1. PowerPoint Slides for Professors Spring 2010 Version PowerPoint Slides for Professors Spring 2010 Version This file as well as all other PowerPoint files for the book, “Risk Management and Insurance: Perspectives in a Global Economy” authored by Skipper and Kwon and published by Blackwell (2007), has been created solely for classes where the book is used as a text. Use or reproduction of the file for any other purposes, known or to be known, is prohibited without prior written permission by the authors. Visit the following site for updates: http://facpub.stjohns.edu/~kwonw/Blackwell.htmlhttp://facpub.stjohns.edu/~kwonw/Blackwell.html. To change the slide design/background, [View]  [Slide Master] W. Jean Kwon, Ph.D., CPCU School of Risk Management, St. John’s University 101 Murray Street New York, NY 10007, USA Phone: +1 (212) 277-5196 E-mail: Kwonw@stjohns.eduKwonw@stjohns.edu

2. Risk Management and Insurance: Perspectives in a Global Economy 25. Financial Services Integration Click Here to Add Professor and Course Information

3. Study Points  Meanings and forms of integration  The economics of integration  Management issues in integration  Public policy concerns in integration  The future of financial services integration 3

4. Meanings and Forms of Integration 4

5. Meanings of Financial Services Integration  Meaning It occurs when a financial service traditionally associated with one of the three main financial sectors is produced or distributed by companies in another financial sector. It occurs at one of three levels: (1) supplier, (2) product or (3) advice.  Various terms Bancassurance Allfinanz Universal bank Financial conglomerate – de facto or mixed  Advisory integration 5

6. Structures for Delivery  Full integration  Universal bank (German variations)  Bank (or insurer) patent  Holding company arrangement  Joint venture (or other similar arrangements) 6

7. Full Financial Services Integration (Figure 25.1) 7 Banking Activities Securities Activities Insurance Activities Other Financial Activities

8. Universal Bank – German Variant (Figure 25.2) 8 Commercial Banking Activities Investment Banking Activities Insurance Activities Securities Activities

9. Bank Ownership (Figure 25.3) 9 Commercial Banking Activities Securities Activities Other Financial Activities Insurance Activities

10. Holding Company (Figure 25.4) 10 Financial Services Holding Company Banking Activities Other Financial Activities Securities Activities Insurance Activities

11. The Economics of Integration 11

12. The Economics of Integration  Cost effects  Revenue effects  Profit efficiency 12

13. The Economics – Cost Effect Analysis  Economies of scale  Economies of scope in production resulting from Investment operations Information technology Distribution Reputation  Operational efficiencies 13

14. The Economics – Revenue Effect Analysis  Economies of scope in consumption  Market power 14

15. The Economics – Profit Efficiency Analysis  A conglomerate could incur greater costs (resulting in cost inefficiency) yet realize greater revenues (from revenue efficiency) such that net profits increased.  The reverse is also possible. 15

16. Management Issues in Integration 16

17. Issues in Integration (Figure 25.5) 17

18. Group Structure  De jure (law-based) structure  De facto (fact-based) structure  Group structure decisions also relate to whether the necessary manufacturing platforms will be acquired or created de novo. Organic growth has been more successful than growth through acquisition. Organic growth requires more time (investment). 18

19. Operational Complexity  Especially relevant when integration is accomplished via merger or acquisition  The problem of complexity seems largely to be ignored at present. “It is, to say the least, surprising that there should be such widespread and critical [sic] acceptance of this need, with no precise distinction between types of business and without meticulous analysis of the many drawbacks that these processes may involve and of the problematic nature of their purported advantages.” 19

20. Corporate Culture  Corporate cultures varying across firms/industries Challenges for management of financial conglomerates, especially those resulting from merger and acquisition.  National differences in management dedication to shareholder value – a principal-agent agency problem Focused banks Operate within a culture of shareholder value, use internationally accepted accounting principles and have a sharper focus on retail banking operations Universal banks Operate within a managerial culture, follow inferior accounting practices and believe in universal banking as a concept 20

21. Inexperience and Lack of Expertise  Pose vexing problems at the early stage of integration Particularly relevant in markets where financial services integration was unprecedented  Joint ventures and strategic alliances between domestic and experienced foreign companies may prove most appealing to both domestic and foreign entrants. 21

22. Marketing and Distribution  Distribution among the most challenging for management of integrated financial institutions Especially those groups created via merger and acquisition Insight 25.1  Channel conflict less of a management challenge for de novo operations  Marketing issues associated largely with demand-side economies of scope 22

23. Target Market Clarity  Management must be clear about the group’s target market. Management must determine The classes of products to be offered Asset accumulation Debt management and asset protection products Distribution channels  To date, most success in financial services integration has been in the retail market.  Some financial products may carry the potential of creating diseconomies of scope Nonlife insurance is perhaps the most commonly discussed product line. 23

24. Financial Management Issues  Enterprise risk management Understanding the risk profile of the group as a whole  Performance appraisal Banks historically have focused on interest spread, with return on equity of more recent importance. Life insurers increasingly use embedded value analysis. Nonlife insurers use combined and operating ratios and return on equity. 24

25. Conflict of Interest  Conflicts Salesperson’s stake Stuffing fiduciary accounts Bankruptcy risk transfer Tie-in sales Internal information transfer  Incentive conflicts can be managed through regulation or by finding a market solution  Management of reputational risk is an increasing concern. Franchise Goodwill 25

26. Public Policy Concerns 26

27. Public Policy Concerns  Financial services regulators are concerned primarily with three broad categories of market imperfections: Information problems Market power Negative externalities  Regulatory interventions Prudential Market conduct Competition policy 27 Refer to Figure 25.5

28. Public Policy Concerns – Information Problems  Six issues in prudential regulation Transparency Contagion Double and multiple gearing Unregulated group entities Fit and proper requirements Regulatory arbitrage  Issues in market conduct regulation Conflict of interest 28 “Issues in prudential regulation” discussed in pages 669-673. “Issues in market conduct regulation” discussed in page 673.

29. Information Problems – Transparency  Group transparency  Disclosure (to external parties)  Large international financial conglomerates can be particularly complex 29

30. Information Problems – Contagion  The risk Financial distress encountered by one unit in a financial conglomerate could have adverse effects on the financial stability of the group or on the entire market (i.e., negative externalities)  Two types of contagion Psychological Inter-group exposures such as: Credit extensions or lines of credit between affiliates Cross-shareholdings Intra-group trading in securities Insurance or other risk management services provided by one unit for another Intra-group guarantees and commitments 30

31. Information Problems – Gearing  Types Double gearing Multiple gearing  The issue is more on the proper assessment of a financial conglomerate’s consolidated capital That is, less on the ownership structure flowing from it 31

32. Information Problems – Unregulated Entities  Excessive leveraging An intra-group exposure An unregulated parent issues debt or other instruments not acceptable as regulatory capital in a downstream entity and downstreams the proceeds to a subsidiary firm in the form of equity or other regulatory capital May also occur when the unregulated entity is an intermediate holding company  With an unregulated holding company, an assessment of group-wide capital adequacy should encompass the effect of the holding company’s structure. 32

33. Information Problems – Fit and Proper Requirements  The probity and competence of the top management  For regional and international financial conglomerates, issues of supervisory jurisdiction arise. 33

34. Information Problems – Regulatory Arbitrage  To the extent that industry-specific regulations and taxation differ, arbitrage possibilities are created.  Arbitrage possibilities influence decisions about the structure of the group.  A move toward consolidated financial regulation suggested as a solution 34

35. Public Policy Concerns – Market Power  Market power could: Arise from size alone if barriers to entry are great Evolve through predatory pricing  The predatory pricing option seems remote, provided there are not substantial barriers to entry. 35

36. Public Policy Concerns – Negative Externalities  Systemic risk, most commonly associated with commercial banking  Are financial conglomerates riskier? A “too-big-to-fail” (TBTF) position?  Does financial service integration pose additional burdens on the safety net? Safety nets such as deposit insurance, guaranty funds, the discount window and payment system guarantees 36

37. Regulatory Structure  Single regulator? Could minimize the problems of information sharing and coordination associated with sector-specific supervision Permit a less complex approach for addressing issues discussed above Facilitate needed harmonization of accounting and capital adequacy requirements across financial intermediaries Lessen opportunities for regulatory arbitrage  Is creating a single regulator feasible in the local market? No international consensus has yet emerged on this issue. 37

38. Regulatory Structure  Consolidated regulation suitable in a market where: Similar products/services are offered by different types of intermediaries in the same market segments. Institutions in competing sectors have similar strategies for growth and development in the domestic and/or the international market. Institutions in one sector create systemic risk exposure for another industry. Competing sectors are at a similar and advanced stage of development. Institutions are combining in ways that make it difficult to distinguish a bank from an insurance firm. The financial services industry is pushing for reform to meet competitive pressures. 38

39. The Future  The present pressures for integration seem strong. The globalization of business in particular and financial services specifically fosters integration.  Financial services innovation and production efficiency are essential to economic development. How integrated financial services fit into this evolution? Whether it poses unacceptable risk to consumers and the financial system?  The market will determine whether financial conglomeration makes good business sense and, if so, the optimum operational structure. 39

40. The Future  Regulatory convergence in two dimensions Those aspects of national regulation and taxation that are specific to one financial services industry or its products can be expected to cause increasing distortion. International differences in regulation and taxation of financial institutions and products increasingly will afford opportunities for international regulatory and tax arbitrage. 40

41. Discussion Questions 41

42. Discussion Question 1  If bancassurance becomes a globally accepted method of insurance distribution, are consumers more likely to be helped or harmed? How would your answer differ if the same question were asked about a perfectly competitive market compared with an oligopolistic market? 42

43. Discussion Question 2  From a strictly marketing perspective, what role might culture play in the process of financial services integration? As the executive vice president of marketing for a global conglomerate, how might your overcome these challenges? 43

44. Discussion Question 3  Speculate about the degree to which each of the following market segments would be affected (either positively or negatively) if financial services competition were dominated by financial services conglomerates: low, middle and upper income? 44

45. Discussion Question 4  What are some of the political ramifications of financial services integration? As the financial services regulation czar for the E.U., list the three most pressing challenges you would have to overcome. How would you accomplish each? 45

46. Discussion Question 5  Choose any two public policy issues. Argue either for integration, citing potential solutions, or against integration, citing reasons why the issue cannot be overcome? 46

47. Discussion Question 6  If full integration were permitted tomorrow in your country, how would the financial landscape look 1, 10 and 25 years from now? What would be the impact on (a) the national economy and (b) consumers? 47