Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Changing Landscape of the Financial Services Industry: What Lies Ahead?

Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Changing Landscape of the Financial Services Industry: What Lies Ahead?

Article excerpt

Bell & Howell Information & Learning Formula Omitted...

The financial services industry has experienced significant changes over the past two decades. Hundreds of banks have been consolidated, restructured, or newly formed. In addition, deregulation of where banks can operate and what they can do has encouraged both geographic and product diversification. The most recent aspect of this transformation trend is the passage of the Gramm-Leach-Bliley (GLB) Act, which loosens restrictions on banks' abilities to engage in the previously restricted activity of underwriting securities and permits banks to underwrite insurance policies.

This paper examines some of the potential consequences of GLB for the structure of the U.S. financial services industry. In it, we ask how the industry may evolve as this new legislation interacts with the consolidation trend already under way, what types of mergers are most likely to occur, and how profitable and risky the resulting firms might be.

We begin by reviewing the consolidation trend that has occurred within the U.S. banking industry over the past ten years. We explore reasons for the trend, focusing on the factors responsible for the recent pick-up in its pace. Consolidation accelerated following the 1980s deregulation of restrictions that prohibited bank expansion across geographic markets and into other financial services. If history is any guide, we ought to see further consolidation following the passage of GLB. Stock price reaction to its passage suggests that market participants also anticipate more financial consolidation, especially in the life insurance business.

We then test whether better diversification post-GLB can improve the risk-return trade-off faced by financial companies. We do so by constructing hypothetical, pro-forma mergers between bank holding companies (BHCs) and firms in each of the other three major financial services industries: life insurance, property and casualty insurance, and securities. The results suggest that, ceteris paribus, mergers between BHCs and life insurance firms will produce firms that are less risky (and no less profitable) than those in either of the two individual industries. Mergers between BHCs and either securities firms or property and casualty firms raise BHCs' risk measures only slightly. Similar to the analysis of stock returns, these results point most strongly to combinations of banks and life insurance companies.

As a final step, we review how the financial services industry has evolved in Europe. A European bank's ability to expand into other financial activities, unlike that of a U.S. bank, is relatively unrestricted. In recent years, these banks have made significant inroads in the life insurance industry. By examining these advances, we can better understand the role of scope economies in the banking industry's evolution, something we cannot infer from the pro-forma data analysis.

Overall, our findings point to continued consolidation among financial firms. The consolidation trend within the banking industry will likely continue as banks respond further to the elimination of prior restrictions. Moreover, the recent elimination of barriers preventing banks from engaging fully in securities underwriting and insurance will allow them to take advantage of both diversification and economy-of-scope benefits as they expand into these industries.

RECENT CONSOLIDATION TRENDS IN A DECADE OF CHANGE

Several hundred bank mergers and acquisitions (M&As) have occurred each year over the past two decades. However, during the past decade, megamergers-M&As between institutions with assets of more than $1 billion each-have occurred much more frequently. Most recently, M&As in the United States and elsewhere have increased dramatically in size; such activity between institutions with assets in excess of $100 billion has become almost commonplace. Based on market value, nine of the ten largest M&As in U. …

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