Integration and Globalization

Competition (both domestic and foreign), new technology,

deregulation…all about breaking down walls

Major themes

• Financial service providers– commercial banks– investment banks– insurance companies– other financial intermediaries

• Integration of financial services

Major themes

• Financial services consolidation and globalization

• Conglomerates– bancassurance– universal banks

• Globalization of financial services

Driving forces

• Demand pull– changing buyers– changes in awareness

• Supply push– distributional efficiencies– economies of scale and scope

• Political forces– diminishing role of government

Regulation and public policy

• Regulation of financial institutions– Europe– Asia– North America

• Public policy issues

Financial Intermediation: A functional view

• financial functions are more stable than financial institutions - that is, functions change less over time and vary less across geopolitical boundaries

• competition will cause the changes in institutional structure to evolve toward greater efficiency in the performance of the financial system

Financial Intermediation: A functional view

• How to design “new” financial systems?– Eastern Europe– Deregulated financial systems such as Korea– De-re-regulated systems such as India or

Mexico (more about that later)

• Functional perspective gives better answers on how to design new systems

What does a financial intermediary do?

• The primary function of any financial system is to facilitate the allocation and deployment of economic resources, both spatially and temporally, in an uncertain environment

• How?

• By getting buyers and sellers together who are dispersed due to information barrier

Six core functions of a financial system

• Function 1: A financial system provides a payments system for the exchange of goods and services.

• Function 2: A financial system provides a mechanism for the pooling of funds to undertake large-scale indivisible enterprise.

Six core functions of a financial system

• Function 3: A financial system provides a way to transfer economic resources through time and across geographic regions and industries.

• Function 4: A financial system provides a way to manage uncertainty and control risk.

Six core functions of a financial system

• Function 5: A financial system provides price information that helps coordinate decentralized decision-making in various sectors of the economy.

• Function 6: A financial system provides a way to deal with the asymmetric-information and incentive problems when one party to a financial transaction has information that the other party does not.

Financial Intermediaries: Dynamics of institutional change

• Ways of managing risks has changed: round the clock trading, financial futures, junk bonds, ATM, LBO etc.

• Changes are due to advances in technology, understanding of theory which have led to reduction in cost of transactions

• Reduction in transactions costs lead to greater volume of trade in financial markets

Changes...

• “Commodization” leading “opaque institutions” to “transparent institutions”

• banks to money market mutual funds

• financial futures on equities indices instead of market wide index funds

• “junk” bond method of financing

• US: national mortgage market rather than savings institutions

Changes...

• Securitization removes assets from financial intermediaries balance sheets by packaging in convenient form and selling the packaged securities in the financial markets

• Process is common in mortgage, auto loan, credit card, leases on consumer durable

• Process “unbundles” financial intermediaries

What do financial intermediaries do?

• Financial intermediaries bring users of funds and suppliers of funds together

• Traditional portfolio intermediation

• Expenses are covered by the spread

• Competition squeezes spread, institutions respond by cutting expenses to maintain profit levels or expand in areas where they did not operate before

Banks

• Commercial banks take in short term deposits and make personal/commercial loans

• Japan has most of the largest commercial banks

• Investment banks bring together issuers of securities (stocks and bonds) with the investors (here US dominates)

And others...

• Other intermediaries– insurance companies: “borrows” short and

“lends” long– mortgage banks: mortgage funding and

repackaging them– mutual funds: gather small investors to invest

in stocks, bonds and other securities

What is happening...

• Financial integration: Products move from one class of financial institution to another

• Financial service convergence: one sector provides instruments usually associated with another sector

• Example: securities linked life insurance products

Service consolidation and conglomeration

• Many countries have no restriction of bank holding insurance companies or vice versa (France, UK, Germany)

• Some have very strict rules (for example, US and Japan)

• Consolidation leads to new public policy issues and regulatory issues

Bancassurance or allfinanz

• Alliance between banks and insurers for the sale of insurance through banks

• But, insurer is responsible for “manufacturing”

• Banks are used as the distribution channel

• In principle, bancassurance means both way traffic but in reality it is mostly one way

Universal banks

• Fully integrated: bank, securities, insurance and other

• Germany: insurance, mortgage, other (by a banking and securities company)

• UK: securities and insurance (by a bank)

• US: banking, securities, insurance (by a holding company)

Bancassurance

• France is the leader

• Credit Agricole launched it’s own life insurance company in 1986 (Predica)

• It has sold insurance through branches since 1970, so not surprising

• 18 months later Predica became the #2 life insurance company in France!

Examples

• In 1994, 63% of new life policies sold through banking channel

• Other countries: Spain, Italy, the Netherlands, Belgium, Germany, UK

• Is that a threat to insurance companies?

• If it is a simple selling of insurance by banks, the answer is yes

• But, there are many other possibilities

Examples

• The most spectacular example of bancassurance is in the merger of two large companies to create a powerful new financial services entity such as ING of the Netherlands. Formed in 1990 by a merger of the country's largest insurance company, Nationale-Nederlanden NV, and the third-largest banking group, NMB Postbank, ING has become a remarkable success story.

Examples

– The company has experienced considerable success distributing insurance products through its bank branches. On the life insurance front, about 8% of ING's total new domestic business comes from sales through the 400 branches of its Internationale Nederlanden Bank subsidiary, corresponding to the former NMB Bank network. A further 2% comes from sales through the Postbank network that serves four million households through 2,100 post offices

Lessons in bancassurance

• 1. Target the right customer.

• 2. Maximize distribution possibilities.

• 3. Integrate insurance products into the bank culture.

• 4. Sell the right products.

• 5. Use a knowledgeable sales representative.

How to target the right customer

• Banks are not waiting for people to walk into their branch offices for insurance

• They target people who are taking out mortgage loan, auto loan, etc.

• The also have a database of people with their income, net worth and other information

• Direct marketing and telesales

Integrate insurance products into the bank culture

• Two advantages

• First, bank-named products capture the trust of the bank customer who has come to have confidence in his or her bank.

• Second, bank brand names encourage staff, who are critical to the referral process, to make those referrals (they may be reluctant to do so for “outside” products)

Selling the right product

• The most successful products for bancassurers have been life insurance products of a sort, mostly savings investment-type products. In France, banks offer a product called bon de capitalisation, a tax-advantaged deposit account with a life insurance element to it. In other countries the life insurance products are similar.

In other markets…

– In markets such as the United Kingdom and Holland, banks have developed hybrid bank products to supplement mortgages. A home buyer can buy a home through a loan at the bank and pay only the interest during the life of the loan--essentially a balloon mortgage. Meanwhile, the borrower takes out a cash-value life policy that is sufficient to cover the price of the home plus a little extra. At the end of the policy's term or in the event of death the loan is paid off.

Use a knowledgeable sales representative

• The sale of life/pension products generally requires skills that generalist (bank) branch personnel don't have. – The traditional agent uses a one-on-one approach. – Banks are utilizing branches, ATMs, direct mail,

telephone and many other resources. – The successful bank agent will have to rethink

what they do against bank customer profiles and be flexible in terms of customer approach.

Emerging structures

• 1. Banking bringing in independent brokers to distributed through branches.

• 2. Joint ventures between banks and insurers.

• 3. Banks starting up their own insurance operations.

• 4. Banks buying up insurance companies and distributing their products through the bank.

Meanwhile in Mexico...

– The consequences for insurers that fail to pursue bank distribution channels are illustrated by insurers' results for 1994 in Mexico, where premium growth among medium-sized and small insurers helped the Mexican insurance market grow 14.7% over the prior year. The largest growth came from small insurers (premiums of less than 132 million pesos) with 24.4% growth and medium-size (premiums of less than 800 million pesos) with 20.2%.

Meanwhile in Mexico...

• Aetna, the Hartford insurer announced in 1996 an agreement to form a bancassurance joint venture with Grupo Financiero Bancomer

• Aetna expects to pay $ 115 million for a 49 percent stake in the venture, which will sell life and property insurance through Bancomer's 848 retail bank branches.

Meanwhile in Mexico...

• Before 1982, banks were private

• But, they did traditional banking

• In 1982, 58 banks were nationalized

• 18 survived and sold in 1991-2

• They emerged as financial groups rather than as traditional banks

US market

• Fragmentation exists within the insurance and banking industries. On one side, insurers are encumbered by an "average acquisition expense estimated at 175 to 200 percent of each dollar of new life premium."

• Therefore, many insurers are quietly forging relationships with banks as well as other distribution channels to increase efficiencies

Position of intermediaries

• Insurance intermediaries (agents and brokers) concerned about consumer protection issues specifically cite the following problems associated with bank involvement: (1) safety and soundness (contagion), (2) unfair competition, (3) coercion (tie-in sales), and (4) service quality.

Contagion

• Intermediaries argue that banks will not be fiscally sound due to the risk of contagion (a dominolike effect wherein one unit of a business brings down the entire parent), which could cause adverse micro- and macroeconomic repercussions. This risk presumes the bank is both the manufacturer and distributor of the insurance products

Unfair competition

• Intermediaries argue that banks represent unfair competition.

• Global evidence reveals that bank entry into insurance distribution stimulates free market competition.

• In Europe, bank-based insurance thrives by selling simple, commodity-like insurance policies to branch customers

Coercion

• Intermediaries argue that banks will coerce customers into purchasing insurance products. Although such a threat certainly exists, the infrequency of reported incidents in current bank/insurance activities does not indicate a widespread problem– German insurance supervisory authorities

prohibits the linkage of insurance contracts and loans if the face amount exceeds the total loan

Quality of service

• Intermediaries argue that banks will not be able to deliver a high quality of service or advice. In light of recent U.S. bank mutual fund problems, this is a valid concern. Successful European bancassurers use trained bank-based insurance advisers to sell standardized products and to service existing customers.

Position of banks

• Conversely, banks contend their admittance to the insurance playing field would have positive effects such as

• competition (choice),

• convenience (access), and

• efficiencies (enhancing contract value).

Competition

• Banks contend that their insurance services will have a positive effect on competition. – Banks have enjoyed immediate success as

distributors of insurance in Europe. Credit card operations, branch systems, and specialized financial services (e.g., trust, employee benefits, and personal/commercial loan operations) have potential efficiencies of scale and scope unmatched by traditional distribution alternatives.

Examples

• These competitive efficiencies have been credited with reducing term life insurance premiums by 14 percent in Australia from 1990 to 1994 and 8 percent in New Zealand from 1989 to 1993. Additionally, a 1994 Canadian survey ascertained that a Quebec consumer could enjoy up to a 35 percent insurance discount purchasing through the caisses populaires

Convenience

• Banks contend their entrance would increase both customer convenience and access to insurance services. The issue of convenience is of special importance being that most customers prefer "one-stop” shopping. Access to the financial services marketplace is already available to the lowest income levels of society through local bank branches

Efficiency

• Banks argue that their entrance would increase efficiencies and thereby enhance product value. European bancassurance results prove this to be true– Banks rely on cross-selling ratios between 10 to

15 percent to enhance profitability within their "core banking services.” Banks have higher productivity than do traditional distribution channels-a more efficient lead generation system

Forces driving financial services integration and globalization

• Demand forces– changing buyer behavior– more consumer awareness– reduction in employer provision of security

• Supply forces– Other competition (bancassurance)– Economy of scale (larger-cheaper)– Economy of scope (one product-another)

Government and political forces

• Governments are shrinking– their role as provider of various services is

getting smaller

• Liberalization

• Globalization

Globalization: why?

• Rapid advances in telecommunications and information technology are expanding the boundaries of tradability in services-the fastest-growing component of both trade and foreign direct investment. – For developing countries, promising new avenues for

exports are opening, especially in relatively labor-intensive long-distance services - data processing, software programming, clerical and professional services

Unbundling of services

• Progress in IT is making it possible to unbundle the production and consumption of information-intensive service activities. – Research and development (R&D), computing,

inventory management, quality control, accounting, personnel, secretarial, marketing, advertising, distribution, and legal services

• Nontradeable goods are becoming tradeable