From the customer’s perspective, banks diversifying into insurance business may bring about purchasing economies and consumer economies of scope. These are advantages such as lower information, search, monitoring and transaction costs that customers can derive from ‘one-stop shopping’. Customers also in a sense, feel sheltered when dealing with a reputable institution (banks in this case) with whom they may already have some relationship with.
6Studies carried out in the US on individual preferences for ‘one-stop financial service’ showed a negative correlation between income earned and individual preferences for one-stop shopping; lower income groups ($30,000 and under) preferred one-stop shopping while higher income groups ($30,000 – over $50,000) preferred separate facilities i. e. banking done separately from insurance etc. Similarly, lower educational categories (less than high school, up to some college) preferred one-stop shopping while 43% of college graduates preferred separate facilities.
Therefore, this case for banks diversification into insurance will depend on the type and/or category of customers already in the banking firm. The graph below further intensifies the arguments for banks diversifying into insurance business as it shows a growing trend in banks in Europe engaging in sales of life insurance products. There is a clear distinction between the share of life insurance sales by banks in France and the other European countries shown. The UK banks have the lowest share of life insurance sales in most recent years compared to the other countries.
Netherlands and Spain have about the same percentage (30%) of banks involved in life insurance sales, while Italy and Germany are both below 30% but well above the UK’s 20% level. However all countries show on average, a 23% growth from the 1986 level that in to most recent years. However, evidence suggests that diversification is not always a good strategy as it has its detriments, which are explained in the subsequent paragraphs. Firstly, the crucial case for banks diversifying based on economies of scope and scale often fails to occur in practice. Llewellyn, D.
T (1997) describes scope economies as a sufficient condition not a necessary condition for diversification to be feasible. He also stated that even where cost-reducing synergies may exist, these might be offset by the costs of managing a diversified business. For instance as banks diversify into insurance (broadening their scope), it becomes increasingly difficult to manage the firm efficiently thus resulting in uncontrolled bureaucracy and possible diseconomies of scale and scope. Limited practical evidence has been found for the existence of scale economies in banking.
7Studies conducted by Berger and Humphrey (1991), Pulley and Humphrey (1993) and other earlier researchers, indicates the absence of significant economies of scope in the finance sector. Steinherr and Huveneers (1990) concluded that the supposed advantages of banks diversifying are inclined to be accentuated. There is always the marked problem of conflict of interest when bring two different institutions (e. g. banks and insurance companies) together. Gardener (1990)8 noted that ‘a key challenge has been the organisational and managerial problems of integrating different corporate culture and styles’.
Hence, combining banking and insurance services can lead to contamination of one by the other resulting in an overall disadvantage. It is also difficult to identify and benefit from economies of scope when different cultures and practices are brought together. Loehnis (1987) comments that regulatory bodies have discouraged banks from diversifying into insurance business principally because of fear of conflicts of interest particularly amongst depositors and policy-holders9. As was noted earlier, there is the possibility that banks diversifying into insurance can increase overall risk for the firm.
Despite the positive results for bank/insurance firms obtained by Brown et al, Borio and Filosa (1996) concluded that no significant track record exists for banking/insurance10. Gilbart (1988) discovered that there is no stated reason to suppose that diversification reduces over all risk since it depends upon multifaceted factors such as the expected profitability of the new business area, it’s riskiness, its correlation with existing parts of the business, the relative size of the different business areas and the extent of any synergies implied by alleged economies of scope11.
Gardener (1990) further explains that synergy and risk are closely related and that market and technological synergy for instance, may both increase a firm’s risk. Also Llewellyn, D. T (1991) suggests that though diversification may reduce the probability of failure, it may raise the overall cost of failure because a wider range of financial services are involved. This point is particularly a regulatory concern since they have to choose between allowing diversification if the probability of failure is reduced and curtailing diversification while the cost of failure is increased.
Furthermore, there is the possibility of banks diversification into insurance business leading to a concentration of power. A successful diversification can lead to an expansion in the banks’ capacity and market share; this might result in increased entry barriers and hence impeding competition and contestability in the financial sector. Problems of moral hazard may arise if a few large institutions dominate the financial sector. However, this case has little or no empirical standing and only seems to be viable in theory.
Firms engaging in diversification are usually concerned that regulation and compliance costs of the now extended business may be exceptionally high. It is already generally believed that banks in most countries are more highly regulated than other institutions because of their somewhat exclusive yet very important nature in the economy. Therefore, a bank taking on another important institution like an insurance company is bound to be more strictly regulated and face very high compliance costs to ensure that customers are not being exploited and that the firm maintains or even increases efficiency.
Regulators on the other hand may be concerned at their own capacity to regulate a very diverse financial institution such as a bank selling or manufacturing insurance products. 12It is apparent that regulators in most countries seem disinclined to consent to banks engaging in insurance underwriting especially through the ownership of insurance companies. Also, the Governor of the Bank of England expressed his views on banks diversifying into insurance by stating that supervisors or regulators are particularly apprehensive about banks taking on insurance companies of the same size as this could set a problem for regulators12.
In summary, the arguments for and against banks diversifying into insurance business have been carefully considered from the viewpoint of the bank itself, its customers and regulatory authorities. There has been relevant empirical evidence supporting both the case for banks to diversify into insurance and the case against. Nevertheless, reaching a precise conclusion as to whether banks should be allowed to diversify into insurance business is not very straightforward.
From the arguments for and against put forward earlier, it is clear that the decision by banks to diversify and/or by regulatory authorities to allow diversification depends on factors such as the particular aspect of the insurance business banks intend on diversifying into, the size of the banking and insurance institutions, the form of diversification etc which need to be carefully considered before reaching a conclusion.
For instance the argument that banks diversifying into insurance business reduces overall risk might only be feasible when the bank adopts agency form of diversification rather than own diversification, also, the argument against banks diversifying into insurance business based on the fact that this might lead to a concentration of power might only be applicable to a large bank diversifying into a large insurance company rather than a fairly large bank and a smaller insurance company and so on.
It is however safest to draw on a conclusion based on the current trend in most countries. Over the years, banks in most countries have increasingly diversified into all types of insurance business (most especially life insurance) leaving us with the most accurate assumption that the benefits from this venture might exceed the costs.