Entry Decisions and Adverse Selection: An Empirical Analysis of Local Credit Markets

During the last decades there has been a widespread relaxation of legal entry barriers into the banking industry, with potential benefits for financial integration and competition. Obstacles to banks geographical and business expansion have been removed and branching has been substantially liberalized. This paper analyses the determinants of entry decisions into local credit markets using a unique data set before and after deregulation of the Italian banking industry. We estimate an entry model à la Poisson and find evidence that spreads between loan and deposit rates drive entry only for newly chartered banks, but does not affect the decision to open branches of banks operating in other markets. Branching by outside banks is instead positively correlated with business opportunities in the provision of financial services which do not require the acquisition of substantial proprietary information. Both these results are consistent with the hypothesis that in credit markets incumbents have an informational advantage over new entrants.     

The Prudential Supervision of Financial Conglomerates in the European Union

Abstract

Around the world, the formation of financial conglomerates is gaining importance. In the United States, the provisional agreement between Congress and President Clinton’s administration to break down the barriers between banking, insurance, and securities firms by repealing the Glass-Steagall Act is no less than revolutionary. Meanwhile, in the European Union (EU), where the establishment of financial groups working in all three sectors has long been permitted, the Financial Services Action Plan (COM 1999),¹ as endorsed by European Heads of State at the Köln Council, identifies the further development of prudential rules for financial conglomerates as a top priority for EU financial services legislation in the coming years.

The focus of EU prudential legislation is on individual financial services undertakings, that is, on the bank, insurance company, or securities undertaking and not on the position and operation of the conglomerate as a whole. From this angle, the potential danger is one of a growing mismatch between the prudential approach, which looks at the individual legal undertakings separately, and the business approach, which manages and controls the conglomerate as a whole in different product and geographic areas. For this reason, the basic EU prudential framework has been supplemented to address the conglomerate dimension.

This paper presents an overview of financial services prudential legislation in the EU. It explains the role of the European Commission and gives a summary of the basic prudential framework for financial services, focusing on the single passport concept and the principle of mutual recognition. It examines the recent history of financial concentration and conglomeration in Europe and discusses general prudential issues arising from financial conglomerates. The paper also examines existing EU prudential legislation on financial conglomerates and how this might be developed in the future. Finally, some conclusions are drawn. It is hoped that this brief overview of how the European Union has tackled and is tackling the difficult issue of financial conglomerate supervision might be of interest to North American readers at a time when the United States is changing its prudential legislation to permit the development of financial conglomerates.     

AT THE CROSSROADS: THE LIFE INSURANCE INDUSTRY AND FINANCIAL SERVICES REFORM

Abstract: In September of 1996, The Board of Directors of the American Council of Life Insurance ("ACLI")reversed decades of policy and embraced for the first time the concept of reciprocal ownership or "affiliations" between life insurance companies and commercial banks. Under this new policy mandate, the ACLI is advocating federal legislation that would permit banks to sell all types of insurance and control insurance underwriters through separate affiliates or subsidiaries. In return, 1) insurers would have the authority to acquire banks; 2) the insurance activities of banks would be fully subject to state insurance regulation; and 3) federal bank regulators would be precluded from preempting state regulatory authority.
This article reviews the various factors that precipitated this watershed policy decision, discusses the structural and regulatory issues that are important to life insurers, and speculates briefly on the prospects for financial services legislation.     

Shadow Banking,Risk Transfer,and Financial Stability

Shadow banking is the process by which banks raise funds from and transfer risks to entities outside the traditional commercial banking system. Many observers blamed the sudden expansion in 2007 of U.S. sub‐prime mortgage market disruptions into a global financial crisis on a “liquidity run” that originated in the shadow banking system and spread to commercial banks. In response, national and international regulators have called for tighter and new regulations on shadow banking products and participants. Preferring the term “market‐based finance” to the term “shadow banking,” the authors explore the primary financial instruments and participants that comprise the shadow banking system. The authors review the 2007–2009 period and explain how runs on shadow banks resulted in a liquidity crisis that spilled over to commercial banks, but also emphasize that the economic purpose of shadow banking is to enable commercial banks to raise funds from and transfer risks to non‐bank institutions. In that sense, the shadow banking system is a shock absorber for risks that arise within the commercial banking system and are transferred to a more diverse pool of non‐bank capital instead of remaining concentrated among commercial banks. The article also reviews post‐crisis regulatory initiatives aimed at shadow banking and concludes that most such regulations could result in a less stable financial system to the extent that higher regulatory costs on shadow banks like insurance companies and asset managers could discourage them from participating in shadow banking. And the net effect of this regulation, by limiting the amount of market‐based capital available for non‐bank risk transfer, may well be to increase the concentrations of risk in the banking and overall financial system.     

Financial conglomeration and monitoring incentives

If combining insurance and banking services generates scope economies in terms of monitoring the customers, competition in the financial markets becomes more intense after financial conglomeration. The pro-competitive effect reduces the prices of the financial services, increases monitoring and improves financial stability. Increased monitoring allows financial regulators apply lower capital requirements for financial conglomerates.     

Winners and Losers as Financial Service Providers Converge: Evidence from the Financial Modernization Act of 1999

The Financial Modernization Act of 1999 dramatically increased insurers' and investment banks' authority to provide an array of financial services and allowed commercial banks to offer investment banking and insurance services. In this paper we examine the market response to this legislation. We find a strong positive response among insurance companies and investment banks, and no significant response among commercial banks. Larger institutions in all three financial sectors earn higher abnormal returns. Additionally, better performing banks earn higher abnormal returns. Our results suggest that allowing financial convergence can add value through synergies and that large players are needed to exploit the scope economies.     

Which factors support trust in the recommendation process of pension products? Trust and pension products

During the financial crisis of 2008/2009, financial institutions such as banks and insurance companies have lost trust of their customers. In the recommendation process of pension products, trust plays an important role since cash flows from retirement products accrue decades ahead. Using the results from a survey, we find that financial institutions still struggle to deliver trust to their customers when they recommend different categories of retirement products. Other recommending parties such as academic financial experts or close friends, however, are able to establish a high level of trust. We therefore investigate factors of alternative channels to establish trust such as the recommendation process or product features.

     

Valuing the Potential Transformation of Banks into Financial Service Conglomerates: Evidence from the Citigroup Merger

The merger between Citicorp and Travelers Group on April 6, 1998 could have emitted two relevant signals for firms that provide financial services. The first signal is the endorsement by two prominent financial institutions that benefits from cross‐selling of bank services with insurance services, brokerage services, and other financial services can be realized. The second signal is that regulators will allow the combination of commercial banking with insurance underwriting and full‐service brokerage, paving a path for similar combinations in the future. We document a favorable share price response for commercial banks, insurance companies, and brokerage firms, which supports the argument that the merger sets a precedent for other combinations between banks and nonbank financial services that will facilitate cross‐selling and efficiencies.     

商业银行交叉销售的现状分析与策略建议

新世纪以来,银行、保险、投资等多领域金融产品的交叉销售成为各家金融机构获取客户、服务、扩张和盈利的重要工具。文章分析了当前商业银行交叉销售的现状,指出国内银行业已取得基本确立交叉销售的经营理念和经营模式、初步建立CRM系统为交叉销售提供技术支持等成效,但仍存在市场定位不明、销售手段单一、产品缺少重点等不足。文章从客户策略、产品策略、渠道策略、服务策略、队伍策略、激励策略等方面就推进我国商业银行交叉销售提出建议。     

Assessing competition in the banking industry: A multi-product approach

This paper investigates the competitive aspects of multi-product banking operations. Extending Panzar and Rosse’s (1987) model to the case of a multi-product banking firm, we show that higher economies of scope in multi-product banking are associated with lower Panzar–Rosse measures of competition in the banking sector. To test this empirical implication and determine the impact of multi-production on market power, we use a new dataset on the Brazilian banking industry. Consistent with our theoretical prediction, we find that banks that offer classic banking products (i.e., loans and credit cards) and other banking products (i.e., brokerage services, insurance and capitalization bonds) have substantially higher market power than banks that offer only classic products. These results suggest a positive bias in the traditional estimates of competition in which multi-output actions are not considered.     

WHY BANKS HAVE A FUTURE: TOWARD A NEW THEORY OF COMMERCIAL BANKING

According to some observers, the commercial bank–an institution that conducts the twin activities of accepting deposits payable on demand and originating loans–has outlived its usefulness and is in a state of terminal decline. The broad statistical evidence for this contention, however, is somewhat mixed. While some studies suggest that the role of banks in the United States is declining, others suggest that banks are simply using new vehicles to offer their services and that their role has not diminished at all. This article takes a different approach to analyzing the future of banks by examining the economic rationale for their past existence and exploring the extent to which this rationale can be expected to hold up in the future. The author begins by explaining why the two core banking activities–taking in deposits payable on demand and originating non-marketable loans–are performed by the same institutions. The explanation turns on the recognition that both activities essentially require the institution to come up with cash on short notice–that is, to provide liquidity. Scale economies in providing liquidity explain why both activities are provided by the same entity. Deregulation and innovation have increased competition in the financial services industry, which has forced banks to concentrate on the essentials of liquidity provision. This is why the outward nature of banks' activities has changed (for example, banks today often sell instead of holding loans, and provide back-up lines for commercial paper instead of originating loans), though not their underlying economic rationale (particularly the credit evaluation and monitoring involved in “relationship” banking). Beneath the surface reality of dramatic changes in financial products and services, the fundamental banking business of liquidity provision is alive and well. Moreover, in the course of performing their traditional activities, banks have acquired competencies that enable them to perform a variety of other financial and nonfinancial activities that deregulation and innovation have opened up to them. As part of their evaluation of these nontraditional activities, bankers must ensure that their organizational structures, controls, and compensation policies are appropriate for the new environment of deregulation and technological change.     

Openness, profit opportunities and foreign banking

Using new data from the World Bank and OCC surveys, we show correlations across a wide range of countries between foreign banking and domestic economic, financial and bank regulatory conditions. Foreign banking tended to be more prevalent in countries that were more open to foreign ownership of their banks, more open to banks’ engaging in a wider range of financial activities and more open to international trade. Restrictions on foreign ownership of domestic banks that were in place in the late 1970s reduced the current extent of foreign banking. Foreign banking was negatively correlated with current restrictions on banks’ securities, insurance and real estate activities. Countries that had more international trade tended to have more foreign banking. Foreign banking was more pervasive in countries where banking was more profitable and where the domestically-owned banking sector was smaller relative to GDP.     

Any regulation of risk increases risk

We show that any objective risk measurement algorithm mandated by central banks for regulated financial entities will result in more risk being taken by those financial entities than would otherwise be the case. Furthermore, the risks taken by the regulated financial entities are far more systemically concentrated than they would have been otherwise, making the entire financial system more fragile. This result leaves three options for the future of financial regulation: (1) continue regulating by enforcing risk measurement algorithms at the cost of occasional severe crises, (2) regulate more severely and subjectively by fully nationalizing all financial entities, or (3) abolish all central banking regulations, including deposit insurance, thus allowing risk to be determined by the entities themselves and, ultimately, by their depositors through voluntary market transactions, rather than by the taxpayers through enforced government participation.     

Return Dependence and the Limits of Product Diversification in Financial Firms

Copula‐GARCH models indicate dependence between bank returns and those to insurance underwriting, securities brokerage, and mortgage finance increased during the recent crisis. In contrast, dependence between banks and the broader market was little changed. The crisis‐related jump in return dependence within the financial services sector was greatest for banks that had previously appeared the most independent. Larger banks were also especially prone to increased dependence. These findings raise doubts about the ability of financial conglomerates to diversify effectively and highlight the need for policy progress in methods for resolving such institutions should they become illiquid or insolvent.     

Balancing the regulation and taxation of banking

This study gives an overview of bank taxation as an alternative to prudential regulations or non-revenue taxation. We review existing bank taxation with a view to eliminating distortions in the tax system, which have incentivized banks to engage in risky activities in the past. We furthermore analyze taxation of financial instruments trading and taxation of banking products and services and their ability to finance resolution mechanisms for banks and to ensure their stability. In this respect, we put forward the following arguments: (1) that a financial transaction tax is economically inefficient and potentially costly for the economy and may not protect taxpayers; (2) that a bank levy used to finance deposit guarantee and bank resolution mechanisms is potentially useful for financial stability, but that it poses the threat of double taxation, together with the proposed Basel-III Liquidity Coverage Ratio; and (3) that we support the elimination of exemption from value added tax (VAT) for financial services in order to provide banks with a level playing field, while retaining exemption for basic payments services. This is expected to improve efficiency by reducing the wasteful use of financial services.     

Institutional development and bank stability: Evidence from transition countries

This paper takes advantage of the dynamic nature of institutional reforms in transition economies and explores the causal effects of those reforms on bank risk. Using a difference-in-difference approach, we show that banks’ financial stability increases substantially after these countries reform their legal institutions, liberalize banking, and restructure corporate governance. We also find that the effects of legal and governance reforms on bank risk may critically depend on the progress of banking reforms. A further examination of alternative risk measures reveals that the increases in financial stability among banks mainly come from the reduction of asset risk. Banks tend to have lower ROA volatility and fewer nonperforming loans after reforming the institutional environment. Finally, we split our sample into foreign and domestic banks and find that the enhancement of financial stability is more pronounced for domestic banks.     

BANK FAILURE AND CONTAGION EFFECTS: EVIDENCE FROM HONG KONG

In this paper the influence of three Hong Kong bank failures on stock prices of the colony's banking industry is examined. As deposit insurance is nonexistent in Hong Kong, the world's fourth-largest financial center, an interesting environment is provided for testing contagion effects of bank failure on other healthy financial institutions. By examining contagion effects in an environment void of explicit deposit insurance, this study should provide interesting insights into the resiliency of modern-day financial markets. In turn, insights should also be provided into debates concerning the role and reform of deposit insurance and the rationale for regulation of the financial services industry in general. The results indicate that unexpected bank failure causes significant negative stock price reactions within the banking industry; yet, some banks are less affected than others.     

U.S. financial deregulation : Upheaval and promise

Financial deregulation in the U.S. has ample ramifications for international banking. For U.S. based international banks, the deregulation shifts the emphasis back to the now deregulated U.S. market. For foreign banks in the U.S. deregulation is a mixed blessing. One aspect of the deregulation is interstate banking, another is merger across industry lines. Thus Parker, a pen manufacturer, owns several financial institutions including a bank. All this functional integration may be exaggerated. Banks will continue to operate more or less as they have done in the past. The changes will be evolutionary rather than revolutionary in nature, and they will lead our industry from the production of banking services to the production of financial services.     

Comparison of sales performance across financial service sectors

In the new world of financial services, comparisons are going to have to be made on the productivity and performance of the various sales representatives within the industry: stockbrokers, bank sales representatives, financial planners and insurance agents and brokers. This paper discusses the problems involved in making cross-sector comparisons and proposes a way to compare the production of sales representatives who sell equity products with sales representatives who sell risk products. Comparisons are also presented for sales rep earnings and turnover.     

THE GRAMM‐LEACH‐BLILEY ACT OF 1999: RISK IMPLICATIONS FOR THE FINANCIAL SERVICES INDUSTRY

We document significant risk changes in the financial services industry following the passage of the Gramm‐Leach‐Bliley Act of 1999. Banks experience an increase in risk regardless of whether they have taken steps to participate actively in the investment banking business. Insurance companies also experience an increase in risk, whereas securities firms experience a decrease in risk. We attribute the increase in risk for banks and insurance companies to the fact that the securities business is relatively more risky, and the decline in risk for securities firms to the fact that they can now diversify into relatively less risky banking and insurance businesses.