Source: http://economictimes.indiatimes.com/ As more and more banks in India get into the insurance business and the line between banking and insurance gets blurred, the impact of events in the insurance sector on the banking system can no longer be ignored. Banks are the backbone of the payments system in a modern economy. The integrity and safety of the banking system is, therefore, paramount. If problems in the insurance business spill over to the banking business, the contagion effect could have far-reaching consequences for the economy as a whole. Given its systemic implications, should regulators, especially in countries like India where there are two distinct regulators — one for banking and another for insurance — worry? Of course! But reassuringly for regulators, a recent (May 2007) paper by Marco Stringa and Allan Monks of the Bank of England looks at the inter-industry contagion effects in the context of the UK life insurance and banking industries during stress periods in the past decade and concludes that spillover to the banking sector came essentially through ownership. The links through capital markets and effects on confidence were not materially significant. The study uses the ten largest UK-owned banks as a proxy for the UK banking system (they accounted for more than 90% of all UK-owned banks’ assets over the period studied) and all UK-owned life insurers that belonged to the FTSE 100 index. It then tries to assess the significance of spillovers from the life insurance sector to the banking system during the times of stress, using equity prices as a proxy. The argument being that in the past decade, the correlation between the equity price of banks and life insurers has increased markedly mainly due to banks’ increased involvement in the life insurance market. Inter-linkages originate not only from from direct channels — ie counter-party exposures — but also from indirect channels via the impact of adverse and unexpected news on financial markets and consumers’ confidence. Although accounting data provide a means to obtain a first estimate of counter-party exposures, they are less useful in measuring the quantum of the remaining two channels. The paper tries to capture all three possible channels of contagion by applying an event-study approach to equity price movements. In the UK financial system, the direct potential credit exposure of large UK-owned banks from loans to the life insurance sector is limited. But ownership interests are potentially more significant. Six of the ten largest UK-owned banks own life insurance subsidiaries, although their scale varies markedly. Therefore, there are several direct channels through which life subsidiaries might affect their parents: via reductions in banks’ operating incomes, via the cost of insurance re-capitalisation and via the direct effect on banks’ Tier 1 capital of any change in the ‘embedded value’ of a life insurance subsidiary. In addition, given their involvement in capital markets, and the service they provide to households and corporations, life insurers have the potential to indirectly affect UK banks through capital markets and consumer confidence channels. The paper reports that in 2001-03 when equity markets went into a tailspin, UK life insurance companies, which traditionally invested heavily in equities, were seriously affected by the prolonged fall in equity prices. So in June 2002, the Financial Services Authority (FSA) — the UK financial services regulatory body — was compelled to amend the resilience test for life insurers to allow insurers to take account of the extent to which equity price levels were already below their average over the previous three months. In January 2003, the FSA had to intervene again to enable life insurers to waive some regulatory rules on the calculation of solvency, provided that they remained strong on the ‘realistic’ solvency measure and continued to meet EU minimum requirements. Each insurer experienced a significant reaction, but there was no spillover to the UK banking sector as a whole. And while elements within the banking sector responded to the sector-wide events, these reactions were not pervasive. In fact, bancassurers were the only group whose equity prices were significantly affected by disruptions in the UK life insurance sector, suggesting that the spillover to the banking sector came only through ownership while the links through capital markets and effects on confidence were not materially significant during the events considered. Article Publish by: www.investmentbankingcentral.com