Chapter 14 – Investment Banking, Insurance, and Other Sources of Fee Income
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CHAPTER 14
INVESTMENT BANKING, INSURANCE, AND OTHER SOURCES OF FEE INCOME
Goal of This Chapter: This chapter is designed to explore several of the most important non-
deposit financial services banks have offered to the public in recent years, including investment
banking, trust services, investments in stocks, bonds and mutual funds, insurance policies, and
annuities and examine their possible benefits.
Key Topics in This Chapter
• 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
Chapter Outline
I. Introduction
II. Sales of Investment Banking Services
A. Key Investment Banking Services
B. Linkages between Commercial and Investment Banking
C. Possible Advantages and Disadvantages of Linking Commercial and Investment
Banking
D. Key Issues for Investment Banks of the Future
III. Selling Investment Products to Consumers
A. Mutual Fund Investment Products
B. Annuity Investment Products
C. The Track Record for Sales of Investment Products
D. Risks and Rules for Selling Investment Products
IV. Trust Services as a Source of Fee Income
A. History of Trust Services
B. Roles of Trust Departments
C. Types of Trusts
V. Sales of Insurance-Related Products
A. Types of Insurance Products Sold Today
1. Life Insurance Policies
2. Life Insurance Underwriters
3. Property/Casualty Insurance Policies
4. Property/Casualty Insurance Underwriters
B. Rules Covering Insurance Sales by Federally Insured Depository Institutions
VI. The Alleged Benefits of Financial-Services Diversification
A. An Example of the Product-Line Diversification Effect Reducing Risk
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B. Potential Economies of Scale and Scope
VII. Information Flows within the Financial Firm
VIII. Summary of the Chapter
Concept Checks
14-1. What services are provided by investment banks (IBs)? Who are their principal clients?
The primary role of investment bankers is to serve as financial advisers to corporations,
governments, and other large institutions. Investment banks help underwrite a number of
14-2. Why were U.S. commercial banks forbidden to offer investment banking services for
several decades? How did this affect the ability of U.S. banks to compete for underwriting
business?
14-3. What advantages do commercial banks with investment banking affiliates appear to have
over competitors that do not offer investment banking services? Possible disadvantages?
Investment banking services complement traditional lending services allowing commercial
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Investment products include stocks, bonds, mutual funds, annuities, and other nondeposit
14-5. What risks do investment products pose for the institutions that sell them? How might
these risks be minimized?
There are several risks involved in the sale of investment products. The value of these products is
market driven and customers may blame the bank when they do not reach their earnings goals.
Because of their reputation, customers may hold depository institutions to a higher standard than
14-6. What exactly are trust services?
14-7. How do trust services generate fee income and often deposits as well for banks and other
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Assets managed by the trust departments include deposits and, in some cases, these deposits can
14-8. What types of insurance products do banks and a number of their competitors sell today?
What advantages could these products offer depository institutions choosing to sell insurance
services? Can you see any possible disadvantages?
Financial institutions are starting to offer several insurance products. One product that they offer
today is life insurance in which the bank promises to pay a beneficiary a specific cash payment
14-9. 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?
Convergence is the bringing together firms from different industries in order to create large
lower.
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These things mean that banks and other financial institutions may be more efficient and
14-10. How can financial-service customers limit the sharing of their private data by different
financial-service firms? In what ways could customer information sharing be useful for financial
institutions and for their customers? What possible dangers does information sharing present?
Financial-service firms must inform customers of their policy regarding the sharing of
information with other parties. Financial-service firms must also inform customers about how the
14-1. Suppose the management of the First National Bank of New York decides that it needs to
expand its fee-income-generating services. Among the services the bank is considering adding to
its service menu are investment banking, the brokering of mutual funds, stocks, bonds and
annuities, sales of life and casualty insurance policies, and offering personal and commercial
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drop as the firm would get larger. Because of the economies of scope, it may become cheaper to
jointly produce two or more services than having to produce each service separately.
b. What potential disadvantages might the bank encounter from selling these fee-generating
services?
There are many potential disadvantages that First National Bank might encounter from selling
allege that they were misled about the risks associated with investment products or were charged
excessive service fees. In addition, First National needs to be sure to comply with all regulations
concerning selling investments products.
Customers could confuse First National’s traditional products with their investment products if
First National does not disclose the differences between their traditional products and the new
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It is possible that the revenues will rise and expenses will fall, increasing the return to the bank.
14-2. A commercial bank decides to expand its service menu to include the underwriting of
new security offerings (i.e., investment banking) as well as offering traditional lending and
deposit services. It discovers that the expected return and risk associated with these two sets of
service offerings are as follows:
Expected return—traditional services
3.50%
Expected return—security underwriting
10.75%
Standard deviation—traditional services
2.50%
Standard deviation—security underwriting
8.25%
Correlation of returns between two services
+0.25
Proportion of revenue—traditional services
70.00%
Proportion of revenue—security underwriting
30.00%
Please calculate the effects of the new service on the banking company’s overall return and risk
as captured by the bank’s standard deviation of returns.
The banks expected return from the overall service menu is calculated as:
( ) ( )
TS TS NS NS
E(r) = R × E r + R ×E r = 0.70 (3.50 percent) + 0.30 (10.75 percent) = 5.68 percent
Where,
E(r)
= Expected return from the overall service menu
= Proportion of revenue from traditional services
( )
TS
Er
= Expected return from traditional services
NS
R
= Proportion of revenue from security underwriting
( )
NS
Er
= Expected return from security underwriting
The bank’s standard deviation can be calculated as follows:
( )
( )
2 2 2 2
r TS TS NS NS TS TS TS,NS TS NS
σ = R × σ + R ×σ + 2× R 1-R × ρ × σ× σ
= 3.37%
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Where,
r
σ
= Standard deviation of overall return
2
TS
R
= Squared proportion of revenue from traditional services
2
TS
σ
= Variance of revenue from traditional services
2
NS
R
= Squared proportion of revenue from security underwriting
2
NS
σ
= Variance of revenue from security underwriting
= Proportion of revenue from traditional services
RNS = Proportion of revenue from nontraditional services
TS,NS
ρ
= Correlation of returns between traditional and security underwriting
TS
σ
= Standard deviation of return from traditional services
NS
σ
= Standard deviation of return from security underwriting
14-3 Based on what you learned from reading this chapter and from studies you uncovered on
the Web, which of the financial firms listed below are most likely to benefit from economies of
scale or scope and which will probably not benefit significantly from these economies based on
the information given?
a. A new bank offering traditional banking services (principally deposits and loans) was
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d. A bank holding company with just over $10 billion in assets also operates a security brokerage
subsidiary, trading in stocks and bonds for its customers.