Chapter Fourteen

Investment Banking, Insurance, and

Other Sources of Fee Income

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 Key Topics

• 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

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 Introduction
• Financial institutions have faced a struggle recently to attract the
funds they need in order to make loans and investments and boost
their revenues
• Whenever deposit growth slows, financial-service managers
frequently are forced to pursue new sources of funds and new ways
to generate revenue
• Important source of growth in future revenues – fee income
▫ Revenues derived from charging customers for the particular
services they use
▫ Monthly service charges on transaction accounts
▫ Commissions for providing insurance coverage for homes and
businesses
▫ Membership fees for accepting and using a particular credit or debit
card
▫ Fees for providing financial advice to individuals and corporations
▫ “Swipe fees” at the point of sale
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 Introduction (continued)
• The drive among competing financial firms to generate more fee
income as an increasingly important revenue source comes from
several sources
▫ A desire to supplement traditional sources of funds (such as
deposits) when these sources are inadequate
▫ An attempt to lower production costs by offering multiple services
using the same facilities and resources (economies of scope)
▫ An effort to offset higher production costs by asking customers to
absorb a larger share of the cost of both old and new financial
services
▫ A desire to reduce overall risk to the financial-service provider’s
cash flow by finding new sources of revenue not highly correlated
with revenues from sales of traditional services
▫ A goal to promote cross-selling of traditional and new services in
order to further enhance revenue and net income
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 Sales of Investment Banking Services
• One banking service that has been prominent, but volatile, is investment banking
• Many leading U.S. banks recently either acquired or formed their own investment
banking affiliates in order to serve corporations and governments around the
world
▫ For example, JP Morgan Chase’s acquisition of Bear Stearns
• Leading investment banks in the world today:
▫ Citigroup
▫ JP Morgan Chase
▫ Morgan Stanley
▫ Goldman Sachs
▫ Credit Suisse
▫ UBS
▫ Nomura Securities
▫ Deutsche Bank
▫ Raymond James
▫ Banc of America Securities
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 Sales of Investment Banking Services
(continued)
• Key Investment Banking Services
▫ Traditionally, the best-known and often the most profitable
investment banking service is security underwriting
▫ The purchase for resale of new stocks, bonds, and other
financial instruments in the money and capital markets on
behalf of clients who need to raise new money
▫ One of the most profitable underwriting services – initial public
offerings (IPOs)
▫ Leveraged buyouts (LBOs)
▫ Involve the acquisition of a company, usually by a small group
of investors, and typically are funded by large amounts of debt
▫ Recently, many investment banks jumped into the hedge
fund business
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 Sales of Investment Banking Services
(continued)
• Examples of client questions that investment bankers can
assist in answering:
▫ Should we (the investment bank’s clients) attempt to raise
new capital? If so, how much, where, and how do we go about
this fund-raising task?
▫ Should our company enter new market areas at home or
abroad? If so, how can we best accomplish this market-
expansion strategy?
▫ Does our company need to acquire or merge with other
firms? Which firms and how? And when is the best time to do
so?
▫ Should we sell our company to another firm? If so, what is
our company worth? And how do we find the right buyer?
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 Sales of Investment Banking Services
(continued)
• With passage of the Gramm-Leach-Bliley (GLB) Act of
1999, the full range of investment banking services was
opened up for adequately capitalized and well-managed
commercial banking firms
• Research studies suggest that investment banking revenue
and profitability are positively, but not highly, correlated
with commercial banking revenues and profitability
▫ There may be some significant product-line diversification
effects
• It is not yet clear that the benefits alleged from this new
service dimension have offset the costs and risks involved

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 Sales of Investment Banking Services
(continued)
• Investment banks today are wrestling with the question of what
kind of financial firm they need to be in the future
▫ What mix of services should they be offering to achieve high and
sustained profitability?
• A few commercial bank–investment bank combinations have
shown promise for the future, despite ongoing struggles to fend
off losses following a huge mortgage market meltdown in 2007–
2009
• Recently both investment banks and commercial banks have
been under intense pressure to raise large amounts of new
capital
• Many observers anticipate more mergers
▫ It is not clear that future commercial bank-investment bank
combinations will consistently turn out well
▫ One likely outcome is greater government regulation
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 Selling Investment Products to Consumers
• In recent years many of the largest business and household
depositors have moved their funds out of deposits at banks and
thrift institutions into investment products
▫ Stocks, bonds, mutual funds, annuities, and similar financial
instruments
• Mutual Fund Investment Products
▫ One of the most popular of the investment products
▫ Each share in a mutual fund permits an investor to receive a pro
rata share of any dividends or other forms of income generated by a
pool of stocks, bonds, or other securities the fund holds
▫ If a mutual fund is liquidated, each investor receives a portion of
the net asset value (NAV) of the fund after its liabilities are paid off,
based on the number of shares each investor holds
▫ Proprietary funds versus nonproprietary funds
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 Selling Investment Products to Consumers
(continued)
• Annuity Investment Products
▫ Annuities are a hedge against living too long and outlasting one’s
savings
▫ Fixed annuities promise a customer who contributes a lump sum of
savings a fixed rate of return over the life of the annuity contract
▫ Variable annuities allow investors to invest a lump sum of money in
a basket of stocks, mutual funds, or other investments under a tax-
deferred agreement, but there may be no promise of a guaranteed
rate of return
▫ Recently a new type of annuity contract has appeared, the equity-
index annuity
▫ Combines the features of both fixed and variable annuities
▫ One advantage for financial firms selling this service is that
annuities often carry substantial annual fees
▫ One significant disadvantage with annuities sold through
depository institutions is they typically compete with selling
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 Selling Investment Products to Consumers
(continued)
• Several problems and risks are associated with sales of
investment products
• Current U.S. regulations require that customers must be
told orally (and sign a document indicating they were so
informed) that investment products are:
1. Not insured by the Federal Deposit Insurance
Corporation (FDIC)
2. Not a deposit or other obligation of a depository
institution and not guaranteed by the offering
institution
3. Subject to investment risks, including possible loss of
principal
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 Trust Services as a Source of Fee Income
• Trust services is the management of property owned by
customers, such as securities, land, buildings, and other assets
▫ Among the oldest nondeposit services that banks and some of their
closest competitors offer parts of the financial firm
• Trust departments often generate large deposits because they
manage property for their customers
• Deposits placed in a bank by a trust department must be fully
secured
• Popular kinds of trusts:
▫ Living trusts
▫ Testamentary trusts
▫ Irrevocable trusts
▫ Charitable trusts
▫ Indenture trusts
• Establishment of fiduciary relationship is critical
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 Sales of Insurance-Related Products
• Banks can use their branches to sell insurance
▫ Over 100 banks today sell their own insurance products in the
United States
• Types of insurance products sold today:
▫ Life insurance policies
▫ Property/casualty insurance policies
• Life insurance underwriters and property/casualty
insurance underwriters manage their respective risks

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 Sales of Insurance-Related Products
(continued)
• There are mandatory public disclosures on the part of
depository institutions selling insurance products that stipulate:
1. An insurance product or annuity is not a deposit or other
obligation of a depository institution or its affiliate
2. An insurance product or annuity sold by a depository institution
in the United States is not insured by the FDIC, any other agency
of the U.S. government, the depository institution itself, or its
affiliates
3. Insurance products or annuities may involve investment risk and
possible loss of value
4. U.S. depository institutions cannot base granting loans on the
customer’s purchase of an insurance product or annuity from a
depository institution or any of its affiliates or on the customer’s
agreement not to obtain an insurance product or annuity from an
unaffiliated entity
• These disclosures must be made both orally and in writing
before completion of the sale of an insurance product
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 The Alleged Benefits of Financial-Services
Diversification
• When two or more different industry types merge with each
other, this strategic move is called convergence
• One possible benefit is the relatively low correlation that may
exist between cash flows or revenues generated by the sale of
traditional industry products versus the sale of nontraditional
products
▫ But because streams of revenue from different product lines may
move in different directions at different times, the overall impact of
combining these different industries and products under one roof
may be to stabilize combined cash flows and profitability
▫ The risk of failure might also be reduced
• This potential consequence of the convergence of two or more
financial-service industries is called the product-line
diversification effect
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 The Alleged Benefits of Financial-Services
Diversification (continued)
• Example of what could happen to overall institutional risk by
combining traditional and nontraditional financial services
▫ Suppose a banking company decides to add insurance services to its
existing product menu
▫ It expects to earn a 12 percent average return from sales of its
traditional banking products and a 20 percent return from selling or
underwriting insurance services
▫ These two service lines are equally risky in the variance of their cash
flows (with a standard deviation of about 5 percent each)
▫ The banking firm expects to receive 20 percent of its revenues from
insurance sales and 80 percent from sales of traditional banking
products
▫ The cash flows from the two sets of services are negatively correlated
over time with a correlation coefficient of -0.50
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 The Alleged Benefits of Financial-Services
Diversification (continued)
• What would happen to the bank’s overall return from
sales of traditional and nontraditional products in this
case?

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 The Alleged Benefits of Financial-Services
Diversification (continued)
• And what happens to the risk of return for this bank?

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 The Alleged Benefits of Financial-Services
Diversification (continued)
• And what happens to the risk of return for this bank?

• Offering both traditional and nontraditional banking services

lowers the bank’s standard deviation of its overall return
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 The Alleged Benefits of Financial-Services
Diversification (continued)
• Other potential benefits from offering multiple services include economies of scale
and economies of scope
• Economies of scope refer to a situation in which the joint costs of producing two or
more services in one firm are less than the combined cost of producing each of
these services through separate firms
• For example, if a single financial firm produces two services (S1 and S2), instead of
producing only one service (S1), using the same resources, its cost of production (C)
may be lower as follows

• As a result, expanding the number of financial services offered may result in more
intensive use of resources, reducing overall costs and widening a multiservice
firm’s profit margin
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 Information Flows within the Financial Firm
• Financial firms have become more and more like pure
information-gathering, information-processing, and
information-dispersing businesses
• The Gramm-Leach-Bliley Act of 1999 allowed financial-
service companies to share customer information among
their affiliated firms and also with independently owned
third parties provided customers did not expressly say
“no” to (or “opt out” of) having their personal data
distributed to others
• Protecting customer privacy became increasingly more
important

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 EXHIBIT 14–1 Key Items That Must Be Included in a
Financial Firm’s Privacy Policy and Be Sent to Its Customers

at Least Once a Year

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 Quick Quiz
• What services are provided by investment banks? Who are their
principal clients?
• What advantages do commercial banks with investment
banking affiliates appear to have over competitors that do not
offer investment banking services? Possible disadvantages?
• What are investment products? What advantages might they
bring to an institution choosing to offer these services?
• How do trust services generate fee income and often deposits as
well for banks and other financial institutions offering this
service?
• 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?
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