Financial services industry ; Bank supervision

Cara S. Lown

English

Research Papers in Economics

FRBNY Economic Policy Review / October 2000 7
How do economists view the synergies between the banking, 
securities, and insurance industries? This timely topic was 
examined by three papers; comments by an industry analyst 
followed.
Overall, the presenters predicted further consolidation in 
the financial industry, each emphasizing different aspects of 
the benefits. Anthony Santomero and David Eckles argued in 
their paper that consolidation will benefit firms through 
revenue enhancement, rather than through cost reduction. The 
study by Cara Lown, Carol Osler, Philip Strahan, and Amir Sufi 
emphasized that banks merging with life insurance firms are 
likely to provide the biggest gains in terms of reduced bank risk. 
Lown et al. offered additional perspective by discussing the 
evolving “bancassurance” industry in Europe, while the paper 
by Randall Kroszner predicted that subsequent regulatory 
changes are likely to occur. Furthermore, Santomero and 
Eckles noted that arguments can be made both for and against 
the increased stability of the resulting financial system, and 
although systemic risk is an appropriate concern, enforcement 
of regulation, competition, and open markets can keep these 
issues at bay. 
However, in his comments on the papers, Christopher 
Mahoney observed that with the likely emergence of large 
financial conglomerates, a policy of “too big to fail” may be an 
appropriate reaction to financial distress, despite growing 
political pressure to do otherwise.
Santomero and Eckles
Anthony Santomero and David Eckles discussed what is
likely to happen in the financial sector in light of the recent 
regulatory and environmental changes that have occurred. The 
presenters began by discussing the impact that these changes 
would have on the operating scale of financial firms. They then 
reviewed five issues relating to firm size, beginning with 
operating costs. The existing literature, they observed, indicates 
that larger institutions may be more efficient in terms of 
average operating costs. Expenses may also be reduced if an 
institution can offer several products at a lower cost than 
separate competing institutions. Yet in reality there seems to be 
little cost improvement resulting from these economies of scale 
and scope. Santomero and Eckles argued that aggregating over 
many businesses adds a layer of complexity, with the result 
being that the overall cost structure does not seem to improve 
very much.
The second issue they addressed was revenue enhancement. 
Rather than cost savings, the driver behind mergers is the 
potential for additional revenue. To the extent that firms can 
cross-sell multiple products and that customers are willing to 
take additional products through the same channel, benefits 
associated with revenue can result. Santomero and Eckles’ 
third issue with respect to firm size is that, for some businesses, 
size is necessary to be competitive. Because the nonfinancial 
The views summarized are those of the presenters and do not necessarily 
reflect the position of the Federal Reserve Bank of New York or the Federal 
Reserve System.
Summary of Session 1 
Presentations
Cara S. Lown, a research officer at the Federal Reserve Bank of New York, 
prepared this summary.8 Banking and Securities and Insurance
industrial sector is consolidating, the scale of the business of 
finance is growing. Hence, by increasing its size, a financial 
organization can conduct an entire transaction on its own—
something it otherwise could not have done. In other words, 
size itself has some positive attributes in the financial industry. 
The last two issues concerned whether or not larger firms 
are inherently more stable. On the one hand, a greater number 
of businesses should, according to the law of large numbers, 
imply greater stability. On the other hand, the businesses 
typically are highly correlated, which can mitigate this law. 
Moreover, when there are a lot of businesses, something is 
likely to go wrong all the time. To the extent that this 
phenomenon occurs, a firm’s value could be more unstable, 
rather than more stable. 
Weighing all of these issues, Santomero and Eckles 
concluded that, on balance, the universal bank is favored. They 
followed with a discussion of how firms are likely to expand. If 
a firm is going to expand a product line, it is more likely to do 
so de novo. If a firm is making a leap, it is more likely to do so 
through an acquisition. A relevant issue, however, is how much 
it costs to enter a business. The presenters observed that as long 
as barriers to entry exist, firms will expand through acquisition 
because it is easier to buy infrastructure than to build it. 
Furthermore, firms will tend to acquire small firms, or to 
extend their own businesses, if they are expanding into a 
market close to their own. But as long as a firm needs a brand 
name to achieve market penetration, it will try to purchase the 
name through acquisition. 
Santomero and Eckles also noted that alliances constitute a 
middle ground. However, they emphasized that what we have 
seen in the industrial sector, and to a large extent in the banking 
sector, is that alliances are a lot of trouble and usually dissolve 
because of governance problems. They also said that the 
resulting structure is not likely to be a single firm type, but 
rather a mix of specialized firms and universal firms. 
A discussion of public policy implications concluded the 
presentation. Regulators are concerned about systemic risk, 
which Santomero and Eckles viewed as an appropriate 
concern: large organizations must be overseen. They also 
contended that there is some truth to the idea that large 
organizations might gain an advantage by having the 
government safety net extended to them. Enforcement of 
regulation, though, should keep these issues in check. In 
addition, the impact of consolidation on the concentration of 
power in their opinion is an issue but, as long as we have 
competition and open markets, it is not a big one. Finally, 
they noted that some people are apprehensive about 
predatory pricing and practices. However, they added that 
many of these practices are illegal, should be the subject of 
enforcement, and are not unique to the new environment. 
The remainder relates to the synergies that could take place in 
these larger firms. According to Santomero and Eckles, 
however, as long as there is sufficient competition to impose 
market discipline, such synergies can create many 
opportunities for consumers. 
Kroszner
Randall Kroszner introduced his paper by noting that his focus 
is on positive analysis—describing what he sees concerning 
how politics and banking work—and makes no judgments. He 
then discussed five theories of regulatory change in order to 
explain why so much of this change has occurred in the 
financial services industries in recent years. 
The first approach to regulatory change—the traditional, or 
public interest, view—represents the idea that government’s 
role is to correct market failures. For example, deposit 
insurance protects small depositors as well as the stability of the 
banking system. A challenge to this view, however, is that many 
regulations are difficult to rationalize on public interest 
grounds. The second approach is the private interest theory of 
regulation. What characterizes this regulatory process is
interest group competition, wherein well-organized groups 
capture rents at the expense of less organized groups. The 
success of the well-organized lobby of small banks is an 
example that has been effective in the discussions of both 
geographic and product expansion. 
The “ideology” of voters and politicians is an alternative 
approach that some researchers have offered to explain the 
widespread economic deregulation that has taken place during 
the past two decades. However, what constitutes ideology—the 
third approach to regulatory change—and whether it can be 
measured independent of economic interests is the subject of 
ongoing controversy. The fourth approach, referred to as the 
institutional approach, concerns how alternative policymaking 
structures influence the incentives of both special interest 
groups and politicians in shaping policy. Kroszner cited the 
structure of the regulatory institutions in the savings and loan 
industry as an example. The structure was seen as being 
vulnerable to industry “capture” and ultimately was 
eliminated. Kroszner also pointed to the interaction between 
congressional committees and interest groups. Finally, the idea 
behind the fifth approach, which he identified as the leviathan 
approach, is that the objective of government is to increase its 
size. An example of this approach is the competition among 
regulators over which agency would be the main supervisor of 
banks with expanded powers.FRBNY Economic Policy Review / October 2000 9
Kroszner observed that, taken together, these five 
explanations for regulatory change suggest that one look to 
technological, legal, and/or economic shocks to understand 
why there has been so much recent regulatory reform in the 
banking industry. He argued that such shocks have in fact 
occurred over the past two decades, and they have served to 
alter the relative strengths and effectiveness of competing 
interest groups.
Kroszner offered examples of these shocks. Technological 
developments such as automated teller machines and cash 
management accounts, for instance, introduced more 
competition, and more options for depositors, while 
Regulation Q and Glass-Steagall left banks unable to respond. 
On the lending side, credit-scoring techniques and better 
information processing began to change the relationship 
character of bank lending. As a result, he noted, alternatives to 
traditional lending have developed and large banks have 
entered the territory of small ones. Moreover, legal shocks such 
as court decisions have eroded the insurance industry’s long-
standing opposition to the expansion of bank powers, while the 
high costs of the savings and loan crises and the bank failures 
of the late 1980s have heightened support for eliminating 
antiquated regulations and strengthening the financial system. 
Kroszner ended by predicting that we will see pressure for 
additional regulatory changes, such as in the supervision of 
insurance at the state level. He added that academic analysis 
can play a role in the debates over these changes by offering 
well-grounded and well-supported arguments. 
Lown et al.
The likely evolution of the financial services industry following 
the passage of the Gramm-Leach-Bliley (GLB) Act was 
considered by Cara Lown, Carol Osler, Philip Strahan, and 
Amir Sufi. They began by reviewing the recent consolidation 
trend in the banking industry, noting that from 1989 to 1999 
the share of total assets held by the eight largest banking 
organizations rose significantly while the share of assets held by 
small organizations fell. Excess capacity in the industry, the 
existence of economies of scale resulting from technological 
developments, and deregulation all contributed to this trend. 
With the passage of GLB, these same factors could fuel 
consolidation across the financial services industries.
Turning to the likely consequences of GLB, the presenters 
described how financial firms’ stock prices reacted when the 
compromise legislation was announced. Large excess returns 
recorded by firms with strong merger and acquisition records 
in the financial sector suggested expectations of future 
consolidation within the sector. Shareholders also appeared to 
favor life insurance companies and bank holding companies 
(BHCs) that had expanded into securities underwriting prior 
to the law’s passage. Lown et al. then discussed whether any 
diversification benefits from combining BHCs with insurance 
and securities firms were significant enough to lower the risk 
of the merged firms. This issue is important because 
diversification would allow these firms to operate with less 
capital or to expand into somewhat riskier and more profitable 
activities. Furthermore, previous studies have not found such 
benefits, and hence they have recommended against allowing 
banks to expand into these other industries.
Using data from large financial firms during the 1990s, 
Lown and her coauthors constructed pro-forma mergers for 
BHCs with life insurance, securities, and property and casualty 
firms, and then calculated risk measures for the resulting firms. 
The presenters, acknowledging the limitations of such a study, 
found that there were clear diversification benefits achieved 
from combining BHCs with life insurance firms. Combining 
BHCs with either securities firms or property and casualty 
firms raised the riskiness of the resulting firm only modestly 
relative to that of the BHC.
Lown et al. also looked at how the financial services industry 
has evolved in Europe, where banking, securities, and 
insurance activities have coexisted in various forms for some 
time. More cross-industry mergers have occurred in Europe 
than in the United States, they observed. Banks and life 
insurance firms merged most frequently, while unions between 
banks and securities firms also were common. In contrast, 
mergers between banks and property and casualty firms almost 
never took place. In an examination of why European banks 
have expanded into life insurance, the presenters indicated that 
banks appeared to have several cost advantages over traditional 
life insurance firms. The main ones are economies of scope, for 
example, using the bank branch system and leveraging existing 
resources in such areas as administration. The European banks 
also have been successful in penetrating the life insurance 
market. Their share of sales averaged more than 20 percent, 
and the banks have actually transformed part of the life 
insurance business by developing products and procedures 
tailored to client needs.
In conclusion, Lown et al. suggested that the three parts of 
their study—the stock price reaction, the diversification 
analysis, and the European model—all point to further 
consolidation in the financial services industry. Moreover, the 
expansion of banks into life insurance seems particularly likely. 10 Banking and Securities and Insurance
Commentary by Mahoney
Offering his comments on the three papers, Christopher 
Mahoney said that he generally agreed with Santomero and 
Eckles’ conclusions, but he was skeptical about synergies and 
cross-sales. He viewed cross-industry mergers as more difficult 
to effect than intraindustry ones, in part because of cultural 
conflicts, but also because there are fewer opportunities for cost 
savings in cross-industry mergers. Furthermore, although the 
acquisition route has its risks, Mahoney saw de novo expansion 
as equally challenging. It is difficult to obtain market share 
through such expansion, he argued, yet franchise value is 
limited without it. Mahoney also agreed with Santomero and 
Eckles’ point that there are risk-reduction benefits to greater 
diversification and that, ceteris paribus, larger and more 
diversified firms are more creditworthy. 
Turning to Kroszner’s paper, Mahoney agreed with the 
conclusion that the enactment of Gramm-Leach-Bliley was the 
result of a rare alignment of interests. GLB was successfully 
enacted only after years of technological change, innovation, 
and economic shocks had fully undermined the Depression-
era structure of the financial services industry and shifted the 
balance of competing interests. The question we now face is, 
what will the financial services structure look like in the 
future?—a question also addressed by Lown et al. Mahoney 
noted that this last paper provided an interesting analysis of 
diversification and the risk-return trade-off in financial 
services. The study predicted that bancassurance combinations 
were the most likely ones following GLB, although other cross-
industry mergers would increase bank risk only modestly. 
However, Mahoney was less optimistic than the authors were 
when it came to mergers between banks and life insurance 
firms. He observed that the cultural challenges of such mergers 
could lead to combined companies that were less profitable 
than the separate entities. He also noted that life insurance is 
less profitable today than banking, a factor that might explain 
the lack of announcements of bank-insurance mergers since 
GLB was enacted.
Mahoney devoted the balance of his remarks to the 
implications of GLB for the safety net and for systemic stability, 
an issue that Santomero and Eckles also examined. He 
indicated that our segmented financial system structure, put in 
place in the 1930s, has worked remarkably well in maintaining 
financial stability over the past sixty-five years. Nevertheless, it 
was inevitable that market forces would attempt to erode the 
barriers, as technological and financial innovations have made 
the separations seem anachronistic. And although Mahoney 
believed that benefits will be derived from entering a new 
financial world, he also thought that we risk greater financial 
instability. In his view, the political costs of rescuing a financial 
firm have risen. This rise has occurred because of an increasing 
discomfort with the moral hazard created by the existence of 
the regulatory safety net, coupled with the erosion of barriers 
between the banking sector and the rest of the financial services 
industry. But he also urged us to remember a key lesson of the 
Great Depression: financial instability is a lot worse than 
inefficiency and moral hazard. 
Mahoney noted that official policy today states that no bank 
is too big to fail, a policy predicated on what he sees as the 
fiction that financial conglomerates can be allowed to fail. Yet 
in times of financial distress, when such a failure is likely to 
occur, he believes that a failure would be intolerable—an 
intolerance he supports. According to Mahoney, it is 
appropriate for some banks to be considered too big to fail. 
Banks are illiquid, confidence-sensitive institutions that
have large exposures to each other and whose solvency is 
unknowable to market participants, especially during times of 
financial distress.
In sum, Mahoney remarked that as a result of GLB, many 
institutions ultimately will emerge as being too big to fail. He 
stressed that it was appropriate to maintain ambiguity around 
this fact, but that we should not deny it too vehemently—or 
prohibit it by law—as we might find ourselves tripping over 
our own words someday.

Banking and securities and insurance: economists' views of the synergies - summary of presentations

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Banking and securities and insurance: economists' views of the synergies - summary of presentations

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Research Papers in Economics