Risk Aversion

Risk Aversion

Over the last several years, a variety of investment firms have undergone a transformation. as, the repeal of the Glass Steagall Act allowed a host of financial service organizations to: become involved in a number of different areas. This means that brokerage houses, banks and insurance companies are actively a part of each other's business activities. The idea was to be able to combine the resources of different financial firms. At which point, they could begin to cross market a variety of products to their customers, in an effort to offer them a total financial solution (to address their needs).

A good example of this can be seen with the Citicorp Travelers merger in 1999. What happened is various executives had complained that the Glass Steagall Act of 1933, prevented business from effectively responding to the needs of customers. As they were limited in the products they could offer and the overall scope of advice that they could provide. Over the years, this led to increased calls by many financial service firms, for Congress to repeal these regulations. Evidence of this can be seen with comments from Robert Froehlich (an analyst) at Scudder Kemper Investments saying, "I think this (the Citicorp Travelers merger) is going to force Congress to look at the Glass-Steagall again. This is because this deal will be able to figure out ways to get around that outdated law. it's going to send a signal to Congress to say 'Wake up. it's not 1933 anymore." ("Travelers, Citigroup Unite," 1998) This is important, because it shows the overall amounts of pressure that many executives from: financial service firms placed on Congress. As they wanted to repeal the law, so that they could dramatically increase: the size of their business and be more responsive to the needs of customers. Commenting about this potential was Don Smith from Houlihan Lokey Howard & Zukin (M&a advisory firm) who said, "In many respects, these companies are different. Travelers is a big brokerage firm through Salomon Smith Barney, big insurance operations, big money operations. These are all separate, in essence, from Citibank's banking operations." ("Travelers, Citigroup Unite," 1998) This is significant, because these comments are: highlighting the arguments that the Glass Steagall Act was out of date and it is underscoring the challenges many large financial service firms are facing.

As a result, the underlying risks for these kinds of companies have increased dramatically. To fully understand what is taking place requires evaluating the threats surrounding these firms. This will be accomplished by: comparing these firms with smaller organizations and looking at the risk -- reward metrics of the two entities. Together, these different elements will provide the greatest insight as to underlying challenges facing large financial institutions.

Background / Problems

The Large vs. The Small Brokerage Firm Issues

In 1933, the Glass Stegall Act was ratified. This was in response to some of the main causes of: the 1929 stock market crash and the subsequent implosion in asset prices. What happened was an extensive investigation revealed that the events of the crash were: that many different financial institutions were interconnected. As investigators found, that a host of financial firms ranging from: banks to brokerage firms were actively involved in a variety of businesses. This was problematic, because the inability to restrict the size of these firms; meant that a larger portion of capital was going into more risky investments. as, loans were being offered to: speculate in stocks, bonds and real estate. The common wisdom among financial executives (at the time), was that the economy was shifting and that this meant that the underlying risks changed dramatically. This is important, because this sense of not accounting for possible threats meant that large asset bubbles developed in: the real estate and stock markets. Once the economy began to slow and the stock market crashed, this money quickly disappeared. As the underlying risks were much more severe than, many financial professionals believed. At which point, a domino effect occurred, as asset prices began to: decline and economic activity collapsed (inviting the Great Depression). This is when it became clear that many of these institutions had overleveraged themselves in variety of areas. (Froeilich, 1999, pp. 257 -- 259)

Between 1929 and 1933, there were a number of bankruptcies (due to the fact that many financial firms did not have access to working capital). This made it difficult to pay their daily operating expenses, as they were holding assets that they could not sell and many customers were defaulting on loans. These two factors forced a variety of banks and financial firms to collapse during this time. The Glass Steagall Act was passed to: limit the activities of these firms and their size. as, these regulations were designed to: prevent the economy from being exposed to the disintegration of a particular organization. The way that this was accomplished is: that it limited the activities of firms and it placed walls between various departments inside an organization (such as: the separation between brokerage as well as investment banking divisions inside Wall Street entities). This is significant, because one could argue that until this law was repealed, the overall risks facing large and small financial firms were balanced. The reason why, is because these regulations kept their overall size limited. Over the course of time, this made it easier to regulate these entities (which helped to provide stability to the financial system). (Lowry, 1984) (Froeilich, 1999, pp. 257 -- 259)

As a result, a shift has taken place in how these firms are accounting for risks and the way many different corporations are structured. What is happening is: various banks, brokerage firms and insurance companies, have become increasingly involved in the activities of U.S. financial firms. This is important, because this shift meant that underlying risks facing the financial system increased dramatically.

A good example of this can be seen with the merger that took place between the Swiss bank UBS and the brokerage firm Paine Webber in 2000.What happened was the bank had been looking for a way to aggressively extend the reach of their investment bank into the U.S. The best way that they could achieve this objective was: purchasing Paine Webber. As they had the resources to be able to successfully integrate UBS' operations into American markets. This is significant, because it meant that many firms that were created after the repeal of the Glass Steagall Act (through: various M&a activity) were focused on having more of a global reach. (Johnson, 2000)

As, the activities of these firms became so large that they were a part of GDP growth for a number of countries around the globe. This increased the overall risks facing the financial system. Once this took place, it meant that it was only a matter of time until the underlying amounts of speculation would lead to increased threats facing the economy. as, banks could effectively sell: a variety of investments around the world to customers, representing them as safe asset classes. Yet, in reality these shift meant that underlying threats to the global financial system increased exponentially.

Evidence of this can be seen with the number of bank failures that took place in 2010. As this year represented the highest amount of institutions, that the FDIC was forced to take over in their entire history (coming in at 157). ("U.S. saw 13 Bank Failures Every Month in 2010," 2011) This is significant, because it showing the overall risks that the repeal of the Glass Stegall Act has placed on larger firms. As they have the ability to: create secondary ripple effects on medium and more specialized institutions. Once this occurred, it meant that any kind of economic recovery would take longer to begin and growth will be very tepid at best.

This also had ripple effects in the field of insurance. What happened was many different carriers began to look at other avenues that would diversify their business model. This is because there was a belief that they could take the same basic principles that they were using to: evaluate risk in insurance and apply them to other businesses. This increased the risks that their business would face, as they began to aggressively become involved in other areas of the markets. Over the course of time, this meant that many different companies became engrossed in a host of asset classes. as, executives were feeling the constant amounts of pressure to: become increasingly involved in asset management and insuring various types of securities. These two factors meant that most companies had changed their business models so much, that they were unaware of the underlying risks that they were facing. Once this occurred, it meant that it was only a matter of time until they would be exposed to systematic failures. (Sullivan, 2007)

A good example of this can be seen with AIG. What took place was that the company wanted to aggressively expand into other areas of asset management after theā€¦