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Monday, 8 March 2010

LIC to set up bank: Nothing more foolish!

The recent news item to the effect that LIC wants to set up a bank is imprudent and unwise. Let's briefly see why this is so.

A bank lends illiquid (its loans are invested in illiquid assets like property, stocks and receivables of its borrowers) and borrows liquid (its deposits have to be repaid anytime the depositor asks for it). Hence, the major objective of an insurance company is to be liquid when no one else is.

An insurance company is very liquid in good times. When disaster strikes, this liquidity is drawn on suddenly. An insurance company manages this huge risk primarily by spreading the risk over a large number of lives or properties as the case may be, in its areas of operation; and distributing some part of the risk globally through reinsurance. Hence the objective of an insurance company is to be liquid when nobody else is. 

We now know that banks are more vulnerable to financial crises than believed before Bear Stearns' demise in 2007.  

We have also seen that natural disasters of all kinds have increased significantly (maybe because of climate change effect). For example, the two deadliest earthquakes in recorded history have happened in the last two years itself (Sumatra, Chile). Hence, we can say that there is a high chance of disasters hitting, resulting in claims for the insurance industry worldwide.

Today, banking and insurance are the riskiest businesses globally. We have seen how RBI's is not allowing banks to become exposed to toxic derivative securities helped India to be insulated from the global financial meltdown. We have also seen the stupidity (it seems in hindsight) of AIG taking on risks of the banking industry by insuring bonds. 

It simply is foolish to expose the liquidity of India's most liquid entity in the riskiest industry by allowing it to diversify into banking, which is almost as risky as the insurance business.