In Europe, the development of bancassurance is divided in three stages. In 1980s, this type of bank operations is limited to certain insurance services such as consumer credit, home property and currency theft. Post-1980s enabled savings insurance into the operations which is also the time when Europe deregulated bancassurance. Finally, the 1990s started the era where banks offered insurance not only on savings but also investment and whole-life contracts. The services offered by this combined operation resulted to lucrative opportunities for customers to use relationship pricing. This enabled them to obtain banking and insurance services for a better price than engaging to two different companies for separate service.
The growth of banks offering insurance services to clients is triggered by historical longevity, deregulation, similarities, non-traditional competition, and changing of distribution channels (e.g. online) prominent in both banking and insurance industries. Earlier studies found that bank-insurance mergers resulted to increase wealth of bidders and targets approximated at 1% and 5% respectively. Other qualitative characteristics of such mergers can provide synergies, diversification and economies of scope. Diversification advantages can be derived by reduced risks particularly pertaining to lower probability of business failure. This feature is offered by insurance companies that participated to bank mergers. However, there are also studies that undermine such activities. Diversified assets are found to have less added-value compared to focused assets. The latter is eminent on horizontal integration. In addition, although risk of failure is reduced in such mergers, return on assets (ROA) had no significant changes attributed to them.
There are specific commonalities of banks and insurance carriers (i.e. carriers). They pool savings, compete for public funds and channel them in investing to capital expenditures. They have priorities and crucial emphasis on law of large numbers, economies of scale, liquidity creation and risk management. All such activities serve as basic frameworks in their strategy and decision-making. For banks, integration of insurance services is important to simplify the process of extending loans and then selling insurance to protect them. Further, although carriers have longer maturity structures in its terms and contracts compared to short-term offers in bank practice, both institutions have primary objective to manage asset-liability portfolios. It means that the reason behind such practices is directed to maximize their portfolios. Finally, their value chain is optimized as insurance brokers/ agents are diluted due to introduction of new technologies and increase geographical expansion of their branches. This propelled direct marketing with less to zero intermediary.
The impacts of bancassurance to merging parties are attached to four hypotheses; namely, information, scale economies, diversification and scope economies. These are hypotheses as they require empirical proof to formally and objectively attach to parties and establish less generalization. A specific empirical record is available for 136 bank-insurance mergers among US and non-US companies from 1997 to 2002. The research found that there is a positive abnormal return for the bidder during merger announcement reflecting its positive wealth creating impact. This advantage is attributed to the emergence of strong evidence of scope economies and weak evidence of scale economies. In-country deals, higher profit targets, and lower systematic risk are causes attached to obtaining higher bidder returns during mergers. In this case, the reduced systematic risk is attributed to diversification hypothesis although supported by weak evidence.
Information hypothesis is a bancassurance phenomenon from increased debt monitoring that can lead to higher borrower value and enhanced certification services and market signaling. In separate operations, banks and carriers have accessed to valuable information about their clients and also the market. The former holds the information concerning private deposit accounts while the latter have the non-bank debt information (i.e. information relating to capital financial market and stock exchanges). Scale economies hypothesis is the phenomenon where the combination of bank-insurance services enables broader customer base and corporate clients. Legal restrictions on underwriting maintain asset specialization between the institutions where banks pull out credit via short-term floating rate deposits while carriers via long-term fixed rate contracts. Diversification hypothesis is largely contributed by carriers as mentioned earlier. It is obtained to empirical studies that concluded that carriers have low risk than banks. However, there is no evidence that earnings are more robust in insurance industry. Lastly, scope economies hypothesis mean that bank-insurance combination can produce two or more outputs more efficiently that separate entities.
There are other catalysts of bancassurance occurrence. The US Financial Services Act of 1999 broadened bancassurance capacities in underwriting and selling insurance products. In Europe, single licensing of carriers within the region is implemented leading to mobilization of regional mergers. According to Swiss Re, bancassurance led to cheaper insurance premium rates and more efficient finance products and services. However, there are three main set-backs. Customers who traditionally keep bank deposits substituted life insurance savings in this position or vice versa. Second, reputation of well-known banks is exposed to carrier risks as the former is more popularly and historically-tested for client relationship based on trust. Lastly, as assets and capital of both institutions are combined, limits situated by regulators on capital requirement are easily reached that causes capacity constraints.
In a study, samples are gathered from European acquiring banks and European targeted carriers to measure the effects of risk and wealth to each party based on 1983-2004 data. The research found that acquirers had reduced systematic risks but their total risks remained constant in relation to home banking indices. This is coupled with negative and significant short abnormal returns that caused reduction in systematic risks or beta. Consequently, with lower beta and high leverage of merged firm, the wealth of shareholders is transferred to debt holders. Further, it is also found that greater synergy is obtained when the size of deal is comparatively larger than the market value of the bidder. Alternatively, the market punished bidders that overpaid for their targets. Finally, the benefits from the merger are greater when acquirers and targets are operating in geographically diverse locations. This is a partial deviation to the preceding study in US that found that in-country deals resulted to higher bidder returns.
In the US, banks-insurance mergers had developed into an interesting transformation where carriers and insurance brokers/ agents (i.e. middlemen) are appropriately classified as prospect for combinations. The role of middlemen in the US bancassurance escalated during late 1990s where large increasingly acquired small agents resulting to consolidated middlemen industry. This progress is compatible with the efforts of carriers to also consolidate in their industry and alternatively internalize the role of middlemen. Prior to these ramifications, 30% of US middlemen are composed by small agents providing risk analysis (i.e. coverage provisions) to customers and screening services for carriers. Profit targets are attained in a cyclical manner wherein they are obtained easily during hard market but difficult during soft market. This periodic value seen by carriers to agents had facilitated fee-based compensation (i.e. commissions) to arrive at reasonable profits even during soft markets as commission is a percentage of insurance sales.
However, the agency relationship of carriers and middlemen did not last long due to several reasons. The deregulation of bancassurance reduced yield on commissions which is aggravated by tighter regulation to profit margins of middlemen, rising insurance costs and introduction of new technology (i.e. internet transactions). The selling of relatively expensive insurance became difficult while internet provided efficient services to customers through direct contact with carriers. Due to these, consolidation in middlemen industry began and predation of carrier roles by large agents followed. As competition between traditional partners is gradually initiated, bancassurance had developed into two broad options. Negotiating banks can choose either middlemen or carriers for the purpose of merger.
Middlemen are traditionally focused on distribution while carriers are on underwriting insurance products/ services. In the interest of merging banks, there are several and distinct advantages of preferring the former. The combination can result to expansion of non-interest revenues (i.e. fee incomes) which is used to diversify risks on net interest rate without sacrificing profitability. Economies of scope can also be obtained wherein middlemen can increase customer base that are customarily bank-based clients, the geographical dispersion of bank branches can augment middlemen channels and bank employees can serve as agents themselves. Another, the merger can create one-stop banking to the benefit of banks. Middle-income bank clients that are traditionally not interested in insurance services can have heightened interest from the merger supported by reputation that is built by banks in previous transactions. Finally, banks can choose whether to create insurance subsidiary or simply act as agent for carriers depending on their strategy.
In the study that sampled mergers and acquisitions of US middlemen industry from 1990 to 2005, the investigation is focused on comparing abnormal stock returns from consolidation between agents, vertical integration between carriers and agents, and bancassurance between banks and agents. It is found that middlemen consolidation can provide wealth effects to shareholders. This is stronger when shareholders of banks merge to them creating bancassurance. In the contrary, vertical integration between property-casualty insurance carriers and agents did not provide significant wealth gains. This phenomenon is possible largely due to the defensive nature of such strategy against middlemen concentration and competing banks. As banks can easily internalize life-health that property-casualty services, mergers and acquisitions (M&A) of banks to agents of the latter led to larger abnormal returns than M&A to agents of the former. Also, distribution of property-casualty insurance can minimize the risks of bank revenues with non-interest fee income and aid in enhancing bank's performance indicators. Lastly, it is found that large banks entering bancassurance experienced diseconomies of scope and smaller abnormal returns compared to smaller banks. This indicated the size effect or possibility of outweighing scope economies by the scope diseconomies.
Banking-Investment Combinations or Universal Banking
In the US, regulation on bank-investment combination are intended to assure protection of the high value consulting abilities of investment banks and prevention of taking substantial risks by commercial ones. Before the Glass-Steagall Act of 2000 is launched totally banning bank-investment integration, the bank-investment service operations in the US under a more lenient Glass-Steagall version in 1970s and 1980s are forecasted for piecemeal reunification. The Act under these earlier periods is argued to have substantial flaws in which not only commercial and investment banks had exploited but also the legal profession. Although the current regulation put bold measures to eradicate these loopholes, it is useful to discuss the history of bank-investment services industry. There are two main flaws of the pre-2000 Act. With respect to commercial banks, there are no barring of underwriting instrument of Federal Government and general obligation bonds extended by states or municipalities and exemption of foreign securities.
As the primary function of commercial banks is for depository and credit, the loopholes provided attractive opportunities to them to enter investment banking albeit excessive risks to potential investment clients and more importantly depositors. However, these adversaries are partially traded-off by several benefits not only to commercial banks but also to entire economy. Using 1975-1984 data, it is found that security underwriters (16.2%) and investment banks (21.5%) have higher return on equity (ROE) than commercial banks (12.3%). The entry of commercial banks to investment banking can improve this profitability measure. In analyzing 1985 data, findings showed that high salaries and profit-sharing schemes enjoyed by employees of investment banks can be concealed if competition increases leading to compress investment banking sector. Clients can afford relatively cheaper investment service. Commercial banks can also re-use and optimize their risk evaluation skills and experience on loan grants for underwriting works. Prominent advantage in bancassurance, the network of relationship eminent in commercial banking including the domestic government and corporate clients abroad can be transferred to investing business.
Further, as experienced by absence of restriction in Europe reflected in Glass-Steagall, securities and investment markets can enjoy lower underwriting spreads fees due to increased competition. The evidence is Europe’s lower concentration ratio (i.e. market share) in its five firm Eurobond market. When such costs are reduced, the economy is in better position to prosper due to increased capital expenditure from government and corporations. Primary beneficiaries of this cost reduction are customers of merger advisory services as this business area is where the bulk of earnings of investment banks are derived (i.e. far larger than underwriting contribution) due to its unique value-added and knowledge-based features. By allowing bank-investment services, US financial industry can improve because companies will channel their funds directly in New York and not the more lenient London market. For commercial banks, the argument that entering investment services can lead to substantial risks is undermined by the fact that underwritten assets last only for days while default on loan can proceed until the due date is reached. Also, loans are more illiquid than deals in underwriting.
Lucrative prices on investment services that commercial banks can offer to their large customer base are a win-win situation to commercial banks, their clients and competition in investment banking. These are the motivation why commercial banks in the US find ways to circumnavigate the loopholes of Glass-Steagall in pre-2000 version. In contrast, risks of combination to commercial banks are hypothesized into two categories; namely, risk to conflict of interest and affiliation risk. The former is observed when combination leads to commercial banks extending credit to finance purchases of securities to support the underwriting affiliate. The latter is a condition wherein the historically-proven steady earnings of commercial banks can be adversely affected by high earnings variability from an underwriting affiliate. Commercial banks have minimal experience in trading activities that can aggravate the inherent risks.
In other studies, the differences and incompatibilities of bank-investment integration are further categorized in three hypotheses. Bank certification hypothesis states that bank-investment services executed by commercial banks reduced information costs and lead to improve financing option to clients. Conflict of interest hypothesis states that commercial banks can misuse this superior information to shift bad debts/ loans to capital markets. Finally, distribution disadvantage hypothesis states that commercial banks are new participant to investment banking that time and funding is required to construct its own distribution channels. This delay and additional expenditure can harm the interest of large clients especially in integrated services. However, commercial and investment bank mergers are unstoppable particularly in 1996 when revenues allowed to commercial banks are increased from 10% to 25%.
Before recent studies, prominence is applied to the notion that commercial banks are better underwriters than investment banks derived from the former practice to underwrite bonds with lower net yields. In contrast, such tendency is attributed to client-underwriting matching wherein both institutions have their own market base that has specific needs. A specific research is conducted on the data from non-utility and non-financial underwriting clients for the period 1991-2000 contradicted the earlier notions about superiority of commercial banks. Consistent with bank certification hypothesis, most of the clients of commercial banks are small firms. The rationale behind this inclination is that flexible future financing is enjoyed by commercial banks when offering service to low cash holding and less capital investment needs of small firms. Consistent to conflict of interest hypothesis, clients of commercial banks with high interest expense resulted in payment for higher net yield to repay bank debts. With superior better information, commercial banks can easily trashed clients to capital market than offering new loan. Consistent to distribution disadvantage hypothesis, the target of commercial banks are size with smaller issues particularly during early entry. Subsequently, clients will pay greater yields when the size of the issue increases in the long-run.
It is also found that the absence of positive net yield differential from commercial bank clients supported the non-dominance of commercial banks in terms of technology or human resource contrary to investment banks. The study found that specific market needs drive market share of each institution. The research implicated that its findings would serve as evidence for both institutions to serve different market segments in domestic environment while operating in cross-border setting can also be tapped. Their separation is also supported because they exist to provide valuable and unique services to their specified markets. As illustration, the upper-hand of commercial banks to provide loan monitoring and effective certification of bond issue is attracted to some firms. This option can intensify preference during re-certification as it is found to create positive market reaction to re-certified firms. On the other hand, investment banks can serve as safety net of firms to prevent private loans to be dumped in capital markets when commercial banks uncovered negative information in its evaluation. Without significant economies of scope from this practice (i.e. lemon-dumping behavior) of the latter institution, the dumped securities of client-firms will be heavily discounted by the market.
The amendments in Glass-Steagall Act in 2000 brought the final solution to the risks in bank-investment combinations by completely disallowing the integration of two services. In the current setting, however, investment banks are threatened by growing appeal of commercial and universal banks. For example, the spin-off of Agere Systems from Lucent Technologies which is formerly administered by Goldman Sachs (i.e. an investment bank) is transferred to J.P. Morgan Chase, Citigroup and Morgan Stanley (i.e. universal banks). The main cause of the transfer is the inability of Goldman to provide credit as additional service to investment consultancy. On the other hand, as multi-service banks, the three universal banks offered purchase of $2.6 Billion of Lucent debts as well as loan of $1.23 Billion. In this regard, it is concluded that the competitive position of investment banks relies on its ability to sacrifice as much as 30% of its ROE for the purpose of credit capabilities or merge with commercial banks outside US territory.
In dispute of this argument, there are also cases where expertise and skills outweighed credit offerings supporting the continuous market prominence of investment banks. As an illustration, J.P. Morgan Chase and UBS are focused on investment-grade and high yield debt, Citigroup only on high-yield debt issues while Deutsche Bank prioritizes investment-grade debt sector. This shows that universal and investment banks have specific market segments which supported the findings of 1991-2000 analysis of US non-utility and non-financial underwriting clients above. Further, investment banks undermine the debt capacity of commercial banks this service is the simplest investment issue. Most of their clients trust them to address more sophisticated issues such as M&A and initial public offering (IPO) deals. Universal banks also had increased its market share not because of competition but from acquisitions of value-adding banks offering services that inflamed synergies. In the case of Lucent spin-off, qualities of commercial and universal banks are preferred as the company needed interference in IPO and equity support. The linking of spin-off to new funding is triggered by economic downturn and subsequent credit requirements. Commercial and universal bank preference is argued to cease once credit crunch is ended and expertise will matter most in M&A and IPO making credit capabilities only sweetening to key competencies of investment banks.
There are also researches that found overstatements in integration of commercial and investment combinations in post-2000 Glass-Steagall Act. Unlike small firms and individual clients, large corporations do not require one-stop banking rather preferred specialization among service providers to select the best breed. Bank-investment clients are also prone to end-up as riskiest borrowers. Third, the provision of credit grants to clients simply outstrips the service fees that such combinations derive from investment banking services. The new Basel Capital Accord is also a threat to syndicated loans exploited by bank-investment combinations due to restrictions to maintain higher capital requirement for low-rated borrowers to enable matching of risks. Finally, as universal banks have larger underwriting experience than commercial ones, it is recommended that they should increase credit ability and improve underwriting skills to compete with investment banks. For commercial banks, integration to investment banking is recommended to be fully-revisited due to regulation and questionable synergy. For investment banks, it is recommended that they should not shift focus from superior authority in underwriting and advisory skills to credit capabilities because their service still holds the most lucrative areas in financial services industry.
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