Thursday, March 25, 2010

Is SBI's foray into general Insurance wise?

A few days back, I criticised LIC's intention to get into banking.

Now comes a report that, to top its foray into Life Insurance, SBI intends to enter General Insurance business before end of April, 2010. They have already been recruiting managers for this venture for the last 10 months, and are almost ready to launch.

The same logic and criticism applies to SBI's joint venture with Insurance Australia Group too. It is bad enough that they have ventured into Life Insurance. This makes it worse, in my view. Why?

Banking and Insurance are the two most risky businesses worldwide, and involve two completely different challenges. Insurance companies have to deal wisely with a surfeit of liquidity (usually) and banks have to constantly manage threat of liquidity shortfalls. Combining both reduces the strength of the combination to overcome threats and severe demands on liquidity that affect both industries. The recent global recession is an example of a threat to both industries simultaneously. Enough financial pundits (Nouriel Roubini, Nassim Taleb, et al) have predicted that this could happen again, and in our lifetimes.

We in India escaped the impact of the global crash because of three major factors: 
  1. Our financial institutions were just not allowed to invest in derivative securities and there was consequently hardly any significant secondary market trading in debt securities;
  2. Our banks had a very significant liquidity padding (SLR/CRR) that was nearly absent in the first world; and 
  3. Our banks were not major players in any part of the banking business, and our insurance players were similarly almost absent in the banking sector.
Now the situation is set to change -- in the name of development and liberalisation. 

Banks are getting into insurance, and insurance companies are getting into banking. This in my view magnifies the riskiness of both businesses, and does not diminish it. I am not even talking of conflict of interest here, which can also rise considerably.

There is constant clamour for reduction in SLR/CRR, which, in my view is nothing but an operating profit cushion against the banking industry's inability to extract risk-adjusted returns on their lending and assurance intermediation (L/Cs, Bank Guarantees, etc) businesses, which the RBI has, in its wisdom, resolutely resisted, and I really hope they continue to do so..

In addition, our stock exchange margining system and transaction settlement system worked even better than in the US in containing huge negative exposures of individual players, mainly because algorithmic trading (which can very rapidly put through transactions involving mind-boggling amounts) was not permitted in India. Now algorithmic trading is permitted, and probably accounts for about 20% of all trades today. This percentage is set to zoom, giving traders with access to this technology a huge edge, and reducing retail investors to mere peripheral price takers. Given that our markets still do not have depth comparable to the first world exchanges, a runaway rogue trading program has the potential of putting almost the entire exchange settlement and margining system at risk, leading to a possible rapid stock market crash or boom. 

I hope I am wrong.  

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.