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Banking vs Insurance - which has better cost of leverage?


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I see Buffett has always liked both insurance and banking. They are cousins but which is actually better if run well? Both use other people's money - depositors vs policy holders. And they have leverage ratios usually 4:1 for Insurance and 10:1 for banks/investment banks. Which business model has the lowest cost of capital all things being equal? Does the extra leverage of banks compensate for having to eventually pay depositors some interest? Combined ratio can be under 100% for well run insurer long term. Also is there a difference in the assets they can hold? Standard insurer holds mostly government bonds but it seems banks do many more loans like real estate, commercial loans , although less so equities. Any thoughts on if they should do roughy the same from the cost of financing benefit and type of investments they can make?

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I see Buffett has always liked both insurance and banking. They are cousins but which is actually better if run well? Both use other people's money - depositors vs policy holders. And they have leverage ratios usually 4:1 for Insurance and 10:1 for banks/investment banks. Which business model has the lowest cost of capital all things being equal? Does the extra leverage of banks compensate for having to eventually pay depositors some interest? Combined ratio can be under 100% for well run insurer long term. Also is there a difference in the assets they can hold? Standard insurer holds mostly government bonds but it seems banks do many more loans like real estate, commercial loans , although less so equities. Any thoughts on if they should do roughy the same from the cost of financing benefit and type of investments they can make?

 

Don't know if you can generalize like that.  There are many different kinds of insurance companies, P&C, lifers, reinsurers, etc.  And many different types of banks.  Global SIFI's, small regionals, super regionals, consumer finance, etc. Much like stock market investing, there are many different ways of making money in it, you need to find the one that suits the current environment and your personality.

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I think scorpiancapital's hypothetical question is using a well-run bank's deposits vs. a well-run insurance company's float to make investments.  I have been thinking about this as well. 

 

Munger and Buffett have talked about this too.  They were not happy when they had to sell their bank as a result of the 1969 Bank Holding Company Act.  Here is one of the videos:

 

With the insurance companies, you get a little more flexibility in what you can invest in and regulators don't jump at you the moment you are making losses. 

 

With banks, as we saw in the GFC, regulators can really make you sell shares at the bottom to dilute your shares by orders of magnitude (Citigroup) or take over the bank (WaMu), when your Common Equity Tier 1 capital ratio is too low.  If you want to own equities in the bank using depositors' money, the regulations make you count them at a multiple when computing your Risk Weighted Assets.  For example, for publicly traded equity, adjustment factor for RWA is 300%, for non-publicly traded equity, it jumps to 400%, and for other equity it jumps to 600%.  This effectively has almost a proportional effect on how much base Common Equity Tier 1 you need to hold.  So, effectively your leverage goes down. Then, if the marked-to-market prices of your investments fall, you have to increase your Common Equity Tier 1 to meet the required capital by recapitalizing at that time, i.e. by selling shares at the bottom.

 

That said, I think using depositors' capital to make investments is probably doable, but you need someone meticulous to be running the bank.  If I was running the bank, I can think of several ways to juice up the ROA without taking any additional risk.  I bet Munger and Buffet are thinking the same when they say they didn't like having to sell the bank, and wouldn't mind owning 25% of a bank now that the rules have changed.  However, risks are still there as you need to have processes in place to make sure your employees don't screw up in making loans/investments just like risks are in place that your underwriters don't screw up in insurance, but with banks risks are more SEVERE and can materialize really FAST with regulators ready to jump at you if marking your investments to market and CECL losses on loans take your CET1 capital under what you need to have.

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I think scorpiancapital's hypothetical question is using a well-run bank's deposits vs. a well-run insurance company's float to make investments.  I have been thinking about this as well. 

 

Munger and Buffett have talked about this too.  They were not happy when they had to sell their bank as a result of the 1969 Bank Holding Company Act.  Here is one of the videos:

 

With the insurance companies, you get a little more flexibility in what you can invest in and regulators don't jump at you the moment you are making losses. 

 

With banks, as we saw in the GFC, regulators can really make you sell shares at the bottom to dilute your shares by orders of magnitude (Citigroup) or take over the bank (WaMu), when your Common Equity Tier 1 capital ratio is too low.  If you want to own equities in the bank using depositors' money, the regulations make you count them at a multiple when computing your Risk Weighted Assets.  For example, for publicly traded equity, adjustment factor for RWA is 300%, for non-publicly traded equity, it jumps to 400%, and for other equity it jumps to 600%.  This effectively has almost a proportional effect on how much base Common Equity Tier 1 you need to hold.  So, effectively your leverage goes down. Then, if the marked-to-market prices of your investments fall, you have to increase your Common Equity Tier 1 to meet the required capital by recapitalizing at that time, i.e. by selling shares at the bottom.

 

That said, I think using depositors' capital to make investments is probably doable, but you need someone meticulous to be running the bank.  If I was running the bank, I can think of several ways to juice up the ROA without taking any additional risk.  I bet Munger and Buffet are thinking the same when they say they didn't like having to sell the bank, and wouldn't mind owning 25% of a bank now that the rules have changed.  However, risks are still there as you need to have processes in place to make sure your employees don't screw up in making loans/investments just like risks are in place that your underwriters don't screw up in insurance, but with banks risks are more SEVERE and can materialize really FAST with regulators ready to jump at you if marking your investments to market and CECL losses on loans take your CET1 capital under what you need to have.

 

History rhymes,

too many times.

 

www.washingtonpost.com/archive/business/1990/02/18/the-s-l-junk-bond-link/af7c5d43-e4b0-4e24-8c2f-95135a7b041a/

 

First it was junk,

then it was homes,

what's the next vehicle,

to make fodder for poems?

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Isn't there some rule now that banks must separate investment and core banking operations?

I also looked at brokerage firms as bank substitutes these days.

Sounds from all this that the key is who you get into bed with. The reputation. Even in insurance, there are so many run of the mill insurers, if there is nothing special or you can't trust or understand what management is doing it is like delegating your capital to endless layers of a black box process.

 

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Regarding the separation, I think you might be thinking about investment banking business, where (1) one arm is acting as seller's broker, and (2) another arm invests bank's own balance sheet.

 

What I was talk about was a bank that (a) takes deposits and (b) lends out that money as loans/investments.

 

Yes, you hit it right on the nail that banks and insurance companies are not "businesses that are so wonderful that an idiot can run them."

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