Commercial Banking Chapter 14

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

Bank Management Risks

•Several problems and risks are associated with sales of investment products

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

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

•Trust services is the management of property owned by customers, such as securities, land, buildings, and other assets

▫Among the oldest non deposit services that banks and some of their closest competitors offer parts of the financial firm

•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

▫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

•Popular kinds of trusts:

▫Living trusts which allow trust officers to act on behalf of a living customer without a court order, generally help to avoid expensive probate proceedings if the property owner dies or becomes legally incompetent, and may be revoked or amended by the customer as desired ▫Testamentary trusts which arise under a probated will and are often used to save on estate taxes. If properly drawn, a testamentary trust can sometimes be used to protect a customer's property from the claims of creditors or beneficiaries who may make unreasonable demands that might prematurely exhaust the trust's assets ▫Irrevocable trusts which allow wealth to be passed free of gift and estate taxes or may be used to allocate funds arising from court settlements or private contracts ▫Charitable trusts which support worthwhile causes, such as the arts and care of the needy ▫Indenture trusts which usually collect, hold, and manage assets to back an issue of securities by a corporation and then are employed to retire the securities on behalf of the issuing company when their term ends

▫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

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

•Current U.S. regulations require that customers must be told orally (and sign a document indicating they were so informed) that investment products are:

1.Not insured by the Federal Deposit Insurance Corporation (FDIC) 2.Not a deposit or other obligation of a depository institution and not guaranteed by the offering institution 3.Subject to investment risks, including possible loss of principal

•There are mandatory public disclosures on the part of depository institutions selling insurance products that stipulate:

1. An insurance product or annuity is not a deposit or other obligation of a depository institution or its affiliate 2. 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 3. Insurance products or annuities may involve investment risk and possible loss of value 4. 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

NEWER SOURCES OF FEE INCOME FOR MANY BANKING FIRMS

Commissions and fees from investment banking activity (security underwriting) services provided for corporations and governments around the globe. • Brokerage commissions for aiding customers in purchasing and selling stocks, bonds, mutual funds, and other assets. • Fiduciary income- trust service fees for managing the assets of individuals, businesses, charities, and foundations. • Commissions for the sale of insurance-related products to businesses and individuals, including insurance policies, pension programs, and annuity plans. • Servicing fees that arise from securitizing and selling loans off the balance sheet, including monitoring borrowers' compliance with the terms of the loans they receive and keeping records of payments received.

•Establishment of fiduciary relationship is critical in trusts

However, their activities usually center upon establishing a fiduciary relationship with a customer, protecting that customer's property, making asset management decisions, planning a customer's estate, ensuring that estate property is passed in timely fashion to those entitled to its benefits, and assisting businesses in raising and managing funds and in providing retirement benefits to employees. Trust departments must follow the terms of a trust or agency agreement and any court orders that have been issued. They are expected to be competent and diligent in their fiduciary and agency activities and are legally liable for losses due to negligence or failure to act as a prudent decision maker would.

Nonproprietary Funds

In this case the offering institution acts as broker for an unaffiliated mutual fund or group of funds but does not act as an investment advisor. Nonproprietary funds are distributed and managed by an unaffiliated company that may, however, rent lobby space inside a bank's branch offices or sell its shares through a broker who is related to the offering institution in some way. Usually the institution involved receives a commission for any sales of shares in nonproprietary funds passing through its offices.

TRADITIONAL SOURCES OF FEE INCOME FOR MOST BANKING FIRMS

Service charges on checking accounts, savings deposits, and for customer use of automated teller machines (ATMs), including fees for non sufficient funds (NSF) and excessive withdrawals from deposits. • Credit card service fees, including card membership fees, late-payment fees, etc. • Commitment fees for making credit available over a designated time period. • Fees for use of safe deposit boxes to keep customers' valuables secure. • Rental of the financial firm's property to individuals and businesses.

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

Important source of growth in future revenues

fee income

Proprietary Funds

larger banking firms may offer these through one of their affiliated companies. In this case the banking firm's staff will advise the fund about trading opportunities and will buy and sell shares at the request of its customers. One prominent example is Mellon Bank's Dreyfus Corporation with its extensive family of mutual funds. Banking firms are permitted to ( 1) offer investment advice, normally the greatest source of fee income; (2) serve as transfer agent and custodian for mutual fund shares, keeping records of who owns shares and who is entitled to receive fund reports and earnings; and (3) execute the transactions dictated by the fund's investment adviser.

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

▫Recently, many investment banks jumped into the hedge fund business

virtually unregulated private investment pools often affiliated with an 1B or other fiduciary. Hedge funds offer their clients (mainly wealthy investors and institutions) the possibility of higher investment returns by taking on relatively risky assets and heavy use of debt to fund those assets. Hedges often put together a broad range of assets, including stocks, real estate, commodities, and mortgage-backed securities, in an effort to profit no matter which direction the market goes (hence a "hedge")

•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?

Bank Management Investment Products

▫Stocks, bonds, mutual funds, annuities, and similar financial instruments

▫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)

•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