Presenter: J. David Cummins, Temple University "The Future of Financial Services”, organized by Capco and NYU-Poly The Post-Crisis World of Finance June 16, 2011

1. 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, 2011
Copyright 2011 J. David Cummins, all rights reserved. Not to be used except for personal use
without written permission.

2. 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

3. Motivation For Discussion
Deregulation 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

4. 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?

5. 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?

6. European Union’s: 2nd Banking g
Coordination 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

7. European Union’s: Third Generation
Insurance 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

8. The Financial Services Modernization
Act (G
A 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)

9. Financial Holding Company Under GLB
Financial Holding
Company
Insurance
Mutual Fund
Commercial Bank Investment Bank Group
Company
C
Insurance Agency
I A Securities Agency
S iti A Life I
Lif Insurer P/L Insurer
I

10. 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?

11. 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

12. 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

13. 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

14. Financial Sector Integration:
g
Deregulation 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

15. Financial Sector Integration:
g
Deregulation 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

16. Financial Sector Integration:
g
Deregulation 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?

17. Retail Integration: Bank Share of US
g
Individual 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%

18. Bank Share of US Annuity Premiums:
y
Fixed vs. Variable
45%
40%
35%
30%
25%
20% Fixed
15% Variable
10%
5%
0%

19. US Bank Life Insurance Premiums
$1,400
$1 400 2.5%
2 5%
$1,200
2.0%
$1,000
Amount ($ millions)
% of Total Market
1.5%
$800
T
t
$600
1.0%
$400
0.5%
$200
$0 0.0%
Amount % of Market

20. 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

21. 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

22. Top 10 Writers of Fixed Annuities
Sold 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

23. Largest Insurer Owned US Banks
Insurer-Owned
2009 Premiums
Company Bank (000s)
ING Groep N.V.
p ING Bank,
, 90,293,933
, ,
USAA Insurance USAA Federal Savings 37,922,355
State Farm Mutual State Farm Bank 16,157,711
Mutual of Omaha Mutual of Omaha Bank 4,109,578
Nationwide Mutual Nationwide Bank 3,206,002
Principal Financial Principal Bank 2,376,140
Prudential Financial, Inc. Prudential Bank & Trust 1,785,822
UNIFI Mutual Holding
Company Acacia Federal Savings 1,387,290
Allstate Corporation Allstate Bank 1,210,623
American International
Group, Inc. AIG Federal Savings Bank 1,127,943

24. Bancassurance Penetration: Europe
Turkey
Poland
Portugal
Belgium
Spain
p Life
Italy Non-life
Germany
France
UK
0 0.2 0.4 0.6 0.8 1

25. 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

26. 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

27. Financial Sector Integration:
g
1990s & 2000s
 Larger insurers aggressively enter
wholesale financial services
 Insuring financial products
 Issuing financial guarantees
 Issuing credit default swaps (CDS)
 Derivatives trading
 Investment management
 Compete directly with banks, hedge
funds, and broker dealers

28. Financial Sector Integration:
g
1990s & 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

29. Financial Sector Integration:
g
1990s & 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

30. Life Insurer Asset Backed Securities
as % of Surplus
For 36% of life insurers ABS ≥ 100% of surplus.
100%
90%
us
Percent of Surplu
80%
70%
60%
50%
40%
30%
20%
10%
0%
0.0% 10.0% 20.0% 30.0% 40.0%
Percent of Insurers

31. 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

32. Why Diversification May Create
y y
Shareholder 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

33. Why Diversification May Destroy
Shareholder 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

34. Trends in Insurance Strategies:
g
1970s-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

35. 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

36. 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.

37. 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

38. 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

39. 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

40. Interconnectedness: Evidence from
Operational 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

41. 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)

42. 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

43. 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

44. 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

45. Hypotheses – Inter-industry effect:
yp y
Effect 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

46. 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

47. Inter-Sector
Inter 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.

48. 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 Insurers
I-Bank events affect insurers more strongly than C-bank events.

49. 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.

50. 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

51. 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

52. 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

53. 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?