Monday, March 08, 2010

LIC to set up bank: Nothing more foolhardy!

The recent news item to the effect that LIC wants to set up a bank flies in the face of basic financial prudence and wisdom that has been reinforced by recent events in the world.Let's briefly see why this is so.

A bank lends illiquid (its loans are invested in illiquid assets like property, stocks and receivables of its borrowers) and borrows liquid (its deposits have to be repaid anytime the depositor asks for it). Hence, the major raison d'etre of a bank is managing mismatched liquidity. This is impossible in times of financial uncertainty, and if the bank loses depositors' trust. At such time, the liquidity gap forces the bank into bankruptcy unless it is rescued by the central bank. 

An insurance company is very liquid in good times, indeed, awash in liquidity. When catastrophe strikes, this liquidity is drawn on suddenly. An insurance company manages this huge risk primarily by dissipating the risk over a large number of lives or properties as the case may be, in its areas of operation; and distributing the residual risk globally through reinsurance. Hence, the raison d'etre of an insurance company is to be liquid when nobody else is. 

We have seen that extreme financial risks do not conform to the normal distribution, and that the distribution they conform to have "fat tails". Hence, we now know that banks are more vulnerable to financial crises than believed before Bear Stearns' demise in 2007.  

We have also seen that natural catastrophes of all kinds have increased significantly (maybe because of climate change effect). For example, the two deadliest earthquakes in recorded history have happened in the last two years itself (Sumatra, Chile). If we go back 10 years, a blip on the cosmic clock, we find many more unusual natural disasters like flash floods in Oman (a desert!), raging forest fires in Indonesia, Australia and the US, and many others. Further, a major earthquake is overdue in California. Hence, we can say that there is a heightened expectation of exposure to catastrophes and claims for the insurance industry worldwide.

Today, banking and insurance are unarguably the riskiest businesses globally. We have seen the wisdom of RBI's not allowing banks to become exposed to toxic derivative securities.  We have also seen the foolhardiness (it seems in hindsight)  of AIG taking on unmeasured risks of the banking industry by insuring bonds. 

It simply is foolhardy to potentially commit the liquidity of India's most liquid entity in the riskiest industry by allowing it to diversify into an industry that has been shown to be almost as risky as the insurance business.

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