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 rea- son to believe the trend has continued since then. In Canada, two large bank mergers were proposed by the indus- try in 1998, and rejected by Ottawa. The issue of bank merg- ers 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 commensu- rate 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 cross- selling. Mergers also can bring about operating cost reductions. They offer the potential to realize scope economies through cross-selling prod- ucts and services. They may be able to realize scale economies in research and development, as well as in consolidat- ing computer and network operations. While these benefits can accrue through the natural growth of firms, mergers help firms realize these bene- fits 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 com- panies 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 merg- ers 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 earn- ings risk. Larger firms are more diffi- cult to manage than their smaller counterparts, and unless management procedures are adjusted to compensate for the increased size, the newly creat- ed 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 manage- ment involved in the property and casual- ty business is concep- tually similar to banks’ risk manage- ment 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 opera- tions would be more inefficiently per- formed 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 busi- ness units and thus adds to the diffi- culty of managing merged firms. Post- merger, 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 possibil- ities increase in importance if the com- bined firm conducts business in sever- al different countries. Many, if not most, mergers have not worked out well for the acquiring firm’s sharehold- ers, J.P Morgan Chase being a promi- nent example.

Then there are the challenges of systems integration. For example, Citigroup’s biggest task involved inte- grating the Citicorp and Travellers infor- mation 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 link- ing 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 anticipat- ed 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 inte- gration 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 possibil- ity that anticipated growth may not be realized as rapidly as expected. To cite the Citigroup expe- rience 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 cross- selling of banking and insurance products did not materialize as fore- cast. 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, poten- tial loss in incentives, and loss of mar- ket discipline. Integration difficulties suggest that the hoped-for decreases in overall transactions costs might not be obtained for some time.

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Concentration creates larger financial intermediaries while con- vergence creates both larger and more complex ones. Increasing size and complexity lead both to addi- tional 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 ”œtoo big to fail” syndrome.

Currently, international banks’ belief in the importance of merg- ers is being tested in another way. New combinations of commercial and investment banking have realized cer- tain 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 com- plexity, regulators may have to devel- op 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 indi- vidually. Moreover, while the neces- sary regulatory learning is taking place, the opportunity for regulatory errors rises.

Do increasing concentration and convergence create additional possibil- ities for systemic risk? It is difficult to give a clear-cut answer to this ques- tion. 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 inter- dependencies between formerly separate businesses. On the other hand, to the extent that the merged institutions are perceived to be ”œtoo 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 pay- ing 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 operat- ing costs, increased ability to compete internationally, con- sequently greater earnings for Canada, enhanced possibili- ties for financing massive technological change, greater scope for some forms of cross- selling, 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 ”œpure hell,” as he put it in testi- mony to the Senate Banking Committee on the difficulties in managing newly merged firms. To deal with possible reductions in competition, it may some- times be necessary to sell off a limited number of branches or business lines. Regulatory insistence on good manage- ment 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 efficien- cies gained are passed on to the con- sumer. Post-merger service charge increases or increases in the deposit- lending rate spreads should not be tol- erated. Indeed, if claims of merger effi- ciencies and synergies are to be believed, then price decrease guaran- tees should be obtained. It should be acknowledged that Canadian service charges are relatively low in compari- son with the rest of the world. Canadian consumers need to be reas- sured that those charges will remain that way.

It also must be acknowledged that the Canadian public has been unfavourable toward previous domes- tic merger proposals. The unfavourable perception is at least partially attributa- ble to the banks’ public relations cam- paigns. If not their own worst enemies, they are certainly their own worst pro- ponents. At the same time, the Canadian public appears largely indif- ferent 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. 

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