Lawrence Pistell raises concerns about the potential lack of enterprise-wide knowledge in the new bank/insurer institutions and potential consequences for the global economy.
The consolidation of the insurance and banking industries raises concerns for corporations and individuals because it is impossible predict the results of merging industries that have been separated since the Glass-Steagall Act of 1933. Large concentrations of capital could potentially generate enormous concentrations and new kinds of risk. The profit objectives of managing the new merged financial enterprise could create competing interests among functions that were formerly segmented (i.e. commercial banking, insurance and investment banking).
Consumers should question how (and what kinds of) risks are being transferred by new entities that have the potential to wield so much power. This power should be viewed not only in terms of the financial services industry and its customers, but also in terms of the economy as a whole. A mega-financial institution's aggregate capital base clearly allows it to leverage itself to an unprecedented degree.
Even without leverage, the question arises whether enough knowledge exists within these financial conglomerates to respond to a crisis that could spill over the bulkheads that exist to separate and protect the banking and insurance functions. It is important to note that the ‘powerhouse' institutions have a strong incentive to cross-market to major customers. Indeed, this cross-marketing seems to be generating new ‘hybrid' products, which join the powerful derivative products that have existed for some time.
Less than three years ago, the near collapse of Long Term Capital Management (LTCM), a hedge fund which lost more than 90% of its capital, precipitated a $3.6bn bailout by its major US lenders. Financial leverage, in this case, vastly amplified LTCM's power. The total nominal outstanding positions of the small (in terms of employees) firm exceeded $1trn according to some press estimates.
The partners of the Greenwich, Connecticut-based firm, considered geniuses by the financial community, had committed their fund to enormous leveraged positions in stocks, bonds and derivatives, the unravelling of which began to affect the financial markets generally.
Executives of the firm were considered experts at risk modelling. Indeed, one of LTCM's leaders was a Nobel laureate in economics, who returned to Stanford's Business School to write after the bailout. Nevertheless, the expertise needed to diffuse the crisis had to come from outside the corporation; the resources within the corporation were incapable of responding to the public exposure to loss. Had it not been for the concentrated intervention of the best financial minds of the time, including Alan Greenspan and major lenders, this collapse could have seriously destabilised the US financial markets.
Since this episode, the magnitude and use of derivative products have only increased in bank/insurer organisations – organisations whose corporate structures are evolving at an unprecedented rate. Bank/insurers themselves are certainly using the new capital market instruments to spread risk.
Through securitisation, institutions may have found a way to market catastrophe risks to investors, bypassing, or in some cases augmenting, traditional insurance. But securitisation is still a small slice of the risk-spreading pie.
It may be very difficult to determine where risk is concentrated at any one time because modern financial management occurs with lightning speed. Bank/insurer organisations can affect or react to change almost instantaneously. In the event of crisis, these institutions will act to protect their own interests and the interests of their shareholders. This is their purpose and obligation. There can be enormous value in being a first-mover in today's knowledge-based world economy.
Risk taking and risk transfer will likely occur on an unprecedented scale in the future. Being a first-mover is nothing new, however. In June of 1815, Nathan Rothschild, of the English branch of the Rothschild family, made huge profits in the London stock market by hiring a ‘fast yacht' to bring news of the outcome of the Battle of Waterloo hours before other London traders discovered Napoleon had lost.
How well do these bank/insurer enterprises know themselves? What tools do they use to integrate their aggregate exposures to loss so that, in a crisis, they do not trigger a chain reaction of huge proportions? We all recognise that enterprise-wide risk exists. What we need to know is whether adequate knowledge and its attendant safeguards exist within the enterprise itself.
We expect, of course, that enterprise-wide knowledge is concentrated in the minds of a corporation's senior management. Surely this is so in many corporations.
However, today's top management is more mobile than ever, and there is limited longevity on almost any management team. In the case of insurer/banks or bank/insurers, top management will probably be more sensitive to one type of risk than another. For example, Sandy Weill quickly took the upper hand over John Reed following the merger of Citicorp and Travelers into Citigroup. The combined institution is undoubtedly influenced by the risk proclivity of its CEO. The merger of Citicorp and Travelers created the largest financial services organisation in the world, with over $700bn in combined sales.
A striking case of lack of enterprise knowledge occurred in the 1995 collapse of Barings plc, one of Britain's oldest and most respected merchant banks. In this case, a single rogue trader, Nicholas Leeson, speculating on Asian futures markets, eventually led to $1.32bn in losses for the firm and its sale to a Dutch banking and insurance group for a nominal sum. An official inquiry by the UK House of Commons Board of Supervision levelled ‘withering criticism' on Barings' headquarters and Far Eastern management and on its auditors. Barings' senior management had no system in place for proper management, and control of Leeson's activities.
Barings' auditors did not pick up on the enormous positions taken by Leeson on the Singapore Stock Exchange. Designated individuals within the new bank/insurer enterprises must understand not only the aggregate risk exposure of the insurance and banking sides but also the relationship between the two.
For example, a major earthquake could generate huge claims on the insurance side and, at the same time, numerous insolvencies on the banking side. The question is whether or not the bank/insurers model their towers of exposure and combine them to form a total exposure scenario – that is, whether or not their enterprise knowledge is integrated.
Subsidiaries of most financial conglomerates report to their separate regulatory authorities, and in all likelihood model their risk exposures separately. But it is possible that insurer/banks are evolving and integrating faster than the regulatory authorities can establish methods to evaluate and ensure their solvency. Therein lies a major potential risk.
Although the regulatory structures of the banking and insurance industries are quite different, it is doubtful that a single regulatory authority exists with the capability to respond to a crisis involving both banking and insurance elements simultaneously.
To some degree, we are in uncharted waters. Risk taking always brings an enterprise into new areas. However, because of the new concentrations of risk, a major crisis in the US involving bank/insurers could have a devastating effect on the global financial markets. We should be forewarned by the example of Japan, with its tangle of cross-shareholding interests.
In the US, financial conglomerates seek to contain damage through the parent/subsidiary relationship. Subsidiaries have traditionally contained losses within their structure without draining assets from the parent and other business units. However, a major financial or natural catastrophe could simultaneously drain several subsidiaries, or force a parent to offset massive financial loss or collapse in one subsidiary structure by taking a more conservative risk posture in another subsidiary.
A parent company that endures the collapse of a major subsidiary will undoubtedly seek to contain the loss but it will, at the very least, lose a major leg of its business. If external authorities intervene, pressure could come from different directions and different regulatory centres.
Organisations that are increasingly dependent upon intangible assets (be they organisational knowledge, intellectual property, or even corporate reputation) will find it difficult to purchase products that address the exposures presented by lack of enterprise-wide knowledge. Some products may exist, but a great deal of exposure to loss will be retained. Risk & Insurance magazine, which recently conducted a poll of risk managers at 50 major corporations, found that many had concerns about how to manage knowledge and assess its values and risks. These risks included risks to the company's knowledge. This article is only an initial discussion of an area that needs further exploration.