Effects of US Bank Mergers on Bank Risk and Value

Contents

1 Introduction

2 Theoretical considerations
2.1 Potential risk effects of bank mergers
2.2 Risk effects of geographic and product diversification
2.3 The link between risk and value
2.4 Further sources of potential value gains

3 Empirical evidence
3.1 The Z-Score as a measure for the analysis of risk effects of bank mergers
3.2 Evidence on risk effects of US bank mergers
3.2.1 Direct risk effects of US bank acquisitions
3.2.2 The relationship between bank risk and size
3.2.3 Testing the “diversification hypothesis”
3.2.4 Comparison of the reviewed studies’ results
3.3 Potential impacts of diversification on value

4 Conclusion

Appendices

A Factors affecting potential diversification benefits

B Derivation of the Z -score

C Further approaches to the analysis of risk effects of bank mergers

D Study description: Craig et al. (1997)

E Study description: De Nicoló (2000)

F Study description: De Nicoló et al. (2003)

G Test of the diversification hypothesis by Berger (1998)

H Overview: Studies on risk effects of US bank mergers

I Overview: Event studies on potential value effects of diversifying mergers

J Definition of geographic and activity diversification versus focus

References

1 Introduction

The historically strongly regulated banking industry in the United States of America (US) was characterized by a large amount of small banks that were not allowed to offer services in other areas than their home state and where even restricted in operating within their home state. The recent acts of deregulation, mainly the 1980s interstate banking pacts, the 1982 Garn-St Germain Act, the 1994 Riegle-Neal Act, and finally the 1999 Financial Services Modernization Act lead to a consolidation wave in the US banking industry that reduced the number of commercial banks by almost 50% between 1984 and 2003.^[1] Especially as a consequence of the Riegle-Neal Act that allowed full nationwide banking, there occurred a wave of “mega-mergers” creating banking institutions with an asset size in the $1,000bn range such as Citigroup in less than ten years.^[2]

This enormous concentration of the US banking market raised diverse issues for research. The most important topics are implications for monetary policy, effects on the payment and settlement system as well as on competition, credit flows, and bank efficiency and value, and the impacts on financial risk.^[3] The latter is a source of special concern because banks are by definition highly levered firms, so that their risk exposure needs to be continuously controlled and managed. Moreover, a failure of one bank could put stress on the whole banking system. This source of “systemic risk” is a worry particularly for regulators.^[4]

This paper focuses on the impacts of domestic US commercial bank mergers and acquisitions (M&As) in the 1990s on individual institutions. I consider potential changes in a bank’s risk exposure and how these changes can affect a merged bank’s value. The outcomes may offer a basis for potential changes of systemic risk and implications for regulatory policy, though these are not explicitly taken into account.

Section two provides a review of research on theoretical considerations. Four potential sources for risk changes following a bank merger will be identified, the main being benefits from diversification. However, the latter can only be achieved under certain circumstances. Afterwards, I will draw a link between risk and value effects.

Section three considers empirical research on US bank consolidation of commercial banks with a main focus on the 1990s. First, the Z -score is introduced as an empirical measure of insolvency risk exposure. Then I will discuss studies of risk effects of US bank mergers which show partly clashing results. Moreover, I will shortly review some event studies analyzing potential value creation through risk diversification.

Section four summarizes the most important results.

2 Theoretical considerations

2.1 Potential risk effects of bank mergers

Mergers can influence individual bank risk through geographic and product diversification, managerial efficiencies, operating risk, and market power rents.^[5] These impacts can be thought of as shifting a bank’s hypothetical risk-return frontier.^[6]

Higher market power through a bank merger can lead to higher price setting power and an “increase in franchise value, equivalent to an increase in capital [that] could lower the firm’s risk profile”^[7]. Market power can only be increased, if two banks operating in the same market merge, so that this potential is not likely to be available to geographically expanding mergers.^[8] Moreover, large clients have an access to many sources of funding at least in all US states, if not world-wide.^[9] Additionally, antitrust authorities tend to block or at least alter market-power increasing mergers.^[10] Therefore, market power benefits are not always possible in a bank merger.

A rise in operating risk might occur when top management is less able to supervise its employees directly because of an increase in size,^[11] thus creating opportunities for internal fraud. Expanding the product line into areas outside the acquirer’s core competence can additionally expose the merged bank to an unintended higher degree of credit and market risk.^[12] Also technological risk might increase since a greater bank is more dependent on its technological infrastructure. Especially the integration process of technological systems following a merger bears technological risk in terms of data losses and efficiency losses when employees have to become used to the new systems. Though most sources of operational risk can be adequately controlled for, management should not underrate potential shifts in operational risk exposure due to a bank merger.

Managerial efficiencies can have one the one hand positive effects through returns to scale as well as returns to scope in the case of a product diversifying merger, and on the other hand negative effects when diseconomies of scale arise because of organizational inefficiencies.^[13] Group of Ten (2001) argues that managerial efficiency gains “could lower risk by increasing expected returns, pushing up the efficient risk-return frontier, and providing more of a buffer against variation in returns.”^[14] This underlies the assumption that for every risk level on the efficient frontier, through the merger there are higher expected returns than by just combining the two banks’ stocks in an investor’s portfolio. This can only be the case if the efficiency gains themselves do not add much to the volatility of the merged bank’s returns. The assumption appears reasonable, but for a final assessment one might need more specific knowledge on the source of the efficiency gains.

2.2 Risk effects of geographic and product diversification

When analyzing risk effects of bank mergers, most research concentrates on potential benefits from diversification. Following the deregulation in the 1990s, US bank mergers offer chances for risk decreases due to geographic and product diversification. When banks located in different geographic locations merge, low or even negative correlations between the merged entities’ returns may lead to a portfolio diversification effect, implying a lower variance of returns.^[15] A combination of different business lines may lead to a similar effect as long as correlations between the merged activities are low.^[16]

However, a possible diversification effect of merging the parties’ asset portfolios does not necessarily imply a reduction of risk. Merged banks also tend to use the benefits of diversification to be able to decrease their regulatory capital and to involve in additional risky activities,^[17] e.g. “to shift from securities to loans and take on additional credit risks and earn higher expected returns for the same amount of equity and overall risk”^[18]. This behavior is referred to the “diversification hypothesis”^[19].

Moreover, correlations between the businesses of a banking conglomerate are not always small or negative. They can also be positive, especially if management expands in related business areas where it perceives the bank to have a “comparative advantage”^[20].

There are even indications that risk of failure can increase through diversification. The bad performance of one business unit can have adverse effects on the whole banking conglomerate because “the consolidated entity has a franchise value and a brand name that are intimately intertwined with all of its businesses”^[21]. For instance, depositors could withdraw their funds, if only a small division of the conglomerate faces a shock, implying higher liquidity problems and higher financing costs. Thus, the correlation between business units increases through just merging them. Moreover, the financial distress of one division in a banking conglomerate can lead other units or even the whole conglomerate into trouble because the distressed unit is not winded down like if it was operated stand-alone.^[22] Also the local regulator being responsible for a conglomerate’s subsidy is not likely to “sit idly by and allow a retrenchment of bank funds and commitments of support”^[23], if the unit faces bankruptcy. Conversely, the holding company might be charged so that the distressed division could “cripple the entire entity”^[24].

Referring to Winton (1999), potential benefits from diversification are also linked to the skewness of the merging banks’ return distributions and to loan monitoring effectiveness and incentives. A low acquirer’s as well as a high target’s downside risk provide little incentive for diversification. Moreover, risk decreases from diversification are less likely to occur when monitoring effectiveness in the newly entered sector is low. Diversification can increase the bank managers’ incentives to monitor loans so that risk is reduced. However, this effect is also constrained by skewness of returns and monitoring effectiveness. A deeper discussion of these issues can be found in Appendix A.

To sum up, risk benefits from diversification cannot be taken for granted. They might occur when correlations between the merged banks’ returns are low, but the realization of risk decreases is constrained by managers’ objectives, by the skewness of the merging parties’ return distributions, and by the effectiveness of monitoring.

2.3 The link between risk and value

Generally a decrease of a firm’s risk because of a more diversified asset portfolio can be assumed to have zero value effect because investors can diversify themselves by choosing their portfolio of preference.^[25] If an investor selects a portfolio consisting of two banks’ stocks, he will only take portfolios into consideration that are located on the efficient risk-expected return frontier. A merger of the two banks would just represent one point on this efficient frontier. So a risk decrease due to diversification following a merger would simply mean that there occurred a move on the efficient frontier because the banks’ asset portfolios’ returns are not perfectly correlated. Consequently the investor will not pay a premium for this merger since the move on the efficient set curve depicts a trade-off between risk and expected return. Vice versa, a value increase can only be assumed, if the merger achieves a shift-up of the efficient frontier so that a higher expected return can be gained for diversified risk.^[26]

Bank mergers offer diverse opportunities for a shift of the efficient frontier rather than a mere move on it. Banks are highly levered companies and thus they face a considerable risk of failure. Because bankruptcy is costly, lenders require compensation.^[27] If diversification can lower the bank’s return volatility significantly, the costs of funding as well as the likelihood of regulatory restrictions and costs in case of financial distress can be reduced, implying lower expected costs an thus an increase in value.^[28] A related opportunity is the possible increase of earnings in business areas where “customers value a bank’s reputation for stability”^[29], e.g. letter of credits where a first class rating of the bank is required.

Further value gains from diversification may come from improved efficiency, if diversification expands the “skill set of managers”^[30], as well as a raised after-tax income. The latter could be the result of a less than proportional tax schedule where the expected tax burden declines because of a reduced variance of returns.^[31]

Additionally, banks are no possessors of assets who have to take the returns as they come. Instead, through loan monitoring they have an influence on their asset portfolios’ returns.^[32] Cerasi et al. (2000) argue that monitoring costs have diseconomies of scale, because loans are monitored by people who can work only on a limited number of projects, so that “monitoring more loans entails overload costs”^[33]. Therefore, diversification benefits that are the result of a growth in bank size, e.g. through a merger, are offset by monitoring costs rising in bank size, so that an optimal size of the bank can be derived.^[34] This idea suggests that in case there are any risk benefits from diversification, value increases would be plausible for mergers of smaller banks, but not for the bank mega-mergers, all else being equal.

Another relationship between risk and value can be referred to regulatory issues. As deposit insurance provides moral hazard incentives, “a merger or acquisition gives the acquiring bank a good opportunity to increase its deposit insurance subsidy either by increasing its risk exposure or by attempting to become too big to fail”^[35]. The mere hunt for larger size can be value increasing if a level is reached where the conglomerate is perceived to be “too big too fail”.^[36] This means that for the case the large organization is financially distressed, the government and the regulatory institutions are believed to serve as a lender of last resort in order to deter adverse consequences for the whole financial system. This would imply a free insurance against bankruptcy risk, so that cost of debt might decrease.^[37] However, government will seek to prevent mergers that are thought to exploit its safety guarantees,^[38] so that this goal of growth cannot be always achieved.

2.4 Further sources of potential value gains

Diversification and risk reduction are not the main drivers of consolidating activities; they merely represent one of many sources of potential shareholder value maximization.^[39] If value is to be maximized by consolidating activities, managers hope either to gain market power in order to increase revenues or to realize efficiency gains in order to decrease costs.^[40] Both potentials have already been discussed in section 2.1, though they are more a source of synergies and value creation with risk reduction being rather a potential side-effect. As for any other firm,^[41] also for banks efficiency gains are a mere potential and a rise in market value depends on specific characteristics and a strategic fit of the merged firms.

3 Empirical evidence

3.1 The Z -score as a measure for the analysis of risk effects of bank mergers

The Z- score measures a bank’s probability of insolvency. It is defined by:

illustration not visible in this excerpt

The derivation of Z is shown in Appendix B.

Z has the three components mean return on assets illustration not visible in this excerpt, volatility of return on assets s, and equity cushion E/A. The studies reviewed in Section 3.2 analyzed the effects of mergers on Z as well as on its components so that both default risk and return volatility are examined, the latter being generally referred to risk in modern portfolio theory.

Z stands for the “number of standard deviations a return realization has to fall in order to deplete equity”^[42] so that a lower Z means a higher exposure to default risk.^[43]

In order to compute Z, its components can be identified with help of either market or book values. There are pros and cons for both approaches. Accounting data are influenced by legal rules and may be manipulated by management, whereas market data are much more volatile (implying a higher s) and “may reflect random noise or … exogenous shocks which are unrelated to the true profitability of the firm”^[44]. Though the latter effects may be neutralized by subtracting a market mean of Z,^[45] an analysis with help of both market and accounting data might be adequate as s has an important impact on Z.^[46]

A shortcoming of Z is that it is a one-period measure where a potential succession of negative return realizations is not taken into account. Additionally, by just estimating insolvency risk by illustration not visible in this excerpt and s, one does not pay attention to a bank’s possibly skewed return density function. Particularly a bank’s returns from loans can be assumed to be skewed to the left since banks can loose all of their investment, but their gains are limited to the promised interest payments plus principal.^[47] As insolvency risk is related to a probability under the left tail of a return density function, it should not be just estimated by the volatility and the mean.^[48] Both issues can lead to an underestimation of default risk.^[49]

Though not employed in analyses of domestic US bank mergers, other approaches have been used in studies on international or foreign consolidation. As evidence on risk effects of US bank concentration is rare,^[50] I deem these measures worth to be compared to Z in the following two paragraphs.

Total Relative Risk (TRR)^[51] measures the risk of a bank as the variance of market returns over the variance of a banking index.^[52] Though this approach entails the advantage of comfortable measurement, its main shortcoming is that it merely measures the return volatility s and does not allow conclusions on a bank’s exposure to insolvency risk.

A very complex approach is the estimation business sector-specific loss density functions.^[53] These are the basis for a Value-at-Risk calculation for the pre- and post-merger banks based on the composition of their loan portfolios. The advantage of this approach is that it takes into account a probable skewness of a bank’s return function and computes a bank’s risk exposure consistent to internal risk management models.^[54] However, the setup’s main disadvantages are its enormous complexity and the fact that only a bank’s exposure to credit risk is considered, neglecting a bank’s trading book activities.

Overall, though an empirical analysis based on the Z -score suffers from some shortcomings, it outperforms other approaches particularly in terms of depth of. Thus,Z can be regarded as an adequate basis for empirical research on risk effects of bank mergers.

[...]

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^[1] The number is for FDIC-insured commercial banks; see Saunders et al. (2006), p. 660. For a more detailed history of the US banking deregulation, see Saunders et al. (2006), pp. 645 – 652.

^[2] See Saunders et al. (2006), pp. 652 – 653, for an overview on bank mega-mergers.

^[3] See Group of Ten (2001) who provide a comprehensive overview on issues related to financial consolidation.

^[4] See Group of Ten (2001), pp. 126 – 127, for a definition of systemic risk.

^[5] See Group of Ten (2001), p. 127.

^[6] See Berger et al. (1999), p. 145, Group of Ten (2001), p. 128.

^[7] Group of Ten (2001), p. 131.

^[8] See Berger et al. (1999), pp. 144 and 152.

^[9] See Berger et al. (1999), p. 152.

^[10] See Berger et al. (1999), p. 152, Group of Ten (2001), p. 131.

^[11] See Group of Ten (2001), p. 131.

^[12] See Group of Ten (2001), p. 132.

^[13] See Group of Ten (2001), p. 130.

^[14] Group of Ten (2001), p. 132.

^[15] See Group of Ten (2001), p. 128, Santomero et al. (2000), p. 15. As mentioned by Winton (1999), p. 4, theoretical studies on banking frequently assume zero correlation, consequently assuming risk decreases due to diversification without doubt: see e.g. Cerasi et al. (2000), p. 1703.

^[16] See Group of Ten (2001), p. 130, Santomero et al. (2000), p. 15.

^[17] See Berger et al. (1999), p. 160.

^[18] Berger (1998), p. 83.

^[19] Berger (1998), p. 97.

^[20] Santomero et al. (2000), p. 15.

^[21] See Santomero et al. (2000), p. 15.

^[22] See Chionsini et al. (2003), p. 3.

^[23] Santomero et al. (2000), p. 15.

^[24] Santomero et al. (2000), p. 15.

^[25] See Winton (1999), p. 1.

^[26] See Berger et al. (1999), pp. 145 and 157.

^[27] See Winton (1999), p. 1.

^[28] See Berger et al. (1999), p. 157, Santomero et al. (2000), p. 15, and Winton (1999), p. 1.

^[29] Santomero et al. (2000), p. 15.

^[30] Berger et al. (1999), p. 145.

^[31] Santomero et al. (2000), p. 15.

^[32] The model of Winton (1999) also has a structure where return and risk benefits of diversification depend on monitoring effectiveness and incentives.

^[33] Cerasi at al. (2000), p. 1702.

^[34] See Cerasi et al. (2000), p. 1716.

^[35] Craig et al. (1997), p. 26.

^[36] See Berger et al. (1999), pp. 145 – 146, and De Nicoló (2003), p. 27.

^[37] See Berger et al. (1999), p. 146.

^[38] See Berger et al. (1999), p. 147.

^[39] See Berger et al. (1999), p. 144, and Craig et al. (1997), p. 26.

^[40] See Berger et al. (1999), p. 144.

^[41] See Weston et al. (2004), pp. 132 – 134.

^[42] De Nicoló (2000), p. 9.

^[43] See De Nicoló (2000), p. 9.

^[44] See Boyd et al. (1988), p. 11, for a deeper discussion.

^[45] E.g. as done by Craig et al. (1997); see Section 3.2.1.

^[46] See Boyd et al. (1988), p. 11.

^[47] See e.g. Saunders et al. (2006), pp. 337 – 341.

^[48] Also in internal risk management models, e.g. CreditMetrics, the assumption of a normal return distribution can underestimate the actual risk exposure; see Saunders et al. (2006), p. 338.

^[49] See De Nicoló et al. (2003), p. 27.

^[50] See section 3.2.

^[51] Employed by Amihud et al. (2002) and Buch et al. (2004).

^[52] See Appendix C for a deeper discussion of TRR.

^[53] See Appendix C for a more detailed desciption. This method was employed by Chionsini et al. (2003).

^[54] E.g. CreditMetrics; see Saunders et al. (2006), pp. 336 – 339.