Expansion into Insurance Product-lines and Bank Shareholder Returns

The prospects of Congress permitting bank expansion into insurance continues to concern bankers, insurers and investors. Based upon event study methods, abnormal returns to investors of banks engaging in currently permitted insurance activities are found to be significant over the 1974-1990 period. Further, disaggregated results suggest that there were significantly higher returns to more recent engagements, as compared to engagements prior to 1982. INTRODUCTION AND LITERATURE REVIEW The United States banking industry has been one of the most heavily regulated industries in the world. Motives for regulation of banks are attributed to promotion of industry safety as well as to promotion of a competitive structure. Much of the current regulatory structure concerning pricing, geographic and product restrictions can be traced to the banking laws passed in the 1930’s like Glass-Steagall. However, banks have evolved past the single office and branching systems prevalent in the 1930’s to the point where now the bank holding company has become the dominant form of bank organization. As the influence of bank holding companies has grown, regulations have been enacted to control their activities. The first significant action passed by Congress was the Bank Holding Company Act of 1956. This Act restricted the non-banking activities of multiple bank holding companies. The Federal Reserve Board was granted authority to regulate bank holding company activity and the Act required several bank holding companies to divest non-bank subsidiaries [Lash, 1987]. One-bank holding companies were not regulated by the 1956 Act. This loophole led to rapid expansion of this organizational form of banking. By 1968, one-bank holding companies were being formed by most of the major banks in the U.S. and many offered non-banking services. In response, Congress amended the Bank Holding Company Act in 1970 to include one-bank holding companies and to further specify permissible non-bank activities in Regulation Y of the Federal Reserve Board. All permissible activities were required to be closely related to banking activities. Activities not permitted included: insurance premium funding, underwriting credit insurance not related to credit extension, sale of level-term credit life, underwriting mortgage guaranty insurance, underwriting property and casualty insurance, and underwriting home loan life mortgage insurance. The Garn-St. Germain Depository Institutions Act of 1982 relaxed many price and geographic restrictions on Bank Holding Companies. However, in contrast to its overall impact to further reduce banking restrictions, it increased restrictions on bank holding companies’ insurance activities. The Garn-St. Germain Act prevented bank holding companies from becoming principals, agents, or brokers when providing insurance services, and permitted only seven exceptions: credit life associated with extension of credit, property insurance associated with loans, insurance sales in small towns, insurance sales by small banks, supervising certain retail insurance agents and two grandfathering clauses [Mason and Massey, 1991]. *San Jose State University and Visitor, Massey University, NZ **The University of Michigan The authors are grateful for suggestions from Andrew Thompson and session participants at the Midwest Finance Association Meetings where an earlier version of this paper was presented. We also wish to thank Michael Garner for his excellent research assistance. Journal Of Financial And Strategic Decisions 14 The regulatory climate since the early 1980s has become more receptive to expansion of bank product-lines into insurance markets, and the Federal Reserve Board has issued statements pressing for product-line deregulation of the banking industry. The Federal Reserve Board has also interpreted the exemptions to the regulatory acts very liberally, particularly grandfathering clauses. To stop the Federal Reserve Board from weakening previous laws concerning insurance activities, the Saving and Loan Industry Recapitalization Act of 1987 placed a temporary moratorium on new banking powers. However, the moratorium expired early in 1988 and was not extended. Federally chartered bank holding company interest in insurance has been stimulated in recent years by both foreign and domestic competition. Many European banks have greater flexibility in offering insurance products than U.S. banks and have expanded these services in recent years [The Economist, 1991]. National and state chartered banks are subject to regulations of non-bank activity which are generally similar to those of federally chartered bank holding companies [Felgran, 1985]. However, in 1983 national banks were permitted to rent lobby space to independent insurance agents with rent being related to the volume of business or earnings of the insurance firm. Concurrently, state chartered banks have been given more flexibility when undertaking nonbanking activities. For example, South Dakota allows an expanded menu of insurance products, and allows nonSouth Dakota chartered bank to acquire State chartered banks. The passage of Proposition 103 in California opened the insurance markets in one of the largest states. And in 1990, Delaware passed a much debated law which allowed banks chartered in Delaware to underwrite and sell insurance. The Delaware law could have an impact on cash-flows and asset liability management for banks taking advantage of it. Cash-flows may increase if expansion into insurance product lines offsets the loss of more traditional banking profit sources. Diversification into insurance product lines may also reduce interest rate risk. A study by Ambrose, Brown and Winters [1992] finds support for increased cash-flow, but these authors do not find interest rate reduction benefits through expansion into insurance product lines. Several recent events have also broadened national and state banks’ ability to enter nationwide insurance markets. In 1987, the FDIC modified its regulations and permitted insured banks to underwrite life insurance with certain safeguards in place. And in 1988, a Federal Court upheld a ruling by the Comptroller of the Currency (OCC) allowing national banks to sell insurance from offices in towns with populations of less than 5,000. However, a recent ruling by a U.S. Appeals Court has restricted the ability of the OCC to permit banks to sell insurance in small towns [Banking Week, February 18, 1992]. Legislation considered, but not passed by the House Banking Committee would have limited certain national banks insurance activities, but protected Delaware Laws [Wall Street Journal, July 5, 1991]. While insurance interests have opposed banks entry into their markets, insurance regulations do not generally prohibit bank control of insurance companies. In states such as Illinois, insurance agents have had some success in fighting legislation aimed at permitting banks chartered outside of Illinois to sell insurance [Verisario, 1990]. In general, however, except for restrictions such as the Appleton Rule for New York-based insurers, state-by-state variations in insurance regulations do not make an effective deterrent to bank entry. Clearly, banks’ expansions into insurance product-lines has been changing over the past decade. Prior to 1982, the regulatory climate was not receptive to such behavior. It was thought that by allowing non-bank activities the competitive nature of the insurance industry, as well as banking safety and stability, could be compromised. Events after 1983 indicate a changing regulatory climate toward bank insurance activity, and increasingly competitive marketplace. With this dichotomy in mind, this paper examines bank holding companies entry into insurance to examine the impact of product-line expansion into insurance services on bank shareholders returns. Several previous studies have considered the effects of bank holding company product-line expansion. Eisenbeis, Harris and Lakonishok [1984] examined changes in returns to shareholders resulting from 1970 legislation permitting engaging in non-bank activities, and found that gains were small and insignificant. Eisenbeis and Wall [1984] and Brewer [1989] both concluded that one needs to examine specific types of acquisitions to answer questions concerning profitability and risk. Swary [1981] and Saunders and Smirlock [1987] examined bank acquisitions of mortgage firms and discount brokerages, respectively, both finding small, insignificant effects on bank shareholders’ wealth. Brewer, Fortier and Pavel [1988] found limited potential for risk reduction through diversification into a set of non-bank activities, and Kwast [1989] and Rosen et al. [1989] found limited potential for diversification advantages to bank entry into security and real estate activities, respectively. Recently, however, Brewer [1990] found decreases in bank return volatility associated with non-bank activities, including insurance. Simulation studies have also been used to examine the existence of diversification benefits. Boyd and Graham [1988] simulated hypothetical mergers using COMPUSTAT data and concluded that combining life insurance Expansion Into Insurance Product-Lines And Bank Shareholder Returns 15 companies and banks reduced risk in the combined firm as well as returns. Christiansen and Pace [1992] also examined the potential impact of insurance, securities, and real estate powers on bank holding companies from 1971-1989. They conclude that insurance powers offer the greatest potential to increase earnings at the same or lower risk, or decrease risk at the same or higher earnings of the bank before the merger. Based upon the existing body of literature on bank product-line expansion, the null hypothesis underlying this investigation is that expansion into insurance product-lines will not be associated with significant changes in returns to investors in bank holding companies. However, it is hypothesized that there may be differences in returns before and after 1982, due to changes in the regulatory climate and competition in the marketplace which may make insurance product lines more attractive to bank holding companies. Following a brief section on the event study methods employed, the data for this study are analyzed and then discussed.