At the conclusion of part II, we defined the guidance that was available for lenders with regard to force-placed insurance, and mentioned how the largest banks have taken a tried and true collateral risk transfer product and turned it into a bank fee income product.
For 100’s of years, traditional banks had grown organically as their net income was transferred to risk capital on their balance sheets. Banks made money by collecting deposits in the form of checking accounts and CD’s and then used this money to make loans to both consumers and local businesses. The difference between the interest paid to the depositors and the interest collected on loans is known as net-interest margin. This was the primary income source for banks. Like other businesses, traditional banks “bought” deposits low and “sold” loans high.
Under this business model, banks that operated on net-interest margin did not possess the capital to acquire more than one or two banks. All this changed with the Bank Holding Company Act of 1956.
Wikipedia defines the benefits of bank holding companies as follows:
Becoming a bank holding company makes it easier for the firm to raise capital than as a traditional bank. The holding company can assume debt of shareholders on a tax free basis, borrow money, acquire other banks and non-bank entities more easily, and issue stock with greater regulatory ease. It also has a greater legal authority to conduct share repurchases of its own stock.
The downside includes responding to additional regulatory authorities, especially if there are more than 300 shareholders, at which point the bank holding company is forced to register with the Securities and Exchange Commission. There are also added expenses of operating with an extra layer of administration.
Bank Holding companies were able to raise large amounts of capital as publically traded companies. This allowed a few very aggressive bank holding companies to acquire a large number of smaller banks to become some of the largest banks in the world.
Here are a few facts from the FDIC….
• 7300 FDIC Insured banks in the USA
• $13.9 Trillion in assets at FDIC insured banks
• $7.8 Trillion of these assets are controlled by 4 banks
This represents 56% of all assets at FDIC banks are controlled by 4 of the 7,300 banks. Not quite the 80/20 rule!
I described net-interest income in the paragraphs above. This is one of two major income streams for banks. The other is called non-interest income, or may be called “fee income”. This is revenue generated from other activities within the bank not associated with interest. This includes checking account fees, loan origination fees and investment fees. In addition, if a large bank owns an insurance operation, the net income derived from commissions is also categorized as fee income on the bank’s income statement.
Let’s compare the ratios of net-interest income and fee income for various size banks:
The table above is generated from the most recent call reports from typical banks within the asset size groupings. As you can see from the table above, trillion dollar banks rely on fee income to drive 49% of their revenue, where mid-size and community banks still rely on net interest income and only derive 15-17% of their income from fees.
So here is my opinion on why the largest banks are currently under scrutiny for force-placed insurance.
1. These banks are actively traded and they are under constant scrutiny from Wall Street analysts to drive earnings. Fee income represents half of their income.
2. These banks all have insurance operations that began taking large commissions on force-placed insurance which in turn drove fee income to the bottom line.
3. Force-placed insurance providers did not properly advise these large clients with regard to potential operational risks associated with commissions and fees associated with force-placed insurance.
4. Bank risk managers did not properly evaluate operational & reputational risks associated with force-placed insurance as a fee income product.
So in items 2 through 4 above, a few risk managers from both the insurance and banking industries ignored the guidance that was available from the 1996 NAIC Model Act and changed a proven collateral risk transfer technique into a fee income banking product.
Over the next few years, as litigation moves through the courts, we will re-live the force-placed industry’s history that was originally created in 1991. As history repeats itself, a very few banks will once again paint the entire force-placed industry with a very broad brush.
In conclusion, I hope I have shown that not all banks need to operate their force-placed program as a fee income product. The above table shows that over 99% of banks continue to operate with net interest margin as their primary income source and are not under pressure to use force-placed insurance to drive fee income. The vast majority of these banks continue to utilize force-placed insurance as it was originally designed: a risk management tool used to transfer collateral risk.
In Part IV, I will bring you up to speed on all of the regulatory and civil actions that are taking place with regard to force-placed insurance. We will discover the common denominators that make up the operational and reputational risks that were not properly managed.
Jim Gilpin is a principal and EVP of Miniter Group, who is a provider of collateral risk management solutions to the lending industry. In 2007, Miniter introduced borrower-centric approach insurance tracking for forced placed insurance. To learn more about Borrower-Centric Insurance Tracking, visit Miniter’s informative website at www.miniter.com and follow Jim on twitter at @JimGilpin