Consolidation of the Financial System - Essay Example

The last decade in most of the developed world has been characterised by intensified consolidation of the financial system. A very high number of such integrating efforts were evident across the globe and of these the mergers among banks, particularly those within domestic territories accounted for the higher shares. Over the course of the 1990s, more than half of the banks came together in nations like Japan, Italy and Canada. As a result, in many nations like Belgium, France, Canada, Sweden, The Netherlands etc, banking concentration reached a very high degree (Carletti, Hartmann & Spagnolo, 2007). A very significant consolidation occurred very recently in the USA when Wachovia Corporation, fourth in the list of the Top 50 bank holding companies in the USA (NIC, 2008), acquired Golden West Financial, the branches of which operate under the name of The World Savings Bank. This step provided Wachovia with an additional reach of 285 branches across 10 states .Given the already substantial dominance of Wachovia Corp., such an acquisition has significant bearings on competition for the overall industry. To perceive the extent of impacts such integration and financial integration across the world are likely to have on competition, efficiency as well as financial stability we shall explore the possible impacts in light of the nature of banking mergers to the extent of detail allowed by the scope in what follows. In banking literature the improvement of efficiency, growth through acquisition, realization of economies of scale or scope, diversification of earnings and risk, or attempts to increase market power are identified as the prime motivations for mergers (Berger,2003 and Ameletal.,2004 in Koettar et al, 2007). The major benefits derivable from bank mergers are generally posited to be the increased financial profitability gains accruable through reduced expenses based on creation of scale and scope economies and increased gross revenues, increased benefits of the significantly increased lending capacities, tax benefits accruable from expensing the enhanced asset base as well as from deductions or credits in taxes otherwise forfeited; and increased market power (Stewart, 1991). Accordingly, the major motivations for banking mergers lie in creating scale and scope economies, geographically extending reach and control, enhancing the capital base through consolidation and expanding the product base and increasing market power. However, it has been observed in empirical studies that all mergers are not necessarily performance enhancing and more importantly some of them defy the stipulated motivations. There can be conditions in which mergers actually lead to performance deterioration based upon the nature of the merger. Distinctions in types of mergers have shown that there can be performance gains in certain conditions, but this gain is not universally true for all mergers undertaken. We now turn to identify different merger types and explore their implications on performance gains in case of bank mergers. According to the efficient management hypothesis, mergers are motivated by the potentially increased efficiency of banks performing inefficiently by acquiring them and replacing the prior management with a more efficient one (Roll, 1986 in Koetter et al, 2007). Empirical studies (Berger, 1997; Berger et al., 1999 in Koetter et al, 2007) have found bank performances in terms of efficiency improving after being acquired which essentially conform to the hypothesis. Such findings imply that mergers do enhance performance gains by increasing efficiency. However, it has been found that while the risk hazard of a takeover is reduced in such inefficient performer acquisitions, the hazard of bank failures are substantially raised (Wheelock and Wilson, 2000 in Koetter et al, 2007) and consequently, the probability of acquiring, or being acquired are significantly and differentially influenced by efficiency conditions (Koetter et al, 2007). Koetter et al (2007) distinguish between distressed and non-distressed banks in case of mergers and show that the likelihood of distressed as well as non-distressed mergers is increased by deductions in financial positions, earnings and efficiencies. It is found in this study that the likelihood of being acquired is increased for underperforming banks. Though this supports the efficient market hypothesis, this likelihood of inefficient banks being acquired by highly efficient counterparts is found to be significantly lower. The finding of this study more important for the present purpose is that the likelihood of mergers is higher for financially underperforming banks. Even in case of non-distressed mergers, evidence of presence of underperforming banks is found. This implies “pre-emptive distress resolution considerations” (Koetter et al, 2007) to be major motivation behind mergers. Another important distinction between merger types that sheds light on the impacts of merger activity particularly in relation to the posited benefits is that between voluntary and forced mergers. Forced mergers are those undertaken as interventions by the government in pursuit of financial consolidation. A study by Chong, Liu, & Tan (2006) explored the effects of forced mergers on economic value of the activity in comparison to voluntary mergers for Malaysian Banks. The study found forced mergers adversely affect aggregate economic value and the acquiring partner gains at the expense of the acquired partner’s loss. In case of voluntary mergers however, there was positive value generation and aggregative efficiency improvements and it was found that the acquired banks gained at the expense of acquiring banks, though overall there is no significant decline in value. Thus, it was found that mergers do not universally generate positive net economic value. Voluntary and forced mergers have opposite impacts from this perspective. Distinguishing between large and small mergers, activity focusing and activity diversifying mergers and geographically focusing mergers and geographically diversifying mergers is also significant in the evaluation of performance gains attainable from mergers. Such distinctions have been found to have considerably high degrees of significance in explaining differences of merger outcomes in terms of long-term operating performances (Cornett, McNutt & Tehranian, 2006). Though it is found that merger activity increases overall operating performance, the extent of this impact varies in case of the above mentioned differences. Larger bank mergers, activity focusing mergers and geographically focusing mergers are found to produce higher industry adjusted performance gains compared to smaller bank mergers, activity diversifying mergers and geographically diversifying mergers (Cornett, McNutt & Tehranian, 2006). These gains are attributed to the enhanced revenues as well as cost reductions and among these the former is observed to have greater significance. Therefore, what emerges is that although it is theoretically postulated that all merger activity leads to performance gains and value additions accrued through cost reductions reduction, increased market power, reduced earnings volatility, and scale and scope economies, and is strongly motivated by efficiency enhancement considerations, this brief review of recent empirical literature suggests that these value gains are not universally valid for all merger types. Demarcations between distressed and non-distressed mergers, forced and voluntary mergers, small and large mergers, activity focusing and activity diversifying mergers and geographically focusing and geographically diversifying mergers are found to be important as merger activity is observed to have differential impacts under these criteria of differentiation. References: Carletti, E., Hartmann, P. & Spagnolo, G. (2007) Bank Mergers, Competition, and Liquidity, Journal of Money, Credit and Banking, Vol. 39, No. 5 Chong, B.S., Liu, M.H., & Tan, K.H., (2006) The wealth effect of forced bank mergers and cronyism, Journal of Banking & Finance 30 : 3215–3233 Cornett, M.M., McNutt, J.J, & Tehranian, H., (2006) Performance Changes Around Bank Mergers: Revenue Enhancements versus Cost Reductions, Journal of Money, Credit, and Banking, Vol. 38, No. 4 Koetter, M., Bos, J.W.B., Heid, F., Kolari, J.W., Kool, C.J.M., & Porath, D., (2007) Accounting for distress in bank mergers, Journal of Banking & Finance 31: 3200–3217 NIC (2007) Top 50 bank holding companies (table) http://www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx Stewart, G. B.(1991). The Quest for Value A Guide for Senior Managers, Harper Business: New York,375-382. Read More