Question

A diversified financial conglomerate has five units (subsidiaries). One unit conduct thrift operations; the second unit conducts consumer finance operations; the third, mutual fund operations; the fourth, securities operations; and the fifth, insurance operations. As a financial analyst for the conglomerate;s holding company, you have been asked to assess all of the units and to indicate how each unit will be affected as economic conditions change as well as which units will be most affected.

In the past few months, all economic indicators have been signaling the possibility of a recession. Stock prices have already declined as the demand for stocks has decreased dignificantly. It appears that the pessimistic outlook will last for at least a few months. Economic conditions are already somewhat stagnant and are expected to deteriorate further in the future months. During that time, firms will not consider mergers, new stock issues, or new bond issues.

An economist at your financial conglomerate believes that individual investors will overreact to the pessimistic outlook. Once stock prices are low enough, some firms will acquire target firms whose stock appears to be undervalued. In addition, some firms will buy back some of their own stock once they believe it is undervalues. Although these activities have not yet occurred, the economist believes it is only a matter of time.

1. Your strategy is to identify the units that will be less adversely affected by the recession. You believe that the units' different characteristics will cause some of them to be affected more than others. Which will be the least and the most affected? Why?

2. Currently, each unit employs economists who develop forecasts for interest rates and other economic conditions. When assessing potential economic effects on each unit, what are the disadvantages of this approach versus having just one economist at the holding company provide forecasts?

Answer 1

(1): The unit that will be least affected is the insurance operations unit. This is because even in times of economic downturn and recession people will buy insurance like health insurance, motor vehicle insurance, home owners policy etc. so as to keep themselves protected from meeting unexpected expenses.

The unit that will be most affected will be the securities operations. This is because in times of recession all types of financial markets will be affected be it money markets or bond markets or mortgage markets or stock markets or future markets or options markets or swap markets. All aspects of securities operations will be negatively impacted during times of recession and economic stagnation and this will lead to fall in the revenues of the securities operations unit by a considerable amount.

(2): Having a separate economist for each unit is disadvantageous when compared to having a single economist at the holding company level. This is because when each economist provide their own forecast there will be a difference in the forecasts due to difference of opinions. Forecasting has a subjective element attached to it and hence all the economists will paint a different picture. This will lead to confusion at the holding company level and no particular strategy could be devised to tackle the problem of economic stagnation and downturn.

On the other hand if there is one single economist at the holding company level there will be no such confusion and all the units will work under the common set of assumptions and forecasts and this will ensure unity in strategy and eventually lead to optimal strategy formulation and implementation.