A massive restructuring of financial institutions around the world has taken place in the past two decades. In the United States alone, more than 8000 commercial and saving banks were taken over between 1987 and 1997, leaving fewer than 9000 in place. In the European Union, the number of credit institutions decreased from 12,250 to 9,285 between 1985 and 1997. There is every reason to believe the trend has continued since then. In Canada, two large bank mergers were proposed by the industry in 1998, and rejected by Ottawa. The issue of bank mergers has since been re-opened by Finance Minister John Manley, and the discussion has been re-visited by the Senate Banking Committee and the House Finance Committee in intensive hearings in the fall of 2002 and winter of 2003.
Throughout the world, financial systems are witness to increasing asset concentration and to the convergence of formerly separate financial businesses. Both trends are the result of mergers, some purely domestic, others involving institutions from more than a single country. The forces stimulating the current merger wave are technological change, the globalization of business, the resulting increased competition, and the widespread belief that large and well-capitalized firms have advantages in attracting international business. Executive compensation commensurate with the size of organizations, the reduced chance of being a takeover target, and the ability to charge higher prices may provide additional incentives for mergers.
Although some analysts cite lower regulatory barriers as still another contributing factor to mergers, permissive changes in regulation are very often a response to industry initiatives. Regulation can deter, but not prevent, changes in business activity based on sound economics. For example, despite a regulatory prohibition against interstate banking, US banks organized interstate operations through holding companies prior to the relaxation of the prohibition.
Mergers are intended to improve earnings capabilities in several ways. They often are aimed at capturing additional international business. For example, Citigroup has recently reported increased profit flows from their operations in Germany and Japan. They usually are intended to realize revenues from offering new domestic products and services, as well as from finding new ways of crossselling. Mergers also can bring about operating cost reductions. They offer the potential to realize scope economies through cross-selling products and services. They may be able to realize scale economies in research and development, as well as in consolidating computer and network operations. While these benefits can accrue through the natural growth of firms, mergers help firms realize these benefits more quickly.
In addition to affecting average earnings capabilities, mergers can affect earnings risk. A 2000 study, The Changing Face of the Financial Services Industry, by Cara Lown and others found that hypothetical mergers of banks and life insurance companies can realize scope economies and bring about a reduction in bankruptcy risk. On the other hand, the same research also showed that combining banking and property/casualty insurance companies yields little or no scope economies and can create a modest increase in bankruptcy risk. Another 2000 study for the Federal Reserve Board of New York suggests that mergers will generally reduce operating risks, or at least not increase them. These benefits in risk management can occur through the pooling effects of mergers.
Then there is the question of whether firms’ governance can affect both average earnings and earnings risk. Larger firms are more difficult to manage than their smaller counterparts, and unless management procedures are adjusted to compensate for the increased size, the newly created firm will not necessarily realize any improvement to earnings. Nevertheless, imaginative new forms of governance might be able to improve existing earnings prospects. For example, it might be conjectured that the risk management involved in the property and casualty business is conceptually similar to banks’ risk management activities, and that integrating these activities might be able to reap a new source of scope economies. The merging firms, however, must be able to show that such symbiotic operations would be more inefficiently performed through joint ventures (an example of a joint venture of such a mutually beneficial operation exists for cheque clearing).
Increasing concentration implies increasing size that leads in turn to increasingly challenging management issues. Similarly, convergence creates new interdependencies among business units and thus adds to the difficulty of managing merged firms. Postmerger, firms can be subject to an increased risk of operating losses, at least during the period that management needs to acquire additional skills to govern the new firm. These possibilities increase in importance if the combined firm conducts business in several different countries. Many, if not most, mergers have not worked out well for the acquiring firm’s shareholders, J.P Morgan Chase being a prominent example.
Then there are the challenges of systems integration. For example, Citigroup’s biggest task involved integrating the Citicorp and Travellers information systems. Citigroup has not been very successful in this integration, even though history suggests the difficulties were readily predictable. Citicorp took an $889 million charge for restructuring and centralizing operations in 1997, and in 1998 spent approximately $100 million merging its computers and linking its banks throughout 100 countries. Also in 1998 Travelers anticipated that integrating the computing systems of Salomon and Smith Barney would take one or two years, but subsequently revised the estimate to about ten years. Despite this history, Citigroup anticipated that a fully integrated business could operate profitably after two to three years. However, to date, the difficulties of integrating the information systems have continued. Merged firms in many other industries have had similar integration challenges. We need look no further than that AOL Time Warner fiasco, where shareholders have seen a $100 billion meltdown of market capitalization.
Mergers also present the possibility that anticipated growth may not be realized as rapidly as expected. To cite the Citigroup experience again, asset size has not increased as quickly as forecast, and cross-selling has failed to materialize as quickly as forecast, partly because markets for financial products have recently exhibited less integration at both the retail and wholesale levels. At the retail level, Citigroup’s crossselling of banking and insurance products did not materialize as forecast. The same has been true at the corporate level. Large businesses have come to select the best provider for each financial transaction rather than relying on a house banker. Moreover, multinationals have been taking more responsibility for their own risk management in preference to paying insurance premiums.
In the near term, the Citigroup merger led to higher governance costs resulting from: the need for additional training, potential misalignments in the governance of certain deals, potential loss in incentives, and loss of market discipline. Integration difficulties suggest that the hoped-for decreases in overall transactions costs might not be obtained for some time.
Concentration creates larger financial intermediaries while convergence creates both larger and more complex ones. Increasing size and complexity lead both to additional management challenges and to greater difficulty in valuing assets. Complexity increases the difficulty of winding down any institution that might fail. At the same time, increased size and complexity also can contribute to creating a “too big to fail” syndrome.
Currently, international banks’ belief in the importance of mergers is being tested in another way. New combinations of commercial and investment banking have realized certain economies at the cost of creating potential conflicts of interest. Banks that are involved in both lending and securities underwriting are particularly vulnerable to suffering from conflict of interest. They may gain earnings from realizing scope economies, but later experience adverse reputation effects from becoming embroiled in perceived conflicts of interest.
Increased size and complexity require regulators to boost their screening and monitoring activities. To cope with increased size and complexity, regulators may have to develop new tools and learn how to use them. As a result, it is not clear whether the extra costs of enhanced supervision can be offset by the fact that, after a merger, there is at least one less firm to be supervised individually. Moreover, while the necessary regulatory learning is taking place, the opportunity for regulatory errors rises.
Do increasing concentration and convergence create additional possibilities for systemic risk? It is difficult to give a clear-cut answer to this question. As management difficulties grow, the possibilities of posting operating losses become greater, and hence the probability that an individual firm will experience difficulty increases. With fewer institutions, the perception of contagion may be increased, and of course a merger intensifies the interdependencies between formerly separate businesses. On the other hand, to the extent that the merged institutions are perceived to be “too big to fail,” the possibilities for contagion effects may be reduced.
The main issue with increased concentration is that the prices of services could increase, while interest rates for deposits could decrease to the detriment of consumers. The Dutch experience was that mergers resulted in consumers paying 400 million guilders more a year. Given the increasing emphasis on international operations, domestic consumers may become concerned that they are paying for the foreign adventures of the banks. Such cross-subsidization of one business unit of another has been found in the case of European banks using their consumer banking profits to finance their market presence in institutional banking.
The most relevant issue is whether mergers will create net benefits for Canada. Addressing this issue involves assessing the prospects for enhanced earnings, increased productivity, and reductions in domestic competition. The principal benefits of a merger to Canada are reduced operating costs, increased ability to compete internationally, consequently greater earnings for Canada, enhanced possibilities for financing massive technological change, greater scope for some forms of crossselling, and possible improvements in customer service quality.
The principal costs relate to possible reductions in competition, particularly in local markets, as the head of the Competition Bureau, Konrad von Finckenstein, pointed out to Royal Bank and Bank of Montreal when he killed their proposed 1998 merger. And even Scotiabank Chairman Peter Godsoe warned his employees that the first two or three years following any merger would be “pure hell,” as he put it in testimony to the Senate Banking Committee on the difficulties in managing newly merged firms. To deal with possible reductions in competition, it may sometimes be necessary to sell off a limited number of branches or business lines. Regulatory insistence on good management practice offers the main possibility for offsetting losses from merger-created management difficulties.
Regulators will have to draw the line on consolidations at some point. Where that point should be will depend on the extent of economies of scale and scope and on the number and nature of firms, so that enough domestic competition is on hand to ensure that a portion of the efficiencies gained are passed on to the consumer. Post-merger service charge increases or increases in the depositlending rate spreads should not be tolerated. Indeed, if claims of merger efficiencies and synergies are to be believed, then price decrease guarantees should be obtained. It should be acknowledged that Canadian service charges are relatively low in comparison with the rest of the world. Canadian consumers need to be reassured that those charges will remain that way.
It also must be acknowledged that the Canadian public has been unfavourable toward previous domestic merger proposals. The unfavourable perception is at least partially attributable to the banks’ public relations campaigns. If not their own worst enemies, they are certainly their own worst proponents. At the same time, the Canadian public appears largely indifferent to the possibilities that mergers can increase Canada’s international competitiveness, as well as equally indifferent to the possibility that if Canadian financial institutions do not perform as well as those in the rest of the world, the ultimate existence of our financial industry is endangered.
