Mergers and aquisitions in the USA banking - Dissertation Example

WHAT IS THE IMPACT OF CONSOLIDATION ON THE WEALTH OF SHAREHOLDERS IN THE AMERICAN BANKING SECTOR? RESEARCH METHODS AND METHODOLOGY [Instructor’s Name] [Issue Date] Word Count: 3, 971 (Excluding the Bibliography) Table of Contents Abstract………………………………………………………………….……………………3 1.1 Introduction………………………………………………………………………………4 2.0 Research Problem…………………………………………………………………..……6 2.1 Statement of the Problem……………………………………………………6 2.2 Purpose of Study…………………………………………….………...……6 2.3 Hypotheses……………………………….……………….…………..….…6 2.4 Sources of Data & Information………………………………………..……7 2.5 Significance of the Study…………………………………….………..……7 2.6 Limitations of the Study………………………………………………..…...8 3.0 Literature Review…………………………………………………………………..……8 4.0 Methodology………………………………………………….…………..……..……13 4.0 Data Analysis………………………………………………………………14 4.1 Theoretical Framework…………………………………...…..…….………17 4.2 Elements of the Theoretical Framework…………………………………..17 5.0 Results……………………………….………………………………….………….…19 . 6.0 Conclusion………………………………………………………………..…….…..…20 . Bibliography………..………………………………………………………………….……21 Abstract For the past fifteen years or so mergers and acquisitions in the world of American banking have increased tremendously. There are a number of reasons behind this, such as increase in competition among the financial institutions, the deregulation of the banking sector and upheavals in the economy as well as the interest rates. The paper studies the impact of the consolidation of banks and its effects on the wealth of the shareholders. Though it is largely thought that consolidation is likely to have a positive effect on the wealth of the shareholders, study has found that it is not the case. Thus the thesis discusses in detail the reasons due to which the financial firms of USA are likely to undergo the process of mergers and acquisitions and its impact on the shareholders’ monetary resources. The sample spaces taken for the project are the mergers and acquisitions of the past ten years. The recent most acquisition in the American banking sector is taken into account (the acquisition of Golden West Financial by Wachovia in 2006) is studied in great detail. 1.0 Introduction The period from the 1930s to the mid 1970s has been the most stable in the history of the American banking sector (Grullon, Michaely, Swary, 1997). However, causes such as an increase in competition, the deregulation of the banking sector and upheavals in the economy as well as the interest rates of the country has resulted in numerous unprecedented problems for the bankers. Due to the unpredictability and uncertainty of the environment it has become exceptionally competitive and complicated for the executives to conduct business in the American banking sector (White, 1992). In the past few years an increasing number of acquisitions have taken place in the American baking sector. In the year 2000, Chase Manhattan acquired J.P. Morgan & Co. Inc. and became J.P. Morgan Chase and Co. In the same year, Wells Fargo & Co. acquired First Security Co. and became Wells Fargo & Co. Similarly; in 2001 four major acquisitions took place in the U.S. Banking sector. Firststar Corp. got hold of U.S. Bancorp, First Union Corp. obtained Wachovia Corp. and the FleetBoston Financial Corp. acquired Summit Bancorp. In 2002, the Citigroup Inc. purchased the Golden State Bancorp, Inc. In the year 2003 BB&T Corp. bought the First Virginia Banks Inc. and Den norske Bank ASA took over the Gjensidige NOR Sparebank ASA Bank. In the year 2004, Bank of America Corp. consolidated with the FleetBoston Financial Corp. and J.P. Morgan Chase & Co. gained Bank One. In the year 2005 three major consolidations among the American banks took the form of Banco Popular acquiring Quaker City Bank, Regions Bank purchasing the Union Planters Bank and Wachovia consolidating with South Trust. (http://www.answers.com/topic/list-of-bank-mergers-in-united-states). The latest acquisition has been on 8th of May 2006 when Wachovia acquired Golden West Financial for $24.2 billion (http://www.answers.com/topic/wachovia). Therefore, in this project the researcher has looked into the consolidation of the above-mentioned American Banks and has tried to discover the impact of these acquisitions on the wealth of the shareholders. An important point to note over here is that in every acquisition and merger there are two sets of shareholders involved; the one acquiring and the other being acquired. Hence, keeping in mind this point of view the researcher aims to study both of the sides of the acquisition and/or merger. Banning (1999) has stated that, “there are several reasons why one bank might acquire another, including achieving an improved competitive position against a multi-market competitor, responding to competitive threats from other banks as the industry consolidates, reaping efficiency gains from combining overlapping operations, and creating asset growth to improve managers employment stability or compensation”. There are a number of researchers who believe that the mergers and acquisitions do not result in a better financial position or in the enhanced performance of the bank (Hawawini & Swary, 1990; Rose 1987; Toyne & Tripp, 1998). However, at the same time there are a number of researchers who believe that the consolidation of banks have created greater value of the banks, thus in turn generating more profits for the shareholders (Cornett & De, 1991; Cornett & Tehranian, 1992). The sample spaces taken are the mergers and acquisitions of the past ten years. The reason behind the duration is that the American banking sector was relatively stable before this time period. Though, banks did undergo the process of consolidation but not at such a large scale &/or fast pace as the present banks. Therefore, in this study we will examine the impact of the mergers and acquisitions of banks in USA on the wealth of the shareholders. 2.1 RESEARCH PROBLEM Statement of the Problem Do the shareholders benefit from the consolidation of the banks? Specific literature on bank mergers has tried to evaluate the gains that the financial institution receives by undergoing the process of consolidation (Hawawini & Swary, 1990; Rhoades, 1994; Pilloff & Santomero, 1998; Berger, Demsetz and Strahan, 1999). Therefore, in this study we wish to answer discuss these gains with reference to the wealth of the shareholders. 2.2 Purpose of the Study The purpose or the goals of this research study are; To underline the factors that result in mergers and acquisitions in the American banking sector. To study the effects that the consolidation of American banks has on the profitability of its shareholders. 2.3 Hypothesis The researcher built the following hypotheses to help answer the thesis question; Though not at the time of the merger; shareholders eventually (at a long-term period) benefit from the consolidation of the bank(s). At the time of an acquisition the wealth of those shareholders that are being acquired increases, whereas the wealth of the acquiring shareholders decreases. 2.4 Sources of Data & Information Secondary data has been used to conduct the research in this study. The sources of data that have been used are; Research Journals, Books, Newspapers, Online Journals. Magazines, Ezines, The Internet, 2.5 Significance of the Study Mergers and accusations in the banking sector have been thoroughly studied and explored in the previous decades. However, the significance of this thesis lies in the researcher’s aim to study the consolidation of the financial institutions with regards to its shareholders. The intention is to look at the pros and cons of mergers/acquisitions by keeping in view the benefits that the shareholder may reap and the losses that he/she may have to risk when the business undergoes a process of consolidation. Special consideration needs to be paid to this topic as the results of the thesis may be applied by the financial institutions of other countries (such as Great Britain) to help them forecast the effects of mergers on the shareholders of their own financial institutions. 2.6 Limitations of the Study The following are the limitations of the study; Primary data has not been collected in this thesis. The entire thesis is based on the secondary data collected through various sources. As the thesis is a student study, lack of finances has been a significant constraint. The research study had to be completed within a certain period thus; the time factor has also been a noteworthy check. 3.0 Literature Review Mergers can be defined as the, “pooling by firms of their separate interests into newly-constituted business, each party participating on roughly equal terms”. http://www.wps.prenhall.com/wps/media/objects/516/529139/glossary.html It can also be said that a merger occurs when, “… two firms agree to form a new company”. http://www.media.pearsoncmg.com/intl/ema/uk/0131217666/student/0131217666_glo.html Or that they are “…a combination of two companies into one larger company. Such actions are commonly voluntary and involve stock swap or cash payment to the target. Stock swap is often used as it allows the shareholders of the two companies to share the risk involved in the deal”. http://www.en.wikipedia.org/wiki/Mergers However, mergers are different from acquisitions in the sense that an acquisition is defined as the, “purchase of another company with cash or stock”. http://www.gcsaa.org/mc/benefits/glossary.asp But, the term mergers and acquisition combined may be defined as, “The phrase mergers and acquisitions or M&A refers to the aspect of corporate finance strategy and management dealing with the merging and acquiring of different companies as well as assets. Usually mergers occur in a friendly setting where executives from the respective companies participate in a due diligence process to ensure a successful combination of all parts. Historically, though, mergers have often failed to add significantly to shareholder value”. http://www.en.wikipedia.org/wiki/Acquisitions The period from the 1930s to the mid 1970s has been the most stable in the history of the American banking sector (Grullon, Michaely, Swary, 1997). However, causes such as an increase in competition, the deregulation of the banking sector and upheavals in the economy as well as the interest rates of the country has resulted in numerous unprecedented problems for the bankers. Due to the unpredictability and uncertainty of the environment it has become exceptionally competitive and complicated for the executives to conduct business in the American banking sector (White, 1992). According to Kerin and Varaiya (2001), “mergers and acquisitions are common pathways to sales and asset growth…” The past decade has seen an increase in the number of mergers and acquisitions in the banking industry. The reason being that the consolidation of banks is thought to result in a reduction of expenses, an increase in the level of market influence and a cutback in the various factors of unpredictability associated with the earnings. If the merger/acquisition of the bank results in all three of the above features, then the wealth of the shareholders will ultimately increase. However, the theoretical aspect of merging two separate entities is easier than its practical processes. If the two merging entities are unable to fuse in a sufficient manner then the consolidation will not result in the increase in value for the shareholders in particular or the banking industry in general. In addition, it should be noted that mergers are more beneficial if the value of the consolidated bank is more than its separate bodies (Pilloff, 1996). However, according to Kerin and Varaiya (2001), “the strengthened U.S. dollar … has contributed to this trend”. Mayer-Sommer (2006) is of the view that most banks need to stay ahead of technological innovations related to banking. Technological banking may include the debit cards, the credit cards, e-banking, atm machines, online customer services etc. Therefore, he believes that in order to stay abreast of all the latest advancements most banks have no choice but to consolidate with one another. The following are some of the many reasons why the consolidation processes may not result in a profitable venture for the bank as given by Pilloff. The executives of the uniting banks may not be able to look after the recently acquired assets of the firm. The enormous efforts behind merging a bank often results in a loss of objectives as well as the benefits of consolidation. In order to avoid being acquired by a bigger and more powerful financial institution, executives often make reckless decisions of mergers which prove to be detrimental to the well being and prosperity of the bank. White (1992) states that, “Though some banks may merge for fear of liquidation or bankruptcy, the majority (approximately 75%) are dynamic and upcoming financial institutions that consolidate solely for strategic purposes. The reasons behind this may be a gain in market power, economies of scale and/or improvements in the levels of capital.” Since the late 1970s many American banks have been declining in terms of capital levels therefore; thus it is a significant reason behind the high rate of mergers and acquisitions in the recent years (Grullon, Michaely, Swary, 1997). Similarly Banning (1999) has also defined a number of reasons why a bank might acquire another. He has stated that, “there are several reasons why one bank might acquire another, including achieving an improved competitive position against a multi-market competitor, responding to competitive threats from other banks as the industry consolidates, reaping efficiency gains from combining overlapping operations, and creating asset growth to improve managers employment stability or compensation”. There are a number of researchers who believe that the mergers and acquisitions do not result in a better financial position or in the enhanced performance of the bank (Hawawini & Swary, 1990; Rose 1987; Toyne & Tripp, 1998). However, at the same time there are a number of researchers who believe that the consolidation of banks have created greater value of the banks, thus in turn generating more profits for the shareholders (Cornett & De, 1991; Cornett & Tehranian, 1992). According to Jensen (1986) the managers working at the bank and the stakeholders (stockholders &/or shareholders) of the bank have a conflict of interest. The managers often like to advance their own personal goals by reinvesting the profits rendered by the financial institution into other projects of the firm. Thus, though the wealth in itself belongs to the stakeholders, the managers try to utilize the free cash flows generated by the firm for the attainment of their personal goals. However, it has been mentioned by Jensen, that in order to absolve the inefficiencies generated by the free cash flows and among the managers and the shareholders, a bidder firm usually takes over the ‘target firm’ and either distributes the wealth (the free cash flow) back to the shareholders or re-invests it in some other projects. It should be noted that the shareholders have the right to change the management of the bank at anytime that it wishes to do so through a majority vote. The new firm that has taken over the bank is likely to become more effective than the previous one. The extent of its effectiveness is dependent upon the amount of free cash flow of the bank. The greater the free cash flow, the more effective the new firm is likely to become. Therefore, those firms that have a significant amount of cash flow is likely to attack more potential bidders than those that do not. The bidders for highly liquid firms are usually unsure of the exact value of the firm and are likely to pay more. Thus, those firms that are highly liquid in nature and have a large amount of free cash flow are more likely to consolidate or be acquired by another firm. Amit, Livnat and Zarowin (2003) have defined two other types of banking institutions that are highly likely to pursue the process of consolidation. The first types of firms are those that are insolvent in nature, are highly in debt and are about to go bankrupt. The second types of firms are those that are in a healthy financial position. However, these firms undergo the processes of mergers and acquisitions simply to gain greater market share and to have more power and control. However, according to Kerin and Varaiya (2001), “shareholder wealth is only created when a firm’s Return on Equity (ROE) exceeds the corresponding cost of the equity capital. When the return on equity is equal to the cost of equity then the shareholders’ wealth is preserved, but when the return on equity is less then the equity capital then the shareholders’ wealth is destroyed”. 4.0 Methodology As a descriptive study that is based on secondary sources, the logical pattern of events to follow is to gain as much information as possible about the mergers and acquisitions that have occurred in the past in the American banking sector. After collecting the required data the next step is to analyze it and determine the various points of views regarding of the different researchers. The idea of the study is to give the reader a thorough understanding of the points under discussion. However, the research hypothesis is based upon a gap in the previous researches. Though a number of research articles have been written solely on the mergers and acquisitions of the banking sector and at the same time a number of individual articles have also been written on the wealth of the shareholders, rarely any articles have been found where the consolidation processes with regards to the wealth of the researches is found. In addition, the research is done on the basis of the American banking system. There are two reasons behind this. One is that there is tremendous amount of secondary information regarding the American banking system present. The second reason is that the researcher wanted to study the banking sector of a country upon which the systems of numerous other nations was based. Therefore, as American banks are present all over the world and a large proportion of countries (especially the underdeveloped and the developing nations) are in the process of adopting or already have accepted the American system of banking; the researcher felt that it was the only universal model to be studied that would be understood by people of other nations. The analysis for the merger deals is based on the share prices and share price returns for both the acquiring companies and the companies being acquired. The returns to the shareholders of acquired firm are observed during the period of acquisition and the returns to the shareholders of acquiring firm are observed over a period after the acquisition to see the extent of synergy realization. The share prices indicate the buildup of share prices as a result of intentions showed by one bank for taking over another bank. While on the other hand the returns during the merger period show the short term and long term perspective for shares of both companies. The merger deal that has been studied and taken as an example is a recent one where Wachovia bought Gold West Financial for $25 billion. The daily closing share prices for both banks were collected for the period 1st January 2005 to 30th June 2006. The data was downloaded from Yahoo finance website (The same technique will be applied to all of the aforementioned banks in the industry). Data analysis The share prices for both banks are illustrated below: The share prices for both banks are following a somewhat similar pattern, which is evident that both banks are impacted in a similar fashion by the macroeconomic policies. The interested development in the share price pattern follows the merger deal where the share price of Wachovia is showing a falling trend while Gold West Financial is showing a rising trend. This evident is supported further by the following illustration showing returns for both shares. Once again the returns graph shows that the returns on both shares were somewhat similar rendering to the fact that both banks belong to the same industry and thus are affected by same factors for generating returns for their investors. But the takeover move carried out by Wachovia has resulted in inflated returns for Fold West Financials while shareholders for Wachovia have experienced short-term abnormal negative returns. The case under consideration helps identify the important impact of merger deals on shareholders. There are short-term fall in returns on shareholders of acquiring firms while the acquirer shareholders experience short-term gains. The gain is premium for a discontinuity of future income if the acquired firm ceases to exist. But as in this case if the firm continues to exist the long-term returns on acquirer firm is suppose to show a rising trend to justify the synergies on which the acquisition was based. The theoretical framework has been provided in order to facilitate the reader. 4.2 The Theoretical Framework Moderating Variable Independent Variable Dependent Variable Intervening Variable 4.2 Elements of the Theoretical Framework The Independent Variable The Independent variable is one that can be “manipulated by the experimenter”. (http://cnx.org/content/m10802/latest/). It is also known as a variable that might influence the “measure of the outcome for the researcher” (http://www.childrens-mercy.org/stats/definitions/iv.htm) Thus, the independent variable chosen in this paper are the mergers and the acquisitions of the American banks. This is the variable that affects the outcome of all of the others. The type of merger it is, the business environment that the consolidation took place in and most importantly the loss or gain in wealth of the shareholders is based on this factor, hence it is known as the independent variable. The Dependent Variable The dependent variable is a factor whose values in different treatment conditions are compared… that is by how much the value of the dependent variable changes when the conditions of the independent variable are changed. (http://en.wikipedia.org/wiki/Dependent_variable) In this study the dependent variable is the shareholders wealth. The shareholders of both the acquiring and the acquired firm will be included in this factor. The Moderating Variable This is the variable that lies between the independent and the dependent variable and answers the question of how or when (http://en.wikipedia.org/wiki/Mediator_variable). The researcher finds that how a consolidation process will take place and when it will occur is best dependent upon the managers and the executives of the bank. Hence, they have been taken as the moderating variables in the theoretical framework. The Intervening Variable The intervening variable is “a hypothetical concept that explains relationships between the dependent and the independent variable.” (http://en.wikipedia.org/wiki/Intervening_variable). As the entire study is based on the U.S. banking sector and this is what ties all of the variables together, the researcher feels that this is the intervening variable in the research paper. 5.0 Results We have found that mergers and accusations occur as a result of the following three reasons. Conflict of interest between the management and the shareholders. To prevent bankruptcy and/or insolvency of a bank. To gain market share and strategic planning. The consolidation of a bank does not always result in a profitable venture for the stakeholders due to the following reasons, The executives of the uniting banks may not be able to look after the recently acquired assets of the firm. The enormous efforts behind merging a bank often results in a loss of objectives as well as the benefits of consolidation. In order to avoid being acquired by a bigger and more powerful financial institution, executives often make reckless decisions of mergers which prove to be detrimental to the well being and prosperity of the bank. In addition, we have found that in every consolidation process, there are two segments of shareholders. The ones with the bank being acquired and the other belong to acquiring bank. During the process of acquisition, the shareholders of the acquiring bank do not gain wealth. However, the shareholders of the bank being acquired do gain in wealth. 6.0 Conclusions The expected conclusion for the paper is that at the time of consolidation, the company that is undergoing the process of acquisition has a gain in cash flows and therefore there is also a gain in the wealth of its shareholders. However, on the other hand the bank that is acquiring the other one looses its free cash flow (though in the long –term we can say that the overall assets of the firm increases) and thus, the monetary wealth of those shareholders decreases. Our research has repeatedly shown that at the time of a merger or acquisition there is not a gain in the wealth of the shareholders. However, we have found that after some time, especially in the case where there is a large amount of free cash flows in the bank, the acquisition eventually results in an increase in the wealth of the shareholders. But, overall the process of consolidation does not increase the wealth of the shareholders. References Amit, R., Livnat, J. & Zarowin, P., (2003) A Classification of Mergers and Acquisitions by Motives: Analysis of Market Responses, Contemporary Accounting Research, Vol. 6, No. 1, Pp. 143-158. Banning, Kevin (1999) Ownership Concentration and Bank Acquisition Strategy: An Empirical Examination The International Journal of Organizational Analysis, Vol. 07, No.02, and Pp. 135-152. Berger, A. N., Demsetz, R. S. & Strahan, P. E., (1999). The Consolidation of the Financial Services Industry: Causes, Consequences and Implications for the Future Journal of Banking and Finance, Vol. 23, Pp. 135-194. Bruner, Robert F. (2004) Applied Mergers and Acquisitions Wiley Finance Publishers. Cornett, M.M., & De, S. (1991) Common Stock Return to Corporate Takeover Bids: Evidence from Interstate Bank Mergers. Journal of Banking and Finance. Vol. 15, Pp. 273-296. Cornett, M.M., & Tehranian, H. (1992) Changes in Corporate Performance Associated with Bank Acquisitions. Journal of Financial Economics, Vol. 31, Pp. 211-234. Grullon Gustavo, Michaely Roni and Swary Itzhak (1997) Capital Adequacy, Bank Mergers and the Medium of Payment Journal of Business Finance and Accounting Vol. 24, No.19. Hawawani, G. A., & Swary, I. (1990) Mergers & Acquisitions in the U.S. Banking Industry. New York: Elsevier Science. Jensen, M. C., (1986) Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review Papers and Proceedings Pp. 323-329. Kerin, R. & Varaiya N., (1985) Mergers and Acquisitions in Retailing Journal of Retailing Vol. 61, No. 1. Mayer-Sommer, Alan P. (2006) Impact of Community Bank Managers on Acquiring Shareholder’s Returns National Association for Bank Cost and Management Accounting. http://www.findarticles.com/p/articles/mi_qa4148/is_200601/ai_n16431092/print Pilloff, S. (1996) Performance Changes and Shareholder Wealth Creation Associated with Mergers of Publicly Traded Banking Institutions Journal of Money, Credit, and Banking, Vol. 28, No. 3. Pilloff S., Santomero, A., (1998) The Value Effects of Bank Mergers and Acquisitions. Rhoades, S.A. (1994) A Summary of Merger Performance Studies in Banking 1980-93 and an Assessment on the “Operational Performance” and “Event Study” methodologies. Board of Governors of the Federal Reserve System, Washington D.C. Rose, P.S. (1987). The Impact of Mergers in Banking: Evidence from a Nationwide Sample of Federally Chartered Banks. Journal of Economics and Business Vol. 39, Pp. 289-312. Toyne, M.F., & Tripp, J.D. (1998). Interstate Bank Mergers and their Impact on Shareholders Return: Evidence from the 1990s. Quarterly Journal of Business and Economics, Vol. 37, No. 4, Pp. 48-58. White, L. J. (1992), Change and Turmoil in the US Banking: Causes, Consequences & Lesson Journal of Business Finance and Accounting Working Paper Series, Vol. 24, No. 1. Glossary http://wps.prenhall.com/wps/media/objects/516/529139/glossary.html Accessed August 27, 2006 Not Available http://www.media.pearsoncmg.com/intl/ema/uk/0131217666/student/0131217666_glo.html Accessed August 26, 2006 Mergers and acquisitions - Wikipedia, the free encyclopedia http://www.en.wikipedia.org/wiki/Mergers Accessed August 27, 2006 Mergers and acquisitions - Wikipedia, the free encyclopedia http://www.en.wikipedia.org/wiki/Acquisitions Accessed August 27, 2006 GCSAA - Member Central - Glossary of financial terms http://www.gcsaa.org/mc/benefits/glossary.asp Accessed August 27, 2006 List of bank mergers in United States: Information From Answers.com http://www.answers.com/topic/list-of-bank-mergers-in-united-states Accessed August 27, 2006 Wachovia: Information From Answers.com http://www.answers.com/topic/wachovia Accessed August 27, 2006 Variables http://cnx.org/content/m10802/latest/ Accessed August 27, 2006 Definition: Independent variable http://www.childrens-mercy.org/stats/definitions/iv.htm Accessed August 27, 2006 Dependent variable - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Dependent_variable Accessed August 27, 2006 Mediator variable - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Mediator_variable Accessed August 27, 2006 Intervening variable - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Intervening_variable Accessed August 27, 2006 Yahoo! Finance - Get stock quotes, market news, mortgage rates & currency info http://finance.yahoo.com/ Accessed August 27, 2006 Read More