Mergers and Consolidation Between Banking and Financial Services Firms: Trends and Prospects

CRS Report for Congress
Mergers and Consolidation Between
Banking and Financial Services Firms:
Trends and Prospects
Updated August 29, 2006
Walter W. Eubanks
Specialist in Economic Policy
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Mergers and Consolidation Between Banking and
Financial Services Firms: Trends and Prospects
Competitive, legislative, and regulatory developments in financial services in
the United States have all contributed to significant industry changes. The landmark
financial services legislation, the Gramm-Leach-Bliley Act (P.L. 106-102, GLBA)
has been speeding ongoing changes in the U.S. financial services industry. Overall,
it allows providers flexibility in responding to economic trends. Global and
especially technological advances continue to affect the financial services industry
in ways yet unforeseen. Such factors are part of the larger picture reflected in recent
mergers among large banking organizations in Europe and Japan as well, and
expanding or contracting product lines of domestic financial institutions.
Mergers of very large banking organizations in Europe and Japan move the size
of single organizations to new heights. American providers of financial services are
similarly growing through combinations, as exemplified by the fusion of J.P. Morgan
into the Chase Manhattan companies, and the joining of Wachovia and First Union,
not to mention the increasing span of Citigroup. BankAmerica acquired FleetBoston,
to form the largest banking company in America and the second largest in the world.
Increasing diversification of financial services within single entities in the
United States is occurring through acquisitions and internal development of new
businesses. GLBA allowed new affiliations among banks, insurance, and securities
firms and increased diversification within individual financial organizations. In
response to this increased flexibility, many institutions have taken advantage of
expanded organizational arrangements. Some have done so to marked advantage,
while others have retreated from their diversifications. The most prominent backer
of GLBA, Citigroup, has shed the insurance businesses it went to great lengths to
acquire and validate through that law, and was cautioned in 2005 by the Federal
Reserve on future expansions.
Specific changes for policy consideration depend on the predominant ways in
which the financial system unfolds. GLBA clearly ended the isolation of the
investment banking business from the commercial banking businesses through its
repeal of the Glass-Steagall Act of 1933. The financing of Enron, WorldCom,
Parmalat, and other questionable corporations through both securities and loans from
prominent financial holding companies has called the commercial and investment
banking combination of businesses into some question.
In the 109th Congress, the Financial Services Regulatory Relief Act of 2006 (S.
2856), which is in conference with the House version of this bill, may have an impact
on the concentration of financial services providers. It includes provisions that
address the risks that large, complex banking/securities firms must confront in the
new GLBA environment. The dynamics of consolidation combined with the
commingling of financial services have made risk management more difficult for the
services providers and their regulators.
This report will be updated as developments warrant.

Consolidation Worldwide...........................................1
Mergers of Large Financial Institutions in the United States.................4
Expanding Lines of Business for U.S. Financial Companies................5
Risk Management.................................................9
Banking ................................................10
Insurance ...............................................10
Securities ...............................................10
List of Tables
Table 1. The World’s Largest Financial Services Firms, 2004...............3
Table 2. Top Ten Industry Line Merger and Acquisitions, Year to Date 2005, by
Number and Value of Deals......................................7
Table 3. Top Three Bank Holding Company Assets, as Reported for the Buyer
Alone and After Adjustment for Deals.............................9

Mergers and Consolidation Between
Banking and Financial Services Firms:
Trends and Prospects
Two types of structural trends affecting banking and financial services firms
have been prominent. First, there have been amalgamations of financial companies,
including banks, into ever-larger entities generally within the same industries.
Second, there has been increasing diversification of financial services offered within
single entities, whether through acquisitions or internal development of new
businesses, crossing industry lines. Ultimately, these size and product changes will
shape the performance of the domestic and international financial systems. As
nations gain experience with these changes, legislative and regulatory bodies in the
United States and elsewhere will be maintaining oversight to evaluate possible
effects. Volatility in the insurance and securities sectors adds impetus to changes in
financial acquisitions as well. Problems of corporate governance in nonfinancial
sectors have come to have a large role in the evolution of financial companies.
Consolidation Worldwide
Consolidation is occurring not only in the United States, but worldwide. Varied
factors are contributing. In Japan, a dominant factor is the belief that the nation
requires larger institutions to ease recovery from serious financial difficulties. In
Europe, the business philosophy is that cross-boundary transactions are increasing
within the European Union, now with a largely common monetary system and set
of business practices, and with former communist countries. The belief driving
change in the United States is that organizations containing diversified financial
services should have a place alongside compartmentalized financial services firms.
Much of the change, not only domestically but worldwide, is taking place
through holding companies, which “hold” controlling stock positions in banks and
other financial companies through two forms of absorption: merger and acquisition.
Technically the term “merger” denotes one corporation purchasing another and
absorbing it entirely into its own structure, while “acquisition” means one (holding)
company buying another to “control” it. In this country, most financial fusions of
large size take the form of an acquisition. Canada, too, has moved toward a holding
company-based framework of financial firms’ acquisitions.
In the increasingly international financial economies of a computerized world,
new institutions spring up while existing institutions, feeling threatened, assemble
in defensive reaction. Prominent observers believe that large bricks-and-mortar
providers of services and small, niche providers are the most likely to survive the
onslaught of their new and more nimble competitors. Those in the middle, in size or

technology, might seem less likely to succeed in a volatile world of rising energy
costs and interest rates. Changes under way in European Union financial regulation,
including Financial Conglomerate and Investment Services Directives, are likely to
increase pressures to consolidate across border geography and industry lines within
the Union. Resistance to external acquisitions of financial firms in France, Germany,
and Italy is dwindling, suggest that deals within the European Union will continue.
The Biggest Mergers Worldwide
The government-sponsored fusion of Dai-Ichi Kangyo Bank, Fuji Bank, and the
Industrial Bank of Japan made the resulting trillion-dollar group nominally the largest
banking organization in the world by assets. It and another Japanese firm created by
merger as an alternative to collapse, Mitsubishi Tokyo, have kept that nation’s
institutions at the top of asset sizing. Japanese super-giants, and the European ones
to a lesser extent, have emerged as the result not of strength but of weakness.
Japanese banks, in particular, keep vast quantities of severely overvalued bad loans
and investments on their books, calling into question their actual asset sizes and
making them fall behind in operating results and market value. American
institutions resulting from acquisitions are among the world’s largest, as they were
years ago. The U.S. companies Fannie Mae and Freddie Mac have grown to
dominate their mortgage market without major acquisitions, however, by relying on
governmental support. General Electric and Berkshire Hathaway, often treated as
“nonfinancial” entities, appear among the largest businesses doing financial services
as the result of acquisitions.
It is hard to compare the “sizes” of financial business that result from corporate
deals and internal growth, when they are so varied. Banks, historically sized by
assets, have become more interested in revenue-generating nonlending activities.
Insurers share many of the assets-on-hand features of banks, except in their health
lines, yet are subject to payouts on policies and thus might be sized by assets or
revenues. Transaction-based firms such as securities broker/dealers and mortgage
bankers try to minimize their own assets at risk, and thus are generally stratified by
revenues or profits. Financial analysts often analyze businesses of any kind,
including financial entities, by the value of their enterprise in the marketplaces for
stocks and bonds: what investors believe the firm’s activities are “worth.”
Multinational operations of every large financial company worldwide can move it up
or down in comparative ranking when exchange rates shift. Thus, a variety of
standards are used to construct Table 1, which is an approximation of the “sizes” of
the world’s largest financial firms.
Not all mergers succeed. One prominent example, called off before it happened,
was of Deutsche Bank and Dresdner Bank in Germany. That proposed merger would
have created a banking organization that would then have become the largest
anywhere. Dresdner instead sold itself to the Allianz insurance firm in mid-2001,
in a transaction that weakened the new buyer. Other mergers, here including that of
Citigroup noted below, and abroad, which observers had anticipated would become
successful have not worked out. Such marketplace downside phenomena do not raise

public policy questions if bankers accomplish the mergers within acceptable
guidelines and do not cause national or international economic problems.
Table 1. The World’s Largest Financial Services Firms, 2004
NameHeadquartered InPrincipal Business(es)
Citigroup USA Banki ng/Securities
General ElectricUSAIndustrial/Financial
American InternationalUSAInsurance
HSBC GroupUnited KingdomBanking
ING GroupNetherlandsBanking/Insurance
UBS Switzerland Banking/ Securities
Royal Bank of ScotlandUnited KingdomBanking
JP Morgan ChaseUSABanking/Securities
Berkshire HathawayUSAInsurance/Investments
BNP ParibasFranceBanking
BarclaysUnited KingdomBanking
Fannie MaeUSAMortgages
AXA GroupFranceInsurance
Wells FargoUSABanking
Credit Suisse GroupSwitzerlandBanking/Securities
Morgan StanleyUSASecurities
Allianz WorldwideGermanyInsurance
Wachovia USA Banki ng
Mizhuo FinancialJapanBanking
Societe Generale GroupFranceBanking
Freddie MacUSAMortgages
Merrill LynchUSASecurities
Banco SantanderSpainBanking
Source: Adapted by CRS from data known asThe Forbes Global 2000.”
Note: Ranking is based on a composite metric for sales, profits, assets, and market value.

Should institutions grow so large as to become instruments of national policy,
or pose systemic risks to their economies, however, they are “too-big-to-fail”:
governmental intervention will almost certainly occur to assure their survival in case
of difficulty. This is the financial situation of Japan. Its government has propped up
enormous bad loans and investments in the financial system, consequentially
encouraging mergers of banks and other financial companies through deposit
insurance, tax, and regulatory mechanisms.
Mergers of Large Financial Institutions
in the United States
As for banking-based entities, fusions of U.S. institutions beginning in the mid-
1990s significantly changed the country’s financial institutions both in size and
diversification of services. The buoyant economic environment, with its richly
valued stock prices, encouraged corporate deals of all kinds, including in finance.
U.S. banking law changed to encourage large amalgamations by market
extension across America, coast-to-coast or regionally. Major financial legislation:
the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (P.L. 103-
328) envisioned these mergers. That act provided the statutory authority and set the
framework for bank holding companies to acquire banks outside their home states
and for banks to secure branches on an interstate basis. As a result, the share of
industry assets of the ten largest U.S. banking organizations essentially doubled in
the decade ending in 1999, before a major statutory incentive noted below.
Meanwhile, financial industries remain much less concentrated than many others.
In notable deals, the most prominent was the formation of Citigroup, which
uniquely mixed domestic and international financial services of many kinds. It
anticipated P.L. 106-102, discussed in more detail below, in its combination of
banking, securities, and insurance businesses into one holding company. Its
formation predated enactment of that law that would ratify all of its deals, because
it had received a special regulatory exemption from the Federal Reserve. Citigroup
also expanded by acquisition along traditional lines, including recent deals for
European American Bank, Golden State Bancorp in California, and Banamex in
Mexico, and into the securities and insurance businesses. The complex formation of
J.P. Morgan Chase included the former Chemical taking over Chase Manhattan,
several securities businesses, and then J.P. Morgan before changing its name. Name
change also occurred after Wachovia absorbed First Union, the latter having been on
a value-destroying path of multiple acquisitions. Insurance companies, too, are
engaging in mega-mergers, most notably the acquisition of American General by
American International Group and of Lincoln Re by Swiss Reinsurance Co.
Bank of America startled the world of finance by announcing fusion with
FleetBoston Financial to create a banking company holding 10% of U.S. banking
deposits. The expanded institution is a truly nationwide bank, along lines envisioned
in the Riegle-Neal Act of 1994, and yet touching upon that law’s national deposit
share limit of its 10%. Its announcement sparked a wave of mergers among smaller

bank-based companies, as well as of J.P. Morgan Chase buying Bank One. Deal
flows of this, as most, industry sectors have accelerated into early 2005.
Such mergers are important steps in the evolving deregulation of the
traditionally tightly limited commercial banking and insurance industries, even while
finance began shifting away from bank loans and deposits to securities throughout
America. Investment banking and other securities firms have become perhaps even
more important than traditional commercial banking to acquirers. Antitrust concerns
over geographic concentration of traditional banking products remain, however: the
Justice Department has required divestiture of branches as a condition of some recent
banking fusions. Antitrust concerns embody societal views that banks should
provide customer services in an atmosphere of some competition: customers ought
not to be charged much more for or be discouraged from financial services because
of declines in numbers of providers. Many believe that financial fusions have
disadvantaged individuals and small businesses upon creation of large, complex
financial organizations lacking a community orientation. Securities and insurance
companies might siphon funds away from localities even further, in that view.
Expanding Lines of Business for
U.S. Financial Companies
Industry observers expected a wave of growth and diversification among United
States institutions following ongoing application of legislation enacted in 1999: the
Gramm-Leach-Bliley Act (P.L. 106-102, GLBA). That law eases affiliations among
banking, insurance, and securities firms in the U.S., including those owned by foreign
parties, and increases diversification within individual financial organizations. Most
prominently, GLBA followed the fusion of Travelers Insurance with the bank holding
company Citicorp, which would eventually would have to dissolve unless legislation
would allow the combination of banking with insurance under one roof. Responding
to the increased flexibility in GLBA, institutions have been rapidly making new
organizational arrangements.
GLBA has several provisions easing diversification by financial services
companies. Structurally, companies subject to bank regulation may expand their
array of financial products through several options. GLBA provides for a financial
holding company option and a financial subsidiary option. A new mechanism is also
in place for the Federal Reserve and the Department of the Treasury to decide what
is an appropriate financial activity, besides activities authorized by name in GLBA.
Companies wishing to expand services through a holding company framework
have more latitude to do so post-GLBA. In that measure, Congress repealed
provisions of the 1933 Glass-Steagall Act that had long precluded the affiliations of
banks and securities firms, and parts of the 1956 Bank Holding Company Act that
formerly precluded affiliations of banks and insurance underwriters. Bank holding
companies wishing to become financial holding companies (FHCs) file notice of
their election to choose new status with the Fed, as do foreign banks under a
modified procedure. FHCs have since grown to prominence. More than 600
domestic and foreign financial firms of all sizes have become FHCs. Securities-

based investment bank holding companies, such as Merrill Lynch, have similar
potentials under Securities and Exchange Commission regulation.
Another way for commercial banks wishing to expand product lines directly is
through the creation of financial subsidiaries (FS). This arrangement allows banks
to own companies doing financial activities that the banks may do, directly, or more
significantly, activities that banks may not otherwise engage in directly. Banks
wishing to do so follow the certification and notification procedures prescribed by
their primary federal regulator, most prominently the Office of the Comptroller of the
Currency, which charters and regulates national banks. The Federal Reserve and the
Federal Deposit Insurance Corporation govern FS of state banks. An institution’s
chartering authority, whether the OCC or a state, must also permit contemplated
activities. Many FS are insurance agency subsidiaries.
An unforeseen aspect is that despite GLBA’s encouragement, fusions of
insurance and banking companies have not been going on rapidly. Volatile, often
low, returns on many lines of insurance underwriting (policy-writing) and
investments deter bankers. The property-casualty sector in particular remains
unattractive for most FHCs not only following the events of September 2001, but
also because it lacks a nationally uniform system of regulation such as depository
institutions enjoy. The prototype FHC, Citigroup, reversed its course to exit the
property-casualty underwriting business by divesting Travelers Insurance. In contrast,
profits in the insurance field are generally greater and more predictable in the sales
or agency capacity that banks often undertake through subsidiaries, because policy
losses do not negatively affect sales commissions.
Insurance companies themselves have been moving very slowly into the banking
field following the example of MetLife becoming a FHC in 2001. Securities firms
are, conversely, taking on full-service banking, especially Merrill Lynch, which has
come to have major deposits in the banks it controls under GLBA. Momentum may
be gathering for both nonbanking industries increasingly to fold banks into their
operations, especially if economic uncertainties keep the attractiveness of federally
insured deposits as safe assets high in comparison with securities.
Competition measured as numbers of providers nationwide seems likely to
continue its decline. Overcapacity in financial businesses became reduced over time
before GLBA through consolidation. In sectors except securities, the top ten firms
have increased their share of assets since the mid-1990s while the number of
participants shrank. The number of commercial banks fell from about 25,000 before
World War I to less than 8,000 recently. Securities brokers and dealers numbered
more than 9,500 in 1987 and have likewise declined in number. (Investment “firms,”
however, if defined to encompass investment advisors, asset managers, mutual funds,
hedge funds, etc. have grown over time.) Life insurance underwriters fell from about

2,200 in 1985 to less than 1,600 in 2000. Today’s approximately 3,000 property-

casualty insurers are generally expected to fall by perhaps one-third. Most U.S.
savings and loan associations vanished years ago, through waves of supervisory
mergers — like the Japanese mode that increasing size can paper over bad loans —
as well as by collapse. Fewer than 1,500 such “thrift institutions” remain.

Customers generally believe that enough providers to serve them, at least for
transacting business across political boundaries such as many insurance and
securities companies have historically done. Even for mortgages, the historical major
and locationally limited products of savings and loan associations, a national market
developed through brokers and other parties for this financial product — even though
the number of associations shrank sharply because of losses and failures of firms.
Simultaneously, nonfinancial providers offer new customer choices relating to
financial services. Consumers may use financial services through software products
offered by nonfinancial providers. While Internet-only banking has not been a great
success to date, offerings of online access to bricks-and-mortar financial institutions
have proven viable. Various kinds of businesses are also linking their products to
other services, directly for advertising revenues or for a slice of transactions as
“agents.” Such new products are increasing competition for business in this sense.
In other expansions into non-traditional businesses, banking companies have
taken on trading in the kinds of derivatives that Enron marketed. UBS Warburg, a
unit of diversified banking company UBS of Switzerland, beat out Citgroup to take
on Enron’s failed trading operations. The Office of the Comptroller of the Currency
has allowed a large national bank to initiate trading in energy derivatives. The
Federal Reserve has allowed FHCs to enter further into agricultural and energy-
related commodities derivative businesses. Using a provision of GLBA known as
“merchant banking,” which allows FHCs to invest in nonfinancial businesses, Bank
One acquired the camera and imaging businesses of the failed Polaroid Corporation.
Restructuring and growth for its own sake in a revitalized economy seem to
characterize many transactions. Financial business transactions remain prominent.
Table 2 presents the year-to-date industry rankings of the ten largest industry sectors
involved in merger activity, in which financial business deals appear. (General
merger and acquisition activity remains far below its crest in 1999, however.)
Table 2. Top Ten Industry Line Merger and Acquisitions, Year
to Date 2005, by Number and Value of Deals
ClassificationNumberof DealsValue of Base EquityPrice, $ Billion
Household Goods 8$54
Communications 106 42
Retail 75 23
Computer Software, Supplies and Services385 22
Oil and Gas29 20
Drugs, Medical Supplies, and Equipment81 16
Miscellaneous Services232 13
Broadcasting117 12
Insurance 69 12
Banking and Finance 59 11
Source: proprietary data.
Note: Figures are as of April 4, 2005 and change weekly.

Regulators are already implementing a mode of containment of risks that may
arise from new financial activities, such as limits on direct investments of banking
companies via merchant banking. That practice involves taking a direct equity
position in businesses as part of financing them, a Wall Street/venture capital practice
allowed for FHCs in GLBA. Similarly, the Federal Reserve’s clarification of
“firewalls” that define proper transactions inside FHCs that banks can make with
riskier nonbank parts of the same organization, in “Regulation W,” may restrain both
risks and returns from diversification within FHCs. Insurance interests have
contested GLBA’s bank insurance sales provisions in court filings recently, while
other insurance provisions and interactions between depository institutions and
commercial firms remain open.
In the 109th Congress, financial holding companies’ activities were a critical
focus of the Financial Services Regulatory Relief Act of 2005 (H.R. 3505) and the
Financial Services Regulatory Relief Act of 2006 (S. 2856). Both bills were passed
by their respective houses, and a conference is in the process of ironing out their
differences. The provisions of these bills address the interactions between depository
institutions and commercial firms, and reaffirm the regulatory authority of state
insurance supervisors. Another bill, H.R. 111/S. 98, seeks to keep bankers from
moving into the field of real estate.
Two “mega-mergers” in the commercial banking sector increased concentration
of industry assets in America as a whole. They are Bank of America purchasing
FleetBoston Financial, and J.P. Morgan Chase purchasing Bank One. Both were
presented to stockholders, regulators, and customers as improvements in providing
bank-related financial transactions across America, spreading the businesses into
many new states, and increasing the sizes of the firms for efficiencies. Some
questioned their effects on localities and smaller clients, however.
Table 3 presents pre- and post- acquisition amounts of corporate assets, and
shares of total industry assets of these three largest U.S. banking entities. Data are
presented of the third quarter of 2003, before parties announced the first of these
transactions. Measures of economic concentration in general analytical use include,
among others, this “three-firm seller concentration ratio.” (Antitrust analysis brings
additional, more complex, measures into determining anti-competitiveness from
mergers.) Table 3 shows actual figures, and summed results as if the deals had
occurred at the time. When bankers consolidate, they typically close branches and
lay off employees. In reaction to such cost-saving contraction, many customers seek
other financial providers. Post-transaction assets will thus be less than the sum of
both partners’ resources.

Table 3. Top Three Bank Holding Company Assets, as Reported
for the Buyer Alone and After Adjustment for Deals
Total Assets, Share of Assets ofBank Holding
Company$ BillionsCompanies, %
B ef ore Af ter B ef ore Af t er
Citigroup Inc.$1,208$1,208 13.9% 13.9%
J.P. Morgan Chase and Co. 792 1,0839.112.5
Bank of America Corp. 737 9338.510.7
Source:Bank and Thrift Holding Companies with the Most Assets on Sept. 30, 2003,” American
Banker Online, January 29, 2004; “Report on the Condition of the U.S. Banking Industry, Third
Quarter, 2003, Federal Reserve Bulletin, Winter 2004, p. 51; computations by the Congressional
Research Service.
Note: The aggregate bank holding company asset series used as a divisor for the last two columns
excludes very small companies.
Of the $8.7 trillion of such bank holding company assets on September 30,
2003, the largest three firms held 31.5%. Adjusted by summing assets, disregarding
customer loss, these firms would have collectively held a 37.1% national asset share.
That figure represents a significant increase in the asset concentration of banking
services nationally. Industry rankings remain the same when adjusted.
Observers believe that these mega-mergers will encourage a wave of
consolidation and, thus, increase resource concentration in banking. For example,
Regions Financial announced its deal for Union Planters a few months later, seeking
to create a peer FHC. This sector remains more competitive than most others in the
economy, however, if viewed through the lenses of other antitrust criteria because of
its many providers and the many financial services available from nonbank providers
and over the Internet.
Risk Management
The dynamics of consolidations combined with the commingling of financial
services have made risk management more difficult for the services providers and
their regulators. In the GLBA framework, where services such as banking, insurance,
and securities trading are provided by a single institution, the responsibilities of
regulating financial institutions are more complicated because the regulators no
longer have the separation of the lines of businesses that they had in the past. Driven
by technological advances and competition among providers, new products have
helped to erase the traditional lines of demarcation in financial services that the
regulatory structure and markets were built upon. Bank regulators, for example,
continue to lower barriers to bank entry into commodity futures and options
businesses, and insurance has become a popular bank product. Rules and regulatory
requirements concerning these products often fall under the supervision of multiple

regulators. As bankers have gotten more involved in the securities business, the
business has changed, causing risk management issues to fall under the jurisdiction
of bank regulators and the Commodity Futures Trading Commission (CFTC). But,
most regulatory changes have occurred after the risks have risen sufficiently to show
the deficiencies. Consequently, regulators are now placing great emphasis on
improving credit-risk management, developing and improving their methods of
measuring risk on a transaction-by-transaction basis. These methods are attempts
to better quantify risk and establish more formal and disciplined processes to
recognize price and manage risk.
To ensure compliance to federal regulators’ risk management requirements,
bank regulators have been moving from the traditional regime of periodic
examinations to in-house examiners. The Office of the Comptroller of the Currency,
and the Federal Reserve System, for example, have placed resident examiners in the
24 largest national banks. These examiners, and specialists in areas such as
commercial and retail credit, capital markets, bank technology, and asset
management, provide the regulators with real-time risk management information.
In addition, the federal regulatory agencies are in the rulemaking stage of
implementing the Basel II capital accord as well as modifying the existing capital
accord, Basel I, to make them more sensitive to the changing risk in banks’
portfolios. Under the Basel risk-based system, each asset’s probability of default is
estimated in each line of business, such as mortgages, consumer loans, credit card,
and automobile loans. Given the probability of default, the agencies require the
banks to keep the appropriate level of capital on hand. A similar methodology is set
up for commercial paper as well as derivatives, equities, and bonds.
Banks and insurance and securities firms sell deferred annuities, term life
insurance and property-casualty, to individuals and commercial entities.
Consequently, most of these financial services providers have become proficient at
managing the risk inherent in these products. Consolidation is taking place within
each sector as banks general merge with banks and insurers with insurers. However,
risk management in the insurance business has evolved along similar form in both
the banking and insurance sectors. For example, risk sharing is a common risk
mitigating technique used by bankers and insurers. The institution finances its risks,
either directly or through an insurer or reinsurer, by selling bonds to institutional
investors. The payment of interest or principal depends on the occurrence or severity
of the insured event. Finite risk insurance is an established risk management tool.
These are multi-year, multi-peril, and/or multi-trigger coverages that combine self-
financed reinsurance protection and an agreement that the reinsurer will not cover
losses above a specified amount. This risk management tool reduces earnings
volatility for the insured and limits the reinsurer’s exposure. In addition, insurers and
bankers are active in the credit risk transfer market, where insurers are net protection
sellers and banks are net protection buyers. While these instruments may enhance
the efficiency and stability of credit risk, they tend to be complex and lack
transparency. Consequently, supervisory authorities have been introducing more
complex requirements to make these transactions more transparent.

Like the insurance industry, with the exception of exchanges, significant
consolidation has not taken place in the securities industry. However, the
development of financial instruments that incorporate characteristics of banking and
insurance products has also complicated risk management in the securities industry.
Furthermore, over-the-counter instruments such as swaps, caps, collars, and floors
are increasingly popular alternatives to exchange-traded instruments. Exchange-
traded instruments are standardized contracts for a fixed amount, delivered at a
specified date at a particular location. Over-the-counter instruments are custom
designed to reflect specific needs of the participants. These instruments are one-on-
one arrangements, with a fee-earning broker who could be attached to a securities
firm, an insurance company, or a bank. Many of these instruments are not
transparent, have default risk exposure, and have limited risk protection, and they are
legally enforceable contracts.
Risk management — defined as the limitation of the risks faced by an
organization due to its exposure to changes in financial market variables — has been
a significant force behind recent changes in the business pursuits of a number of the
firms. For example, a number of firms have significantly increased their involvement
in proprietary trading or trading for their own accounts, wide ranging trading that can
range from domestic equities, to derivatives, to foreign securities. Some firms have
also significantly boosted their presence in the private equity market by taking direct
investment stakes in worldwide enterprises. In the last few years, a number of firms
have become brokerage intermediaries for hedge funds. And in an attempt to lure
back the institutional investor trades, a number of securities firms have become
increasingly willing to commit their own capital to help facilitate the institutions’
large block trades. Recently, the New York Stock Exchange and the NASDAQ
Exchange each merged with a electronic-based securities trading rival. And due in
part to concerns that the consolidations could provide the two exchanges with an
opportunity to boost their trade transaction fees, a number of Wall Street firms have
acquired stakes in smaller, rival regional stock exchanges to reduce the risk of higher
transaction cost from the larger exchanges.