Download - Consolidation Financial Services Industry

The consolidation of the nancial services

industry: Causes, consequences, and

implications for the future

Allen N. Berger a,b,*, Rebecca S. Demsetz c, Philip E. Strahan c

a Board of Governors of the Federal Reserve System, Mail Stop 153, Federal Reserve Board,

20th and C Sts. N.W., Washington, DC 20551, USAb Wharton Financial Institutions Center, Philadelphia, PA 19104, USA

c Federal Reserve Bank of New York, New York, NY 10045, USA

Abstract

This article designs a framework for evaluating the causes, consequences, and future

implications of nancial services industry consolidation, reviews the extant research

literature within the context of this framework (over 250 references), and suggests

fruitful avenues for future research. The evidence is consistent with increases in market

power from some types of consolidation; improvements in prot eciency and diver-

sication of risks, but little or no cost eciency improvement on average; relatively little

eect on the availability of services to small customers; potential improvements in

payments system eciency; and potential costs on the nancial system from increases in

systemic risk or expansion of the nancial safety net. 1999 Elsevier Science B.V. Allrights reserved.

JEL classication: G21; G28; G34; E58; L89

Keywords: Banks; Mergers; Payments; Small business

Journal of Banking & Finance 23 (1999) 135194

* Corresponding author. Tel.: (1) 202 452 2903; fax: (1) 202 452 5295; e-mail: [email protected]

0378-4266/99/$ see front matter 1999 Elsevier Science B.V. All rights reserved.PII: S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 1 2 5 - 3

1. Introduction

The nancial services industry is consolidating around the globe. Mergersand acquisitions (M&As) among nancial institutions are occurring at a torridpace in the US, may occur at a rapid pace in the near future in Europe undermonetary union, and may be part of the solution to problems of nancialdistress in Asia and elsewhere. Moreover, we may be on the brink of a newwave of M&As between large banking organizations and other types of -nancial service providers worldwide.

While there has been considerable research on nancial services industryconsolidation, much is yet to be understood. The main purposes of this journalspecial issue are to bring together the most up-to-date research and promoteadditional research on this important topic. The main purposes of this intro-ductory article in particular are to design a framework for evaluating thecauses, consequences, and future implications of nancial services industryconsolidation, review the extant research literature within the context of thisframework (over 250 references), and suggest fruitful avenues for future re-search.

In our framework, the main motivation behind consolidation is to maximizeshareholder value, although we also consider the motives of other stakeholders,particularly managers and governments. Value may be maximized throughM&As primarily by increasing the participating rms market power in settingprices or by improving their eciency, and in some cases by increasing theiraccess to the safety net.

Our framework predicts that the pace of consolidation will primarily bedetermined by changes in economic environments that alter the constraintsfaced by nancial service rms. We identify ve such changes that may bepartially responsible for the recent rapid pace of consolidation technologicalprogress, improvements in nancial condition, excess capacity or nancialdistress in the industry or market, international consolidation of markets, andderegulation of geographical or product restrictions.

The consequences of consolidation include not only the direct eects ofincreased market power or improved rm eciency, but also some indirecteects. One potential indirect consequence may be a reduction in the avail-ability of nancial services to small customers. Potential systemic consequencesof consolidation include changes in the eciency of the payments system andchanges in the safety and soundness of the nancial system. In principle, policymakers may balance the expected social benets and costs of these conse-quences in setting rules on consolidation or in approving/disapproving indi-vidual M&As. In practice, however, it may be dicult to quantify thesebenets and costs.

Our framework divides the research literature on the consequences ofconsolidation into two logically separable categories static analyses and

136 A.N. Berger et al. / Journal of Banking & Finance 23 (1999) 135194

dynamic analyses. Static analyses are dened here to be studies that relate thepotential consequences of consolidation to certain characteristics of nancialinstitutions that are associated with consolidation, such as institution size.However, static studies do not use data on M&As. These analyses are notnecessarily intended to provide information about the eects of consolidation,but they nonetheless may prove useful in predicting the consequences ofM&As. For example, static analyses of scale eciency may give valuable in-formation as to the eciency eects of M&As in which the institutions sub-stantially increase their size.

Dynamic analyses are dened here to be studies that compare the behaviorof nancial institutions before and after M&As or compare the behavior ofrecently consolidated institutions with other institutions that have not recentlyengaged in M&As. Dynamic analyses take into account that M&As are dy-namic events that may involve changes in organizational focus or managerialbehavior. These analyses also incorporate any short-term costs of consum-mating the M&A (legal expenses, consultant fees, severance pay, etc.) or dis-ruptions due to downsizing, meshing of corporate cultures, or turf battles.Dynamic analyses are more inclusive than static analyses. For example, dy-namic analyses of the eciency consequences of consolidation include changesin X-eciency (distance from optimal point on the best-practice ecientfrontier) as well as the changes in scale, scope, and product mix ecienciesincluded in static analyses.

Our framework also emphasizes the importance of considering the ex-ternal eects of consolidation, dened here as the reactions of other nancialservice providers to M&As in their markets. The changes in competitiveconditions created by M&As may evoke signicant reactions by rival rmsin terms of their own organizational focus or managerial behavior that mayeither augment or oset the actions of the consolidating rms. For example,if consolidating institutions reduce their availability of credit to some smallbusinesses, other institutions may pick up some of the dropped smallbusiness credits if it is value maximizing for them to do so. Only by in-cluding the external eects can the total eects of consolidation be deter-mined.

Section 2 presents some ``facts'' of consolidation summary statistics thatprovide background information for the discussion that follows. Section 3reviews the causes of nancial consolidation and identies changes in theeconomic environment that may aect the pace of consolidation. Sections 46review the research literature on three potential consequences of consolida-tion changes in market power, eciency, and the availability of services tosmall customers, respectively. Section 7 addresses two potential systemicconsequences of consolidation, changes in payments system eciency andnancial system safety and soundness. Section 8 extrapolates from the extant

A.N. Berger et al. / Journal of Banking & Finance 23 (1999) 135194 137

research to draw implications for future consolidation and for future re-search. 1

2. The ``facts'' of nancial consolidation

Tables 15 report aggregate statistics on trends in nancial consolidation.As shown in Table 1, the number of US banks and banking organizations(stand-alone banks and top-tier bank holding companies (BHCs)) both fell byalmost 30% between 1988 and 1997. During this period, the share of totalnationwide assets held by the largest eight banking organizations rose from22.3% to 35.5%. We also look at measures of concentration at the local level dened as a Metropolitan Statistical Area (MSA) or non-MSA county giventhe evidence discussed below that markets for most retail banking products arelocal. Despite all the consolidation activity, the average local market depositHerndahl index actually declined slightly over the period, falling by about 4%for MSAs and by about 5% for non-MSA counties. Total bank oces rose by16.8%, although total bank plus thrift oces declined by 0.1% in part becausebanks acquired branches formerly owned by failed thrifts.

Structural changes in the US banking industry from M&As, de novo entry,and failure are shown in Table 2. Several hundred M&As occurred each year,about half of the in-market type and half of the market-extension type. Duringthis period, ``megamergers'' M&As between institutions with assets over $1billion each became common, most of them occurring between institutionsin dierent states. Although not shown in the table, some very recent M&As inthe US and elsewhere have increased dramatically in size, some reaching thescale of ``supermegamergers'' M&As between institutions with assets over$100 billion each. Based on market values, nine of the ten largest M&As in UShistory in any industry occurred during 1998, and four of these CiticorpTravelers, BankAmericaNationsBank, Banc OneFirst Chicago and

1 The other contributions in this special issue were presented at a conference sponsored by the

Federal Reserve Bank of New York in March 1998. Each full-length research paper is accompanied

by discussants comments. We also include shorter contributions of conference panelists. Topicscovered are the causes of consolidation (Milbourn et al., 1999; Flannery, 1999, Hadlock et al., 1999;

Hubbard, 1999; Esty et al., 1999; James, 1999), the consequences of consolidation for eciency

(Hughes et al., 1999; Cummins et al., 1999; Ferrier, 1999; Fried et al., 1999; Peristiani, 1999;

Hancock et al., 1999; Hendricks, 1999), the consequences of consolidation for the availability of

services to small customers (Jayaratne and Wolken, 1999; Petersen, 1999; De Young et al., 1999;

Rosen, 1999; Avery et al., 1999; Udell, 1999), international perspectives on consolidation (Saunders

and Wilson, 1999; Kroszner, 1999; Peek et al., 1999; Eisenbeis, 1999), the role of policymakers

(Boot, 1999; Calomiris, 1999; Kashyap, 1999; Kwast, 1999; Santomero, 1999; Solomon, 1999), and

the expansion of bank powers (Boyd, 1999; Kane, 1999; Mishkin, 1999; Saunders, 1999; Thakor,

1999).


Tab

le1

Co

nce

ntr

ati

on

,o

wn

ersh

ip,

an

dn

um

ber

of

rm

sin

the

US

com

mer

cial

ban

kin

gin

du

stry

a

Nu

mb

ero

f

US

ba

nk

cha

rter

s

Nu

mb

ero

f

ba

nk

ing

org

an

iza

-

tio

ns

Nu

mb

ero

f

ba

nk

ing

o

ces

Nu

mb

ero

f

o

ces

in

ban

ks

plu

s

thri

fts

Eig

ht

rm

con

cen

tra-

tio

nra

tio

Ass

ets

inb

ran

ches

an

dagen

cies

of

fore

ign

ban

ks

to

tota

lb

an

kin

g

ass

ets

Per

cen

to

f

do

mes

tic

ban

ks

that

are

fore

ign

-

ow

ned

Dep

osi

t

Her

n

dah

l

inM

SA

s

Dep

osi

t

Her

n

dah

l

inn

on

-

MS

A

cou

nti

es

19

88

13

,130

98

81

59

,518

84,7

05

22.3

%14.2

%6.0

2020

4316

19

89

12

,727

96

20

60

,720

84,3

69

22.6

15.0

6.2

2010

4318

19

90

12

,370

93

91

62

,753

84,3

60

22.3

15.7

6.9

2010

4291

19

91

11

,949

91

68

63

,896

83,4

73

25.7

17.0

6.7

1977

4257

19

92

11

,496

88

73

63

,401

81,1

98

26.4

17.0

6.5

2023

4222

19

93

11

,001

84

46

63

,828

80,3

54

28.1

15.9

6.4

1994

4234

19

94

10

,491

80

18

65

,597

81,6

78

29.7

15.7

6.4

1976

4208

19

95

99

84

76

86

66

,454

81,9

20

30.4

15.1

6.4

1963

4171

19

96

95

75

74

21

67

,318

82,9

82

34.3

15.3

5.3

1991

4145

19

97

92

16

72

34

69

,464

83,8

99

35.5

15.7

3.9

1949

4114

aS

ou

rce:

Rep

ort

so

fIn

com

ea

nd

Co

nd

itio

na

nd

NIC

,199897,

FD

ICH

isto

rica

lS

tati

stic

so

nB

an

kin

g,

an

dM

eyer

(1998).

Ab

an

kin

go

rgan

izati

on

isa

top

tier

ba

nk

ho

ldin

gco

mp

an

yo

ra

sta

nd

-alo

ne

ba

nk

.A

do

mes

tica

lly

chart

ered

ban

kis

con

sid

ered

fore

ign

-ow

ned

ifit

isat

least

50%

ow

ned

by

a

fore

ign

ba

nk

ing

org

an

iza

tio

n.

Th

eco

nce

ntr

ati

on

rati

ois

base

do

nto

tal

ass

ets

of

do

mes

tica

lly

chart

ered

ban

ks.

Th

eD

epo

sit

Her

n

dah

lis

10,0

00

tim

es

the

sum

of

squ

are

dm

ark

etsh

are

sb

ase

do

nd

epo

sits

for

ban

kin

go

rgan

izati

on

so

per

ati

ng

inM

etro

po

lita

nS

tati

stic

al

Are

as

(MS

As)

or

no

n-M

SA

cou

nti

es.

Th

e19

97

g

ure

for

fore

ign

ow

ner

ship

isfo

rth

ese

con

dq

uart

er.

All

oth

er

gu

res

are

yea

r-en

d.


NorwestWells Fargo occurred in banking (Moore and Siems, 1998). Inaddition, the recent UBSSwiss Bank Corp. supermegamerger created thelargest bank in Europe.

Other changes in industry structure occurred as high rates of failure reducedthe number of banks while high rates of de novo entry increased the number ofbanks. During the latter part of the 1980s, each year about 200 banks failedand about 200 new banks were formed (although the de novo banks weregenerally much smaller than the failed banks). Both failure and entry declinedin the early 1990s, while rates of entry picked up in the mid-1990s as industryprotability rose.

Table 3 gives data for US nonbank nancial institutions. The life insurance,propertyliability insurance, and securities brokerage industries have changed

Table 2

M&As, failures, and entry in the US commercial banking industrya

M&As of unaliated banking organizations

Total In-market Market

extension

Mega-

mergers

(Interstate)

De novo

entry

Failures

1988 468 192 276 14 228 209

(7)

1989 350 195 155 3 201 206

(2)

1990 366 195 171 6 175 158

(2)

1991 345 189 156 16 107 105

(12)

1992 401 164 237 23 73 98

(15)

1993 436 222 214 15 59 40

(10)

1994 446 237 209 15 48 11

(11)

1995 344 115 229 20 110 6

(16)

1996 311 190 121 26 148 5

(14)

1997 207 NA NA 15 207 1

(11)

a Source: (Rhoades, 1996, Tables 4, 10, 18) and Meyer (1998). Figures for 1997 are estimated.

Mergers are dened here as combinations that bring together under common ownership banks that

had been independent. Mergers of aliated banks are not included. When a multibank holding

company is acquired, each commercial bank in that holding company is counted as a separate

merger. Market extension mergers are dened as those where the target bank is located in a dif-

ferent market from the acquirer, where a market is dened as a Metropolitan Statistical Area

(MSA) or non-MSA county. Both the target banking organization and the acquiring banking

organization must have total assets over $1 billion to be considered a megamerger.


Tab

le3

Co

nce

ntr

ati

on

inn

on

ba

nk

seg

men

tso

f

na

nci

al

serv

ices

inth

eU

nit

edS

tate

sa

Lif

ein

sura

nce

Pro

per

ty

lia

bil

ity

insu

ran

ceS

ecu

riti

es

rms

Savin

gs

inst

itu

tio

ns

Cre

dit

un

ion

s

Nu

mb

ero

f

rm

s

Ass

et

sha

reo

f

eig

ht

larg

-

est

rm

s

(%)

Nu

mb

ero

f

rm

s

Ass

et

share

of

eigh

tla

rg-

est

rm

s

(%)

Nu

mb

ero

f

rm

s

Cap

ital

share

of

ten

larg

est

rm

s(%

)

Nu

mb

ero

f

rm

s

Ass

et

share

of

eigh

tla

rg-

est

rm

s

(%)

Nu

mb

ero

f

rm

s

Ass

et

share

of

eigh

tla

rg-

est

rm

s

(%)

19

88

13

67

41

.79

40

32.5

6432

57.5

3175

13.5

13,8

75

6.3

19

89

12

88

40

.41

19

332.4

6141

61.8

3100

15.0

13,3

71

6.5

19

90

12

23

39

.01

27

232.4

5827

63.6

2725

18.2

12,8

60

6.7

19

91

12

21

38

.11

26

732.2

5386

62.1

2386

19.9

12,9

60

6.8

19

92

11

77

37

.21

23

232.2

5260

62.2

2086

19.3

12,5

94

7.4

19

93

11

87

36

.41

19

731.5

5292

63.4

1726

17.7

12,3

17

7.7

19

94

10

82

35

.31

18

731.3

5426

60.9

1532

19.2

11,9

91

7.9

19

95

10

54

34

.91

17

933.7

5451

59.3

1420

21.7

11,6

87

7.9

19

96

10

01

34

.71

13

836.1

5553

58.5

1322

21.3

11,3

92

7.8

19

97

NA

NA

NA

NA

5597

55.5

1201

30.6

11,2

38

8.0

aS

ou

rce

an

dN

ote

s:L

ife

Insu

ran

ce:

Cu

mm

ins

eta

l.(1

999),

Nati

on

al

Ass

oci

ati

on

of

Insu

ran

ceC

om

mis

sio

ner

s,L

ife

Hea

lth

An

nu

al

Sta

tem

ent

Data

Tap

es(K

an

sas

Cit

y,

MO

,a

nn

ua

l),

an

dA

mer

ica

nC

ou

nci

lo

fL

ife

Insu

ran

ce,

Lif

eIn

sura

nce

Fact

Bo

ok

(Wash

ingto

n,

DC

).A

nin

sura

nce

rm

isa

ho

ldin

gco

mp

an

yo

wn

ing

mu

ltip

lein

sura

nce

com

pa

nie

s,o

ran

ind

epen

den

tin

sura

nce

com

pan

y.

Pro

per

tyL

iab

ilit

yIn

sura

nce

:C

um

min

set

al.

(1999),

A.M

.B

est

Co

mp

an

y,

Bes

tsIn

sura

nce

Rep

ort

s:P

rop

erty

C

asu

alt

y(O

ldw

ick

,N

J,A

nn

ual)

,an

dA

.M.

Bes

tC

om

pan

y,

Bes

tsA

ggre

gate

san

dA

ver

ages

:

Pro

per

tya

nd

Ca

sua

lty

(Old

wic

k,

NJ,

An

nu

al)

.S

ecu

riti

es:

1998

Sec

uri

ties

Ind

ust

ryF

act

Bo

ok

.T

he

nu

mb

ero

f

rms

isth

en

um

ber

of

NA

SD

mem

ber

s.

Co

nce

ntr

ati

on

isb

ase

do

nth

esh

are

of

cap

ita

la

tth

ete

nla

rges

t

rms

sin

ceth

eass

etsh

are

info

rmati

on

isn

ot

avail

ab

le.

Savin

gs

Inst

itu

tio

ns:

Th

rift

Fin

an

cia

lR

epo

rts,

19

88

19

97

.In

clu

des

sav

ing

sa

nd

loan

ass

oci

ati

on

san

dfe

der

al

savin

gs

ban

ks.

Cre

dit

Un

ion

s:N

ati

on

al

Cre

dit

Un

ion

Ad

min

is-

tra

tio

n.

Incl

ud

esb

oth

fed

era

la

nd

sta

tech

art

ered

cred

itu

nio

ns.


Table 4

Values of target institutions in M&A activity in nancial services from 1985 to 1997a

Target institution Acquiring institution

Commercial banks Securities rms Insurance companies

Panel A: Domestic M&As

US

Banks 241 6 0.3

(51.8%) (1.2%) (0.1%)

Securities 15 74 14

(3.2%) (15.9%) (3.0%)

Insurance 0.2 27 88

(0.1%) (5.8%) (18.9%)

Europe

Banks 89 23 11

(36.0%) (9.3%) (4.4%)

Securities 9 19 6

(3.6%) (7.7%) (2.4%)

Insurance 20 24 46

(8.1%) (9.7%) (18.6%)

Panel B: International M&As

USNon US

Banks 9.5 3.0 0.6

(13.6%) (4.3%) (0.8%)

Securities 4.4 14.7 3.9

(6.3%) (21.0%) (5.6%)

Insurance 0.2 7.7 25.9

(0.3%) (11.0%) (37.1%)

Intra-Europe

Banks 15.0 4.3 11.2

(17.9%) (5.1%) (13.4%)


(10.4%) (6.9%) (0.4%)

Insurance 0.4 1.1 37.0

(0.5%) (1.3%) (44.2%)

EuropeNon Europe

Banks 14.5 15.6 1.0

(14.5%) (15.6%) (1.0%)


(4.3%) (15.9%) (3.1 %)

Insurance 0.3 12.9 32.7

(0.3%) (12.9%) (32.6%)

a Sources: DeLong et al. (1998) and Securities Data Company. The rst gure is the dollar value (in

billions) of M&A activity and the second number in parentheses is the percentage of the total (these

sum to 100 for each 33 matrix). Figures reported are the sums of the equity values of the targetinstitutions.


much less than banking. The securities and life insurance segments weresomewhat less concentrated in the mid-1990s than in the late 1980s, while thepropertyliability insurance segment was somewhat more concentrated. Therewas a substantial reduction in the number of thrift institutions and a corre-sponding increase in concentration due to the high rate of thrift failure in thelate 1980s and early 1990s. The credit union industry remains very uncon-centrated, presumably because of its not-for-prot status and because itsmembers must have a ``common bond,'' such as employment at the same rm.

Panel A of Table 4 reports the ow of domestic M&A activity within the US(rows 13) and within individual European nations (rows 46). The valuesshown are the sums of the market values of all target institutions over 19851997, and the percentages of the US or European activity these represent. Inthe US, 51.8% of nancial M&A activity came from banks consolidating withother banks. Consolidation across sectors in the US (the o-diagonal elementsof the matrix in the rst three rows) has been relatively uncommon, only 13.4%of the activity. In Europe, consolidation across sectors was more important,37.5% of domestic M&A activity.

Panel B of Table 4 reports international M&A activity between US and non-US institutions (rows 13), between institutions operating in dierent Euro-pean nations (rows 46), and between European and non-European nancialinstitutions (rows 79). As was the case for the domestic M&As, internationalM&As within sectors exceeds M&As across sectors, but the across-sectorM&As are relatively more important for European institutions. A comparisonof panels A and B indicates that for US institutions, domestic M&As dominateinternational M&As for banks, securities rms, and insurers by large margins.

Table 5

Depository institutions and oces in the group of ten countries 1996a

Number of

institutions

Number of

oces

Number of

inhabitants per

oce

Number of

oces per

institution

Belgium 143 9464 1075 66.2

Canada 2497 16,209 1857 6.5

France 547 47,263 1238 86.4

Germany 3509 70,118 1169 20.0

Italy 939 40,030 1436 42.6

Japan 4635 77,013 1634 16.6

Netherlands 126 6820 2277 54.1

Sweden 125 3859 2291 30.9

Switzerland 372 7512 946 20.2

United Kingdom 561 36,507 1611 65.1

United States 23,123 95,777 2772 4.1

a Source: Statistics on Payment Systems in the Group of Ten Countries, Bank for International

Settlements, December 1997. The number of oces for the US includes commercial banks, thrifts,

and credit unions.


For Europe, domestic banking M&As dominate international M&As, but thisis not true for the securities and insurance industries. For these two industries,the combination of intra-Europe and Europenon-Europe M&As in panel Bexceeds the within-nation M&As in Europe in panel A.

Table 5 compares the structure of depository institutions in the eleven G-10countries in 1996. The US has a much more fragmented industry than anyother developed country almost 10,000 more institutions than the other 10nations combined. Table 5 also suggests that the US is not ``overbranched''relative to other developed countries the 2772 inhabitants per oce in theUS is the highest of all of the G-10 countries.

3. The causes of nancial consolidation

In our framework, the primary motive for consolidation is maximizingshareholder value. In the absence of capital market frictions, all actions by therm, including consolidation activities, would be geared toward maximizingthe value of shares owned by existing shareholders. The preferences of otherstakeholders would be taken into account only in so far as they aected thevalue of shares through the cost of funds, supply of labor or other factors ofproduction, or the demand for services. In practice, however, managers andgovernment often aect consolidation decisions more directly.

In this section, we outline and review the literature on the value maximizingand non-value maximizing motives for nancial consolidation. We then iden-tify ve types of changes in the economic environment that may have led to therecent accelerated pace of consolidation.

3.1. The value-maximization motive

Financial service rms can maximize value in one of two main ways throughconsolidation by increasing their market power in setting prices or by in-creasing their eciency. It is dicult to determine the goals of M&A partici-pants, but there is evidence consistent with the notion that some M&As aredesigned to increase market power. Research described in Section 4 belowsuggests that in-market M&As that substantially increase market concentra-tion may increase market power in setting prices on retail services. Presumably,this was an expected consequence of many of these M&As and provided atleast part of the motivation. Also supporting this presumption are the ndingsthat about half of the US bank M&As are in-market (Table 2) and manyEuropean bank M&As are of this type as well (Vander Vennet, 1997).

Research described in Section 5 below also suggests that M&As may in-crease eciency, consistent with the presumption that expected eciency im-provements provide part of the motivation for M&As. In addition, a number


of studies have found that in a substantial proportion of M&As, a larger, moreecient institution tends to take over a smaller, less ecient institution, pre-sumably at least in part to spread the expertise or operating policies andprocedures of the more ecient institution over additional resources. In theUS, acquiring banks appear to be more cost ecient than target banks onaverage (Berger and Humphrey, 1992; Pillo and Santomero, 1998). Anotherstudy of US banks found that acquiring banks are more protable and havesmaller nonperforming loan ratios than targets (Peristiani, 1993). Simulationevidence also suggests that large X-eciency gains are possible if the bestpractice banks merge and reform the practices of the least ecient banks(Savage, 1991; Shaer, 1993). Case studies of US bank M&As support the ideathat potential eciency gains act to motivate some M&As as well (Calomirisand Karceski, 1998; Rhoades, 1998. However, one study of US banks foundthat while poorly-capitalized banks are more likely to be acquired, banks witha high degree of cost ineciency are, ceteris paribus, less likely to be acquiredwithout government assistance (Wheelock and Wilson, 1998).

European studies also suggest that M&As may be motivated in part by thepotential for eciency gains. One study found that large, protable banks tendto be acquirers, while small, unprotable banks tend to be targets (Focarelli etal., 1998), while another found that large, ecient banks tend to acquire small,less ecient banks (Vander Vennet, 1997). Similar potential for improvementswere possible in M&As between UK banks and building societies (Altunbaset al., 1995).

Some evidence also suggests that eciency concerns may motivate consol-idation in other segments of the nancial industry. Acquirers in the US lifeinsurance industry tend to be more ecient than average, and targets tend tobe nancially impaired (Cummins et a., 1999). In the credit union industry,acquirers tend to be larger than average, while targets tend to be smaller and inweaker nancial condition than non-target credit unions (Fried et al., 1999).

Eciency (as broadly dened here) may also be improved by M&As if greaterdiversication improves the risk-expected return tradeo. Consistent with thisidea, one study found that U.S. acquiring banks bid more for targets when theconsummation of the M&A would lead to signicant diversication gains(Benston et al., 1995). Diversifying M&As may also improve eciency in thelong term through expanding the skill set of managers (Milbourn et al., 1999).However, studies outside of nancial services suggest that diversifying M&Asare generally value-reducing, and that increases in corporate focus are value-enhancing (Lang and Stulz, 1994; Berger and Ofek, 1995; John and Ofek, 1995).

In addition, although it is not exactly market power or eciency, someinstitutions may try to increase the value of their access to the governmentsnancial safety net (including deposit insurance, discount window access,payments system guarantees) through consolidation. If nancial market par-ticipants perceive very large organizations to be ``too big to fail'' i.e., that


explicit or implicit government guarantees will protect debtholders or share-holders of these organizations there may be incentives to increase sizethrough consolidation in order to lower the cost of funding and increase thevalue of shares. 2 International comparisons over a 100-year period show howchanges in the structure and strength of safety net guarantees may aect -nancial institution risk-taking, and by extension, the motive to consolidate toincrease the value of access to the safety net (Saunders and Wilson, 1999). Asdiscussed in Section 7 below, the net subsidy from the safety net may also beextended when banking organizations are consolidated with other types ofinstitutions.

3.2. Non-value maximizing motives

As noted above, stakeholders other than shareholders may have a directeect on consolidation decisions. We consider here the roles of managers andgovernments, who appear to have more inuence over consolidation decisionsfor nancial institutions than for nonnancial rms. 3

3.2.1. The role of managersManagers may be able to pursue their own objectives in consolidation de-

cisions, particularly in banking where corporate control may be relativelyweak. Banking regulations in the US weaken the corporate control market bygenerally allowing only other banks and BHCs to acquire a bank. The regu-latory approval/disapproval process may also deter some acquirers. In addi-tion, most US banks are small and are not publicly traded. Perhaps as a resultof these conditions, hostile takeovers that replace management are rare in USbanking (Prowse, 1997). However, corporate control appears to improve whenintrastate and interstate banking deregulation increases the number of poten-tial acquirers, which has been found to increase market discipline, reduce themarket share of poorly run banks, and generally raise protability (Schranz,1993; Hubbard and Palila, 1995; Jayaratne and Strahan, 1996, 1998).

One managerial objective may be empire-building. Executive compensationtends to increase with rm size, so managers may hope to achieve personalnancial gains by engaging in M&As, although at least in part the higherobserved compensation of the managers of larger institutions rewards greaterskill and eort. To protect their rm-specic human capital, some managers

2 Regulators may also help protect large nancial institutions by encouraging other institutions

to lend to or invest in a nancially distressed institution.3 Debtholders may play a lesser role in the consolidation decisions of nancial institutions than

nonnancial rms. This is because nancial institution debtholders may be protected in whole or in

part by the safety net, and by government supervision which tends to block M&As that create

substantial risks.


may also attempt to reduce insolvency risk below the level that is in share-holders interest, perhaps by diversifying risk through M&A activity.

There is evidence that banking organizations may overpay for acquisitionswhen corporate governance structures are not suciently well-designed toalign managerial incentives with those of owners. For example, banks thathave addressed managerial agency problems through high levels of managerialshareholdings and/or concentrated ownership experience higher (or less nega-tive) abnormal returns when they become acquirers than banks that have notaddressed these agency conicts as well. In addition, abnormal returns atbidder banks are increasing in the sensitivity of the CEOs pay to the perfor-mance of the rm and to the share of outsiders on the board of directors (Allenand Ceboyan, 1991; Subrahmanyam et al., 1997; Cornett et al., 1998). Thisevidence suggests that entrenched managers with little pay sensitivity to per-formance or outside pressure may make acquisitions that do not maximizeshareholder wealth.

Managerial entrenchment may also prevent some value maximizing M&Asby reducing the willingness of some nancial institutions to become targets ofM&As. One study found that banks in which managers hold a greater share ofthe stock are less likely to be acquired and that this eect is much larger atbanks where management leaves following an acquisition (Hadlock et al.,1999). This is consistent with the idea that management teams with largeownership stakes can block outside acquisitions.

3.2.2. The role of governmentThe government plays a direct role in consolidation decisions through re-

stricting the types of M&As permitted (e.g., limits on interstate or internationalM&As, or M&As between banks and other rms), and through approval/disapproval decisions for individual M&As. In part, this is to limit the gov-ernments liability and prevent exploitation of ``too big to fail'' and expansionof the safety net, as described in Section 3.1 above. Regulatory review of bankM&A applications in the US attempts to prevent consolidation in which ex-cessive increases in risk are expected. Regulators also prevent in-market M&Asif the increases in concentration are expected to result in excessive increases inmarket power. Regulators may block M&As to promote other policy goals aswell. For example, US banking organizations may be prevented from makingacquisitions if they do not meet the lending standards of the Community Re-investment Act (CRA). 4

4 For a review of CRA issues, see Thomas (1998). Community advocates may reinforce this

government motive by petitioning regulators to block proposed M&As on these grounds. In some

cases, consolidating banks make well-publicized pledges to provide credit to small businesses and

make loans in low income neighborhoods during the regulatory approval/denial process.


In contrast to these restrictions on M&As, government may also encourageconsolidation (beyond the safety net incentive discussed above). During peri-ods of nancial crisis, the government may provide nancial assistance orotherwise aid in the consolidation of troubled nancial institutions. For ex-ample, the FDIC provided nancial assistance to allow healthy banks topurchase over 1000 insolvent US banks between 1984 and 1991. In other na-tions, governments have sometimes directly acquired troubled institutions.

3.3. Why is consolidation accelerating?

Our framework predicts that the pace of consolidation will primarily bedetermined by changes in economic environments that alter the constraintsfaced by nancial service rms. A relaxation of constraints may allow con-solidation that increases shareholder value or make it easier for managers topursue their own goals through consolidation. We identify ve key changesthat may help explain the recent fast pace of M&A activity technologicalprogress, improvements in nancial condition, excess capacity/nancial dis-tress, international consolidation of markets, and deregulation.

3.3.1. Technological progressTechnological progress may have increased scale economies in producing

nancial services, creating opportunities to improve eciency and increasevalue through consolidation. New tools of nancial engineering, such as de-rivative contracts, o-balance-sheet guarantees, and risk management may bemore eciently produced by larger institutions. Some new delivery methodsfor depositor services, such as phone centers, ATMs, and on-line banking, mayalso exhibit greater economies of scale than traditional branching networks(Radecki et al., 1997). As discussed in Section 7 below, advances in paymentstechnology may also have created network economies and scale economies inback-oce operations.

An important caveat is that technologies embodying scale economies may insome cases be accessed at low cost by small nancial institutions. The new toolsof nancial engineering, advanced depositor delivery services, or paymentstechnologies may be distributed to small nancial institutions through corre-spondent banking systems, through franchising or outsourcing to rms spe-cializing in the technologies, shared ownership or mandatory sharing ofpayments networks, etc. (discussed further in Section 7 below). 5 Nonetheless,some evidence discussed in Section 5 below suggests that scale economies in

5 Despite economies in sharing technology, some institutions may keep their own information

and back-oce technologies to improve their future options for expansion into dierent activities

(Thakor, 1999).


banking have increased in the 1990s, consistent with technological progressthat favors larger institutions.

3.3.2. Improvements in nancial conditionRecent improvements in the nancial condition of institutions may be an-

other factor behind the increase in M&As. In the US, bank protability brokerecords in the mid-1990s. Low interest rates and high stock prices also reducednancing constraints on M&A activity, although they raised the price of targetrms as well. Evidence from outside banking suggests that nancial conditioncan aect investment, although the reason why condition matters is less clear(Fazzari et al., 1988; Froot and Stein, 1991; Hoshi et al., 1991; Lamont, 1996;Kaplan and Zingales, 1997). One possibility is that external nance is morecostly than internally generated funds, so rms may invest in more positive netpresent value projects when they are ush with cash. It is also possible that asmore ``free cash ow'' becomes available, managers may choose to acquireother rms to suit their own goals (Jensen, 1986) The data suggest that M&Aactivity in banking appears to respond more to low-interest rate and highstock-price environments (Like that of the US in the mid-1990s) than doesM&A activity in nonnancial industries, despite the fact that stock deals aremore common than cash acquisitions in banking (Esty et al., 1999).

3.3.3. Accumulation of excess capacity or nancial distressConsolidation may also be an ecient way to eliminate excess capacity that

has arisen in the consolidating rms industry or local market. When there isexcess capacity, some rms may be below ecient scale, have an inecientproduct mix, or be inside the ecient frontier. M&As may help solve theseeciency problems. M&As may also help remove excess capacity more e-ciently than bankruptcy or other means of exit in part by preserving the pre-existing franchise values of the merging rms.

There is some evidence of excess capacity problems arising for US banks,which have lost market share to competing nancial institutions on both sidesof the balance sheet since the end of the 1970s. On the asset side, US bankshave lost a substantial proportion of corporate lending to foreign banks, otherintermediaries, and capital markets, although they have made up for some ofthis lost business through o-balance sheet activities (Boyd and Gertler, 1994;Berger et al., 1995). On the liability side, households now hold a greater shareof their wealth outside of bank deposits as the supply of substitutes providedby competing nancial institutions, such as mutual funds, has grown.

Consolidation may similarly be an ecient way of resolving problems ofnancial distress, which are not entirely distinct from excess capacity problems.Institutions that are troubled because of excess capacity in their industry ormarkets, their own ineciency, or underperforming investments are often ta-ken over as an ecient alternative to bankruptcy or other means of exit. The


evidence cited in Section 3.1 above that target nancial institutions tend to berelatively inecient, have high nonperforming loan ratios, and have low capitalratios is consistent with nancial distress motivating consolidation. 6 As notedabove, regulators may also act to spur consolidation in periods of nancialcrisis.

3.3.4. International consolidation of marketsThe consolidation of nancial service rms across national borders may also

derive in part from the international consolidation of markets. The transfers ofsecurities, goods, and services in international markets creates demands forcurrency, deposit, loan, and other services by international nancial institu-tions. Thus, the globalization of markets has likely contributed to cross-borderM&As and the globalization of nancial service rms, although the causationlikely works in the other direction as well (Kwast, 1996a; Meyer, 1998).

3.3.5. DeregulationRestrictions on banks ability to expand geographically were relaxed in the

1980s and early 1990s in the US with a series of removals of restrictions onintrastate and interstate banking, concluding with the RiegleNeal InterstateBanking and Branching Eciency Act of 1994, which permits interstatebranching in almost all states. 7 The prior geographic restrictions on compe-tition may have allowed some inecient banks to survive. The removal of theseconstraints allowed some previously prohibited M&As to occur, which mayhave forced inecient banks to become more ecient by acquiring other in-stitutions, by being acquired, or by improving management practices inter-nally. 8

The US evidence suggests that consolidation accelerated as a result of de-regulation. M&A activity increased in states after they joined interstatebanking agreements (Jayaratne and Strahan, 1998). In addition, the percentageof deposits held by subsidiaries of out-of-state BHCs in the typical state ex-panded from 2% to 28% between 1979 and 1994 (Berger et al., 1995). Removalof in-state branching restrictions also spurred consolidation in the US, asmultibank BHCs often merged their subsidiary banks into branching systems.Deregulation also appeared to result in signicant entry into local markets viade novo branching (Amel and Liang, 1992; Calem, 1994; McLaughlin, 1995).

6 See Berger and Humphrey (1997) for a summary of evidence on the eects of ineciency and

nonperforming assets on the probability of nancial institution failure.7 See Berger et al. (1995) for year-by-year details on the changes in state laws.8 Of course, deregulation is not strictly exogenous. The emergence of new technologies in both

deposit taking and lending may have encouraged deregulation (Kroszner and Strahan, 1997).

Another impetus may have been the rash of bank and thrift failures in the 1980s, which increased

awareness of the advantages of geographically diversied institutions (Kane, 1996).


There has also been limited deregulation of restrictions on bank powers inthe US. Restrictions on investment banking and other powers of commercialbanking organizations were put in place by the Banking Act of 1933 (theGlassSteagall Act), the Bank Holding Company Act of 1956, and that Acts1970 amendment. Liberalization of these powers began in 1987, when theFederal Reserve expanded BHCs abilities to underwrite corporate debt andequity through ``Section 20'' aliates, but the revenue from such underwritingcould not exceed 5% of the subsidiarys total revenue. This restriction wasraised to 10% in 1989, and then to 25% in 1996. 9 Following this last dereg-ulation, Bankers Trust acquired Alex. Brown, Inc., BankAmerica acquiredRobertson Stephens, NationsBank acquired Montgomery Securities, andCiticorp merged with Travelers, which owns Solomon/Smith Barney (Saun-ders, 1999). 10

Despite the geographic and bank powers deregulation, the remaining reg-ulations likely will continue to restrain consolidation activity. The RiegleNealAct caps the total amount of bank and thrift deposits that any organizationmay reach by M&A to 30% in a single state and 10% nationally. The 1998BankAmericaNationsBank M&A created an institution with more than 8% ofdeposits in the US, so the ability of the consolidated institution to make furtheracquisitions may be limited. This cap may make it dicult for any bankingorganization to operate in all 50 states, although an institution may exceed the10% cap through internal growth or may circumvent the restriction in part byusing non-deposit funding or reduce the need for funding by moving assets othe balance sheet. The bank powers restrictions also appear to hamper con-solidation. As of this writing, regulatory/legislative hurdles remain for the in-surance underwriting component of the 1998 CiticorpTravelers M&A.

Europe has also been undergoing deregulation. The European Unionbanking directive has allowed banks to operate fairly freely across nationalboundaries in Europe since 1993 and the implementation of monetary unionshould also foster international M&As. However, as indicated in Table 4above, to date there has been little intra-Europe international consolidation ofbanks, although there has been considerable consolidation of other nancialinstitutions. This suggests there may be other impediments to intra-Europeinternational bank consolidation, some of which are discussed in Section 8.

9 As of 1996, BHCs share of the US corporate debt underwriting market was 16.3% of dollarvolume or 20.4% of issues, while their share of corporate equity underwriting was 2.2% of dollar

volume or 1.9% of issues (Gande et al., 1998).10 A recent event study found positive wealth eects of the 1987 liberalization, but negative

wealth eects and positive measured risk eects of subsequent liberalizations (Bhargava and Fraser,

1998).


4. Research on the market power consequences of consolidation

4.1. Background on market power

M&As among institutions that have signicant local market overlap ex antemay increase local market concentration and allow the consolidated rm toraise prots by setting prices less favorable to customers. This may aect ratesand fees on retail deposits and small business loans, as these products aretypically competed for on a local basis. M&As of the market-extension typethat join institutions in dierent parts of a nation or in dierent nations are lesslikely to increase local market power.

The focus on local markets is partly because of policy guidelines used in theM&A approval/denial process in the US (the cluster approach), partly becauseresearch discussed below nds that local market concentration is statisticallysignicantly related to prices, and partly because research indicates thathouseholds and small businesses almost always choose a local nancial insti-tution (Kwast et al., 1997; Kwast, 1999). Wholesale nancial services, such aslarge corporate loans, derivative contracts, and group insurance productsgenerally trade in national or international markets. It seems unlikely thatconsolidation would create substantial market power against the large clientsfor these services, who typically can choose among many suppliers. 11

The static literature on market power usually examines the eects of localmarket concentration on nancial institution prots and prices, but does notuse information on M&As, whereas the dynamic literature directly examinesthe prots and prices of rms that have recently engaged in M&As. An issue inthe market power research is whether statistical controls for eciency are in-cluded. If eciency is not controlled for, then the measured eects of marketconcentration or M&As on prices or prots will be the combined eect ofmarket power and eciency, not the eect of market power alone. Anotherconcern about the extant empirical evidence is that antitrust authorities oftenblock, alter, or deter M&As that are expected to result in substantial increasesin market power. As a result, it may be dicult to nd evidence of large gainsin market power from M&As, even if the potential for such gains exists.

4.2. Static market power analyses eects of market concentration on prices andprots

Most of the studies of the eects of local market concentration on prices andprots used data on US banks from the 1980s, and dened local markets as

11 One exception may be the market for clearing US government securities, in which two banks

serve most of the market.


MSAs or non-MSA counties. This research may give evidence on the staticeects of in-market M&As, which generally increase local market concentra-tion. Studies usually found that banks in more concentrated markets chargehigher rates on small business loans and pay lower rates on retail deposits(Berger and Hannan, 1989, 1997; Hannan, 1991). This result generally heldwhether or not dierences in eciency were controlled for statistically. Otherstudies found that in more concentrated markets, bank deposit rates were``sticky'' or slow to respond to changes in open-market interest rates, and thatthis stickiness was greater with respect to rate increases than decreases, con-sistent with market power (Hannan and Berger, 1991; Neumark and Sharpe,1992; Hannan, 1994; Jackson, 1997). 12

Despite this evidence of market power by banks in the 1980s, there are somereasons to suspect that market power may have declined since that time. First,there may be an increase in the degree of contestability of nancial servicesmarkets because the removal of geographic restrictions on banking organiza-tions allows existing institutions to enter or threaten to enter more localmarkets. In addition, some nancial services have become more like com-modities, making competition more perfect than in the past (Santomero, 1999).Moreover, changes in the delivery of nancial services such as ATM kiosks,telephone banking, on-line banking, expanded use of credit and debit cards,etc. may also have made local markets more contestable and expanded theireective geographic size.

The empirical evidence on this issue is mixed. The relationship between localmarket concentration and deposit rates seems to have dissipated somewhat inthe 1990s (Hannan, 1997, Radecki, 1998), although the relationship betweenlocal market concentration and small business loan pricing still appears to bestrong (Cyrnak and Hannan, 1998). 13 The recent data also suggest that largebanks often set uniform rates for deposits and loans over a state or region of astate rather than over a local market, although the reason for this is not clear(Radecki, 1998). Bank fees on retail deposit and payments services in the 1990sshow very little relationship with measures of local market concentration in the

12 Other tests for market power in the banking industry are unrelated to local market structure.

Some studies have tested for price-taking versus price-setting behavior for banks, with some

support for both positions (Hancock, 1986; Shaer, 1989; English and Hayes, 1991; Hannan and

Liang, 1993). Recent studies of revenue and prot functions generally found that an ``alternative''

specication in which rms choose output prices t the data at least as well as the ``standard''

competitive markets specication in which rms choose output quantities in reaction to exogenous

prices (Berger et al., 1996; Berger and Mester, 1997; Humphrey and Pulley, 1997). In addition,

studies of reserve requirements and rates on certicates of deposit suggest that banks do not pass

through all of the costs of regulatory requirements to customers, implying that banks have market

power (Fama, 1985; Cosimano and McDonald, 1998).13 In part, the changes in the measured eects of concentration on deposit rates may reect

changes in the survey instruments used to collect the rate data.


1990s, consistent with relatively low market power (fee data are not availablefor the 1980s, Hannan (1998)). However, multistate BHCs tend to chargehigher fees to retail customers than other banks, suggesting that these rmsmay not be exerting competitive pressures on prices in local markets. In ad-dition, the data are mixed as to whether contact between geographically dis-persed nancial institutions in multiple local markets results in more or lessfavorable prices for customers (Mester, 1987, 1992a; Pillo, 1997). 14

Despite the ndings of market power in bank pricing, the static literatureusually found quite small eects of concentration on bank prots, especiallyafter statistical controls for eciency were included in the analyses (Berger,1995; Maudos, 1996; Berger and Hannan, 1997). 15 Similarly, the banks thatwere found to have persistently high prots relative to the industry generallywere not those in local markets with the highest concentration or with thegreatest barriers to entry (Berger et al., 1998). 16 One possible explanation ofhow market power may have a much greater eect on prices than on prots isthat managers of weakly controlled rms may take part of the benets of theextra revenues as reduced eort to maximize eciency, or a ``quiet life'' Bergerand Hannan, 1998.

4.3. Dynamic market power analyses eects of M&As on prices and prots

Dynamic market power analyses examine the eects of the M&As them-selves on prices and prots, incorporating any eects of changes in organiza-tional focus or managerial behavior of the M&As, as well as the marketconcentration eects considered in the static literature.

One dynamic study of bank pricing found that bank M&As that involveincreases in market concentration severe enough to violate the US JusticeDepartment bank guidelines (Herndahl over 1800, increase of over 200)

14 There are other issues about market denition and competitiveness which we do not have

space to discuss, such as whether thrifts should be included as competitors to banks in measuring

concentration (Hannan and Liang, 1995; Amel and Hannan, 1998), whether concentration

measures should include small business loans as well as deposits (Cyrnak and Hannan, 1998),

whether large and small banks are equally aggressive competitors (Pillo, 1998), and whether the

cost to consumers of switching between institutions is a signicant source of market power

(Rhoades, 1997; Sharpe, 1997).15 Some of the early research on this topic controlled for market share, rather than eciency, and

debated whether market share better represented eciency or market power. For examples in the

banking literature, see Smirlock (1985) for arguments favoring eciency and Rhoades (1985) for

arguments favoring market power. For examples in the general industrial organization literature

see Smirlock et al. (1984) (eciency) and Shepherd (1986) (market power).16 A related study also showed that high protability from market power or other sources

increased the probability of entry that subsequently lowered prots, but that this competitive

process often did not occur and was relatively slow (Amel and Liang, 1997).


substantially reduced the deposit rates paid by M&A participants, consistentwith market power eects of M&As (Prager and Hannan, 1999). Anotherdynamic study that included a larger sample of M&As many of which didnot involve substantial increases in market concentration found that someM&A categories lowered deposit rates and others raised deposit rates relativeto what was predicted by the level of concentration (Simons and Stavins, 1998).The more mixed results are not surprising, given the inclusion of M&As forwhich substantial market power eects were not expected. Neither of thesestudies accounted explicitly for the eciency eects of the M&As, so theirresults give the combined eects of changes in market power and eciency onprices and cannot disentangle the two eects. One other study did account foreciency and found very small price changes and much larger eciencychanges for M&As among large US banking organizations, although this studydid not focus on M&As involving substantial increases in local market con-centration (Akhavein et al., 1997). A study of Italian M&As found that whenthere was market overlap and the market share of the acquired bank was small,loan rates declined, but this result was reversed when market share was large(Sapienza, 1998).

A number of studies compared bank protability ratios, such as the returnon assets (ROA) or return on equity (ROE) before and after M&As relative topeer groups of banks that did not engage in M&As. Some found improvedprotability ratios associated with M&As (Cornett and Tehranian, 1992;Spindt and Tarhan, 1992; Rhoades, 1998), although others found no im-provement in these ratios (Berger and Humphrey, 1992; Linder and Crane,1992; Pillo, 1996; Akhavein et al., 1997; Chamberlain, 1998). A problem withdrawing conclusions from protability ratios is that they incorporate bothchanges in market power and changes in eciency, which cannot be disen-tangled without controlling for eciency.

Similarly, some dynamic studies have compared simple cost ratios, such ascosts per dollar of assets, before and after M&As (Rhoades, 1986, 1990, 1998,Srinivasan, 1992; Srinivasan and Wall, 1992; Linder and Crane, 1992; Pillo,1996). Again, the problem of disentangling changes in market power fromchanges in eciency arises. These studies did not control for input prices, andso a reduction in costs per unit of output or assets could reect either lowerinterest expenses due to increased market power in setting deposit interest ratesor greater eciency in input usage. Some studies examined operating costratios that exclude interest expenses, and so would not be subject to thisproblem (Cornett and Tehranian, 1992; Linder and Crane, 1992; Srinivasan,1992; Srinivasan and Wall, 1992; Rhoades, 1998). However, these studies maybe biased toward showing benets from M&As. As banks merge and growlarger, they often substitute interest cost-intensive purchased funds for oper-ating cost-intensive core deposits, which would tend to make the operating costratio lower even if there is no decrease in total costs. Use of the cost ratios also


does not account for the fact that some product mixes cost more to producethan others.

Several dynamic studies have employed event study and similar techniquesto look at the eects of bank M&As on market values. The change in thecombined market value for the acquiring and acquired institutions together(adjusted using a market model for changes in overall stock market values)provides an estimate of the eect of the M&A on the present value of futureprots of the consolidated institution. As was the case for the protabilityratios, the results were mixed. Some studies found increases in the combinedvalue around the times of M&A announcements (Cornett and Tehranian,1992; Zhang, 1995), others found no improvement in combined value (Hannanand Wolken, 1989; Houston and Ryngaert, 1994; Pillo, 1996), while stillothers found that the measured eects depended upon the method of nancingchosen, the degree of oce overlap, and other factors (Houston and Ryngaert,1996, 1997; Siems, 1996). A study of domestic and international M&As in-volving US banks found more value created by the international M&As, al-though it also found that more concentrated geographic and activity focus hadpositive eects on value (DeLong, 1998). A study of M&As among banks andbetween banks and insurers in Europe found that many of the events increasedcombined value and attributed the dierences in ndings from many of the USstudies to dierences in structure and regulation in Europe (Cybo-Ottone andMurgia, 1998).

Interpretation of event studies is subject to a number of well known prob-lems, including the possibility that information may have leaked prior to theM&A announcement or that markets may anticipate M&As prior to theirannouncements. These problems may be particularly severe during ``mergerwaves'', such as those that have been occurring in US markets (Calomiris,1999). M&A announcements may also incorporate signals about the under-lying values of the consolidating rms in addition to the change in value cre-ated by M&As. In addition, as was the case for the simple prot and costratios, there is no way to determine whether changes in market values are fromchanges in market power or eciency, since markets evaluate expected changesin protability from all sources equally.

4.4. The external market power eect

Recall that the total eects of M&As also include the external eect thereactions of other nancial service providers in the same markets. It is expectedthat other rms would charge similar prices for similar products and so wouldchange their prices by a like amount as the consolidating institutions when anM&A results in a price change. The data are consistent with this expectation.The static ndings regarding concentration above embody an external eect ofconsolidation on the market power of other rms in the local market, since


their concentration is also increased by in-market M&As. Two of the dynamicstudies also found that prices of the rival banks in the same market changed bysimilar amounts and in the same direction as those of the consolidating insti-tutions (Sapienza, 1998; Prager and Hannan, 1999).

5. Research on the eciency consequences of consolidation

5.1. Background on eciency

Consolidation may increase or decrease eciency in a number of dierentways. M&As may allow the institutions to achieve a scale, scope, or mix ofoutput that is more protable. Consolidation also may be a means to changeorganizational focus or managerial behavior to improve X-eciency. Ourbroad denition of eciency gains also includes improvements in the institu-tions risk-expected return tradeos. Such gains may be particularly importantin nancial institution M&As, which often oer the possibility of diversica-tion gains through investing across regions, industries, etc. and/or throughentering other industries. Reductions in risk may increase shareholder wealthbecause nancial distress, bankruptcy, and loss of franchise value are costly,and because regulators may restrict activities or impose other costs as a rmsnancial condition worsens.

Importantly, eciency gains are made by changing input or output quan-tities in ways that reduce costs, increase revenues, and/or reduce risks to in-crease value for a given set of prices. This is in contrast to market power gainsdiscussed in Section 4, in which value is created by institutions changing pricesto their advantage.

Static eciency analyses evaluate scale, scope, and product mix ecienciesof nancial institutions without regard to how they achieved their currentoutput points. The dynamic analyses examine changes in eciency after M&Asor compare the eciency of recently consolidated institutions with other in-stitutions, incorporating any changes in X-eciency as well as scale, scope, andproduct mix eciencies.

5.2. Static eciency analyses scale, scope, and product mix eciencies

5.2.1. Early scale, scope, and product mix eciencies studiesResearch on nancial institution scale eciencies in the late 1980s and early

1990s usually used data on US banks from the 1980s, and specied multiplebanking products. These studies generally used costs and not revenues, andusually specied a translog functional form, which imposes a U-shape (in logs)on the multiproduct ray average cost curve. The consensus nding was that theaverage cost curve had a relatively at U-shape with medium-sized banks being


slightly more scale ecient than either large or small banks. Only small bankshad the potential for economically signicant scale eciency gains and themeasured ineciencies were usually relatively small, on the order of 5% ofcosts or less. The location of the scale-ecient point the bottom of theaverage cost U diered among studies, but was usually between about $100million and $10 billion in assets, with a larger scale ecient point generallybeing found when the banks in the sample were larger (Hunter and Timme,1986; Berger et al., 1987; Ferrier and Lovell, 1990; Hunter et al., 1990; Noulaset al., 1990; Berger and Humphrey, 1991; Mester, 1992b; Bauer et al., 1993;Clark, 1996).

Despite the dierent ndings, almost all of the studies suggested that therewere no signicant scale eciencies to be gained and possibly some slight scaleeciency losses to be suered from M&As involving large banks. 17 Similarly,studies of cost scale eciency in the insurance industry typically found mostrms to be below ecient scale, but found the largest rms to be above ecientscale (Grace and Timme, 1992; Yuengert, 1993; Gardner and Grace, 1993;Cummins and Zi, 1998). In the securities industry, small specialized rms ap-peared to exhibit economies of scale, while large, diversied rms exhibitedscale diseconomies (Goldberg et al., 1991).

Research on nancial institution cost scope and product mix ecienciesoften came out of the same research studies and used the same cost functions asthe scale eciencies. Scope eciencies were measured by comparing the pre-dicted costs of an institution producing multiple nancial services and a set ofinstitutions that each specialize in producing a subset of these services. Scopeeciencies are often dicult to estimate because there are usually no special-izing rms in the data sample, creating extrapolation problems. 18 Studies ofproduct mix eciencies often reduce these problems by evaluating somewhat

17 Some research also suggests very little potential for scale eciency gains at the bank branch

oce level through in-market M&As by closing oces and transferring the deposits and loans to

nearby oces. Although oces may be considerably smaller than the scale ecient point, the

estimated potential savings in cost scale eciency are relatively small about 3% of total branching

costs in one study because the average cost curve for branches appears to be quite shallow (Berger

et al., 1997). Moreover, anything near these potential gains is unlikely to be achieved because the

branches of the consolidating institutions need to be near each other, and this is relatively rare.

Only 6.8% of urban US banking oces in 1985 and only 3.3% of rural banking oces were

acquired over the next 10 years by banking organizations with oces in the same ZIP code (Avery

et al., 1999). Moreover, there is often a run-o of deposits and assets when branch oces are closed

due to the loss of convenience and other factors (Savage, 1991).18 The problems of extrapolation, often combined with the problems of the translog specication

and the problem of measuring scope eciencies away from the best-practice ecient frontier

(where scope eciencies are dened), can yield measured scope eciency estimates that are erratic

and beyond credible levels (Berger and Humphrey, 1991; Pulley and Humphrey, 1993; Mester,

1993).


dierent output points, such as points near zero outputs, or by using conceptssuch as expansion-path subadditivity which combine scale and product mixeciencies. The empirical results and implications for consolidation of scopeand product mix eciency studies were qualitatively similar to those for thescale eciency studies very few cost savings were implied from consolidatingthe outputs of dierent banks (Berger et al., 1987, Hunter et al., 1990; Noulaset al., 1990; Pulley and Humphrey, 1993; Ferrier et al., 1993).

5.2.2. Recent innovations in scale, scope, and product mix researchDespite this early research, some recent research using dierent econometric

techniques, dierent eciency concepts, and/or more recent data from the1990s suggests that there may be more substantial scale, scope, and productmix eciency gains available from consolidation. A recent analysis found the1990s data displayed substantial cost scale economies, on the order of about20% of costs, for bank sizes up to about $10 billion to $25 billion in assets(Berger and Mester, 1997). The data on larger banks were too thin to draw rmconclusions, but the prospects for cost scale eciency savings or at least littleor no losses from M&As among large banks appears to be greater in the 1990sthan in the 1980s. This change may in part reect technological progress thatincreased scale economies in producing nancial services as described in Sec-tion 3 above. The change in scale eciency may also partially reect regulatorychanges such as the elimination of geographic restrictions on bank branchingand BHC expansion, which may make it less costly to increase scale. Finally,the data suggest that part of the change in scale eciency reects the loweropen-market interest rates of the 1990s, given that a greater proportion of largebanks' liabilities tend to be sensitive to open-market rates (Berger and Mester,1997).

Recent studies have also examined the eects of bank scale, scope, andproduct mix on revenue and prot eciency. The scale results are ambiguous,with some evidence of mild ray scale eciencies in terms of joint consumptionbenet for customers (Berger et al., 1996), and prot eciency sometimes beinghighest for large banks (Berger et al., 1993), sometimes being highest for smallbanks (Berger and Mester, 1997), and sometimes about equal for large andsmall banks (Clark and Siems, 1997). In terms of scope and product mixeconomies, one study found little or no revenue scope eciency between de-posits and loans in terms of charging customers for joint consumption benets(Berger et al., 1996) and another study of prot scope economies found thatjoint production is optimal for most banks, but that specialization is optimalfor others (Berger et al., 1993).

As noted above, we also include improvements in the risk-expected returntradeo from improvements in risk diversication as eciency gains fromconsolidation. Some studies have found that bank managers act in a risk-averse fashion, trading o between risk and expected return, and therefore may


tolerate additional costs expended to keep risk under control (Hughes et al.,1996, 1997; Hughes and Mester, 1998). Taking risk into account adds thepotential for scale, scope, and product mix eciencies in managing risk. Agreater scale, a more diverse mix of nancial services provided, or an increasedgeographical spread of risks usually implies the potential for improved diver-sication, so the same protection against nancial distress can be attained withfewer resources. For example, one early study found scale eciency from di-versication of loan risk as bank loan portfolios increased in size up toabout $1 billion, the standard deviation of the rate of return on loans fellprecipitously, presumably because of diversication benets (McAllister andMcManus, 1993). This does not necessarily mean that large banks chooselower levels of overall risk, as they may choose to take on additional high riskhigh expected return investments in their portfolios to achieve a higher ex-pected rate of return.

Several studies found that higher ratios of equity capital are associated withgreater resources devoted to managing risks, and that these resource costs werelower for the largest US banking organizations, consistent with scale eciency(Hughes et al., 1996, 1997; Hughes and Mester, 1998). Another study foundthat large banking organizations are better diversied but no less risky thansmall institutions large organizations take the benets of an improved risk-expected return tradeo primarily in higher expected returns by increasing theirholdings of risky loans and reducing their equity ratios (Demsetz and Strahan,1997).

Finally, one study looked directly at the diversication gains from im-provements in the riskexpected return tradeo by examining the tradeosamong expected prot, variability of prot, prot ineciency, and insolvencyrisk for large US banking organizations in the early 1990s (Hughes et al., 1999).They found that when organizations are larger in a way that geographicallydiversies, especially via interstate banking that diversies macroeconomicrisk, eciency tends to be higher and insolvency risk tends to be lower.However, greater scale and greater numbers of branches without geographicdiversity was associated with lower insolvency risk but no dierence in e-ciency. Thus, scale alone, holding the scope of operations constant, did notnecessarily improve performance. Rather, gains came primarily from operatingin multiple states, especially when this diversied macroeconomic risk. Simi-larly, one of the other studies found eciency increased with the number ofstates of operation, conrming the benets from geographical expansion(Hughes et al., 1996).

5.2.3. Scale, scope, and product mix eciency eects of combining banks withnonbanks

There is some research on the eciency eects of combining commercialbanks with other types of nancial service rms. A study of cost scope e-


ciency of German universal banks found mostly diseconomies of producingloans and investment-oriented services within the same institution (Lang andWelzel, 1998). Some studies evaluated the risk-reducing potential of combiningbanking and nontraditional activities using US data. Simulation-type studiescombined the rates of return earned by banking organizations and other -nancial institutions from the 1970s and 1980s (Kwast, 1989; Rosen et al., 1989;Boyd et al., 1993). The results were mixed, with some combinations yieldingreductions in predicted failure probability and others predicting increasedprobability of failure. Another study of US rms also found that risk could bereduced by combining banks with nonbank nancial companies, particularlyinsurance rms (Saunders and Walter, 1994). In addition, combining bankingand insurance has been found to have increased competition and diversicationin the UK (Llewellyn, 1996). A recent study of interindustry experience in theUS in the 1990s found that securities subsidiaries provide BHCs with potentialdiversication benets because of low correlations of returns with the rest ofthe BHC (Kwan, 1997).

Some recent research has identied other eciency benets and costs ofcombining banking with other activities. Allowing combinations of banks andother rms, particularly nonnancial rms, may foster a more eective marketfor corporate control in banking, in part through hostile takeovers (Prowse,1997). Permitting banks to have substantial ownership stakes in nonnancialrms may also mitigate information problems that arise when ownership isdiuse or coordination problems associated with the conicting interests ofdiverse stakeholders (Hoshi et al., 1991). In addition, German-style universalbank-dominated nancial systems may oer better intertemporal risk-sharingat the cost of less cross-sectional risk taking than US-style market-based -nancial systems with commercial banks (Allen and Gale, 1997). 19 Alterna-tively, the inclusion of underwriting and lending in the same institution mayalso lead to conicts of interest, such as might occur if an institution un-derwrites additional equity or debt issues to help salvage its own problemloans, although most studies of universal banks suggest that investors un-derstand these conicts (Ang and Richardson, 1994; Kroszner and Rajan,1994, 1997; Puri, 1996; Gande et al., 1997). It has also been argued that theremay be less nancial innovation in a universal banking system because theincentive to produce innovative nancial solutions to attract corporate cus-tomers to commercial banks from investment banks or vice versa would bereduced if the same institution provided both types of services (Boot andThakor, 1996).

19 For a recent review of commercial banks in the securities industry, see Santos (1998).


5.3. Dynamic eciency analyses changes in eciency associated with M&As

The dynamic studies of changes in eciency associated with M&As takeinto account changes in X-eciency how much closer to or further from theoptimal point on the best-practice ecient frontier these rms have moved in addition to changes in scale, scope, and product mix eciency. Thesestudies use the cost frontier, the prot frontier, or the riskexpected returnfrontier. Ex ante, there is great potential for X-eciency improvement fromnancial institution M&As X-ineciencies on the order of 20% or more oftotal industry costs, and about half of the industrys potential prots have beenfound. 20

5.3.1. Cost X-eciency studies of banksThere are a number of studies of the eects of M&As on bank cost X-e-

ciency. These studies employed cost functions to control for input prices,product mix, and other factors. These studies are superior to the cost ratiostudies discussed in Section 4 in that by controlling for prices, they are able todisentangle eciency changes from changes in market power which may beincorporated into prices. The cost function studies also take into account thedierent costs of dierent product mixes. Despite the dierences in method-ology from the cost ratio studies, the results of the cost X-eciency studieswere quite similar. The studies of US banking generally show very little or nocost X-eciency improvement on average from the M&As of the 1980s, on theorder of 5% of costs or less (Berger and Humphrey, 1992; Rhoades, 1993;DeYoung, 1997; Peristiani, 1997). If there were technological gains on averagefrom consolidating branches, computer operations, payments processing, etc.,these may have been oset by managerial diculties in monitoring the largerorganizations, conicts in corporate culture, or problems in integrating sys-tems. 21

The cost eciency studies using data from the early 1990s are mixed. One setof studies of M&As of large US institutions, most of which were in-marketM&As, found modest cost X-eciency gains in most cases (Rhoades, 1998).

20 We review here only the X-eciency eects of M&As. For a general review of X-eciency

studies of nancial institutions, see Berger and Humphrey (1997), and for a recent survey of

insurance industry studies, see Cummins and Weiss (1999).21 The ndings of little improvement in either cost ratios or cost X-eciency do not necessarily

conict with the ndings of large cost savings on the order of 30% or more of the operating

expenses of the target often made in consultant studies. These dierences can be explained

primarily by dierences in the way in which the cost savings are stated. See Berger and Humphrey

(1992) for a detailed discussion.


Another study found very little improvement in average cost X-eciency forM&As of either large or small banks (Berger, 1998). Some recent case studiessuggest that the cost eciency eects of an M&A may depend on the type ofM&A, the motivations behind it, and the manner in which the managementimplemented its plans (Frei et al., 1995, Frei and Harker, 1996; Calomiris andKarceski, 1998; Rhoades, 1998).

5.3.2. Prot eciency studies of banksThe prot eciency eect of M&As is the most inclusive. It embodies the

scale, scope, product mix and X-eciency eects for both costs and revenuesand also includes at least some of the diversication eects. Two studies of theprot eciency eects of US bank M&As from the 1980s and early 1990sfound that M&As improved prot eciency, and that this improvement couldbe linked to improved diversication of risks (Akhavein et al., 1997; Berger,1998). After consolidation, the banks tended to shift their asset portfolios fromsecurities to loans, have more assets and loans per dollar of equity, and to raiseadditional uninsured purchased funds at reduced rates, consistent with a morediversied loan portfolio. In eect, capital market participants gave consoli-dated banks ``credit'' for diversication by allowing them to increase theirlending without penalty of more equity or higher rates on uninsured funds.One study used a Tornqvist productivity index, a value-weighted output indexdivided by a value-weighted input index, which is similar to prot eciencyand obtained consistent ndings (Fixler and Zieschang, 1993). The study of thediversication gains discussed above (Hughes et al., 1999) also conducted adynamic analysis by evaluating how their measures diered for organizationsthat were recent acquirers versus those that were not recent acquirers. Thediversication benets were still present, but were weaker for the recent ac-quirers. 22

5.3.3. Dynamic eciency studies of nonbanksThe few dynamic eciency studies of the consolidation of other nancial

service rms are generally consistent with the dynamic bank M&A studies. Astudy of life insurance M&As in the early 1990s found improved cost andrevenue eciency for acquired rms (Cummins et al., 1999). Credit unions arenot-for-prot organizations, so their eciency must be estimated dierently. Inplace of maximizing prots, they are modeled as optimizing the quantities,

22 See Pillo and Santomero (1998) for additional review of the bank M&A eciency literature,

see Calomiris (1999) for criticisms of the eciency approach, and see Morgan (1998) for additional

review of the diversication benets of consolidation.


prices, and variety of services provided to members, while minimizing oper-ating expenses. One study of credit union M&As found that service provisionper dollar of operating expense improved for members of acquired credit un-ions, but was unchanged in acquiring unions (Fried et al., 1999).

5.3.4. Ex ante conditions that predict eciency improvement