Motivation For Study Deregulation of financial services have set the Integration of the Financial Services stage for broad-based integration: Industry: Banking and Insurance Europe ­ EU Banking and Insurance Directives J. David Cummins United States ­ Gramm-Leach-Bliley Act INSR 812X (1999) Fall 2002 Japan ­ "Big Bang" financial reforms Copyright J.D. Cummins, 2002, for use in INSR 812X only. Not to be reproduced without permission European Union's: Third Generation Bank/Insurance Mergers Insurance Directives (1994) Citigroup formed by merger of Travelers Single EU "Passport" ­ insurer must be and Citicorp (1998): $70 billion licensed in only 1 EU country to operate anywhere in EU Allianz-Dresdner Bank (2001): $20.6 billion Home country supervision ­ insurers are regulated only by home country not host ING-Reliastar (2001): $6 billion countries Insurance market deregulated (e.g., for pricing) except for solvency regulation European Union's: 2nd Banking Coordination Directive (1993) The EU: Limits on Integration Single EU "Passport" ­ bank must be Countries still retain the ability to licensed in only 1 EU country to operate differentially tax domestic and foreign anywhere in EU insurers Home country supervision ­ banks are Legal differences impede uniform contracts regulated only by home country not host Cultural differences may impart a "home countries field advantage" Government ownership creates barriers in Harmonization of laws and regulations some sub-markets (e.g., German savings banks) US: The Gramm-Leach-Bliley (GLB) Act GLB and Financial Regulation Most significant financial services Functional regulation of FHC subsidiaries regulatory change in the past 66 years Removed the remaining walls that fragmented the financial marketplace The Federal Reserve as umbrella supervisor Permits banks, insurers, securities firms, and other financial institutions to affiliate under common ownership through Financial Holding Companies (FHCs) Expanded Powers for FHCs Functional Regulation of FHCs FHCs can engage in a broad array of financial Federal Reserve umbrella regulatory role, "4(k)" activities with limits = "Fed-lite" Commercial banking Banking activities ­ Primary bank Securities underwriting and dealing regulators (FDIC, FRB, OCC) Other investment banking activities Securities activities ­ Securities and Insurance sales and underwriting Exchange Commission Management and sale of mutual funds Insurance ­ State insurance commissioners "Complementary" activities Financial Conglomerates Organization of Financial Services and Universal Banks Specialized firms ­ focus on one functional area, Equity in Non-Financials e.g., commercial banking, investment banking, Universal Bank life and/or non-life insurance, investment advisory Commercial Bank Investment Bank Insurance Co Mutual Fund Company Investment Adviory Firm Financial conglomerates ­ produce more than one Insurance Agency financial services output, e.g., commercial Securities Agency banking, insurance, & investment advising Financial Conglomerate Universal banks ­ produce more than one Commercial Bank Investment Bank Insurance Co Mutual Fund Company Investment Adviory Firm financial output and hold equity ownership of Insurance Agency non-financial firms Securities Agency Financial Holding Company Under GLB Banking Powers in Selected Nations Non- Financial Holding Company Nation Securities Insurance financial Commercial Bank Investment Bank Insurance Co Mutual Fund Company France Yes Yes Yes Insurance Agency Securities Agency Germany Yes Yes ® Yes Why this structure? Italy Yes Yes Yes ® ­ Prevent deposit insurance from covering non- UK Yes Yes Yes banking transactions US Yes Yes No ­ Facilitate functional regulation Definition of Financial Services Integration Manufacturing Financial Services Financial services integration is any event Financial services manufacturers create products for that combines two or more financial financial markets: services organizations involved in the Bank loans and deposits manufacturing or distribution of financial Insurance policies services. Initial and seasoned public offerings Private security offerings Securitized financial products Mutual funds and other investment vehicles Functions of Financial Services Manufacturers Dimensions of Integration Underwriting securities issues National consolidation of financial and insurance policies institutions within a single product category Financial intermediation Integration of multiple categories of Risk diversification financial services into universal-type Risk management organizations Payments processing and safekeeping Consolidation of financial services across Residual risk bearing international borders Other back-office operations Why Conglomeration May Create Value Why Conglomeration May Create Value II Diversification reduces risk, decreasing the By exploiting private information on expected costs of financial distress existing bank or insurance clients Scope economies If merged entity is "too big to fail," cost of ­ Cost-reducing capital may decline ­ Revenue-increasing Hedging uncertainty about skills required for future success (Milbourn, Boot, and Thakor 1999) Coexistence: The Conglomeration and Motivation III Strategic Focus Hypotheses "One-stop shopping" and cross-selling Conglomeration Hypothesis ­ frequently used to justify M&As diversification adds value due to production and consumption complementarities Scope economies literature fi economies of Strategic Focus Hypothesis ­ scope modest or non-existent focusing on core businesses and core competencies maximizes firm value Types of Financial Services Integration Types of Financial Services Integration Scale integration, e.g., M&As among banks Manufacturer 1 Holding Company Financial Service A Scope integration Manufacturer 2 Manufacturer 1 Manufacturer 1 Financial Service A Financial Service B Service C ­ Between types of banks or types of insurers ­ Between banks and insurers Distributor Distributor Distributor Service A Service A Service B Distributor Service C Geographical integration Vertical integration of production and distribution, e.g., ­ bank acquires insurer as manufacturer of products for bank Manufacturer 3 Manufacturer 2 branches Financial Service A Financial Service B ­ bank acquires insurance agency to distribute products for bank Distributor Distributor Service A Service B Why Integration Might Be Value Objectives of Integration Maximizing Maximization of market value (objective of Integration could enable firms to: financial services firms) Improve X-efficiency Creation of efficient and innovative markets Realize scale economies for financial services (objective of policy makers) Realize scope economies Empirical Research: Types of Studies X-Efficiency: Cost Book value (BV) studies Cost efficiency (firm i) = CEi = ­ Efficiency: cost, revenue, profit Costs of an efficient firm producing yi/ Costs of firm i ­ Scale economies ­ Scope economies CEi = 1 for efficient firms Market value (MV) studies CEi < 1 for inefficient firms ­ Drivers of performance ­ Event studies E.g., if CEi = 0.8, firm i could reduce costs by 20% if it operated efficiently Components of Cost Efficiency X-Efficiency: Revenue Pure technical efficiency ­ is the firm using Revenue efficiency (firm i) = REi = the "best practice" technology? Revenue of firm i/Revenue of an efficient firm using input level of firm i Scale efficiency ­ has the firm attained constant returns to scale? REi = 1 for efficient firms RE Allocative efficiency ­ is the firm using the i < 1 for inefficient firms cost minimizing combination of inputs? E.g., if REi = 0.75, firm i could increase revenues by 33% if it operated efficiently How Might Integration Improve X- X-Efficiency: Research Results Efficiency? "The vast majority of financial firms are Remove inefficient firms from the market, inefficient. Therefore, integration has the e.g., acquirers absorb targets or improve potential to cause substantial efficiency gains." their performance Banks: Cost efficiency = 80%, Profit ­ Superior managerial expertise efficiency = 50% (typical findings) ­ Better technology Insurers: Cost efficiency 80% (US non-life), Enable acquirer to become more diversified, Cost and revenue efficiency = 40% (US life) reducing cost of capital Scale Economies in Banking Technology Change and Scale Economies U-Shaped but relatively flat cost curve, "Is changing technology creating opportunities for with average costs minimized between scale economies in financial services?" $100 million and $10 billion (Berger, 2000) Derivatives trading and financial engineering Little evidence of scale efficiency gains New delivery methods (internet banking, call centers) from integration, except for small banks Back-office operations and networking "Consistent with the continued survival of relatively small banks in most markets." Findings for the late-1990s and beyond may contradict prior work. Returns to Scale By Size Decile: US Life Insurers Returns to Scale: Spanish Life Insurers 90% 1 80% 0.9 70% 0.8 0.7 60% 0.6 50% 0.5 40% 0.4 30% 0.3 20% 0.2 10% 0.1 0 0% $25 $46 $66 $88 $114 $156 $241 $411 $613 $1,318 < 30M 30-50M 50-100M 100- 300M-1B 1-2.5B 2.5-5B 5-10B 10-15B > 15B 300M Millions of $ Increasing Constant Decreasing Increasing Constant Decreasing Research Results (BV): Universal Banks More BV Research Results Researchers Sample Results Researchers Sample Results Lang & 89-92, 757 Economies of scale and scope Saunders& 81-86, 15C, Diseconomies of scope for universal Welzel, 96 Ger Co-op present (but co-ops are small) Walter, 94 133 banks banks banks Steinherr& 85-90, 18C, Universal banks have superior risk- Lang & 92, 1490 Ger Scale econ up to Dm2-5 Billion. Huveneers,94 88 banks return trade-off Welzel, 98 banks Cost inefficiencies dominate Allen & Rai, 88-92, 15C, Large non-universal banks are least economies of scale. 96 194 banks efficient, others about the same. Little evidence of scope economies Virtually no scope economies. Sul and Oh, 88-95, 8C, Small universal banks are less X-inefficiency dominates scale and 99 371 banks profitable than non-U banks scope Note: C = countries included in study. Note: C = countries included in study. Economies of Scope Studies: Research Findings (BV): Methodological Critique Scale and Scope The above scope studies suffer from at least Vander Vennet (2000) one of the following defects: ­ Sample: 2375 EU Banks (all major countries), Inappropriate functional form 1995-1996 Imposition of same technology on ­ Topic: cost and profit efficiency, scale, and specialized and conglomerate firms scope economies Old data (pre-1994) ­ Types of banks: Specialized, conglomerate, and Limited number of outputs universal No true specialists Research Findings (MV): Findings (BV): Scale and Scope II Focusing vs. Diversifying Bank Mergers Vander Vennet (2000) DeLong (2001) ­ Universal banks more cost and profit efficient ­ Sample: 280 US mergers announced in 1988- than non-universal banks 95, where 1 partner is a publicly traded bank ­ Conglomerates more cost efficient than ­ Looks at focus vs. diversification on 2 specialists dimensions ­ Unexploited scale economies for small » Geography (G) ­ focusing or diversifying specialized banks » Activities (A) ­ focusing or diversifying ­ Scale diseconomies for the largest banks (> 100 ­ Results: Mergers with both G and A focus earn Billion ECU) +3% market value gain, other combinations neither gain nor lose value Focusing vs. Diversifying Research Findings (MV): Bank Mergers (MV) II Travelers-Citicorp Mega-Merger Why focusing mergers may create value Carow (2000a): ­ Replace inefficient with more effective managers ­ Did the Travelers-Citicorp merger result in ­ Gains in the firm's market power positive wealth effects for firms most likely to benefit from deregulation? ­ Economies of scale ­ Sample: 250 banks, 30 life insurers, 26 health ­ Reduction of over-investment, e.g., in branches or insurers, and 67 non-life insurers ATMs ­ Methodology: Event study, 1 and 2 day window around announcement date (4/6/98) ­ Results: Significant value creation for life insurers and large banks (> $10B) Travelers-Citicorp Mega-Merger: Research Findings (MV): Interpretation of Results Bank Sales of Annuities Carow (2000a): Results: Value creation for Carow (2000b): life insurers and large banks (> $10B); no ­ Research questions: Did removal of entry effect for non-life or health insurers barriers to bank sales of annuities destroy value ­ Joint sale of bank and life insurance/annuity for insurers and increase value for banks? products has potential to create value ­ Office of Comptroller of Currency (OCC) ­ Few synergies between banking and other allowed banks to sell annuities (1985, 1990), types of insurance upheld by Supreme Court (1995, 1996) ­ Large banks most likely to gain from owning life insurer rather than just selling insurance ­ Sample: 89 banks and 44 insurers, 1984-1996 Research Findings (MV): Bank Sales of Annuities II Economies of Scope: Hypotheses Carow (2000b): Conglomeration hypothesis ­ Results: ­ Cost economies from shared inputs, etc. » OCC and court rulings destroyed value for life insurers on average but had no effect on banks ­ Revenue economies from one-stop shopping » Insurers selling through brokers gain value, those selling through exclusive agents lose value Strategic Focus hypothesis ­ Rationale: ­ Agency/admin costs higher in joint production » Entry barriers permitted insurers to earn excess profits ­ Buyers care about products not vendors » Bank entry will lead to a competitive market, so banks will not gain value » Brokerage insurers have more contracting flexibility and do not have sunk costs in product distribution Conglomeration vs. Strategic Focus: Lessons from the 1980s Conglomeration May Create Value Sears ­ "Socks and American Express ­ Production complementarities: stocks" . . . spin-offs "Stuck in the checkout Joint use of inputs fi cost scope economies ­ Allstate line" . . . spin-offs ­ Value is created by joint production ­ Coldwell Banker ­ Shearson Loeb ­ Dean Witter Rhoades ­ Fireman's Fund Consumption complementarities: ­ Etc. One stop shopping fi revenue scope economies ­ Value is created by joint consumption Sources of Cost Scope Sources of Revenue Scope Economies Economies Synergies in use of shared inputs Joint consumption of financial services (one- Client data bases stop shopping): Managerial expertise Value of joint consumption Sales force ­ Reduction in consumer search costs ­ Coordination of insurance and asset portfolios Technology Firms have some control over output prices Brand name and capture some of the value-created by joint consumption Conglomeration May Create Value II Conglomeration May Destroy Value Other benefits Agency costs ­ managers may add ­ Internal capital markets may be less prone to businesses to protect human capital information asymmetries in some cases Administrative and coordination costs ­ Reduced earnings volatility permits higher higher for firms in diverse businesses leverage Value-destroying cross-subsidization across divisions may increase costs Internal capital markets may allocate capital inefficiently Strategic Focus May Create Value Empirical Puzzle Lower agency costs Long term coexistence of insurers Lower administrative and coordination following a focused product strategy and costs insurers following a conglomeration Lower information asymmetries across strategy divisions Managers focus on enhancing product and service quality rather than coordinating unrelated activities Measuring Cost Scope Economies Revenue Economies of Scope Cost scope economies ­ joint production costs Revenue scope economies ­ joint production yields less than specialized production: higher revenues than specialized production: C( 1y, ; 0 ) w + C(y2, ; 0 ) w -C( 1y, y2; ) S R( 1y, y2; ) w - R( 1y ; 0 , ) w - R( , 0 y2; ) w c ( y) w = C( SR(y)= 1 y , y2; ) w R( 1y, y2; ) w Sc(y) > 0 fi cost scope economies C = w'x(y,w) = C(y,w) = indirect cost function SR(y) > 0 fi revenue scope economies R = p(y,w)'y = R(y,w) x = x(y,w) = optimal input vector = non-standard indirect revenue function p = p(y,w) = optimal output price vector Profit Economies of Scope New Scope Economy Concepts Profit scope economies ­ joint production yields C higher profits than specialized production: S1 = CS1(y1, w1) = cost funct. for y1 specialists CS2 = CS2(y2, w2) = cost funct. for y2 specialists ( 1y, y2; ) w - ( 1y ; 0 , ) w - ( , 0 y2; ) S (y) w = C ( J1 = CJ1(y1, y2, w1, w2) 1 y , y2; ) w = y1 cost funct. for firms producing y1 and y2 SP(y) > 0 fi profit scope economies C P = p(y,w)'y - w'x(y,w) = R(y,w) - C(y,w) J2 = CJ2(y1, y2, w1, w2) = non-standard profit function = y2 cost funct. for firms producing y1 and y2 p = p(y,w) = optimal output price vector Modified Composite Function Summary Statistics I: Averages C Diversified Specialists = [ T n n n n m 1 - Life & P-LCosts $779,846 *** $60,710 1 D + q + q q + q r t t i i 2 ij i j ik i k ] Life & P-L Revenues $899,560 *** $73,048 t 1 = i 1 = i 1 = j 1 = i 1 = k 1 Kw = Life & P-L Profits $119,714 *** $12,338 m Life Cost X-efficiency 33.7% *** 56.7% P-L Cost X-efficiency 50.5% *** 75.9% *exp(m 1- m 1 - m 1 - 1 r + Life Revenue X-efficiency 24.5% *** 39.5% l r r k k 2 k k l ) P-L Revenue X-efficiency 54.7% 54.6% k 1 = k 1 = l 1 = Life Profit X-efficiency 18.2% 26.4% P-L Profit X-efficiency 27.5% *** 27.1% Life Personal Insurance $86,040 *** $13,087 C = costs, K = equity capital, Life Commercial Insurance $314,076 *** $28,495 P-L Personal Insurance $405,205 *** $9,226 P-L Commercial Insurance $348,713 *** $18,535 r Life Assets $4,102,469 *** $622,996 i = ln(wi/wm), qi = yi/K, and P-L Assets $2,121,817 *** $117,516 D Life Reserves $3,588,017 *** $555,369 P-L Reserves $1,717,221 *** $85,271 t = year t dummy variable Life Equity Capital $382,952 *** $49,433 ***Significant at 1%, **Significant at 5%, *Significant at 10%. Scope Economies: Averages Summary Statistics II: Averages Using Preferred Method Diversified Specialists P-L Equity Capital $610,847 *** $37,799 Life Specialist -- 51.1% P-L Specialist -- 48.9% Cost Scope Economies Revenue Scope Economies Profit Scope Economies Life Agent Dummy 73.0% *** 35.3% Q1 Median Q3 Q1 Median Q3 Q1 Median Q3 Life Direct Dummy 10.8% ** 3.8% Life Mass Marketing 1.8% 0.9% 66.6% *** 24.8% *** 8.8% ** -50.9% *** -19.5% *** -2.0% -9.6% 3.6% 34.9% *** P-L Vertical Int Dummy 37.5% *** 11.2% P-L Personal Output % 33.1% *** 18.8% P-L Commercial Output % 35.2% * 30.0% *** = significant at the 1% level, ** = significant at the 5% level, * = significant at the 10% level. Life Personal Output % 10.2% *** 27.3% Life Commercial Output % 21.5% 23.8% Life Return on Equity (ROE) 10.2% 10.2% P-L Return on Equity (ROE) 7.9% 9.9% Equity/Assets 25.7% 27.8% Life & P-L Profit Std Dev $0.06 ** $0.07 P-L Stock Dummy 56.8% *** 25.4% Life Stock Dummy 91.9% *** 34.2% ***Significant at 1%, **Significant at 5%, *Significant at 10%. Conclusions I Conclusions II Important to focus on profit scope Insurers on average have: Cost and revenue scope economies provide ­ Cost economies supplementary information ­ Revenue diseconomies Methodology matters ­ traditional method ­ Profit economies for larger firms can give misleading results Conclusions III Conclusions III: A The conglomeration hypothesis is valid for Conglomeration hypothesis valid for: some types of firms and the strategic focus ­ Large insurers hypothesis is valid for other types of firms ­ Insurers with vertically integration distribution systems ­ Insurers emphasizing personal lines ­ Insurers that are more profit X-efficient Foreign Ownership and Efficiency: Conclusions III: B Evidence from EU Insurance Market Strategic focus hypothesis valid for: Following deregulation, foreign insurers have ­ Smaller insurers increased their market share in most EU ­ Insurers using non-vertically integrated nations ­ primarily through subsidiaries distribution systems licensed in the host country. ­ Insurers emphasizing commercial lines Hypothesis: Foreign owned insurers will be ­ Insurers that are less profit X-efficient less efficient than domestically owned insurers in the EU. Rationale for Hypothesis Methodology Possible sources of higher costs for foreign subs: Collect data on market shares by country Domestic firms are more experienced in dealing Estimate cost efficiency for domestic and with the remaining local regulations foreign Cultural and language difficulties ­ Non-life insurers Agency costs are an increasing function of ­ Life insurers distance from the head office: ­ Controlling and monitoring managers more difficult from a distance Insurance Market Penetration by Efficiency of Domestic and Foreign Foreign Firms: Main EU Nations Non-Life Insurers: Main EU Nations Italy Italy Great Britain Great Britain* France France Spain Spain* Germany Germany* 0% 5% 10% 15% 20% 25% 30% 0% 10% 20% 30% 40% 50% 60% Non-life Life Domestic Foreign *by country name indicates statistical significance between domestic and foreign efficiency scores. Efficiency of Domestic and Foreign Life Insurers: Main EU Nations Bank Sales of Annuities: United States Italy 40% 35% Great Britain* 30% 25% France Total 20% Individual 15% Spain* 10% Germany* 5% 0% 0% 10% 20% 30% 40% 50% 60% 1995 1996 1997 1998 1999 2000 Domestic Foreign *by country name indicates statistical significance between domestic and foreign efficiency scores. Bank Sales of Mutual Funds and European Insurance Market Penetration: Annuities: United States Banks and Insurers 250 200 180 UC 200 160 f E 140 ns 150 120 ons o Bank illi 100 illio Insurer 100 80 s: B $ B 60 ium 50 40 Prem 20 0 0 1995 1996 1997 1998 1999 2000 Italy France Germany EQ Funds Debt Funds Other Funds Annuities Italian Insurance Firms: French Insurance Firms: Specialized vs. Diversified Specialized vs. Diversified 300 900 800 250 700 U U C 200 C 600 f E Bank f E 500 Bank 150 ns o Insurer ns o 400 Insurer 100 300 illio illio B B 200 50 100 0 0 Non-life Life Specialist Diversified Non-life Life Specialist Diversified Specialist Specialist German Insurance Firms: Return on Equity: Insurer and Bank Specialized vs. Diversified Owned Insurance Companies 900 18% 800 16% 700 U 14% C 600 12% f E 500 Bank ity (%) 10% Insurance ns o 400 Insurer Eu 8% Bank 300 illioB rn on 200 6% etu 100 4% R 0 2% Non-life Life Specialist Diversified 0% Specialist Germany France Italy Acquisition Expense Ratios: Insurer and Management Expense Ratios: Insurer Bank-Owned Insurance Companies and Bank-Owned Insurance Companies 25% 14% 12% 20% ) ) 10% 15% 8% atio (% atio (% Insurance Insurance e R e R 6% 10% Bank ns Bank ns xpe 4% xpe E 5% E 2% 0% 0% Germany France Italy Germany France Italy Total Expense Ratios: Insurer and Bank Owned Insurance Companies Conclusions: Banks in Insurance 30% Bank penetration of US annuity market is 25% significant and growing ) 20% Bank owned insurers' share of premium atio (% 15% Insurance revenues: e Rns Bank 10% ­ 60% in Italy xpeE 5% ­ 40% in France 0% ­ 20% in Germany Germany France Italy Conclusions II: Banks in Focusing vs. Diversifying Insurance Bank Mergers (MV) III Diversified insurers dominate specialists in Why diversifying mergers may destroy value France, Germany, and Italy ­ Where capital markets are efficient, investors are indifferent between receiving income from the combined Insurer-owned insurers have higher expense entity or from the individual firms ratios than bank-owned insurers in France and Italy Why diversifying mergers may create value ­ Reduce expected costs of financial distress by reducing Insurer-owned insurers have higher ROE sigma risk than bank-owned insurers in France and ­ Where internal capital markets are more efficient than Italy but not in Germany external capital markets (e.g., high information asymmetries between managers and investors) Focusing vs. Diversifying III Why diversification may create value ­ Managerial economies of scale ­ Economies of scope in production and marketing ­ Financial synergies such as earnings smoothing and efficiencies from internal capital market Why diversification may destroy value ­ Failing projects are cross-subsidized ­ Agency problems ­ managers with too much free cash flow take on low or negative NPV projects