Risk Aversion Over the Last

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 This is because this deal will be able to figure out ways to get around that outdated law.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1998) This is significant, because these comments are: highlighting the arguments that the Glass Steagall Act was out of date and it is underscoring the challenges many large financial service firms are facing.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 the repeal of the Glass Steagall Act. This was because they were seeing one of their primary competitors (Travelers) merging with Citicorp (which created a juggernaut of: insurance, banking and brokerage activities). At which point, executives at AIG felt that in order to: maintain their dominance in the industry and offer new products they should become involved in similar activities. The difference was that they would grow the company by expanding into areas that were considered to be speculative to include: commodities, stocks, options and credit default swaps. The way that this was accomplished is by purchasing a host of businesses that were involved in these activities. This is significant, because it meant that a shift would take place in: how managers were accounting for risks and the kinds of activities that they were becoming involved in. With the newly acquired companies; bringing over executives that did not practice the same kind of strategies for dealing with various risks. Over the medium term, this meant that the company would see a dramatic increase in their operating income. as, it multiplied from: $900 million in 1998 to $4.4 billion in 2005. (Sullivan, 2007)

However, in the long-term these different activities meant that executives were increasing the overall risks facing the company. Evidence of this can be seen by looking at the total amount of leverage that AIG has in comparison with their competitors. The below table illustrates the amount of leveraged equity at the company in contrast with others in the industry during 2007. (Sullivan, 2007)

Total Amount of Leverage at AIG in Comparison to their Competitors

Company

Leverage

AIG

11 to 1

Markel

4 to 1

Berkshire Hathaway

2 to 1

Montpelier RE

2 to 1

White Mountain Insurance

4 to 1

Chubb

4 to 1

(Sullivan, 2007)

These different figures are important, because they are showing how AIG had a significantly larger portion of leveraged equity in comparison with the rest of the sector. This is problematic, because it meant that the actions that executives were taking were increasing the overall bottom line dramatically. While at the same time, it was exposing the company to: shifts in the economic cycle and a possible implosion in a host of different asset classes. Once this occurred, it meant that it would be only a matter of time until the entire company would be exposed to the risks that were taken by managers. (Sullivan, 2007)

In many ways, one could argue that the repeal of Glass Steagall Act has increased the overall threats, facing large firms in comparison with smaller entities. as, the lack of regulation is allowing these organizations to: become major threats to the economy. This is because they have become such a vital part of economic activity moving forward; that any kind of volatility will: have an impact upon their lending activities to consumers and businesses. As a result, small firms are more able to deal with these challenges in comparison with their larger counterparts.

Differences in the Risks Associated with Small Firms in Comparison with Large Ones

The biggest risks facing large financial organizations, is that they their interconnected business model will mean that they are overexposed to more risky asset classes. This is problematic, because during times of volatility these kinds of securities will often underperform the markets (due to the high degree of speculation that it involves). As a result, a variety of brokerage houses have increased the possibility that they will face a number of liquidity challenges when these situations arise. At the same time, the lack of regulating these entities (due to a number of companies conducting business in various countries around the world) has made the situation grim. As a variety of financial organizations are effectively able to circumvent the securities laws of different counties. Once this occurs, it means that there is no effective way to know what investments they are holding and the effect that changes in the value could have on the business. At which point, the risks increase that the collapse of one financial firm can cause secondary ripple effects on those organizations they are working with. This is significant, because it showing how the overall threats facing large firms has increased exponentially from these different factors.

In the case of small firms, they are dealing with similar kinds of regulations as the bigger organizations. The big difference is that the overall scope of their business model is focused on: providing various financial services to customers in specific regions and geared towards certain demographics of the population. This means that they are more highly regulated, because they have to follow stricter regulations for their business activities (in comparison with large firms). The reason why, is many of the smaller entities do not cross national borders, which makes it easier to regulate and monitor their activities. This is important, because the underlying amounts of regulation mean that there is: greater scrutiny and transparency for these organizations. (Baum, 2009)

A good example of this can be seen in a study that was conducted by Boston College. They found that those firms that are more regulated have less financial problems down the road. The reason why, is because these regulations limited the overall amounts of speculation and exposure an entity can have to various areas. Over the course of time, this means that these kinds of firms will engage in actions that are in line with regulations (which reduces: the underlying risks facing their organization). This is significant, because it showing a major advantage that these firms have over other larger entities. During times of volatility, this means that that these kinds of organizations are able to withstand more extreme economic conditions. (Baum, 2009)

A second advantage that small firms have over large organizations is: that they do not have the same kinds of access to the public markets. This is because many big brokerage houses / banks will often turn to the equity and bond markets, to help finance the continued expansion of their operations. During times of economic expansion and low interest rates this supports the long-term growth of the firm, by providing them with the capital they need. However, once a major contraction occurs, is when these kinds of organizations will face a tremendous amount of challenges. The reason why, is because the large amounts financing that they conducted in the public markets, which means that they have high levels of debt. This will have a direct impact upon the ability of the firm to: pay their short and medium term expenses. As they have to dedicate a larger amount of their declining profit margins, to cover the interest charges on the outstanding debt. Once this begins to take place, it means that many companies will have trouble maintaining these levels (which brings them one step closer to liquidation). This is important, because it shows how this contributes to the overall threats being faced by larger firms. (Weinberg, 1994, pp. 19 -- 41)

In the case of smaller organizations, they do not have as much access to the public markets. This means that they will keep their levels of debt lower in comparison with other companies. As they will often use more traditional ways to: fund their operations and will maintain larger amounts of cash reserves (on their balance sheet). The reason why, is because executives have to carefully plan how capital will be allocated (due to the fact that there are limited resources available to them). Over the course of time, this means that these kinds of firms will have more of a financial foundation to: deal with various adversities that they are facing. This is important, because it showing how these kinds of companies are protected against tremendous amounts of volatility. (Weinberg, 1994, pp. 19 -- 41)

At the same time, many smaller firms will also engage in strategies that take into account diversification. This is when you are spreading out the assets of the firm among a variety of areas. The basic idea it that by having the firm invested in different asset classes will: protect them and their clients against sudden shift in capital outflows. During times of economic calamities, many investors begin withdrawing funds from a variety of the more speculative assets. This is because, they are concerned about the underlying amounts of risk and the effect that it will could have their portfolios (which causes prices to begin collapsing). When a firm is diversified in a number of asset classes, this will protect them against sudden shocks. Once this occurs, it means that their earnings will be more stable and they can adjust to drastic changes that have taken place in the economy. This is significant, because it is showing how diversification is giving smaller firms greater amounts of stability (in comparison with larger organizations). (Weinberg, 1994, pp. 19 -- 41)

The Risk -- Reward Metrics of the Two Firms

When you look at the risk -- reward metrics between the two different kinds of firms, it is clear that the business model of larger firms encourages them to take on more speculation. What is happening is many of these companies, will often use a host of financial products to address a variety challenges for their customers. The most notable include: derivatives, forward contracts and SWAPs. These are different financial instruments that can be used to provide clients with a larger return, using less capital. Where, they are all focused on speculating, as to if prices will rise or fall in the future surrounding a particular asset class. This is troubling, because these kinds of tools have often been used by speculators to increase their overall return. The problem is: that this has been used to increase the returns of the investment. While at the same time, trying to reduce the underlying risk (through: a strategy known as hedging). This is where, you will take a position that is the opposite of the one you are using, to offset any kind of loss (such as: buying puts to reduce the downside of a common stock). (Stulz, 1996)

Over the last several years, a variety of investment advisors, strategists and investors, have been embracing this strategy as way to achieve these two objectives. The big problem is that this has caused many firms and investors, to believe that this strategy will provide them with the desired return (while lowering their risks). However, in reality this approach has caused the underlying risks of many firms to increase. As they have been using this strategy for their own accounts and they have been encouraging their clients to do the same thing. (Stulz, 1996)

In the case of larger firms, they have been using this approach as common part of their investment philosophy going back many years. This has increased their overall risks dramatically and it has meant that many of the companies are dealing with new threats inside their business model. Evidence of this can be seen in a study that was conducted by Walter Dolde. He found that out of all the Fortune 500 corporations 85% were involved in these kinds of activities. This is problematic, because it means that many executives will assume that this strategy will protect them. Yet, in reality it is increasing their underlying amounts of risk. (Stulz, 1996)