions on BHCs establishing insurance affiliates. </li></ul></ul>
  7. 7. Banking and Insurance (continued) <ul><ul><li>Delaware: liberal laws allowing state-chartered banks to engage in P&C and life insurance. </li></ul></ul><ul><ul><li>Nonbank banks as a route for insurance companies and commercial firms to engage in banking. </li></ul></ul><ul><ul><li>Current challenge to Bank Holding Company Act’s restrictions </li></ul></ul><ul><ul><ul><li>Citicorp and Travelers </li></ul></ul></ul>
  8. 8. Commercial Banking and Commerce <ul><li>Banks can only engage in commercial activities “incidental to banking” </li></ul><ul><li>Restrictions on BHCs are a more recent phenomenon. </li></ul><ul><li>1956 Bank Holding Company Act. </li></ul>
  9. 9. Issues Involved in Expansion of Product Powers <ul><li>Overview </li></ul><ul><ul><li>Safety and soundness issues </li></ul></ul><ul><ul><li>Economy of scale and scope issues </li></ul></ul><ul><ul><li>Conflict of interest issues </li></ul></ul><ul><ul><li>Deposit insurance issues </li></ul></ul><ul><ul><li>Regulatory oversight issues </li></ul></ul><ul><ul><li>Competition issues </li></ul></ul>
  10. 10. Safety and Soundness <ul><li>Risk of securities underwriting </li></ul><ul><ul><li>Firm Commitment </li></ul></ul><ul><ul><li>British Petroleum </li></ul></ul><ul><ul><li>Firewalls as protection from securities affiliate </li></ul></ul><ul><ul><ul><li>Risks from upstreaming or affiliate loans </li></ul></ul></ul><ul><ul><ul><li>Risks from contagious confidence problem </li></ul></ul></ul><ul><ul><li>Benefits from product diversification and geographic diversification </li></ul></ul>
  11. 11. Economies of Scale and Scope <ul><li>Economies of scale opportunities for firms up to $25 billion in asset size. </li></ul><ul><ul><li>Revenue-based for largest FIs </li></ul></ul><ul><li>Economies of scope </li></ul><ul><ul><li>May be limited by firewalls between banks and Section 20 subsidiaries. </li></ul></ul><ul><ul><li>Greater gains possible with universal banking structure as in Germany. </li></ul></ul>
  12. 12. Conflicts of Interest <ul><li>Six potential conflicts </li></ul><ul><ul><li>Salesperson’s stake </li></ul></ul><ul><ul><ul><li>NationsBank example. </li></ul></ul></ul><ul><ul><li>Stuffing fiduciary accounts </li></ul></ul><ul><ul><li>Bankruptcy risk transference </li></ul></ul><ul><ul><li>Third-party loans </li></ul></ul><ul><ul><li>Tie-ins </li></ul></ul><ul><ul><li>Information transfer </li></ul></ul>
  13. 13. Deposit Insurance <ul><li>Deposit insurance </li></ul><ul><ul><li>may provide competitive advantage to banks over other FIs. </li></ul></ul><ul><ul><li>Banks may also gain an advantage from being too big to fail. </li></ul></ul>
  14. 14. Regulatory Oversight <ul><li>Large bank holding companies with extensive nonbank subsidiaries face a complex structure of regulators. </li></ul><ul><li>If further integration of financial services then there may be argument for a single regulatory body. </li></ul>
  15. 15. Competition <ul><li>Procompetitive </li></ul><ul><ul><li>Increased capital access for small firms </li></ul></ul><ul><ul><li>Lower commissions and fees </li></ul></ul><ul><ul><li>Reduce degree of underpricing of new issues </li></ul></ul><ul><li>Anticompetitive </li></ul><ul><ul><li>Long-run outcome could be oligopoly with higher prices for investment banking services. </li></ul></ul>