Solution manual bank management and financial services 9th edition by rose, peter chap014

Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

CHAPTER 14
INVESTMENT BANKING, INSURANCE, AND OTHER SOURCES OF FEE INCOME
Goal of This Chapter: This chapter is designed to explore several of the most important nondeposit financial services banks have offered to the public in recent years, including investment
banking, trust services, investments in stocks, bonds and mutual funds, insurance policies, and
annuities and examine their possible benefits.
Key Topics in This Chapter

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The Ongoing Search for Fee Income
Investment Banking Services
Mutual Funds and Other Investment Products
Trust Services and Insurance Products
Benefits of Product-Line Diversification
Economies of Scope and Scale
Information Flows and Customer Privacy
Chapter Outline

I.
II.

Introduction
Sales of Investment Banking Services
A.

Key Investment Banking Services
B.
Linkages between Commercial and Investment Banking
C.
Possible Advantages and Disadvantages of Linking Commercial and Investment
Banking
D.
Key Issues for Investment Banks of the Future
III.
Selling Investment Products to Consumers
A.
Mutual Fund Investment Products
B.
Annuity Investment Products
C.
The Track Record for Sales of Investment Products
D.
Risks and Rules for Selling Investment Products
IV. Trust Services as a Source of Fee Income
A.
History of Trust Services
B.
Roles of Trust Departments
C.
Types of Trusts
V.
Sales of Insurance-Related Products
A.
Types of Insurance Products Sold Today
1.

Life Insurance Policies
2.
Life Insurance Underwriters
3.
Property/Casualty Insurance Policies
4.
Property/Casualty Insurance Underwriters
B.
Rules Covering Insurance Sales by Federally Insured Depository Institutions
VI.
The Alleged Benefits of Financial-Services Diversification

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Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

A.

An Example of the Product-Line Diversification Effect Reducing Risk

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Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

VII.
VIII.

B.

Potential Economies of Scale and Scope
Information Flows within the Financial Firm
Summary of the Chapter
Concept Checks

14-1. What services are provided by investment banks (IBs)? Who are their principal clients?
The primary role of investment bankers is to serve as financial advisers to corporations,
governments, and other large institutions. Investment banks help underwrite a number of
securities for corporations including common and preferred stock, corporate bonds, government
and federal agency securities and others. In addition, they can provide a number of services
including advising clients regarding acquisitions and mergers, creating and trading in derivatives,
brokering loan sales, setting up special-purpose entities, stock and bond trading, currency and
commodity trading, issuing credit and liquidity enhancements and developing business plans so
companies can expand into new markets.
14-2. Why were U.S. commercial banks forbidden to offer investment banking services for
several decades? How did this affect the ability of U.S. banks to compete for underwriting
business?
The Glass-Steagall Act in 1933 prohibited commercial banks from offering investment bank
services for primary two reasons. One, the bank could force a customer seeking a loan to buy the
securities that they were trying to sell as a condition for getting a loan, and second, the bank
would be exposed to increased risk due to the volatile and cyclical behavior of investment
banking activities. Due to this, U.S banks were not able to compete for underwriting business
with foreign banking firms who in turn captured U.S. customers.
14-3. What advantages do commercial banks with investment banking affiliates appear to have
over competitors that do not offer investment banking services? Possible disadvantages?
Investment banking services complement traditional lending services allowing commercial
banking firms to offer both conventional loans and security underwriting to customers who seek
to raise new funds. In addition, there are economies of scale in information gathering about
clients. Though the benefits of cost and risk reduction through this new service dimension have
not been proven, the commercial banks have transformed investment banking industry by

acquiring some of its largest firms and consolidating smaller investment banks into larger ones.
However, investment banking services are highly sensitive to fluctuations in the economy and
would increase the risk exposure of the commercial bank.
14-4. What are investment products? What advantages might they bring to an institution
choosing to offer these services?

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Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

Investment products include stocks, bonds, mutual funds, annuities, and other nondeposit
services. The most popular investment products offered by depository institutions include mutual
funds.
The potential advantages of offering these services to customers include generating considerable
fee income which may be less sensitive to interest rate movements than traditional services such
as loans and deposits. In addition, it is possible that it might add prestige and may help position
the institution well for the future as more and more individuals start planning for retirement.
14-5. What risks do investment products pose for the institutions that sell them? How might
these risks be minimized?
There are several risks involved in the sale of investment products. The value of these products is
market driven and customers may blame the bank when they do not reach their earnings goals.
Because of their reputation, customers may hold depository institutions to a higher standard than
securities brokers for example. As a result, they may end up getting involved in costly litigation
with customers who are disappointed or who claim that the risks involved were not adequately
explained. In addition, they may have compliance problems if they do not properly register their
investment products with the Securities Exchange Commission or fail to follow the rules laid
down by regulatory agencies, state commissions, and other legal bodies that monitor this market
for the sale of these products.
Regulators already require these products to be sold in a separate area from where deposits are

taken and banks are required to prominently display that these products are not insured by the
Federal Deposit Insurance Corporation. The customers should also be informed that the
investment products are not a deposit or other obligation of a depository institution and not
guaranteed by the offering institution. In addition, customers must be told that these products are
subject to risks, including potential loss of principal. Customers must sign a document stating
they were informed of these risks. The institutions must make sure that the names of these
products cannot be confused with their regular products. Finally, they must demonstrate that they
are regularly monitoring themselves to ensure that their sales personnel are complying with the
regulatory requirements and banks are also supposed to be sure that the products they sell meet
the needs of each particular customer and situation. Compliance with these regulations should
help minimize the risks inherent in these products.
14-6. What exactly are trust services?
Trust departments manage the property of customers including their securities, land, buildings
and other investments. This is one of the oldest services provided by banks. Trust departments
should safeguard and prudently manage a customer’s assets to generate earnings.
14-7. How do trust services generate fee income and often deposits as well for banks and other
financial institutions offering this service?
Trust departments manage the assets of their customers. The financial institution charges their
customers a fee for providing these services and generates fee income.

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Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

Assets managed by the trust departments include deposits and, in some cases, these deposits can
be substantial. This way, trust departments often generate large deposits because they manage
property for their customers. It is worth noting that deposits placed in a bank by a trust
department must be fully secured.
14-8. What types of insurance products do banks and a number of their competitors sell today?

What advantages could these products offer depository institutions choosing to sell insurance
services? Can you see any possible disadvantages?
Financial institutions are starting to offer several insurance products. One product that they offer
today is life insurance in which the bank promises to pay a beneficiary a specific cash payment
in the event of the death of the policyholder. Another insurance product they are interested in is
life insurance underwriting. Here, the institution would manage risks associated with paying life
insurance claims. They want to profit from managing insurable risks and collect more in life
insurance premiums than they pay in claims. Financial institutions are also getting involved in
selling insurance policies for protection from loss due to personal injury, property damage, and
other losses associated with property and casualty insurance products. In addition, they also
underwrite property/casualty insurance risks. Again, by doing this, they want to collect more in
premiums than they have to pay in claims on these contracts.
Because of the growth in consolidation of the insurance industry, the financial service providers
have been buying out their competitors and emerging as global players. Due to this, these
companies seek lower production and marketing costs, diversification of risk exposure beyond
one or two countries, and opening up greater revenue potential from what they see as
“underinsured” markets (especially in Europe and Asia).
On the other hand, selling insurance services requires financial institutions to adhere to strict
consumer protection rules. This is practiced because the public may be misled or misinformed.
For example, the customer may conclude wrongly that insurance products offered by a
depository institution are covered by government-sponsored deposit insurance in case the
customer suffers a loss.
14-9. What is convergence? Product-line diversification? Economies of scale and scope? Why
might they be of considerable importance for banks and other financial-service firms?
Convergence is the bringing together firms from different industries in order to create large
conglomerates offering multiple services in one place. Product-line-diversification suggests that
offering services that are not perfectly correlated with each other has the potential to reduce the
risk (variability) of the cash flows of the overall company. Economies of scale means that there
might be cost savings from being able to produce a larger number of units of the same product
due to greater efficiency and the spreading of a greater volume of output over the firm’s fixed

costs. Economies of scope means that there are potential costs savings resulting from producing
two or more services in one firm. For example, if a single financial firm produces two services,
instead of producing only one service, using the same resources, its cost of production may be
lower.

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Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

These things mean that banks and other financial institutions may be more efficient and
productive in delivering services to customers either resulting in higher profit margins for
companies or cost savings for consumers. These strategies can also result in reduced risk of
failure through greater product-line and geographic diversification.
14-10. How can financial-service customers limit the sharing of their private data by different
financial-service firms? In what ways could customer information sharing be useful for financial
institutions and for their customers? What possible dangers does information sharing present?
Financial-service firms must inform customers of their policy regarding the sharing of
information with other parties. Financial-service firms must also inform customers about how the
customer can opt out of having their information shared with other parties. Generally, the
customer must inform the company within 30 days of being notified that they do not want their
information shared. If the customer fails to notify the service provider of his or her objections to
sharing personal data, then the financial-service firm can share at least some of the customer’s
private information with others, even with outsiders..
This information can be extremely useful to financial institutions because they can use the
information to offer more than one service to the customer. They have already gathered the
relevant information and can target products and services that are particularly a good fit for that
customer. This can benefit them by increasing profits and cash flows and can benefit the
customer by allowing them to get all of their financial services needs taken care of in one place.
However, there are some real dangers that this information can be misused in some cases. For

example, if there is some adverse private information about a particular customer (a very serious
medical condition) that information might be used to deny them several financial services (such
as getting a new mortgage). This customer essentially becomes blacklisted by many financialservices companies.
Problems and Projects
14-1. Suppose the management of the First National Bank of New York decides that it needs to
expand its fee-income-generating services. Among the services the bank is considering adding to
its service menu are investment banking, the brokering of mutual funds, stocks, bonds and
annuities, sales of life and casualty insurance policies, and offering personal and commercial
trust services.
a. Based on what you read in this chapter, list as many potential advantages as you can that
might come to First National as a result of adding these services to its menu.
First National may be able to supplement traditional sources of income with the new fee income
that they generate and also increase the earnings stability. In addition, they may be able to reduce
the risk of the overall institution by adding services that are not very correlated with the
traditional services. They may find that some of these services are less interest rate sensitive than
traditional services. They may be able to generate economies of scale and scope from offering
these services. Because of the economies of scale, the production cost per unit would tend to

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Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

drop as the firm would get larger. Because of the economies of scope, it may become cheaper to
jointly produce two or more services than having to produce each service separately.
b. What potential disadvantages might the bank encounter from selling these fee-generating
services?
There are many potential disadvantages that First National Bank might encounter from selling
fee-generating services. Investment banking activities tend to be much more volatile than
commercial banking activities because of abrupt changes in market conditions and fierce

competition.
These additional services are substantially more risky than commercial banking. If First National
misestimates and the market price and plunges as the sale begins, it will be forced to absorb the
resulting loss.
Moreover, the value of some such services is market determined and their performance can turn
out to be highly disappointing. This may anger the customers who may be holding the services
being offered by First National to a higher standard of performance than a securities broker.
First National could also get involved in costly lawsuits filed by disappointed investors who may
allege that they were misled about the risks associated with investment products or were charged
excessive service fees. In addition, First National needs to be sure to comply with all regulations
concerning selling investments products.
Customers could confuse First National’s traditional products with their investment products if
First National does not disclose the differences between their traditional products and the new
services that they are offering. The same thing is true if they offer insurance products.
c. Are there risks to the bank from developing and offering services such as these? If so, can you
think of ways to lower the bank’s risk exposure from offering these new services?
First National faces the risk of customers not being satisfied with the returns. There is also a
possibility that such customers may feel they have been misled about these products and sue the
bank. The bank can prevent some of this by counseling each customer as to the risks involved in
these products and have them sign a form stating that they understand the risks involved in these
products.
First National must also be careful to be in full compliance with all regulations. These and other
regulatory rules must be conspicuously displayed inside offices of depository institutions where
investment products are sold. Moreover, these products must be sold in an area separate from the
area where deposits are taken from the public.
d. What might happen to the size and volatility of revenues, expenses, and profitability from
selling fee-based services like those mentioned above?

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Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

It is possible that the revenues will rise and expenses will fall, increasing the return to the bank.
In addition, it is possible that the volatility of the bank’s earnings will decrease. It depends, in
part, on how correlated the new services are with the old services. If they are not correlated,
returns can actually rise and volatility can decrease from adding the new services due to the
product-line diversification effect.
14-2. A commercial bank decides to expand its service menu to include the underwriting of
new security offerings (i.e., investment banking) as well as offering traditional lending and
deposit services. It discovers that the expected return and risk associated with these two sets of
service offerings are as follows:
Expected return—traditional services
Expected return—security underwriting
Standard deviation—traditional services
Standard deviation—security underwriting
Correlation of returns between two services
Proportion of revenue—traditional services
Proportion of revenue—security underwriting

3.50%
10.75%
2.50%
8.25%
+0.25
70.00%
30.00%

Please calculate the effects of the new service on the banking company’s overall return and risk
as captured by the bank’s standard deviation of returns.

The banks expected return from the overall service menu is calculated as:
E(r) = R TS × E  rTS  + R NS ×E  rNS  = 0.70  (3.50 percent) + 0.30  (10.75 percent) = 5.68 percent
Where,
E(r) = Expected return from the overall service menu
R TS = Proportion of revenue from traditional services
E  rTS  = Expected return from traditional services
R NS = Proportion of revenue from security underwriting
E  rNS  = Expected return from security underwriting
The bank’s standard deviation can be calculated as follows:
2
2
2
σ r = R TS
× σ TS
+ R×σ
NS

2
+
NS2× R 

TS

1-R


= 3.37%
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TS

×
ρ

× σ× σTS

TS,NS

NS


Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

Where,
σ r = Standard deviation of overall return
2
R TS
= Squared proportion of revenue from traditional services
2
σ TS
= Variance of revenue from traditional services

R 2NS = Squared proportion of revenue from security underwriting
σ 2NS = Variance of revenue from security underwriting
R TS = Proportion of revenue from traditional services
RNS = Proportion of revenue from nontraditional services
ρ TS,NS = Correlation of returns between traditional and security underwriting
σ TS = Standard deviation of return from traditional services
σ NS = Standard deviation of return from security underwriting
14-3 Based on what you learned from reading this chapter and from studies you uncovered on

the Web, which of the financial firms listed below are most likely to benefit from economies of
scale or scope and which will probably not benefit significantly from these economies based on
the information given?
a. A new bank offering traditional banking services (principally deposits and loans) was
chartered earlier this year, gaining $50 million in assets within the first six months.
This bank should benefit from the increase in size as economies of scale take effect. This firm
should continue to enjoy economies of scale as it grows in the next several years. However, these
economies of scale will not continue indefinitely and there is some evidence that economies of
scale are exhausted fairly quickly in banking firms. The bank could benefit from economies of
scope if it has resources that could be used to produce different services.
b. A community bank with about $250 million in assets provides traditional banking services but
also operates a small trust department for the convenience of families and small businesses.
This bank probably does not benefit much from economies of scope. It is possible that the bank
uses the same resources to provide both traditional banks services and trust services, in which
case it could benefit from economies of scope.
c. A financial holding company (FHC) with about $2 billion in assets offers a full range of
banking and investment services, giving customers access to a family of mutual funds.
Economies of scale start to disappear in about this range although there may be some small
economies of scale that still exist up until the size of about 10 billion. As the bank does provide a
range of services, it probably does benefit from economies of scope.
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Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income

d. A bank holding company with just over $10 billion in assets also operates a security brokerage
subsidiary, trading in stocks and bonds for its customers.
This firm appears to be outside of the range where any economies of scale exist. However, the
evidence for economies of scope is clear as the bank provides a wide range of services.
e. A financial holding company (FHC) with $750 billion in assets controls a commercial bank,

investment banking house, chain of insurance agency offices, and finance company and supplies
commercial and consumer trust services through its recently expanded trust department.
This firm appears to be outside of the range where any economies of scale or scope exist.

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