Explain why banks sometimes seek to merge with with
Explain why banks sometimes seek to merge with with or acquire other banks or financial institutions
Great changes have been experiences in banking industry for the past decades. The most apparent alter is a mass of bank mergers, which have expanded both the average size of banks and their territories. Other dramatic changes including the development of Internet banking and the combination of banking with other financial services, for example, insurance and securities underwriting are also encountered.
Figure: Total Number 1995 vs. 2001
(Number of banks declining despite overall growth in the banking sector.)
Consolidation in banking is distinct from "convergence." Consolidation refers to mergers and acquisitions of banks by banks. Convergence refers to the mixing of banking and other types of financial services like securities and insurance, through acquisitions or other means. Consolidation will provide banks with new capabilities,technologies and products, help to overcome entry barriers, ensure immediate entry into new markets and lower operating costs through consolidation of resources.
Background on recent consolidation
The Riegle-Neal Act granted interstate branch banking beginning in 1997. Since then, the number of large bank mergers has risen dramatically. (Figure 1) sketch this trend along with another remarkable trend, i.e., that most of the large bank mergers in recent years involved institutions headquartered in different states; the latter point advises that these are market-expansion mergers, even though the acquirer and the target have few overlapping operations in their respective banking markets. Although the markets they serve are much bigger, until now none of these three mega banks has achieved the goal in having a banking franchise that spans all 50 states, which is feasible in law.
Figure 2:Total Number of Foreign Banks, 1995 Total Number of Foreign Banks, 1995 vs. 2001
Another noticeable fact about the recently announced mega mergers is that the target banking companies are positive institutions that are likely to survive as independent organizations. This is in stark contrast both to the late 1980s and early 1990s in the U.S., when many bank mergers involved relatively feeble banking companies being acquired by somewhat stronger organizations, as well as to some large bank mergers abroad, most notably in Japan. Today the U.S. banking sector is in good function, with record profits and relatively low amounts of problem loans. For example, the return on average assets in 2003 for the two merger targets, Bank One and Fleet Boston, were 1.27% and 1.34%, respectively, while the top 50 bank holding companies averaged 1.28%. This indicates that the recent mega mergers are not motivated by economic weakness but rather by other economic forces.
Major changes in the banking system
One significant phenomenon in the nation's banking system is consolidation. The pace of mergers had been expedited in the 1990s. Some of these mergers made full use of new laws permitting banks to spread within and across state lines. Other mergers were pursued to reduce costs, even though parts to be proven in vain. Merger activity has decreased in recent days, and some specialists anticipate this is just a momentary pause. Even if merger activity is unable to climb up to its previous levels, mergers have influenced banking to some extent.
One important effect of the recent merger wave has been an increase in the role of large banking organizations(figure 3). The biggest change here has involved the so-called mega banks-banks with more than $100 billion of assets. Such banks are much less important in rural markets than urban markets, but their share of rural deposits still increased considerably during the 1990s-from only 1.7% in mid-1990 to 8.2% in mid-2000. The rural deposit share of regional and super-regional banks ($10 to $100 billion range) also rose over the period, though not quite as much. These gains came mostly at the expense of community banks (less than $1 billion in assets). By mid- 2000, these smaller banks still controlled 51.7% of rural deposits, but that share was down from 61.0% ten years earlier.
Another effect of mergers has been a harsh rise in multi-state banking. Most of the mergers in the 1990s were inter-banking organizations from different states. Therefore, there was a big shift in ownership of deposits from organizations based on the same market or the same state to organizations based on another state. This change in ownership has been essential in rural markets as well as urban markets (figure 4). By mid-2000, 28.8% of rural deposits were in banks or branches or out- of-state banking companies, compared with only 12.5% in mid-1990. Some of this increase in out- of-state ownership came at the expense of banking companies located elsewhere in the same state-for example, companies' headquarter in the cities around-but most was at the expense of strictly local banks.
Figure5: Percentage of Total Banking Sector Assets Percentage of Total Banking Sector Assets
The second often-quoted change in the banking system is financial integration- the expansion of diversified financial firms presenting a wide choice of financial services in addition to traditional banking. Some movements in this direction occurred in the 1990s, as banks utilized loop-holes in the laws restricting what they could do. But the trend toward financial integration could perfectly accelerate due to passage of the Gramm-Leach-Bliley Act (GLBA) in late 1999. This law made two major changes. First, it allowed bank holding companies to combine ...
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Figure5: Percentage of Total Banking Sector Assets Percentage of Total Banking Sector Assets
The second often-quoted change in the banking system is financial integration- the expansion of diversified financial firms presenting a wide choice of financial services in addition to traditional banking. Some movements in this direction occurred in the 1990s, as banks utilized loop-holes in the laws restricting what they could do. But the trend toward financial integration could perfectly accelerate due to passage of the Gramm-Leach-Bliley Act (GLBA) in late 1999. This law made two major changes. First, it allowed bank holding companies to combine with insurance and securities companies and cross-sell their products. Second, it allowed bank holding companies that did not combine with other firms to offer new financial services on their own-such as underwriting securities, selling or underwriting insurance, and making equity investments in business firms.
Figure6: Average Total Assets Held by Non-top 5 Average Total Assets Held by Non-top 5 Banks
While GLBA has been widely expected to provoke more mergers between large banking organizations and other financial companies, the new law could also wind up broadening the array of financial services offered by smaller banks. Many small banks, although too small to underwrite securities and insurance, might take advantage of the new authority to sell insurance or engage in merchant banking through the purchase of equity in small businesses. Actually, hundreds of banking organizations under $1 billion in size have already transformed to Financial Holding Companies (FHCs), as required to offer the new financial services. These organizations demonstrate only a small portion of all banking organizations under $1 billion in size but are more numerous than most analysts expected when the law was passed
Benefits of Consolidation Benefits of Consolidation
Banking Sector
* Reduced likelihood of bank failure
* Potential for improved regulation
* Improved capital markets
* Customer benefits from cost savings, larger single counterparty exposures
Individual Banks
* Revenue enhancement
* Stronger capital base
* Cost savings from economies of scale
* Knowledge, technology and risk sharing
* Portfolio, business and geographic diversification
* Promotion of trade among customers Opportunity to focus on the delivery of specialized services
Disadvantages of Consolidation Disadvantages of Consolidation
Banking Sector
* Potential impact on level of systemic risk in the overall market
* Loss of domestic ownership in the financial sector
Individual Banks
* Number of issues to be overcome in the merger / acquisition process
* Reduced competition / innovation
* Increased operating and managerial risk
Economic forces driving mega mergers
We can summarize four economic forces that may drive large bank mergers. First factor is economies of scale-the relationship between the average production cost per unit of output and production volume. An organization that produces a higher volume of output can see its unit cost of production decline because the costs of some of the inputs are entotic, such as administrative and overhead expenses. However, diseconomies of scale may also probably exist. The average production cost may begin to rise when output exceeds a certain volume because it may be much higher to manage a very large organization; these costs may originate from corporate governance issues, difficulties in coordination and execution, and diminished flexibility in responding promptly to changing.markets.
Figure7:Banking Sector Assets as Percentage of GDP
While banking researchers generally agree that economies of scale do exist in the industry at low levels of production, there is less common understanding about whether diseconomies of scale appear at high levels of production. Earlier studies found proof that diseconomies of scale did occur when total banking assets exceeded about $10 billion; however, those results were based on banking data prior to the passage of the Riegle-Neal Act, when banking companies operating in multiple states had to maintain separately capitalized, individually chartered bank subsidiaries in those states. The passage of Riegle-Neal consents these banking organizations to consolidate the individual state charters into a single charter, thus greatly regulating management and operations. On the cost part, it is obvious that the cost structure of running a network of bank branches across multiple states should be more efficient than running a group of individually capitalized bank subsidiaries. On the revenue part, research on mega mergers shows that merged banks experienced higher profit efficiency from increased revenues than a group of individual banks did, because they provided customers with higher value-added products and services (Akhavein, Berger, and Humphrey 1997). Furthermore, a banking organization of a certain scale may even earn a "too-big-to-fail" subsidy due to the market's perception of actual government support of a mega bank in times of crisis. While the mixture of all these factors could raise the most favorable scale of large banking organizations today, it remains to be seen whether a $1 trillion bank is the "right" size.
The second economic force is economies of range-a situation where the joint costs of producing two completing outputs are less than the combined costs of producing two separate outputs. This may result when the production processes of both outputs share some common inputs, including both capital (such as the actual building the bank occupies) and labor (such as bank management). The passage of the Gramm-Leach-Bliley Act (GLB) in 1999 changed the range of allowable financial activities for banking organizations. In the past, banking organizations were forbidden to engage in securities activities unless on a limited, case-by-case basis through their so-called Section 20 subsidiaries. Also, general insurance activities were not allowed for banking firms, barring in very small towns with fewer than 5,000 inhabitants. GLB allows banking organizations to enlarge on securities and insurance activities in a much more straightforward way. Although the two recently announced mega mergers mainly involve in combining banking activities, the possibility of scope economies among banking, securities, and insurance could further increase the ideal size of a large banking organization today compared to pre-GLB days.
The third economic force is the probability for risk variation. Research makes it evident that geographic expansion would provide diversification benefits to a banking organization not only by bring down its portfolio risk on the asset side, but also by undermining its funding risk on the liability side, as it spreads funding activities over a larger geographic area (Hughes, Lang, Mester, and Moon 1999). Moreover, research indicates that product expansion could produce diversification benefits, most notably between banking and securities activities, while less so between banking and insurance (see the survey article by Kwan and Laderman 1999). Thus, a bigger bank is expected to be less susceptible to economic shocks, and that alone could reduce its cost of capital, further compounding the benefits of scale and scope economies that come only from the production process.
The fourth economic force contains the bank managements' personal motivation. These may involve the desire to run a larger organization and the desire to maximize their personal welfare. Empirical research has shown that managerial compensation and perquisite consumption tend to rise with firm size. Research on stock market reactions to mega merger announcements in the 1990s suggests that, averagely, the market did not consider mergers of publicly owned banking companies as providing a significant gain to total shareholders' wealth of the combined company (Kwan and Eisenbeis 1999). The silence of market to merger announcements raises questions about the true significance of the net economic benefits underlying large bank mergers.
Policy implications
Firstly, bank mergers have the inherent ability to raise antitrust concerns, which must be solved adequately before being approved. As bank mergers can adjust banking market structure and because market structure effects banking competition and hence the price of banking services to customers, all bank merger applications are scrutinized by banking regulators. In addition, the Department of Justice has the authority to question any mergers that are thought harmful to competition. Research suggests that the markets for many banking products and services remain local in nature, in spite of the advances in information technology and electronic commerce (Rhoades 2000). Indeed, the recent market-expansion mega mergers themselves are testimony to the importance these large banking organizations attach to maintaining a local market presence. Thus, the current administrative practices of defining banking markets locally in appraising the effects of proposed mergers on competition seem justified. When a proposed merger is found to result in an unacceptably high level of concentration in local banking markets, divestitures in those markets are often required as a condition for regulatory approval in order to maintain meaningful competition. Looking at western states, Laderman (2003) found that changes in concentration of local banking markets were quite moderate despite the large degree of consolidation in banking over the past two decades.
In addition to concerns about banking centralized effects on local market competition, existing banking law also limits banking concentration at the national level. Perhaps impelled by the fear of concentration of banking power, the Riegle-Neal Act forbids any merger or acquisition that results in a combined banking organization controlling more than 10% of the total amount of deposits of insured depository institutions in the U.S. A banking organization could exceed the deposit cap through internal growth, but it would not be allowed to engage in any more mergers or acquisitions. While the combined Bank of America and FleetBoston organization would control about 9.9% of the national deposit share, it is still not yet close to being a truly national bank. Thus, the motivation on building a truly nationwide franchise could be severely restrained by current law. As banking organizations get closer to the cap, policymakers will confront with growing pressure to reconsider both the merits of the deposit cap and the optimal way to accomplish the associated public policy goals.
The creation of mega banks also raises concerns about systemic risk. When banking activities are focused on a few very large banking companies, shocks to these individual companies could have repercussions to the financial system and the real economy. The desire to confine systemic risk may lead policymakers to preserve some kind of cap on banking concentration at the national level.
The increased potential of systemic risk created by mega banks also increases concerns about these banks being considered "too-big-to-fail" (TBTF). In the early 1990s, the FDIC Improvement Act (FDICIA) included measurements to limit the extension of TBTF to failing banks. Specifically, it commanded that the FDIC use the least cost resolution method to handle bank failures, thus greatly raising uninsured bank creditors' exposure to default risk. It seems to have led market participants to revamp their views towards TBTF. This, in connection with the National Depositor Preference law (1993), which put depositors ahead of subordinated debt holders, may explain the research findings showing a significant increase in the sensitivity of the default risk premium of bank subordinated debt to banking organizations' underlying risks after FDICIA. However, there is still an exclusion in FDICIA-which can be applied only in extraordinary circumstances-that allows the FDIC to pay off a failing bank's uninsured creditors if the use of least cost resolution would have serious adverse effects on economic conditions or financial stability. Mega mergers create more such potentially systemically important banks and put a higher premium on credible policies for the orderly resolution of troubled large banking organizations-policies that limit the potential for moral danger while containing their adverse impacts on financial markets.
New view
More definitive results can be found in other recent research that has taken what might be called the "new view" on consolidation. Under this view, bank mergers are not just about adjusting inputs to affect costs; rather, they also involve adjusting output (product) mixes to enhance revenues. Two research efforts taking this approach are Akhavein, et al. (1997), covering mergers in the 1980s, and Berger (1998), covering mergers in the 1990s. These studies find that bank mergers do tend to be associated with improvements in overall performance, in part because banks achieve higher valued output mixes. While these studies do not track all of the channels through which bank mergers affect the value of output, they suggest that one channel has been banks' shift toward higher yielding loans and away from securities.
This channel is particularly interesting given the other results in these studies. They find that merged banks also tend to experience a lowering of their cost of borrowed funds without needing to increase capital ratios. The lower cost of funds is consistent with a decline in the overall risk of the combined bank compared to that of the merger partners taken separately. This apparently occurs even though a shift to loans by itself might be expected to increase risk. One interpretation of these results, then, is that a merger can result in a reduction in some dimensions of risk, which then affords the post-merger bank more latitude to shift to a higher return, though perhaps higher risk, output mix. The sources of diversification could be differences in the range of services, the portfolio mixes, or the regions served by the merging banks.
Conclusions
There are a number of possible economic forces for mega mergers, from economic efficiency to the self-interest of bank management. Due to the far-reaching changes in banking laws in the 1990s, earlier research on bank mergers may not be suitable to today's environment; thus it remains to be seen whether the current bank mega mergers result in any measurable efficiency gains. Nevertheless, the ever-growing scale of bank mergers raises challenging policy questions, including banking concentration at the national level and systemic risk concerns, that must be addressed by policymakers in the course of urging economic efficiency while protecting the nation's financial system.
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