The Economic & Profitability Impact of Mergers & Acquisitions among Banks in Lebanon

Table of Contents

Chapter 1: Introduction
1.1 Overview of Mergers & Acquisitions
1.2 Objectives of Mergers & Acquisitions
1.3 Bank Mergers & Acquisitions
1.4 Overview of the Study Research Design & Empirical Evidence

Chapter 2: Literature Review
2.1 Introduction
2.2 The Economic Incentives for Mergers & Acquisitions
2.2.1 Value-maximization Motives
2.2.1.1 The Operational Efficiency Rationale
2.2.1.1.1 Cost Efficiency
2.2.1.1.2 Revenue Efficiency & Profit Efficiency
2.2.1.1.3 Scale Efficiency/Scale Economies
2.2.1.1.4 Scope Efficiency/Scope Economies
2.2.1.1.5 X-efficiency
2.2.1.2 Diversification
2.2.1.3 Replacement of Inefficient Management
2.2.1.4 Absorption of Weak & Failing Banks
2.2.1.5 Market Power
2.2.2 Non-value Maximization Motives
2.2.2.1 The Role of Managerial Incentives
2.3 Risks of Bank Mergers & Acquisitions
2.4 Review of the Documented Literature & Methodologies on Efficiency Effects of Banks
2.4.1 Applied Methodologies
2.4.1.1 Operating Performance Studies (Ex-post Studies)
2.4.1.1.1 Static & Dynamic Analyses
2.4.1.1.2 Advantages & Disadvantages of OP Studies
2.5 Justifications of the General Findings
2.6 Conclusion.

Chapter 3: Research Design & Methodology
3.1 Populations & Sample Selection
3.2 Sample Description
3.3 Instrumentation
3.4 Selected Variables
3.5 Data Analysis
3.5.1 Descriptive Analysis
3.5.2 Inferential Analysis

Chapter 4: Discussion & Analysis
4.1 Discussion
4.2 Analysis

Chapter 5: Conclusion
5.1 Overview of the Study
5.2 Limitations of the Study
5.3 Implications for the Future
5.4 Policy Implications
5.5 Recommendations for Further Research

References

Chapter 1 Introduction

Who will keep a seat in the banking industry in the near future with the ever-mounting upsurge in information technology? Is there enough room for everyone especially smaller banks" The answer is definitely no. The industry is over saturated. When we add competition from foreign banks & international banks with the advent of e-banking, & potentially from other financial institutions, it is an inevitable fact that consolidation will continue...

1.1 Overview of Mergers & Acquisitions

Driven by globalization of competition, technological developments, & economic or strategic barriers to normal growth, mergers & acquisitions (M&As) have dramatically become the primary means by which many companies around the globe are quickly attempting to grow revenues (Gaplin & Herndon, 2000). All companies in almost all industries are being increasingly faced by new challenges amid the intensifying competition locally & internationally. It is becoming a daily challenge to keep up with new competitors, technological breakthroughs, & ever-more demanding & sophisticated customers. It is widely documented that mergers & acquisitions are the primary methods of consolidation for quick corporate expansion & growth. Most of the M&As literature has used the two terms interchangeably despite the formal distinction that has been drawn between them which has been widely considered as somewhat vague. Both terms are used to refer to transactions involving the combination of two independent firms to form one or more commonly controlled entities where a change of control takes place through a transfer of ownership (Sudarsanam, 1995; OECD, 2001).

Although the history of M&As activity can be dated to before the 1960's, with a substantial increase since the mid-60s - if to consider the case of the United States – it has been viewed that today’s mergers are fundamentally different from those in the previous waves. An exemplary comparison is conducted by Gaplin & Herndon (2000), in the Complete Guide to M&As, between the merger wave of the 1980’s & that of the 1990s or `today's wave' as they refer to it. In the 1980s a merger deal was primarily a financial transaction for controlling undervalued assets. The target was often a dissimilar industry or a business line distinctly separate from the acquirer's main business. Besides, price premiums were less common & the margin of error was often greater in general terms. However, the M&As wave of the 1990's features quite strategic mergers that are not motivated by short-term profits or are dependent on highly leveraged capital structures (Gaughan, 1996). Strategic M&As, as defined in the literature, involve operating synergies whereby the two merging firms are more profitably combined than separate. Stated differently, such mergers result in overall benefits when the consolidated entity is more valuable than the aggregate of the two separate pre-merger firms. Now executives are targeting established customer bases as well as new & better distribution channels & talents that would increase & extend strategic opportunities for farther growth in revenues & share price (Galpin & Herndon, 2000). A primary cause of such perceived gains is performance improvement following the merger, which may be achieved in several ways. For example, if the management of the acquiring firm is superior in efficiency & effectiveness per se to that of the target, then higher levels of performance could be attained by improving the quality of management (Pilioff, 1990; Cummis, Tennyson, & Weiss, 1999). It has been documented in numerous studies that in a substantial proportion of M&As, a larger & more efficient institution tends to take over a smaller, less efficient one, presumably to spread the expertise or operating policies & procedures of the more efficient institution over additional resources (Pilloff & Santomero, 1998; Berger, DeYoung, Genay, & Udell 1999). Benefits maybe also achieved, theoretically speaking, as argued by most researchers in this field, when a more efficient institution is created through offering a more profitable mix of products & services; thus increasing market power which would supposedly lead to higher performance in general terms.

1.2 Objectives of Mergers & Acquisitions

The merger literature has come about a wide variety of motives or reasons that underlie the merger decision, & in any case, more than one motive may trigger or initiate the decision. Mergers in any industry are of interest for many reasons the most important of which is that mergers have the potential to fundamentally restructure an industry in a way that there would be fewer more efficient large firms (Rhoades, ZOCC). 'Numerous empirical studies have attempted to determine the motives for mergers; unfortunately, the actual motives are not directly observable & may differ from those stated by management at the time of the merger announcement (QECD, 200I). In general terms, incentives may vary with firm characteristics such as size or organizational structure, overtime, across countries & across industries. It has been widely agreed & documented that the immediate objective of a merger is self- evidently growth, expansion, & market power (Sudarsanam, I995: Craughan 1996). However, a more fundamental objective maybe the maximization of shareholders' wealth through consolidation aimed at accessing or creating sustainable competitive advantage. In modern finance theory, shareholder wealth maximization is considered a rational criterion for investment & financing decisions (Sudarsanam, 1995) including consolidation activities geared towards value maximization for existing shareholders. The preferences of other stakeholders would be of much concern in so far as they affect the value of share through the cost of funds, supply of tabor or other factors of production, or the demand for products & services (Berger, Demsetz, & Strahan, 1999). However, in practice, consolidation decisions especially in the financial industry are often more directly affected by managers & government, the main players among stakeholders, in most consolidation activities.

1.3 Bank Mergers & Acquisitions

The banking industry worldwide is changing in a quick pace driven by the global forces for change mainly technological innovation & the opening-up to international competition. The bank merger wave emerged first in the U.S. & quickly spread to Europe - after the introduction of the Euro currency - & the rest of the world, induced by the major strategic aim of global banks to improve operating efficiency. Recent years have experienced the most intensive period of reorganization in the history of the financial services industry specifically banking. This has been in part caused by a period of institutional failure & underperformance all around the world. It is worth noting that the recent banking crises in Asia & Latin America have intensified the pressures of change. At the international level, the easing of restrictions on foreign entry & the search by global financial institutions for profit opportunities in the emerging economies have increased the threat of competition from foreign-owned financial institutions in domestic banking systems. Commercial banks now worry most from being displaced by competition from outside their specific sector by powerful new entrants from abroad. So commercial banks in bank centered financial systems are at the verge of losing their traditional close relationships especially with corporate customers in the wake of the increasing pressure from alternative funding sources. This has made mergers a quick resort to face such pressures (Smith & Walter, 1998; Hawkins & Mihaljek, 2001). Banks can more easily acquire other banks & convert them to branches without building costly novo branches across the country if we to consider mergers within the country. But real growth will only be achieved if the mergers allow banks to move into new areas along with new customers (White, 1999; Cvree, Wansley, & Boehm, 2000).

The increase in merger activity in many countries has raised the interest in determining whether bank consolidations are beneficial for both the merged banks & the banking industry as a whole. This has initiated a substantial body of research for testing the efficiency effects & gains from mergers. The bulk of the studies attempt to examine the rationales for bank mergers & have advanced several reasons for bank mergers primarily the need to achieve cost savings & operational efficiencies, to be competitively positioned locally & in the global market place, or to provide a controlled exit of inefficient firms from the industry.

Advocates of nation wide banking claim that bank consolidation will produce more efficient banks & a healthier banking system less subject to bank failures (Mishkin, 1998). Berger, Demsetz, & Strahan (1999) along with Hughes, Lang, Mester, & Moon (1999) provide a comprehensive review about the rationales of mergers & acquisitions in the financial service industry with specific emphasis an the banking industry. In brief their rationales entail:

Cost Benefits: Resulting primarily from economies of scale, improved firm efficiency (cost), risk diversification easier & cheaper access to financial funding.

Economies of Scale : Ball with similar operations are more induced to merge for the perceived potential far high reduction of significant redundant operating costs mainly by eliminating overlapping branches & integrating back office, administrative & marketing functions. The upsurge in information technology (IT), Internet & telephone banking, is by all means a primary driver for consolidation on concern that such technology favors larger firms because of the significantly large initial setup costs relative to the scale of operation of smaller farms. However, this would no longer be the case with the decline in technological costs, making technology affordable far even smaller firms. So here size is no longer a concern as much as efficiency in operations.

Firm Efficiency Improvement: Mergers have been sought as a means to reduce inefficiencies in organizations. Inefficiencies in the banking industry, in both industrial & emerging countries, are estimated to be about 20-25% of the overall casts. The primary cause of these inefficiencies appears to be technical inefficiency i.e. employing excess inputs. This suggests a considerable potential for achieving cost efficiencies via mergers as acquiring banks, in virtue being more efficient than targets, transfer better & more efficient management practices, techniques, & skills to less efficient banks. Nevertheless, this process is not without complexities, if not handled critically & wisely would negatively affect efficiency - no improvements or even deterioration after consolidation.

Greater Diversification: Leading to reduction in risk, which improves the risk expected return tradeoff, larger banks are, virtually, better positioned to develop & use new & more complex financial instruments, & employ sophisticated risk management techniques. Credit risk is diversified as consolidation is expected to widen the segments of both corporate customers & households in terms of both size & quality.

Easter & Cheaper Access to Financial Sources: This is mainly done by larger banks, as they are considered, sometimes for granted, safer due to the perceived greater risk diversification in one place, & the inherent belief that large banks are too big to fail. In general markets do believe that large banks are more likely to obtain assistance from authorities in a crisis than smaller banks. That is to say regulatory authorities are hesitant to let a large bank fail due to the stern social costs associated with that failure.

Revenue benefits from achieving economies of scope (especially for mergers of banks with complementary businesses or banks & non-bank financial institutions). In proved revenue efficiency would be reached as the consolidated entity fortifies its market position in terms of customer base & higher prices, although the latter has not been empirically agreed upon. Consequently higher profits are achieved from reaching economies of scale arrived at from the combination of different product lines &/or economies of scope by offering multiple products & services thus leading to higher market share of the targeted customer activity. The increased market share will make it easier for the bank to attract a larger customer base, & increased size will allow banks to serve large customers.

These are the primary value-maximizing motives behind M&As. Non-value maximizing motives relate to: i) The incentives/role of managers in pursuing or blocking the merger process. For example, managers with desires to control larger firms or increase their own job security might seek mergers even if they do not enhance firm value. ii) The role of government in preventing or motivating mergers to reduce the excess capacity of inefficient firms in the industry.

These two broad arrays of motives are studied within an environmental framework where a lot of factors are influencing the form & the rate of consolidation. The three primary forces encouraging consolidation are: i) Technological Advances. ii) Government Intervention. iii) Globalization of the marketplace - international consolidation of markets. Most of the substantial research effort has focused on cost efficiency - whether mergers reduce costs per unit of output for a given set of output quantities & prices - with recent research emphasizing profit efficiency, which includes the cost efficiency effects of M&As & as well incorporates the revenue effects of the changes in output due to improved market share &/or higher prices. The main focus has been on cost efficiency because virtually most of the bank merger deals were initiated for the purpose of improving performance through increasingly radical cost reduction strategies. Given these motivations & rationalizations for mergers, nevertheless, actual efficiency gains have been widely disputed & no satisfactory results have been unanimously reached, in general, especially in terms of operating efficiencies (Chambeilain, 1998; Bae & Aldrich, 2001). The actual motives for mergers have not been directly observed - empirically; & they might differ from those stated by management at the time of the merger announcement. A major explanation for the witnessed poor or not improved post-merger performance relative to what was expected is that the majority of the deals have been based on aggressive cost-cutting strategies, ignoring or paying less attention to enhancing revenue growth that would potentially lead to higher profitability. So despite the belief that the consolidation trend will continue worldwide , there is growing concern that the cost ­cutting rationale is ill -judged & only few of the deals, based on this motivation, would achieve the predicted post-merger performance potentials.

1.4 Overview of the Study Research Design & Empirical Evidence

Most of the academic studies so far follow one of two approaches - or both - to estimate & evaluate the significance of the post merger gains:

Operating Performance Approach (OP), which compares the pre-merger & post­-merger performance of merged banks using accounting data & financial ratios. These studies are designed to analyze the efficiency consequences of consolidation including changes in X-efficiency, scale, scope & product mix efficiencies, etc. Some OP studies compare the pre- & post-merger performance variables of the merging banks to a control group of non-acquiring banks or similar-sized banks.

Event Study Approach measures the reaction of the stock price of acquirers & targets to a merger announcement. This approach relies on market data rather than accounting data. The rationale behind applying this approach is that the market's reaction is a better indicator of the real economic effects of an announced deal, than accounting data. Some of these studies examine the abnormal returns of acquirers & targets separately; others analyze the total change in shareholder wealth.

Some of the operating performance studies create a hypothetical combined firm by calculating the simple average ratios from the data for the acquirer & the target far the pre-merger period. Few studies have applied the Simulation Techniques rather than directly investigating efficiency effects from comparing financial ratios in order to estimate the potential cost effects of mergers. Mergers are simulated between pairs of banks by comparing the sum of predicted costs for a given pair of banks with the predicted cost of the merged entity whose balance sheet is the simple sum of the balance sheets of the two banks.

In this study, the operating performance approach will be adopted using a selective set of the financial ratios that most studies incorporate to examine cost efficiency, profitability, & balance sheet structure of the mergers studied. Mainly three types of ratios will be used:­

Expense Ratios: Ratio of expenses (interest & non-interest) to assets or operating revenues.

Profitability Ratios: Return on Assets (ROA) & Return on Equity (ROE).

Balance Sheet Items (related ratios): to examine changes in the composition of the assets that might be responsible for expenses or other performance changes. Besides, some of these ratios indicate the asset quality especially by examining the percentage of non-performing assets to total assets, like doubtful loans & loan loss provisions.

The financial ratios of the acquiring bank will be analyzed for the year preceding the merger & two years after the merger. The pre- & post-merger performance variables for the merging banks will be also compared to a control (peer) group. The control group will be selected based on the classification of banks in Lebanon. Therefore, efficiency & performance of the merged entity will be compared with other banks that are similar in terms of magnitude. This will help in controlling for economic conditions affecting performance away from the merger itself in our framework the main motivation behind mergers & acquisitions is the improvement in efficiency in terms of cost & profitability (from revenue enhancement) as well. This is the main incentive of the Central Bank & regulatory authorities to encourage mergers in a way to strengthen the financial system & get rid of less efficient & small banks from a competitive banking sector, with the high market concentration continuing to be in the benefit of the larger banks.

The empirical evidence is varied with no clear improvement in overall operating efficiency, at least in the short term, but with some improvement witnessed in cost components mainly labor due to downsizing of the labor force. Results show that profitability improved following merger in the sense that acquirers were more able, relative to peers, to control the decline in earnings, a situation faced by the whole banking industry due to economic pressures & diminishing spreads. But on average, the mergers seem to have reached few objectives, though some are not evident in the short term. Cost reductions were evident in labor costs, though, more likely, they have been cancelled by other profound expenditures owing to heavy investments in information technology & merger-related costs like costs of integration & indemnity payments to released employees, so on & so forth. Add to this the noise & difficulties arising during the integration process that are not easily predictable pre-merger. The evidence gives some hints for possible factors that could have increased expenses during & after the merger, & are also due to the merger, like the increase in doubtful loans accompanies by an elevated loan loss provisions reflecting the intense provisioning efforts on the behalf of acquirers.

Chapter 2: Literature Review

2.1 Introduction

The global consolidation of the financial service industry, in general, & the banking industry in specific, has been the striking aspect for sometime now with the ever mounting scale of bank mergers being the prominent phenomenon (Milbourn, Boot, & Thaker, 1999). Recent literature on financial consolidation documents that the past decade & recent years have exhibited the most intensive period of reorganization in the history of global financial services industry. It is as well widely observed that this merger wave has been caused in part by institutional failure & under performance in banking & other types of financial services all around the globe. This was argued to be the result, partly, directly or indirectly, of extensive deregulation, interest rate volatility & asset deflation, much greater competition for funds, & in many cases mere managerial incentives (Smith & Walter., 1998). Recently & nowadays, however, failure of banks, knowing that banks are no longer failing at the same rate as before, is not anymore the primary reason behind the consolidation of the banking industry.

The reason lies in the severe competitive environment of this industry & the increased competition from other financial institutions as well, both locally & internationally (Johnson, 1995). Studies by Berger, Demsetz, & Strahan (1999), based on a bulk of researches in this field - financial services industry - predict that the pace of consolidation has been fundamentally determined by changes in economic environments that alter constraints faced by the financial service industry in general & the banking sector in specific, especially technological developments & financial innovations. Add to this the perceived competitive opportunities during a time of extensive globalization & international consolidation of markets.

Merging are scale & scope economies based on the view that larger institutions may be more efficient if redundant facilities & personnel are eliminated within the post merger organization. Costs can be lowered also if one bank can offer several products at a lower cost than the separate banks (Rhoades, 1993; Hughes, Lang, & Mester, 1999; Pilloff & Santomero, 1998). Revenue efficiency is also expected to result from mergers whereby scale economies may enable larger banks to offer more products & services, & scope economies may increase market power by providing multiple products & services. Besides acquiring management may raise revenues by implementing superior pricing strategies, etc. (Pilloff & Santamoero, 1998). With a broader array of financial products, the consolidated bank expects to increase the potential revenues from any transaction. Nevertheless, as argued by Hughes, Lang, Mester, & Moon (1999), while expansion may provide many of the expected benefits, it may as well increase the complexity of the organization in general. Stephen Rhoades (1993) was the first to empirically test the cost efficiency rationale & the issue was revisited in 1998 by Rhoades himself & other researches studying economies of scale in banking. R.hoades (1993) emphasizes that in studying the issue of efficiency gains from mergers, it is important to distinguish between cost reductions & efficiency improvements. This point will be discussed in details later in the chapter, but at this stage it is necessary to point out that cost reductions resulting from cutting employees, closing branches & so forth do not automatically translate into improvements in efficiency as measured by an expense ratio, such as expenses to assets or revenues. But in fact they represent shrinkage of the firm due to reductions in assets (Rhoades, 1993; Rhoades, 1998).

Theoretically speaking, scale/scope economies could be considered as justifications for the bank merger wave. Given the well-established potential for efficiency improvements from the merger, it is worth questioning whether this potential is achieved in practice. Thus researchers have long argued that efficiency analysis is needed to determine if banks actually do make improvements like enhancing performance of back office & branching operations, achieving diversification gains by creating higher-expected revenue investments as well as reducing risk in general, etc. However, empirical evidence could be hardly viewed as providing strong endorsement & has generally failed to reveal ex-post evidence of realized performance benefits. Cost reductions are predicted to result from improved management & operations (Rhoades, 1993; Berger & Humphrey, 1992). This conclusion of not having at all or having small economic benefits, as argued by most researchers, holds across a wide variety of methodologies, samples & time periods. Thus, such disappointing results fueled a controversial debate of why bank consolidation has been & continue to be so prominent when gains are generally not witnessed.

Pilloff & Santomero (1998) point out that the merger event is a complicated transaction that can easily confound analytical attempts to investigate it. But results have always been disappointing in that they leave the reader with no sufficient understanding of why banks are merging, or which banks are merging, or when this wave will come to an end. With the existing empirical evidence being of less support, several issues explain this consolidation wave, the most important of which is strategic considerations, not so closely related to scale & scope economies. Strategic positioning, on the individual bank level & the industry level, might be the driving force & an optimal response to the uncertainties & rapid changes facing the financial industry in any country. So consolidation might be an evolutionary phenomenon & may be followed by a new type of repositioning when uncertainties become more manageable (Boot, 1999).

Still, the wide-documented fact is that, by many measures, there are a variety of benefits that may accrue from mergers even if operating efficiency gains were not achieved or witnessed. Such gains are associated with reduced operating costs, enhanced diversification, & the enrichment of bank-customer base & relationship, different strategic orientation & a good vehicle for growth especially in the case of efficient acquiring firms who most probably complete a merger with favorable efficiency effects. The merger process, as broadly argued, may be successful ex-ante in identifying under-performing targets & situations where there is potential for substantial performance improvement. However, studies on completed US bank mergers, using cost & performance variables although usually failing to find any performance improvement post-merger, they generally confirm that targets have lower efficiency levels than acquirers. Simulation evidence as well provides similar confirmation. Consolidation by all means will serve as a reorganization catalyst for the banking industry to better position itself for facing international consolidation of markets amid the rapid technological breakthroughs.

The remainder of the chapter is structured as follows: Section 2.2 discusses the basic economic incentives for consolidation covering both value-maximization motives & non-value maximization motives. Section 2.3 discusses the market forces encouraging consolidation & the changes in economic environments shaping the pace of this wave. Section 2.4 highlights some of the risks associated with consolidation on the individual firm level & the industry & social level. Section 2.5 reviews the documented literature & methodologies applied to test for efficiency gains from mergers & presents some ex-ante conditions that predict efficiency improvements. Section 2.6 provides some explanations & justifications of the general findings. Section 2.7 is a conclusion to the chapter.

2.2 The Economic Incentives for Mergers & Acquisitions

There are many reasons underlying any merger & acquisition event, & motives may vary with firm size or organizational structure, over time, & across countries. In a general framework, literature on the motives for financial consolidation has categorized the motives into value-maximizing motives & non-value maximizing motives (Berger, Demsetz, & Strahan, 1999; Vander Vennet, 1996).

2.2.1 Value-maximization Motives

Delong (1999) documents based on Miller & Modigliani (1961) that the value to an acquirer of taking over an ongoing concern can be expressed as the present value of the target's earnings &, the discounted growth opportunities the targets offers. As long as the expected rate of return on the growth opportunities is greater than the cost of capital, the merged entity creates value & the merger should be undertaken. The value maximization motive is based on two rationales: Operational Efficiency Rationale & the Equity Market (Market Power) Rationale. It is well documented that financial firms can maximize value in either or both ways through consolidation: by enhancing their efficiency or by increasing their market power in pricing & strengthening their competitive position (Berger, Demsetz, & Strahan, 1999).

2.2.1.1 The Operational Efficiency Rationale

Traditional merger theory stipulates that merger is a transfer of scarce corporate resources from a firm of lesser capability to one that is able to operate more efficiently & is able to put those resources to better use (Avkiran, 1999 based on Ravenscraft & Scherer, 1987). Mergers & acquisitions may be motivated by opportunities to improve firm operating performance as they are expected to enhance the efficiency of the target firm &/or the combined post-merger entity (Cummins, Tennyson, & Weiss, 1999). Mergers are considered to be an important way to achieve operational synergies, the realization of which depends on the potential for economies of scale & scope. If these economies exist, an expansion of the bank size would be accompanied by a less than proportional cost increase (Vander Vennet, 1996). Efficiency is a broad concept that can be applied to many dimensions of a firm's activities. A narrow technical definition states that a firm is cost-efficient if it minimizes costs for a given quantity of output. Also, it is profit-efficient if it maximizes profits for a given combination of inputs & outputs. These definitions take size & technology as given & focus on how production factors are combined; they both measure managerial efficiency - the optimization of existing resources - & technological efficiency, which considers scale & scope economies (OECD, 2001).

Rhoades (1993; 1998) emphasizes that in studying the issue of possible gains from mergers, it is important to differentiate between cost reductions & efficiency improvements. Reduction in operating expenses may result from cutting employees, closing branches, closing computer & back-office operations, & so on. However, such reductions do not necessarily initiate or lead to an enhancement in efficiency.

[...]