The convergence of banking and insurance business interests has led to M&A across the industry. Banks in Europe have recognised the benefits of M&A for banks with insurance companies. Cross-selling and strengthening the capital base and skills base. The new business model was clearly aimed at selling insurance products through the bank’s network, so increasing synergistic revenue. This will satisfy a larger proportion of customer service needs through a one-stop shop.
Risk management methods of both professions must cross-fertilise each other. This has been expected to happen quicker than both professions can imagine, but already we have many situations where big insurance companies, e.g. SwissRe, MunichRe, AON, AIG lend money to business. The Prudential Assurance owns Egg Bank in the UK, while Lloyds-TSB Bank owns four insurance companies including Scottish Widows. Which major bank does not own an insurance company? They perform corporate and trade finance functions in the same manner as banks.
It becomes difficult to manage the different enterprise cultures required in one new organisation. Change management and a modified Weltanschauung (world view) are needed for the merged entity, especially if your bosses have been changed. Furthermore, financial structures will change and the ground can shift under your feet. Insurance companies used to rely on a steady and relatively predictable revenue stream from customers’ premiums. They have found that new income volatility from the investment banking side had a damaging effect on their retail market financial health.
Risk structures and risk appetites may change in the merged corporation, so organic risk management should analyse the likely behaviour of this new investor animal. Insurers’ initial risk perception was more optimistic than it should have been. Some of this stems from the positive risk outlook from marrying a prestigious investment bank. Similarly, the big four UK clearing banks in 1986 tried to nurture an investment bank for their retail banking business. All four have retreated from this ambitious business strategy to various degrees. They should have put pessimistic scenario into their risk plan. Risk has a price, and many merged bancassurance companies initially had a rough ride.
Nevertheless, insurance offers significant contributions to banking, both in terms of crossselling and tapping a skills base. Basel II sees that insurance will become more closely linked to banking and fund management as the finance industry develops. Credit-ratings agencies and insurance companies will be inextricably tied to banks and funds because market transparency means that relative rankings of company “risk” become public. These directly influence insurance policy costs and, more indirectly, how customers view the reputation of these rated companies.
It is great news for consumers to see that this market combines insurance and banking to offer more choice of financing. Stress tests have so far proved that the market has enough resilience to withstand more competition. Yet, new entrants and new products will put a strain upon revenue streams and profit margins.
Research indicates that the opening of the EU financial markets, and the impact of e-banking on traditional bank business lines, will cause likely profit margin erosion. These range from savings/deposits, mortgages, mutual funds and on brokerage. The different risk and business profiles of European banks make it hard to derive general estimates of this impact. Nevertheless, a fall in profitability from margin erosion has been suggested in the range of fi10 % to fi25 % for most banks.7 Banks would do well to assess their risk profiles in response to the changing market drivers.
Another issue is how the broad spectrum of banks, insurance companies and finance houses can be strongly monitored in the market by regulators who traditionally concentrate on banks. The FSA and Basel II are well geared to supervise banks offering traditional products, but they may be less prepared for non-banks providing the same banking products.
The Basel Committee has had to adopt a wider context of what is a bank and what is not. Furthermore, it took a narrow view of banking risk as a combination of the three factors – market, credit and operational risk. This is often too limited and we should consider in addition:
structural risks
strategic risks
reputational risks.
It may appear that these Basel pillars are independent and stand alone. This is the concept of the risk silos. Basel II concentrates on the three types of risk – credit, market and operational risk. Investors could be led to believe that these are the major risk types, and the only ones that matter. Or worse, these are the only business risks that exist.
Banks may feel that risk is not contagious so long as risks are hedged between its divisions, i.e. risk localisation or damage control. But, sources of risk are related and interlinked, and a culture of lax risk awareness can be pervasive throughout the entire bank. Some banks have been more eager to adopt an enterprise risk management view.
This wider risk view permits the integration of risk management across silos to protect businesses adequately. Basel II recognises this principle and goes part way in linking the pillars in a mutually supportive fashion. Basel links the Three Pillars together, partly with supervisory visits and the imposition of regulatory capital. The explicit Basel II doctrine is that you buy all Three Pillars together in a job-lot; you cannot choose not to comply with any one of the Pillars.
The Basel II major progress has been to integrate some of the split risk silos. It will combine market, credit and operational risk within the combined Basel II operating framework. That is not to say that Basel II has its limits or its detractors.
Instruments such as popularly traded bonds will have a credit rating; other obscure bonds may not. There is a default bond rating, and if the bond is inherently risky or unsafe, then it may not benefit the bank trader to get the bond rated especially if the default rating is more lenient than a fair rating. This is not likely to be a loop-hole that will be closed as it is unlikely that any regulator can force all banks to get external credit ratings for their entire bond portfolio. Leeway for local supervisor judgement and initiative will continue to exist.
One factor also lies in the self-certification of risk. Banks at the outset will be presenting their validated risk management models. They know that they will receive regulatory benefits if they can present a good model. It is not in the interests to be forthright with regulators to admit that they have a bad risk management system. Banks are given regulatory capital incentives to validate their risk management models, even when these embed realistic assumptions and inherent weaknesses.
Regulators have to establish consistent standards for comparing across banks and across risk management models. Otherwise, banks will win with the greatest presentations and “sales job” on the regulators. There will be a learning curve for both sides as the banks try to develop ever more sophisticated models, while the regulators gather enough survey data to sniff out who has developed good risk management practices and models. Conversely, this will also lead the supervisors to deduce what constitutes a poor model and risk management practice for Basel II.