1. Investment Banking, Insurance, and Other Sources of Fee Income
Chapter Fourteen
Investment Banking, Insurance, and Other Sources of Fee Income
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2. Key Topics The Ongoing Search for Fee Income
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Key Topics
The Ongoing Search for Fee Income
Investment Banking Services
Mutual Funds and Other Investment Products
Trust Services and Insurance Products
Benefits of Product-Line Diversification
Economies of Scope and Scale
Information Flows and Customer Privacy
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3. 14-3
Introduction
Financial institutions have faced a struggle recently to attract the funds they need in order to make loans and investments and boost their revenues
Whenever deposit growth slows, financial-service managers frequently are forced to pursue new sources of funds and new ways to generate revenue
Important source of growth in future revenues – fee income
Revenues derived from charging customers for the particular services they use
Monthly service charges on transaction accounts
Commissions for providing insurance coverage for homes and businesses
Membership fees for accepting and using a particular credit or debit card
Fees for providing financial advice to individuals and corporations
“Swipe fees” at the point of sale
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4. Introduction (continued)
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Introduction (continued)
The drive among competing financial firms to generate more fee income as an increasingly important revenue source comes from several sources
A desire to supplement traditional sources of funds (such as deposits) when these sources are inadequate
An attempt to lower production costs by offering multiple services using the same facilities and resources (economies of scope)
An effort to offset higher production costs by asking customers to absorb a larger share of the cost of both old and new financial services
A desire to reduce overall risk to the financial-service provider’s cash flow by finding new sources of revenue not highly correlated with revenues from sales of traditional services
A goal to promote cross-selling of traditional and new services in order to further enhance revenue and net income
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5. Sales of Investment Banking Services
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Sales of Investment Banking Services
One banking service that has been prominent, but volatile, is investment banking
Many leading U.S. banks recently either acquired or formed their own investment banking affiliates in order to serve corporations and governments around the world
For example, JP Morgan Chase’s acquisition of Bear Stearns
Leading investment banks in the world today:
Citigroup
JP Morgan Chase
Morgan Stanley
Goldman Sachs
Credit Suisse
UBS
Nomura Securities
Deutsche Bank
Raymond James
Banc of America Securities
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6. Sales of Investment Banking Services (continued)
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Sales of Investment Banking Services (continued)
Key Investment Banking Services
Traditionally, the best-known and often the most profitable investment banking service is security underwriting
The purchase for resale of new stocks, bonds, and other financial instruments in the money and capital markets on behalf of clients who need to raise new money
One of the most profitable underwriting services – initial public offerings (IPOs)
Leveraged buyouts (LBOs)
Involve the acquisition of a company, usually by a small group of investors, and typically are funded by large amounts of debt
Recently, many investment banks jumped into the hedge fund business
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7. Sales of Investment Banking Services (continued)
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Sales of Investment Banking Services (continued)
Examples of client questions that investment bankers can assist in answering:
Should we (the investment bank’s clients) attempt to raise new capital? If so, how much, where, and how do we go about this fund-raising task?
Should our company enter new market areas at home or abroad? If so, how can we best accomplish this market- expansion strategy?
Does our company need to acquire or merge with other firms? Which firms and how? And when is the best time to do so?
Should we sell our company to another firm? If so, what is our company worth? And how do we find the right buyer?
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8. Sales of Investment Banking Services (continued)
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Sales of Investment Banking Services (continued)
With passage of the Gramm-Leach-Bliley (GLB) Act of 1999, the full range of investment banking services was opened up for adequately capitalized and well-managed commercial banking firms
Research studies suggest that investment banking revenue and profitability are positively, but not highly, correlated with commercial banking revenues and profitability
There may be some significant product-line diversification effects
It is not yet clear that the benefits alleged from this new service dimension have offset the costs and risks involved
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9. Sales of Investment Banking Services (continued)
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Sales of Investment Banking Services (continued)
Investment banks today are wrestling with the question of what kind of financial firm they need to be in the future
What mix of services should they be offering to achieve high and sustained profitability?
A few commercial bank–investment bank combinations have shown promise for the future, despite ongoing struggles to fend off losses following a huge mortgage market meltdown in 2007– 2009
Recently both investment banks and commercial banks have been under intense pressure to raise large amounts of new capital
Many observers anticipate more mergers
It is not clear that future commercial bank-investment bank combinations will consistently turn out well
One likely outcome is greater government regulation
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10. Selling Investment Products to Consumers
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Selling Investment Products to Consumers
In recent years many of the largest business and household depositors have moved their funds out of deposits at banks and thrift institutions into investment products
Stocks, bonds, mutual funds, annuities, and similar financial instruments
Mutual Fund Investment Products
One of the most popular of the investment products
Each share in a mutual fund permits an investor to receive a pro rata share of any dividends or other forms of income generated by a pool of stocks, bonds, or other securities the fund holds
If a mutual fund is liquidated, each investor receives a portion of the net asset value (NAV) of the fund after its liabilities are paid off, based on the number of shares each investor holds
Proprietary funds versus nonproprietary funds
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11. Selling Investment Products to Consumers (continued)
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Selling Investment Products to Consumers (continued)
Annuity Investment Products
Annuities are a hedge against living too long and outlasting one’s savings
Fixed annuities promise a customer who contributes a lump sum of savings a fixed rate of return over the life of the annuity contract
Variable annuities allow investors to invest a lump sum of money in a basket of stocks, mutual funds, or other investments under a tax- deferred agreement, but there may be no promise of a guaranteed rate of return
Recently a new type of annuity contract has appeared, the equity- index annuity
Combines the features of both fixed and variable annuities
One advantage for financial firms selling this service is that annuities often carry substantial annual fees
One significant disadvantage with annuities sold through depository institutions is they typically compete with selling deposits
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12. Selling Investment Products to Consumers (continued)
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Selling Investment Products to Consumers (continued)
Several problems and risks are associated with sales of investment products
Current U.S. regulations require that customers must be told orally (and sign a document indicating they were so informed) that investment products are:
Not insured by the Federal Deposit Insurance Corporation (FDIC)
Not a deposit or other obligation of a depository institution and not guaranteed by the offering institution
Subject to investment risks, including possible loss of principal
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13. Trust Services as a Source of Fee Income
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Trust Services as a Source of Fee Income
Trust services is the management of property owned by customers, such as securities, land, buildings, and other assets
Among the oldest nondeposit services that banks and some of their closest competitors offer parts of the financial firm
Trust departments often generate large deposits because they manage property for their customers
Deposits placed in a bank by a trust department must be fully secured
Popular kinds of trusts:
Living trusts
Testamentary trusts
Irrevocable trusts
Charitable trusts
Indenture trusts
Establishment of fiduciary relationship is critical
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14. Sales of Insurance-Related Products
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Sales of Insurance-Related Products
Banks can use their branches to sell insurance
Over 100 banks today sell their own insurance products in the United States
Types of insurance products sold today:
Life insurance policies
Property/casualty insurance policies
Life insurance underwriters and property/casualty insurance underwriters manage their respective risks
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15. Sales of Insurance-Related Products (continued)
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Sales of Insurance-Related Products (continued)
There are mandatory public disclosures on the part of depository institutions selling insurance products that stipulate:
An insurance product or annuity is not a deposit or other obligation of a depository institution or its affiliate
An insurance product or annuity sold by a depository institution in the United States is not insured by the FDIC, any other agency of the U.S. government, the depository institution itself, or its affiliates
Insurance products or annuities may involve investment risk and possible loss of value
U.S. depository institutions cannot base granting loans on the customer’s purchase of an insurance product or annuity from a depository institution or any of its affiliates or on the customer’s agreement not to obtain an insurance product or annuity from an unaffiliated entity
These disclosures must be made both orally and in writing before completion of the sale of an insurance product
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16. The Alleged Benefits of Financial-Services Diversification
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The Alleged Benefits of Financial-Services Diversification
When two or more different industry types merge with each other, this strategic move is called convergence
One possible benefit is the relatively low correlation that may exist between cash flows or revenues generated by the sale of traditional industry products versus the sale of nontraditional products
But because streams of revenue from different product lines may move in different directions at different times, the overall impact of combining these different industries and products under one roof may be to stabilize combined cash flows and profitability
The risk of failure might also be reduced
This potential consequence of the convergence of two or more financial-service industries is called the product-line diversification effect
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17. The Alleged Benefits of Financial-Services Diversification (continued)
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The Alleged Benefits of Financial-Services Diversification (continued)
Example of what could happen to overall institutional risk by combining traditional and nontraditional financial services
Suppose a banking company decides to add insurance services to its existing product menu
It expects to earn a 12 percent average return from sales of its traditional banking products and a 20 percent return from selling or underwriting insurance services
These two service lines are equally risky in the variance of their cash flows (with a standard deviation of about 5 percent each)
The banking firm expects to receive 20 percent of its revenues from insurance sales and 80 percent from sales of traditional banking products
The cash flows from the two sets of services are negatively correlated over time with a correlation coefficient of -0.50
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18. The Alleged Benefits of Financial-Services Diversification (continued)
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The Alleged Benefits of Financial-Services Diversification (continued)
What would happen to the bank’s overall return from sales of traditional and nontraditional products in this case?
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19. The Alleged Benefits of Financial-Services Diversification (continued)
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The Alleged Benefits of Financial-Services Diversification (continued)
And what happens to the risk of return for this bank?
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20. The Alleged Benefits of Financial-Services Diversification (continued)
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The Alleged Benefits of Financial-Services Diversification (continued)
And what happens to the risk of return for this bank?
Offering both traditional and nontraditional banking services lowers the bank’s standard deviation of its overall return
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21. The Alleged Benefits of Financial-Services Diversification (continued)
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The Alleged Benefits of Financial-Services Diversification (continued)
Other potential benefits from offering multiple services include economies of scale and economies of scope
Economies of scope refer to a situation in which the joint costs of producing two or more services in one firm are less than the combined cost of producing each of these services through separate firms
For example, if a single financial firm produces two services (S1 and S2), instead of producing only one service (S1), using the same resources, its cost of production (C) may be lower as follows
As a result, expanding the number of financial services offered may result in more intensive use of resources, reducing overall costs and widening a multiservice firm’s profit margin
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22. Information Flows within the Financial Firm
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Information Flows within the Financial Firm
Financial firms have become more and more like pure information-gathering, information-processing, and information-dispersing businesses
The Gramm-Leach-Bliley Act of 1999 allowed financial- service companies to share customer information among their affiliated firms and also with independently owned third parties provided customers did not expressly say “no” to (or “opt out” of) having their personal data distributed to others
Protecting customer privacy became increasingly more important
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EXHIBIT 14–1 Key Items That Must Be Included in a Financial Firm’s Privacy Policy and Be Sent to Its Customers at Least Once a Year
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Quick Quiz
What services are provided by investment banks? Who are their principal clients?
What advantages do commercial banks with investment banking affiliates appear to have over competitors that do not offer investment banking services? Possible disadvantages?
What are investment products? What advantages might they bring to an institution choosing to offer these services?
How do trust services generate fee income and often deposits as well for banks and other financial institutions offering this service?
What is convergence? Product-line diversification? Economies of scale and scope? Why might they be of considerable importance for banks and other financial-service firms?
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