The B.E. Journal of Economic Analysis & Policy: Topics

The B.E.
Journal of Economic
Analysis & Policy
Topics
Volume 10, Issue 1
2010
Article 16
Diversification in the Financial Services

Industry: The Effect of the Financial
Modernization Act
Faith R. Neale
Pamela Peterson Drake

Steven P. Clark
University of North Carolina at Charlotte, frneale@uncc.edu

James Madison University, drakepp@jmu.edu
University of North Carolina at Charlotte, spclark@uncc.edu
Recommended Citation
Faith R. Neale, Pamela Peterson Drake, and Steven P. Clark (2010) Diversification in the Financial Services Industry: The Effect of the Financial Modernization Act, The B.E. Journal of
Economic Analysis & Policy: Vol. 10: Iss. 1 (Topics), Article 16.
Available at: http://www.bepress.com/bejeap/vol10/iss1/art16
c
Copyright 2010
The Berkeley Electronic Press. All rights reserved.
Diversification in the Financial Services

Industry: The Effect of the Financial
Modernization Act
Faith R. Neale, Pamela Peterson Drake, and Steven P. Clark
Abstract
The intent of the Financial Services Modernization Act of 1999 (FSM) was to strengthen the
overall financial services sector by allowing financial firms to diversify across industries within
the financial sector. Similar to other studies of the reaction to this Act, we observe that investors
consider the FSM to be good news. More interestingly, we also observe that systematic risk increased for some types of firms, but decreased for others as barriers were lowered. This finding is
consistent with the idea that the reduction of regulation may increase systematic risk, but that the
effects of deregulation on risk may be mitigated by anticipated effects of diversification. Specifically, bank holding companies that chose to diversify into other financial industries experienced
increases in systematic risk while those that did not diversify realized decreases in systematic risk.
Overall, we find that the systematic risk of financial firms converged and increased in the past few
years as firms expanded into non-traditional businesses. In addition, we find that the Act reduced
systematic risk for some firms, specifically those that diversified their product lines with insurance
products.
KEYWORDS: deregulation, Financial Services Modernization Act, Glass-Steagall, Gramm-LeachBliley Act, financial services industry
Neale et al.: Diversification in the Financial Services Industry
The Financial Services Modernization (FSM) Act, more commonly

referred to as the Gramm-Leach-Bliley (GLB) Act, changed the shape of the
financial services sector.1 The FSM Act lowered many of the barriers erected by
the Banking Act of 1933 and the Bank Holding Company Act of 1956 that existed
between different financial services businesses.2 In addition, the FSM Act also
affected the regulation of financial services and permits a new form of holding
company, the financial holding company (FHC).3
As required by the FSM Act, the Board of Governors of the Federal
Reserve System (FRS Board) issued a report to Congress in November 2003,
reporting that during the first business day after FSM went into effect (that is,
March 13, 2000), it approved 117 bank holdings companies (BHCs) to become
FHCs.4,5 In 2003, there were 630 financial holding companies. Of these FHCs, 57
of the FHCs participated in securities underwriting and dealing, 26 engaged in
insurance underwriting, 165 in insurance agency, and 26 in merchant banking
activities.6,7 Many firms were taking advantage of the FSM Act, entering into
other financial services that were previously restricted.8
U. S. Public Law No. 106-102, signed into law November 12, 1999.
The Banking Act of 1933, commonly known as the Glass-Steagall Act separated these three
types of firms in an effort to prevent future, similar crashes [June 16, 1933, Ch 89 20, 48 Stat.
188; Aug 23, 1935, Ch 614, Title III, 302, 49 Stat. 707]. At the time of its passage, some
believed that the interaction between investment banks, commercial banks, and insurance
companies contributed to the 1929 crash. There is significant evidence, however, that shows that
the concern over firms with both commercial and investment banking functions was not justified
[Benston (1994), Puri (1994), Ang and Richardson (1994), and Kroszner and Rajan (1994)]. The
Bank Holding Act of 1956 [12 U. S. C. 1841] allowed establishment of bank holding companies,
but prohibited a bank holding company in one state from acquiring a bank in another state.
3
The Act removed some, but not all, regulatory hurdles. The Federal Reserve and the Treasury
have the authority to define new activities that are financial in nature or incidental to financial
activities. Financial holding companies are subject to scrutiny by the Federal Reserve, as well as
the Securities Exchange Commission, the Commodities Futures Trading Commission and state
Insurance Commissions depending on their financial products. There is currently a movement to
replace the individual states regulation of insurance with a federal regulatory body. This change
would be especially beneficial to insurance companies that market their products nationally.
4
One of the requirements for a BHC to become a FHC is that depository subsidiaries must meet
capital requirements and receive at the minimum a satisfactory rating under the guidelines of the
Community Reinvestment Act of 1997 (CRA).
5
By March 2003, there were 630 FHCs, consisting of 600 domestic FHCs and 30 foreign FHCs,
with FHCs accounting for 78 percent of aggregate consolidated assets of all BHCs with continued
growth expected. Some BHCs converted to FHCs by 2003, but had not yet entered in to non-bank
activities.
6
Smaller banks are engaging primarily in insurance agency. BHCs participation in insurance
agency activities is likely underestimated because many BHCs, through affiliated state chartered
banks in areas with populations less than 5,000, were already in insurance agency activities prior
to the FSM Act.
2
Published by The Berkeley Electronic Press, 2010
The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Topics), Art. 16
There are two primary effects of modernization legislation. First, the

changes permit commercial banks, investment banks, securities firms, and
insurance companies to enter each others markets. This had been happening
prior to the legislation, but this legislation provides substantial encouragement to
expand into other financial services areas. Second, the changes encourage
mergers within and across the different financial sectors.9,10,11
A number of researchers examine the association between events related
to the FSM Act and returns of the securities of financial services companies. We
summarize these studies in Table 1. Though the general conclusion is that the Act
is beneficial to financial services firms, the evidence regarding the type of firms
that benefit from the Act is not clear from these studies. For example, some
researchers document a positive reaction for banks securities, whereas others
document a negative reaction for these firms securities.
The purpose of this study is to examine the effects of the legislation on the
financial sector, including depository institutions, non-depository banking
institutions, investment banking, securities firms, and insurance, with the specific
goal of assessing the effect of the Act. We estimate the stock market reaction to
the major legislative actions leading up to and including the final passage of the
Financial Services Modernization Act of 1999, tracking the performance of
financial services firms through 2007.
The FSM Act also allows the Board to determine other permissible activities as needed. In
general, these expanded activities must be incidental to the FHCs financial services business.
There is some allowance for participation in other activities, but significant limitations are placed
on this type of engagement.
8
In comparison, as of June 25, 2009 the Federal Reserve reports 591 FHCs, less than the 626
reported only four months earlier on February 18, 2009.
9
The Riegle-Neal Act (U.S. Public Law 105-24), enacted in 1997, permits interstate branch
banking. However, this Act limits the ability of banks to grow from mergers, prohibiting any
merger that would give a bank more than 10% of the deposit assets in the United States.
10
Notable mergers within sectors include Chase Manhattan and Chemical Banking Corporation in
1995, Morgan Stanley and Dean Witter-Discover in 1997, NationsBank and BankAmerica in
1998, and more recently, Bank of America and Fleet Boston Financial in 2003, and Travelers
Property Casualty and St. Paul Companies in 2003. Notable mergers and acquisitions across
sectors include Bankers Trust and Alex Brown and Sons Inc. in 1997, Travelers and Citicorp in
1998, Pacific Lifecorp and College Savings Bank in 2001, J. P. Morgan & Co. and Chase
Manhattan in 2000, and J.P. Morgan Chase & Co. and Bank One in 2004. Travelers Property
Casualty was spun off of Citigroup in 2002.
11
Though the FSM Act and other loosening of regulations blurs the distinction of these
industries, we observe that, based on the Bureau of Economic Analysis, GDP by industry series,
the share of GDP attributed to the different industry groups within the finance sector has changed
little since the Act.
http://www.bepress.com/bejeap/vol10/iss1/art16
Table 1
Summary of selected empirical evidence on the effect of the passage of the FSM Act on shareholder wealth
Study
Type of firms studied
Period
Sample Findings
size
Akhigbe and Whyte (2004)
Banks, insurance companies, securities firms 1999
406 Positive reaction for banks, securities firms, and insurance companies.
Carow (2001)
Banks, insurance companies, investment

banks
1998
373 Positive reaction for life insurers and banks associated with the CiticorpTravelers Group merger; larger banks have higher positive effects vis--vis
smaller banks.
Carow and Heron (2002)
Banks, thrifts, finance companies, investment 1999

banks, insurance companies
552 Positive reaction for insurance and securities firms, but negative for finance
companies, thrifts, and banks.
Hendershott, Lee and

Tompkins (2002)
Commercial banks, insurance companies, and 1999

investment banks.
472 Positive reaction for insurers and investment banks; larger firms have a greater
positive reaction vis--vis smaller firms.
Lown, Osler, Strahan and

Sufi (2000)
Bank holding companies, securities firms, and 1999

insurance companies
558 Positive reaction, especially strong for securities companies, BHCs with
security advisory subsidiaries, and property and casualty insurers.
Mamun, Hassan, Karels and Life insurers, property/casualty insurers, other 1998-2000
Maroney (2005)
insurers
140 Positive effect for life insurers and property/casualty insurers.
Mamun, Hassan and Lai

(2004)
Commercial banks, insurance companies, and 1998-1999

brokerage firms
389 Positive reaction for all three firm types with banks having the largest reaction
and brokerage firms the smallest. The largest banks and insurers received the
most benefit.
Narayanan, Rangan and

Sundaram (2002)
Bank holding companies and investment

banks
1996-1997
137 Positive reaction to early FSM events for BHCs.
Neale and Peterson (2005)
Life insurers, property/casualty insurers,

accident/health insurers, other insurers
1997-2000
137 Positive overall effect for life insurers and property/casualty insurers.
Strahan and Sufi (2001)
Bank holding companies, securities firms,

insurance companies, insurance brokers
1998-1999
585- Positive reaction to the Citicorp-Travelers merger for BHCs, securities and life
617 insurance firms. Positive reaction to the compromise on the GLB Act for
securities firms, life insurers and property/casualty insurers.
Yeager, Yeager and

Harshman (2007)
Public and private bank holding companies

and financial holding companies
1996-2004
2,166 No change in profitability as a result of the Act.
We differentiate between firms that took advantage of the Act and those
that did not, and are able to consider the conversions to financial holding
companies and the post-FSM wave of intra- and inter-industry mergers. We find
this differentiation helps explain some of the conflicting findings of previous
studies. Past studies also report differing evidence with regard to effects on risk;
hence we control and test for changes in market risk that may influence returns.
In this paper, we contribute to the existing body of literature in several
ways. First, this is the most comprehensive study to date; we consider the market
effects of significant events beginning in 1995 leading up to the legislation as well
as effects for several years after the legislation is implemented. Second, we
consider the effects not only on banking entities, but on insurance and securities
firms. Third, the number of firms we examine is much larger than any other study
of the Act. Fourth, and most importantly, we differentiate firms that did not take
advantage of the Act and examine the impact of diversification on firms that did.
We discuss the history and evolution of the Act in Section I. We discuss
previous research of the Acts effects in Section II. In Section III, we present the
data and methodology of our analysis, and summarize our expectations of the
market reaction to the passage of the act and beyond. We present the results of
our analyses in Section IV and offer summarizing and concluding remarks in
Section V.
I.
The history and passage of the FSM Act
The Financial Services Modernization Act of 1999 was introduced by Senator

Phil Gramm on April 28, 1999 and became Public Law No. 106-102 on
November 12, 1999.12 However, the changes in the regulation of the financial
services industry developed over a much longer period of time as regulators
loosened regulation, proposals were offered, and other, related legislation was
introduced and discussed prior to this particular legislation, as we show in our
summary of events in Table 2. The events that we note span the period January 4,
1995 through November 12, 1999.
12
S. 900, related to H. RES. 355 and H.R. 10.
Table 2
Significant events leading up to and including the passage of the

Financial Modernization Act of 1999
Regime Date
1
January 4, 1995
Event
Representative James Leach introduces H.R. 18 (Glass-Steagall Reform
bill). The bill is referred to the Committee on Banking and Financial
Services.
February 27, 1995 Representative James Leach introduces H.R. 1062 (Glass-Steagall Reform
bill) in the House. H.R. 1062 is reported to the House from the Committee
on Banking and Financial Services.
October 24, 1995
Representative James Leach introduces H.R. 2520 (Glass-Steagall Reform

bill) to the House. H. R. 2520 is referred to Subcommittee on Commerce,
Trade, and Hazardous Materials.
March 26, 1996
The Supreme Court rules in Barnett Banks of Nelson County v. Nelson,

Florida Insurance Commissioner, that states cannot interfere with federal
law that lets nationally chartered banks sell insurance in their local branches
in towns with less than 5,000 in population.
January 7, 1997
Representative James Leach introduces H.R. 10 (Financial Modernization

bill) the House.
January 8, 1997
The Federal Reserve proposes eliminating firewalls and allowing bank

holding companies to create and operate section 20 subsidiaries.
March 31, 1998
The House considers H.R. 10 with amendments.
April 28, 1999
Senator Phil Gramm introduces S. 900 (Financial Services Modernization

bill) the Senate.
May 6, 1999
Senate passes S. 900 as amended.
October 22, 1999
The House and the Senate compromise regarding the Community

Reinvestment Act.
November 4, 1999 Congress passes the Financial Services Modernization Act of 1999.
The first event was the introduction of the Glass-Steagall reform bill,
House of Representatives bill 18 (H.R. 18) by Representative Jim Leach on
January 4, 1995. The purpose of this bill was to enhance competition in the
financial services industry by amending the Glass-Steagall Act to eliminate
prohibitions against bank holding companies engaging in securities activities.13
After its introduction and during its tenure with the House of Representatives, the
bill was referred to subcommittees, committee hearings were held, and
13
In 1987 the Federal Reserve Board began authorizing bank holding companies to engage in
expanded securities operations through section 20 subsidiaries. However, the Board established
a total of 28 restrictions or firewalls that substantially constrained the scale and scope of these
activities. For instance, the Board adopted a revenue test requiring that no more than five percent
of the gross revenue of a section 20 subsidiary could be earned through securities activities from
which member banks were prohibited. In 1989, the Board increased the revenue limit to 10
percent where it remained until 1997.
amendments were added. Leach introduced similar bills, H.R. 1062 and H.R.
2520, the same year. On March 26, 1996, the Supreme Court decided that states
could not interfere with federal law that permits nationally chartered banks to sell
insurance in their local branches in towns with less than 5,000 in population.14
This event is important because it removed barriers in at least fifteen states,
including Florida, Texas and New Jersey. We expect that investors reacted
favorably to this announcement for banks and unfavorably for insurers. Because
each individual state has jurisdiction over the insurance companies doing business
within their state, and each state has its own rules and regulations that insurers
must follow, this ruling raises the issue that some of the individual states rules
and regulations may be unenforceable.
A significant change in regulation of financial services occurred on
January 8, 1997, when the Federal Reserve proposed eliminating many of the
firewalls between bank holding companies and their Section 20 subsidiaries,
making it easier for banks to sell and underwrite securities. The proposed rules
were formalized on August 22, 1997 and this change became effective on October
31, 1997.15
Around the same time as this change in regulation, Jim Leach introduced
the Financial Modernization bill (H.R. 10) and the bill was considered, with
amendments, on March 31, 1998.16 The reform of financial services had a setback on March 3, 1999 when President Clinton promised to veto the bill on the
grounds that it did not contain sufficient consumer protections and, in particular,
was not sufficient to address the needs of low-income and minority consumers.
After its introduction in the Senate on April 28, 1999, H.R.10s related bill,
Senate bill 900 (S. 900), originated in the Committee on Banking hearings and
proceeded through the Senate. The bill was widely debated in the Senate for
many reasons including the issues of shifting control from the Treasury to the
Federal Reserve, privacy protections, and the Community Reinvestment Act. The
compromise over the Community Reinvestment Act occurred on October 22,
1999. The bill became weighed down with unrelated amendments and was later
the foundation of the Financial Services Modernization Act, which passed the
House and the Senate on November 4, 1999.17
14
Barnett Banks of Marion County, N. A. v. Nelson, Florida Insurance Commissioner (94-1837),

517 U.S. 25.
15
Bank Holding Companies and Change in Bank Control (Regulation Y); Amendments to
Restrictions in the Boards Section 20 Orders [Regulation Y; Docket No. R-0958], August 22,
1997.
16
H.R. 1062, H.R. 2520, and H.R. 10.
17
S.900 was voted on by the House as House Resolution 355.
II.
A review of the evidence on the effects of the FSM Act
Some of the change that has taken place in the industry is reflected in the number
of mergers and acquisitions involving financial services firms, as we show in
Figure 1, Panel A. The number and value of deals peaked just prior to the passage
of the Act as firms prepared for the lowering of the barriers. Some of the industry
change can also be seen in the distribution of target firms, as we show in Figure 1,
Panel B. In terms of the type of acquisitions, the proportion of acquisitions with
securities and investment firms as targets increased after the passage of the Act, as
financial institutions entered into the securities business following the Act.
One of the primary motives for change in the regulation of financial firms
was to allow financial companies to expand their lines of business through
diversification and, hence, be able to compete more effectively in the global
marketplace. Simulation evidence of the risk and return consequences of
permitting financial holding companies to expand into other lines of financial
business suggests that mergers between FHCs and securities firms, real estate, and
property and casualty insurance firms are more likely to increase profitability, but
their risk may be affected.18,19
A. Change in profitability
There are several sources of potential increased profitability arising from the FSM
Act: scope economies, scale efficiencies, and X-efficiencies.20 There are three
arguments in support of scope economies; one-stop shopping for consumers,
benefits arising from mergers and acquisitions and reputational effects.21
18
The Financial Services Modernization Act of 1999 defines the financial holding company
(FHC) as a holding company that engages in securities, insurance, and banking activities. The Act
requires that the company declares itself as a FHC and is then subject to regulatory supervision as
detailed in the Act.
19
See Boyd and Graham (1988), and Boyd, Graham and Hewitt (1993). Boyd and Graham
demonstrate that real estate firms are the riskiest of all the possible merger partners. They also
show that mergers with life insurance firms reduce the risk of FHC failure. They attribute this to
the improved matching of asset and liability maturities: banks tend to hold assets and liabilities
with shorter-term maturities, whereas insurance companies hold assets and liabilities with longerterm maturities.
20
Scale economies are the reduction in the average cost of production from the increase in the
scale or size of production. Scope economies involve the reduction in costs associated with the
expansion of product mix through some type of cost complementation. X-efficiencies involve the
efficient use of a firms resources, most often represented as managements ability to control costs.
21
Banks may take advantage of their good reputation, especially as compared to insurers and
investment brokers, to cross-market and cross-sell products [Johnston and Madura (2000)].
Figure 1
Mergers and acquisition by financial institutions, 1997-2007
Panel A
Deal value and number of merger and acquisition deals involving

financial institutions, 1997-2007
Panel B
Distribution of targets in financial institution mergers and acquisitions,

1997 through 2007
Source: SNL Financial
Researchers find positive abnormal returns when BHCs merge with

brokerage firms [Apilado, Gallo and Lockwood (1993)], acquire insurance
companies or investment banks [Hendershott, Lee and Tompkins (2002)], and for
brokerage firms in general with any merger or acquisition.22,23 Researchers also

observed that brokerage firms experienced the largest returns of all financial
services companies upon the announcement of the Citigroup/Travelers merger,
which may indicate that these firms are most likely acquisition targets for banks.
A possible explanation is that brokerage firms with larger, established distribution
channels may have more potential for realizing benefits from cross-selling of
products. Regarding the benefits of one-stop shopping, there is some evidence
that consumers prefer to purchase financial products from specialists who can
customize the products to the individual [Herring and Santomero (1990); Berger
(2000); Berger, Cummins, Weiss and Zi (2000)].
Firms may be able to produce gains from scale efficiency in both
transactions and information costs through mergers [Herring and Santomero
(1990), and Berger (2000)]. A number of researchers offer evidence that mergers
within the financial services industry result in gains in operational efficiency
[Chamberlain and Tennyson (1998), Avkiran (1999), and Haynes and Thompson
(1999)]. However, the gains in efficiency may be mostly through increased
efficiency for the target firms rather than the acquiring firm [Avkiran (1999)].
Additional economies may arise from the insurance companies customer
base and distribution channels, which are traditionally geographically broad
relative to that of banks. Geographic and product diversification may increase
profitability and decrease firm risk, but it could also cause the loss of X-efficiency
for small institutions. This loss of efficiency may be due to diseconomies of
organizational structure and managerial competency across product lines and
regions [Berger (2000)]. Several studies show that financial consolidation makes
very little difference in X-efficiency [Akhavein, Berger and Humphrey (1997),
Berger (2000), and Berger and Mester (1999)]. However, studies of insurer
efficiency suggest there may be room for improvement for insurance companies
[Yuengart (1993), Ryan and Schellhorn (2000), Cummins and Weiss (1993), and
Meador, Madden and Johnston (1986)]. We provide a detailed review of the
insurance literature in Appendix 1.
B. Change in risk
The effect of the FSM Act on the risk of firms in the financial services industries
is unclear. Evidence regarding the effect of changes in regulation on risk within
and across the industries is mixed. Empirical evidence suggests that regulation
reduces systematic and total risk, and that deregulation increases both types of
22
However, there is evidence that the market reacts negatively to mergers of BHCs [Knapp,
Gart and Becher (2005).]
23
According to Section 2 of the Federal Deposit Insurance Act, a bank holding company is any
company which has control over any bank or over any company that is or becomes a bank holding
company."
risk [e.g., Chen and Merville (1986), Binder and Norton (1999), and Fraser and
Kannan (1990)]. Some researchers observe banks that merge with securities firms
realize a small increase in both profit and risk, whereas banks merging with
property and casualty insurers realize lower profits and higher risk [Boyd,
Graham and Hewitt (1993) and Lown, Osler, Strahan, and Sufi (2000)].
Peltzman (1971) posits that regulation reduces risk by buffering firms
from competition, but Akhigbe and Whyte (2004) document a decrease in market
risk for banks, insurance companies, and securities firms, and an increase in
unsystematic risk for banks and insurance companies. Mamun, Hassan, Karels
and Maroney (2005), and Neale and Peterson (2005), report that the FSM Act
reduces risk for insurance companies. 24 Other studies find risk reductions for
banks that diversify, observing that banks have lower risk and become more
diversified after merging with life insurers [Lown, Osler, Strahan and Sufi
(2000)]. These findings may explain, in part, why Citigroup divested itself of
Travelers property and casualty unit, yet decided to retain Travelers life and
annuity line and Travelers Salomon Smith Barney investment unit. Keeton
(2000) argues the FSM Act may stimulate competition by encouraging the
formation of new banks, which may reduce risk in the industry.
Other researchers find that changes in regulation increase risk for some
industries. Strahan and Sufi (2001) document an increase in systematic risk for
insurance companies associated with the passage of the FSM Act, and Mishkin
(1999) finds consolidation harmful to the financial services sector, especially if it
promotes the consolidation of smaller institutions into larger institutions that
might expose the financial system to increased risk.25 Another consideration is
the effect of other legislation that may increase the systematic risk of banking
firms by placing depositors ahead of senior creditors in the event of bank failure.26
In contrast, some researchers do not find any effect on risk. Saunders and
Smirlock (1987) find no effect on systematic risk of banks or securities firms
when expanding into discount brokerage, and Collins, Kwag and Yildirim (2002)
do not find changes in market risk of insurance companies associated with the
24
Mamun, Hassan and Lai (2004) also find that systematic risk was reduced for banks and
brokerage firms after passage of the FSM Act.
25
Black, Miller and Posner (1978) argue that risk may be increased in cases in which (1) the
failure of one entity of a BHC results in a loss of confidence in the banking component of the
BHC, (2) the banking subsidiary makes inappropriate loans to assist the non-banking subsidiary or
its customers or suppliers, or (3) the banking subsidiary becomes liable for the obligations of the
non-banking subsidiary.
26
These provisions are from the FDIC Improvement Act of 1991 (FDICIA). [U.S. Public Law
102-242, December 19, 1991] and the National Depositor Preference law [as part of the Omnibus
Budget Reconciliation Act of 1993. U.S. Public Law 103-66. August 10, 1993].
10
FSM Act. Saunders and Smirlock (1987) offer evidence that indicates that the
risk of bank holding companies does not increase entering into brokerage.27
III.
Data, methodology, and summary of expectations
A.
Sample
We examine the market reaction to the events leading up to and including the
passage of the FSM Act by examining the separate and joint effects on portfolios
of publicly traded companies in the different industries that comprise the financial
services sector. We use the Standard Industrial Classification (SIC) codes from
the University of Chicagos Center for Research in Security Prices (CRSP)
database. These codes are assigned on the basis of the industry in which the
greatest revenues are generated in the given period.28 Specifically, we classify
firms into one of six portfolios according to their SIC codes:29
SIC Description
60
Depository credit institutions
61
Finance companies: Non-depository credit institutions
62
Securities firms: Securities and commodities brokers, dealers, and
investment banking services
63
Insurance carriers
64
Insurance agents, brokers, and services
6712 Bank holding companies30
In our analysis of the effects of the Act, we allow firms to enter and leave
the industry groupings, as they change their dominant line of business.31
Therefore, firms in a given industry portfolio changes over time. The source of
the SIC code is, ultimately, the companys SEC filings and is therefore the
companys assessment of its dominant line of business. We also look at the
sample of firms that do not change their dominant line of business, and therefore
are not signaling any change in their line of business.
We draw the sample of returns on securities from the CRSP database. We
include a securitys returns in the analysis if the company falls into one of the
27
They note banks may benefit from expanding into non-banking businesses by increasing their
proportion of non-interest to interest income earned and reducing their reliance on loans whose
quality may fluctuate with economic conditions.
28
CRSP Stock File Guide.
29
We use Standard and Poor's classification of these companies, which is based on the SIC code
of the largest segment of the companies based on sales.
30
We include all BHCs with a SIC code of 6712 and FHCs from 6710 and 6719.
31
We draw the SIC codes from CRSP. The industry codes in CRSP are drawn from sources
(Nasdaq and Interactive Data) that report they determine these from SEC companies filings.
11
financial services industries and stock returns are available to calculate abnormal
returns around the specified event date. We allow securities to enter and exit the
sample and industry grouping based on data availability and industry code so that
we have the most complete sample possible. Our sample consists of 1,999
financial services companies.
B.
Analysis
We examine the impact of the legislation on firms in the industry by estimating

the abnormal returns associated with the major events in the passage of the Act.
Determining abnormal returns associated with the announcement of legislative
events, however, is challenging for several reasons. First, specific event dates are
difficult to define because of the various proposals, committee work, and
compromises that contribute to the passage of a bill [Binder (1985)]. This requires
that we scrutinize related news items in the popular financial press for the entire
period under consideration. This also requires that we trace the progress of each
related bill whether or not it passed.
Another challenge in examining legislative events arises because the
events affect all firms in the industry; therefore, there is severe clustering in
events and, hence, a loss of independence across the sample if we use standard
event-study methodology.32 We therefore use a time-series, dummy-variable
event study methodology estimation, using industry-based portfolios and daily
stock returns. This method supplements the market model with dummy variables
that take on a value of one if the day is considered an event day and zero
otherwise. The coefficient that we estimate on a dummy variable, therefore, is an
estimate of the average daily abnormal return associated with the event.
We review news reported in the Wall Street Journal, the American
Banker, and the New York Times pertaining to events leading up to the passage of
the Financial Modernization Act. In addition, we trace the evolution of each
relevant bill in both the U.S. House of Representatives and the U.S. Senate. From
this information, we identify eleven major events that lead to the Act.33
Estimating the time-series with all eleven events is informative. We find that the
estimated abnormal returns are similar within each of the three different time
periods. Therefore, in the interest of ease of interpretation, we classify our sample
events into three regimes, as we indicate in Table 2:34
32
Many researchers examining the effect of the Act use this approach, including Ely and
Robinson (1999), Cyree (2000), and Carow and Heron (2002).
33
We identify these events as unique informational events; that is, these dates indicate when new
information regarding changes in legislation is made public.
34
We also estimate the regression with all eleven event dates represented in individual dummy
variables. We find the general conclusions to be similar and therefore choose to represent the
regressions and the related discussion using the more parsimonious model.
12
Regime 1
Regime 2
Regime 3
Events from the introduction of H.R. 18 through the

Supreme Court decision,
Events from the introduction of H.R. 10 through the
approval of S. 900, and
Events from the compromise, the bills passing, and
becoming law.
We use a dummy-variable event analysis on the time series of valueweighted portfolio returns for each SIC portfolio of securities. We estimate the
following equation over the period from the first trading day of 1991 through the
last trading day in 2006:35
3
r =1
r =1
R pt = p + p Rmt + rp rt Drt + rp Rmt rt

Event dummy
variables
Market model beta

regime shifts
[1]
where
is the intercept,
p
is the portfolio beta,
Rmt
Drt
rp
is the return on the value-weighted market portfolio for day t,

is the event-day dummy variable for regime r events and day t,
is the average daily abnormal return for regime r events and portfolio p,
rt
rp
is the regime dummy variable for regime r on day t, and

is the average shift in the market model beta during regime r for portfolio
p.
We capture the eleven announcements detailed in Table 2 in the three

event dummy variables, including both the actual event announcement dates and
the following trading day, to allow for the information to be fully acted upon by
35
We base this approach on the model used by Binder (1985) in his analysis of the effects of
regulation. Similar models researchers use to examine the effects of the FMA Act include Cyree
(2000) and Carow (2001). We also estimate the time-series for a narrower range of trading days.
The conclusions are not sensitive to the beginning and ending dates of the time-series estimation
including dates that extend well beyond the event dates.
13
market participants.36 We base the three regime risk shift dummy variables on the
three key turning points in the passage of the legislation:37
Regime 1:
Regime 2
Regime 3
January 4, 1995 through January 6, 1997

January 7, 1997 through October 21, 1999
October 22, 1999 through December 31, 2006
Analysis of the bills provisions suggests that risk may change due to
provisions in the Act; however, it is not clear whether the bill will affect the
systematic risk of financial services firms. We include the regime-shift dummy
variables to capture any change in systematic risk that accompanies the Acts
passage. An advantage of using the time series approach is that we capture
changes in systematic risk with the p coefficient, which reflects the average
systematic risk throughout the entire period.
We estimate equation [1] as a system of equations using seemingly
unrelated regression, which allows for tests of significance of the slopes of the
different event-dummy variables across the segments.38 Our primary approach is
to allow firms to enter and exit the industry, such that a portfolios days return
reflects all firms that are classified on that day with that industry. We also use an
alternative approach for robustness that classifies firms into their respective
industries based on their industry classification at the beginning of 1995 only.
C.
Summary of expectations
Previous studies show that all financial services industries should realize positive
abnormal returns from the passage of the FSM Act. Unlike previous research, we
perform an additional analysis, differentiating between firms and examining the
36
Though there is a risk that some of these announcements do not have a market impact, the
error from including the irrelevant events outweighs the error from excluding relevant events. The
coefficients, therefore, represent the average market effects of the events in the regime. We base
the regime events on turning points in the likelihood and provisions of the legislation. For
example, Regime 1 represents reform of the Glass-Steagall Act, whereas Regime 2 represents
more forward-looking legislation involving modernizing regulations. Regime 3 represents the
period in which there was more certainty regarding the passage of modernization and includes the
post-Act period.
37
We specifically exclude the event dates and succeeding trading days from the regime dummy
variable, , so that the announcement-day effects do not affect the beta shift. Any temporary beta
shifts on announcement dates are absorbed in the market model beta, p. The use of the regimes
for market risk is similar to that used by Saunders and Smirlock (1987) and Carow (2001). We
prefer the use of a shifting variable that excludes the event days because we are better able to
isolate the true shift, apart from the effects of the event-day abnormal returns.
38
The hypothesis we test is Ho: r1= r2= r3= r4= r5= r6=0, where 1 through 6 indicate the
portfolios and r indicates the regime. The test statistic is F-distributed. We apply this test to each
dummy variable across the six portfolios.
14
effect of the FSM Act on firms that did and those that did not take advantage of
the new freedoms from the FSM Act. We define firms that took advantage of the
FSM Act as those that alter their line of business sufficient to warrant a change in
industry classification.39
In general, we expect large commercial banks (including BHCs and large
depository institutions), securities firms, insurance companies, and independent
insurance agents/brokers to experience positive, abnormal stock returns as a result
of the events leading up to, and passage of, the FSM Act. After differentiating
between firms, we expect to find that only those firms that take advantage of the
Act realize significant, positive abnormal returns. The remaining firms should
experience no change in wealth unless the market views a specific industrys
firms as desirable targets for diversification. Specifically, we expect insurance
agents/brokers to be desirable targets for banks that want to offer insurance but do
not want to underwrite it [Boyer and Nyce (2002), American Bankers
Association (2006), Appendix 1].
It is not possible to state a priori the effect the changes in regulation has
on the risk of the different financial services companies, and the limited evidence
of the effect on risk of cross-industry mergers in financial services is mixed. As
with previous studies, we examine the effect of the FSM Act on the risk of
financial services firms. We expect to find a significant difference between firms
that take advantage of the Act and firms that do not with the anticipation that
firms that make no change in business experiencing no change in risk after
passage of the Act.
IV.
Results
We estimate equation [1] using seemingly unrelated regressions and provide the
results in Table 3, where each industry group is estimated as one equation within
the system of seemingly unrelated regressions.40,41 We do not find any significant
39
In constructing the sample for this part of the event study, we do not attempt to ascertain if a
company pre-announced or otherwise signaled an intention to diversify or merge if the legislation
passed. Rather, we create a subsample of firms that actually remained in the same primary line of
business (i.e., did not change SIC code) during our sample period and compare those results with
the total sample containing all firms. We acknowledge the potential for ex post selection bias when
constructing a subsample in this manner, yet we are not aware of an alternative method that is
feasible. However, inference based on our subsample would remain valid assuming that stock
prices incorporate unbiased expectations about a companys eventual reaction to legislative events
regardless of whether the company made explicit pre-announcements. Because such expectations
can be formed on the basis of publicly-available information, this assumption is consistent with
semi-strong form market efficiency.
40
Because the independent variables are identical across the equations, the estimated coefficients
and corresponding standard errors are equivalent for ordinary least squares estimation and SUR
estimation. The advantage of using SUR is to permit tests of coefficients across equations.
15
effects associated with the events in Regimes 1 and 2. However, we do observe

that the events in Regime 3 have a positive effect on firms in each of the financial
services portfolios, which is consistent with the results of the studies we
summarize in Table 1. We conclude from the results in Table 3 that shareholders
anticipate all sectors of the financial services industry benefit from the passage of
the Financial Modernization Act.
An advantage of using seemingly unrelated regression estimation is the
ability to test hypotheses regarding coefficients across equations. We calculate an
F-statistic for each dummy variable to test whether the dummy variable slopes are
different from one another across the six equations and also to test whether the
slopes are different from zero. We present the calculated F-statistics in Table 3.
We find that the market reaction for Regime 3 events are different from zero, as
indicated by the individual coefficient t-statistics and the F-statistic used to test
significance across portfolios. We also find that the reactions are different across
industries, as indicated by the F-statistic used to test equality of estimated
coefficients across equations. Therefore, not only is a significant, positive return
found for the overall financial services industry, but the returns differ across
financial services industries. Some sectors are expected to benefit more than
others with securities firms experiencing the highest abnormal returns and
depository credit institutions the lowest.
We provide the estimation results for firms that maintain the same primary
line of business from the beginning of the events and through the end of 2006 in
Table 4; these are firms that did not change their primary line of business or
diversify through December 2006.42 Unlike the results from the overall sample in
Table 3, we find significant, positive market reactions for Regime 3 only for
securities firms, insurance carriers and insurance brokers. Our interpretation is
that the market considered this Act beneficial for these industries regardless of
whether or not they were expected to change their primary line of business.
The returns of depository, non-depository credit institutions and bank
holding companies that remain in their same industry are not significantly
affected.
In summary, we find that securities firms, insurance carriers and
insurance agents/brokers benefit from the passage of the FSM Act regardless. On
41
In addition to equation [1], we estimate alternative models. One alternative is the inclusion of
slope dummy-variables to capture any change in market risk around the announcements. Another
alternative is the re-specification of the dummy variables to capture the entire period between
announcements. We do not find that results from these alternative models differed from those
drawn from the results in Table 3.
42
We perform the same analysis for firms that did not change classification from January 1997
through November 1999, the period of the Act evolving up to passage of the Act. With the
exception of bank holding companies the results are similar to those in Table 4. BHCs that remain
in the same classification through November 1999 experience positive, abnormal returns in
Regime 3 and a positive shift in risk in Regimes 1 and 2.
16
the other hand, only those depository, non-depository credit institutions and bank
holding companies that had a strategy to diversify and significantly change their
product lines benefitted from the passage of the Act.
In Tables 3 and 4 we also provide the estimates of the shift in the market
model beta for the three regimes. We find that the adjustment in systematic risk
differs among the portfolios. In general, depository, non-depository credit
institutions, and insurance carriers experience decreases in systematic risk, while
the risk of insurance agents/brokers realize increased across regimes and samples.
The increased risk experienced by insurance agents/brokers is illustrative of the
strong interest in these businesses by FHCs. Many insurance agents/brokers were
acquired by FHCs as a result of the FSM Act. As previously reported, as of
March 2003, of the expanded activities available to FHCs, insurance agency
operations was the most popular. This is particularly true with smaller FHCs
where 65 percent engage in insurance agency operations.43
In Regime 2, for both samples, securities firms experience an increase in
systematic risk. In Regime 3, securities firms for the whole sample realize a
decrease in risk while securities firms that stay in their primary line of business
show no significant change in risk though the direction of the shift is negative.
Regardless, the positive shift experienced by securities firms is greater than the
subsequent negative or insignificant shifts leading to an overall increase in risk.
The risk of bank holding companies shifts only in Regime 2, but the
direction of the shift differs by sub-sample. In the overall sample, Table 3, BHCs
realize a positive increase in risk; however, the sub-sample of BHCs that did not
change industry classification (Table 4) actually experience a decrease in risk.
We conclude that BHCs that changed their industry classification are the drivers
behind the increase in risk for the overall industry sample.
43
The FRC Board defines smaller FHCs as those FHCs with assets under $1 billion.
17
Table 3
The effects of the introduction and passage of the Financial Services Modernization Act of 1999
Estimation of the seemingly unrelated regression estimation of the equation [1] for the system of six industry equations:
3
r =1
r =1

where p is the intercept, p is the portfolio beta, Rmt is the return on the value-weighted market portfolio for day t, Drt is the event-day dummy variable for
regime r events and day t, rp is the average daily abnormal return for regime r events and portfolio p, rt is the regime dummy variable for regime r on day t,
and rp is the average shift in the market model beta during regime r for portfolio p. Table values are estimated coefficients, with corresponding t-statistics
below in parentheses.
Portfolio
Variable
Intercept
Parameter
Depository
credit
institutions
SIC=60
0.0003*
(2.35)
Non-depository
credit
institutions
SIC=61
0.0001
(1.00)
Securities
firms
SIC=62
0.0002
(1.30)
Insurance
carriers
SIC=63
0.0002
(1.71)
Insurance
agents/brokers
SIC=64
0.0002
(1.12)
Bank holding
companies
SIC=6712,
6710, 6719
0.0001
(0.49)
F-statistic
Test of
equality
Test of
significance
1.1740*
(31.49)
1.3925*
(30.63)
1.5730*
(29.04)
0.8288*
(25.16)
0.6783*
(13.41)
1.0177*
(20.45)
Regime 1 events
-0.0019
(-0.74)
-0.0022
(-0.67)
-0.0004
(-0.10)
0.0030
(-1.29)
-0.0021
(-0.60)
-0.0026
(-0.74)
0.15
0.33
Regime 2 events
-0.0002
(-0.10)
0.0040
(1.59)
-0.0031
(-1.04)
-0.0008
(0.44)
0.0023
(0.83)
0.0003
(0.13)
1.19
1.01
Regime 3 events
0.0072*
(2.38)
0.0100*
(2.71)
0.0257*
(5.82)
0.0106*
(3.96)
0.0129*
(3.13)
0.0143*
(3.53)
4.27#
8.23
Regime 1 shift
-0.1604*
(-2.40)
-0.0133
(-0.16)
-0.0145
(-0.15)
-0.0084
(-0.14)
-0.0251
(-0.28)
0.1507
(1.69)
5.16#
4.49
Regime 2 shift
0.2075*
(3.18)
-0.1602*
(-2.73)
-0.0456
(-1.15)
-0.1311*
(-3.68)
0.1939*
(3.18)
0.1898*
(3.47)
0.2406*
(4.02)
-0.0733
(-1.36)
18.78
-0.2337*
(-4.27)
-0.5797*
(-11.79)
22.45#
Regime 3 shift
-0.0651
(-1.45)
-0.3067*
(-7.60)
38.94#
39.60
Market return
Event abnormal returns
Shifts in beta
2
R
61.60%
53.74%
65.49%
54.47%
39.77%
51.12%
System R2 = 34.72%
#
* indicates that the coefficient is different from zero at the 5% level of significance, indicates that the coefficients are different at the 5% level of significance, and indicates that
at least one coefficient is different from zero at the 5% level of significance.
18
Table 4
The effects of the introduction and passage of the Financial Services Modernization Act of 1999 for firms
not changing industry classification
Estimation of the seemingly unrelated regression estimation of the equation [1] for the system of six industry equations, for the 261 firms that stayed in the
same industry throughout the period from January, 1997 through December 2006:
3
r =1
r =1
where p is the intercept, p is the portfolio beta, Rmt is the return on the value-weighted market portfolio for day t, Drt is the event-day dummy variable for
regime r events and day t, rp is the average daily abnormal return for regime r events and portfolio p, rt is the regime dummy variable for regime r on day t,
and rp is the average shift in the market model beta during regime r for portfolio p. Table values are estimated coefficients, with corresponding t-statistics
below in parentheses.
Portfolio
Depository
credit
institutions
SIC=60
0.0003*
(2.24)
Non-depository
credit institutions
SIC=61
0.0001
(0.58)
1.2270*
(26.87)
1.5412*
(24.62)
Regime 1 events
-0.0010
(-0.28)
Regime 2 events
Regime 3 events
F-statistic
Insurance
carriers
SIC=63
0.0002*
(2.05)
Insurance
agents/brokers
SIC=64
0.0001
(0.45)
Bank holding
companies
SIC=6712,
6710, 6719
0.0000
(0.10)
1.6881*
(27.04)
0.7543*
(21.31)
0.6548*
(11.00)
0.7737*
(12.18)
-0.0007
(-0.16)
0.0004
(0.09)
-0.0023
(-0.92)
-0.0027
(-0.64)
-0.0019
(-0.42)
0.10
0.19
-0.0001
(-0.04)
0.0081
(2.34)
-0.0037
(-1.06)
-0.0003
(0.15)
0.0029
(0.88)
-0.0021
(-0.59)
1.72
1.44
0.0070
(2.08)
0.0055
(1.07)
0.0237*
(4.66)
0.0088*
(3.06)
0.0020
(0.38)
2.72#
5.35
Regime 1 shift
-0.0765
(-1.03)
0.0474
(0.42)
-0.0043
(-0.04)
0.59*
0.51
Regime 2 shift
Regime 3 shift
0.0203
(0.41)
-0.2452*
(-5,45)
-0.4319*
(-5.73)
-0.9398*
(-13.88)
Variable
Intercept
Parameter
Market return
Securities
firms
SIC=62
0.0002
(1.17)
Test of
equality
Test of
significance
Event abnormal returns
0.0029*
(2.72)
Shifts in beta
-0.03073
(-0.28)
0.1571*
(2.09)
-0.1249
(-1.85)
0.0439
(0.69)
-0.0293
(-0.69)
-0.1657*
(-4.33)
-0.0027
(-0.03)
0.2609*
(3.64)
0.2271*
(3.53)
-0.1050*
(-1.37)
0.1270
(1.85)
12.79
10.67
43.35#
41.12
R2
56.56%
34.70%
62.50%
44.63%
33.18%
28.91%
System R2 = 33.01%
#
* indicates that the coefficient is different from zero at the 5% level of significance, indicates that the coefficients are different at the 5% level of significance, and indicates that
at least one coefficient is different from zero at the 5% level of significance.
19
In summary, we find the FSM Act does not affect all sectors in the
financial services industry in the same way. Testing the shifts across equations,
we find that the shifts are significantly different from zero and the shifts are
different across the industries, as indicated by the calculated F-statistics, as shown
in Table 3.44
These results support prior studies that report banks and insurance
companies realize a decrease in systematic risk after deregulation and/or entering
another financial services line of business [Keeton (2000), Akhigbe and Whyte
(2004) and Lown, Osler, Strahan and Sufi (2000)], whereas the results are not
consistent with the studies that document increases in risk [Strahan and Sufi
(2001), or no impact on risk for these firms [Saunders and Smirlock (1987),
Strahan and Sufi (2001), and Collins, Kwag and Yildirim (2002)].
We confirm this change in market model betas by estimating beta using a
sixty-month moving window and the CRSP value-weighted index. In Figure 2,
we plot the time-series of market model betas for the estimation of all possible
sixty-month moving windows from the beginning of 1996 through the end of
2007 (our graph only goes through July 2007) for each industry. In this figure,
we see support for the results from our analysis in Table 3.
The systematic risk of depository and non-depository credit institutions
declines with the advent of the FSM Act. One possible explanation is that this is
from the diversification benefits from mergers and expansion of operating
activities. Compared to the period before the passage of the Act, the systematic
risk of bank holding companies changes little with the Act -- first declining and
then rising to pre-Act levels.
The systematic risk of the different types of financial services is dissimilar
prior to the passage of the Act, though the risk for all but securities firms tends to
converge by the time the Act passes; the systematic risk of all but the securities
firms tends to move together over the years 2000 through 2007. Beginning in the
summer of 2005, the systematic risk increases for all types of firms, except
securities firms, with the most dramatic changes for non-depository credit
institutions, which include many of the mortgage originators involved in subprime lending.
44
Akhigbe and Whyte (2004) document that systematic risk declines during their study period of
July-November 1999. Their period corresponds to the end of our Regime 2 and all of our Regime
3 because they classify firms according to the Compustat-assigned industry code, which is the
industry designation as of the end of the database. In their study, they compare betas for the 300day periods before and after the passage of the Act, which means that their before period
includes events such as President Clintons threat of a veto, which may have affected measured
risk. The results that we present in Table 3 reflect portfolio membership that changes as firms
alter their revenue composition sufficient for the SIC code to change.
20
Figure 2
Changes in the market model betas by industry, 1996-2007
Market model betas are estimated using 60 months for value-weighted portfolios of securities and
using the CRSP value-weighted index. The betas estimated starting with monthly returns in
January of 1991 and re-estimated moving up each month for all possible 60-month intervals using
returns through December 31, 2007.
Note: The cutoff dates for the regimes are indicated with vertical dashed lines.
V.
Summary and concluding remarks
The intent of the reformation of the financial services industry through the
lowering of barriers among the financial services industries is to strengthen the
financial services sector by allowing financial firms to diversify their financial
products. The question that arises with any major change in law such as this is:
who benefits? Did the FSM Act strengthen those firms that took advantage of the
Act?
We determine the beneficiaries of this Act by looking at the market
reaction to the news concerning the reformation. We observe that, in general, the
market considers the FSM Act to be good news. The events associated with the
21
completion of the FSM Act is associated with an overall positive reaction in share
prices for firms in all six financial services industries; securities firms, insurance
carriers, insurance agents/brokers, depository and non-depository credit
institutions, and bank holding companies. Using a simultaneous systems
approach, we are able to determine that although there is a consistent, positive
market reaction for each of these industries, the effect differs among these
industries, with the strongest effect for securities firms. One of the more
interesting observations is that bank holding companies that diversified in
response to this act perform better, in other words realized significant positive
abnormal returns, than those that did not.
Additionally, we observe that systematic risk changed throughout the
period of study, with the systematic risk of financial services firms converging
over time. There are three primary observations from our analysis. First, the
changes in systematic risk begin when the likelihood of barrier-lowering
legislation increases. Second, firms that chose to diversify into other financial
industries experience changes in systematic risk. The deregulation and increase in
competition result in increases in systematic risk for insurance agents/brokers,
securities firms, and BHCs that diversified, and decreases in risk for insurance
carriers, depository, non-depository credit institutions and BHCs that did not
diversify after the Act. Third, after an initial decline in overall systematic risk, the
systematic risk of all firms increases in the past few years as firms expanded into
non-traditional businesses. What is clear from our analysis is that the systematic
risk of financial services firms converges after passage of the FSM Act.
Appendix
Expanded literature review of effects from

diversification
Banks may desire to take advantage of scope economies from acquisitions of

insurance companies. There is evidence that insurers and investment banks stand
to gain the most benefit from scope economies compared to commercial banks
that have already undergone some deregulation [Hendershott, Lee and Tompkins
(2002].
Banks entered into insurance, but Citigroups divestiture of Travelers
property and casualty unit suggests that banks may prefer to sell insurance rather
than underwrite it [Boyer and Nyce (2002)]. The American Bankers Insurance
Associations annual Study of Leading Banks in Insurance documents that banks
are choosing to enter the property and casualty market by acquiring independent
insurance agencies [American Bankers Association (2006)]. By acquiring these
agencies, banks are obtaining the customer base, as well as the knowledge and
expertise to sell insurance that typically takes months or years and is very costly
to develop. Through these insurance agencies, banks can concentrate on selling
insurance rather than underwriting it.
22
Researchers find that acquired life insurers gain technical, cost, and
revenue efficiencies, yet the acquirer is more interested in the targets success
with their product than with their level of technical or cost efficiency [Cummins,
Tennyson and Weiss (1999)]. Some researchers do suggest that profit
performance and operating efficiency are not improved with mergers [Boyd and
Graham (1996) and Kwan and Eisenbeis (1999)].
One dimension of performance that is X-efficiency, which is the ability of
managers to control costs. Berger and Humphrey (1994) examine scale
economies, scope economies, and X-efficiency in banking mergers. In their
review and analysis of studies of banking mergers, they contend that the gains
from mergers in banking are more likely to arise from X-efficiency than from
scale or scope economies.
There is a great deal of research on economies of scale in financial
services, especially in the life insurance industry. In general, most life insurers
exhibit increasing economies of scale with very large firms displaying constant
returns to scale [Grace and Timme (1992)]. Further, those life insurers with
increasing or constant returns to scale and financially weak insurers are more
likely to be acquired [Cummins, Tennyson and Weiss (1999)]. Cummins,
Tennyson and Weiss (1999) document increasing returns to scale for life insurers
with up to $1 billion in assets, and then decreasing returns thereafter. They also
document that some life insurers in all size categories have constant returns to
scale. Yuengart (1993) finds scale economies for life insurers with assets up to
$15 billion. Houston and Simon (1970) find increasing returns to scale for life
insurers with premiums up to $100 million and then constant returns to scale
thereafter.
In the property-liability insurance industry, there are economies of scale in
small and medium insurers, suggesting that industry consolidation could lead to
cost reduction for some of these firms [Cummins and Weiss (1993)]. Non-life
firms with higher expense ratios and smaller net income/total assets ratios are
more likely to be acquired [Meador, Madden and Johnston (1986)]. The most
significant factors to predict whether a non-life company will be acquired are net
income to total assets, market value to book net worth and policyholder surplus to
total assets [Meador, Madden and Johnston (1986)].
Akhavein, Berger and Humphrey (1997) attribute increased profit
efficiency to loan portfolios that are more diversified and also to decreased equity
to asset ratios. Berger (2000) argues that diversification of risk leads to increased
revenue efficiency. Similarly, Berger and Mester (1999) find increased profits
and costs, yet the increase in profits is greater than the increase in costs. They
conclude the increase in costs is a result of either additional services or a higher
quality of services being provided. We should note, however, that though the
23
potential for gains in efficiency is large, the actual gains realized may be much
less [Berger (2000)].
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Effects of Bank Megamergers on Efficiency and Prices: Evidence from the
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Akhigbe, Aigbe, and Ann Marie Whyte, (2001). The Impact of FDICIA on Bank
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Akhigbe, Aigbe, and Ann Marie Whyte, (2004). The Gramm-Leach-Bliley Act of
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Financial Research, Vol. 27, No. 3, pp. 435-446.
American Bankers Association (2006) Study of Leading Banks in Insurance.
Washington, DC.
Ang, James and Terry Richardson, (1994). The Underwriting Experience of
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Apilado, Vincent P., John G. Gallo, and Larry J. Lockwood, (1993) Expanded
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Diversification in the Financial Services

Pamela Peterson Drake

University of North Carolina at Charlotte, frneale@uncc.edu

University of North Carolina at Charlotte, spclark@uncc.edu

Diversification in the Financial Services

Neale et al.: Diversification in the Financial Services Industry

The Financial Services Modernization (FSM) Act, more commonly

Published by The Berkeley Electronic Press, 2010

There are two primary effects of modernization legislation. First, the

Neale et al.: Diversification in the Financial Services Industry

Type of firms studied

Akhigbe and Whyte (2004)

Banks, insurance companies, securities firms 1999

Banks, insurance companies, investment

Carow and Heron (2002)

Banks, thrifts, finance companies, investment 1999

Hendershott, Lee and

Commercial banks, insurance companies, and 1999

Lown, Osler, Strahan and

Bank holding companies, securities firms, and 1999

140 Positive effect for life insurers and property/casualty insurers.

Mamun, Hassan and Lai

Commercial banks, insurance companies, and 1998-1999

Narayanan, Rangan and

Bank holding companies and investment

137 Positive reaction to early FSM events for BHCs.

Neale and Peterson (2005)

Life insurers, property/casualty insurers,

Strahan and Sufi (2001)

Bank holding companies, securities firms,

Yeager, Yeager and

Public and private bank holding companies

Published by The Berkeley Electronic Press, 2010

2,166 No change in profitability as a result of the Act.

The history and passage of the FSM Act

The Financial Services Modernization Act of 1999 was introduced by Senator

S. 900, related to H. RES. 355 and H.R. 10.

Neale et al.: Diversification in the Financial Services Industry

Significant events leading up to and including the passage of the

October 24, 1995

Representative James Leach introduces H.R. 2520 (Glass-Steagall Reform

March 26, 1996

The Supreme Court rules in Barnett Banks of Nelson County v. Nelson,

Representative James Leach introduces H.R. 10 (Financial Modernization

The Federal Reserve proposes eliminating firewalls and allowing bank

March 31, 1998

The House considers H.R. 10 with amendments.

April 28, 1999

Senator Phil Gramm introduces S. 900 (Financial Services Modernization

Senate passes S. 900 as amended.

October 22, 1999

The House and the Senate compromise regarding the Community

Barnett Banks of Marion County, N. A. v. Nelson, Florida Insurance Commissioner (94-1837),

Neale et al.: Diversification in the Financial Services Industry

A review of the evidence on the effects of the FSM Act

Mergers and acquisition by financial institutions, 1997-2007

Deal value and number of merger and acquisition deals involving

Distribution of targets in financial institution mergers and acquisitions,

Source: SNL Financial

Researchers find positive abnormal returns when BHCs merge with

Neale et al.: Diversification in the Financial Services Industry