The bidder competition for ABN AMRO

Table of Contents

List of Abbreviations

1 Introduction
1.1 Problem Definitions and Objectives
1.2 Course of the Investigation

2 Global Banking Sector – Theoretical Foundations
2.1 Historical Development
2.2 Definition of a Bank
2.3 Risks Faced by Banks
2.3.1 Liquidity Risk
2.3.2 Credit Risk
2.3.3 Market Risk
2.3.4 Operational Risk
2.4 Types of Banking Services
2.4.1 Retail Banking
2.4.2 Private Banking
2.4.3 Investment Banking
2.5 Sector Consolidation

3 Case Study: The Bidder Competition for ABN AMRO
3.1 Situation pre-Takeover of ABN AMRO
3.1.1 Company Overview and Business Description
3.1.2 Strategic Focus
3.1.3 Key Financial Data
3.1.4 Competitive Environment
3.1.5 SWOT Analysis
3.1.5.1 Strengths
3.1.5.2 Weaknesses
3.1.5.3 Opportunities
3.1.5.4 Threats
3.2 The Bidder Competition
3.2.1 Involved Parties
3.2.1.1 Barclays
3.2.1.2 The Royal Bank of Scotland Consortium
3.2.2 Legal Framework
3.2.3 Course of the Bidder Competition
3.2.3.1 The First Phase – Exclusive Talks and First Bid
3.2.3.2 The Second Phase – Legal Deadlock and Rival Bid
3.2.3.3 The Third Phase – Revised Bids
3.2.3.4 The Fourth Phase – Barclays Withdraws From Bidding
3.3 Situation post-Takeover of ABN AMRO
3.3.1 Positive Consequences
3.3.2 Negative Consequences

4 Reflections of the ABN AMRO Takeover's Effects on the Banking Sector
4.1 Developments in Banking M&A Activity
4.1.1 Europe
4.1.2 United States of America
4.1.3 East Asia
4.2 The Causes of Consolidation
4.2.1 Value-Maximising Motives
4.2.2 Non-Value-Maximising Motives
4.2.2.1 The Role of Shareholders
4.2.2.2 The Role of Managers
4.2.2.3 The Role of Government
4.3 Effects of Consolidation
4.3.1 Efficiency
4.3.2 Competition
4.3.3 Risk
4.3.4 Small Business Lending
4.4 New Challenges for the Banking Sector
4.4.1 Bank Regulation and Risk Management
4.4.2 Financial Stability
4.5 Outlook

5 Conclusion and Implications for Further Research

References

Appendixes

List of Abbreviations

illustration not visible in this excerpt

1 Introduction

1.1 Problem Definitions and Objectives

"Consolidation is the child of competition and the mother of efficiency."

(Calomiris, 1999, p. 616)

As the global economic environment changes the banking sector, banks are positioning themselves in order to compete against one another. Although some banks focus on a particular market niche, the most salient feature of competitive posturing has been a trend toward the consolidation and rapid development of large big banks. The banking sector has experienced rapid consolidation globally, which, to some extent, reflects the general mergers and acquisitions (M&A) activity in the global economy. Mergers and acquisitions in the banking sector appear in the headlines frequently. A recent example is ABN AMRO Holding N.V. (ABN AMRO). This banking group always assumed that it would be on the attacking end of a takeover bid, rather than the receiving end. However, on 23 April 2007 ABN AMRO received a EUR 65.7 billion bid from Britain’s Barclays PLC (Barclays), in what could be the biggest banking merger ever. Then two days later an even bigger potential offer came in from a European consortium led by the Royal Bank of Scotland (RBS), which aimed to dismember ABN. This offer verged on hostility, setting the stage for what emerged to be the longest and most bruising takeover battle in the banking sector’s history.

Despite the fact that considerable research has been done already on banking sector consolidation, much remains to be explored and understood. This thesis looks closely at the background and implications of mergers and acquisitions in the banking sector. It provides a systematic overview of the reasons behind banking sector consolidation by relating theoretical insights to evidence of the fierce bidder competition for, and subsequent takeover of, ABN AMRO. It also investigates the question of to what extent consolidation can be seen as the “child of competition and the mother of efficiency” (Calomiris, p. 16). In addition to that, the thesis aims to highlight the most important implications of consolidation in the banking sector with regard to the future, and discusses potential areas of further research.

1.2 Course of the Investigation

The thesis is structured in five chapters: (1) problem definitions and objectives, and the course of the investigation; (2) theoretical foundations; (3) case study of the bidder competition for ABN AMRO; (4) reflections on the ABN AMRO takeover's effects on the banking sector and (5) conclusion.

Chapter Two deals with the global banking sector's theoretical foundations. It includes conceptual delineations, differentiation of bank risks and banking services, and an introduction to banking sector consolidation. These theoretical foundations are important for understanding subsequent chapters.

Chapter Three analyses the bidder competition for ABN AMRO involving, on one hand, Barclays and, on the other, a consortium comprising the Royal Bank of Scotland, Santander, and Fortis. This deal serves as an example of a takeover within the scope of continuous consolidation in the banking sector. The lengthy bidder competition for ABN AMRO, the strategic reasons behind it and the takeover deal's positive and negative consequences are emphasised. However, the transaction's recency allows for only a preliminary analysis of the transaction's consequences for the consortium's members, because no numbers regarding achieved synergies are available yet. Furthermore, the information sources are limited to articles in the press.

Chapter Four reflects on the ABN AMRO takeover's effects on the banking sector by relating it to views expressed in the literature and suggested by empirical findings regarding the motives for consolidation and its effects. These reflections are again limited by the deal's recency. Therefore, the described challenges and outlook for the banking sector owing to increased consolidation are basically drawn from the literature.

The concluding Chapter Five summarises the main points of the thesis and discusses the importance of the ABN AMRO takeover with regards to current and prospective developments in the banking sector.

2 Global Banking Sector – Theoretical Foundations

The global banking sector is being transformed due to increased competition, regulation and globalisation. The impetus for further consolidation is increasing as a result of margin pressures on one hand, and increasing profits and steadily rising share values on the other.

2.1 Historical Development

During the past two decades the financial markets have seen an unprecedented process of deregulation and globalisation. Many developed and developing countries have opened their financial systems to foreign competition and have allowed capital to flow freely across borders. Particularly in Europe, the progress toward financial liberalisation has been substantial since capital controls were abolished in the 1980s. As these developments have fostered both integration of markets and international mobility, the banking sector has surged, outpacing both the expansion in world trade and economic growth. In the 1990s banks expanded internationally by acquiring and controlling equity interests in foreign banks, opening branches abroad and increasing foreign lending. Banks also moved into new areas of business and enlarged their range of products extensively, especially in the asset management field. According to Porter (2005), international banking can be described as “the leading edge of the current wave of globalization” (p. 49) because consolidation in the banking sector is occurring frequently, as described in Section 2.5. In addition to that, banking regulation has been at the leading edge of international financial regulation. Regulators are concerned that payments and other important banking activities not be disrupted, and that banks have been involved in international crises such as the debt crisis of the 1980s. Banks also increasingly engage in complex financial transactions such as swaps, which entail high degrees of risk (Bakker, 1994; Buch, 2004; Fazio, 2003).

The Basel Committee on Banking Supervision has set forth principles, namely Basel I and Basel II, in order to prevent bank failures by effectively controlling banks’ capital adequacy in relation to the risks they assume, such as credit and market risk. In 2004 Basel II replaced Basel I, the Capital Accord of 1988, and is now implemented in the European Union (EU) and from 2008 onward in the United States of America (US). Basel II promotes financial stability by regulating market discipline and accounting for different types of banking risks. The third section of this chapter explains in detail the various risks banks are exposed to. Although globalisation of financial institutions seems to have generally improved financial stability, it cannot be taken for granted that globalisation also makes financial systems as a whole resilient in the face of extreme events. This highlights the significance of policymakers continuing to ensure that national legal, regulatory, and supervisory arrangements, such as Basel II, evolve to cope with banks' increasingly globalised nature. As described in Section 4.4, in order to maximise institutional globalisation's benefits, further work is required in order to develop effective mechanisms for multinational collaboration concerning ongoing supervisory coordination, crisis management, and crisis prevention (Bakker, 1994; Buch, 2004; Fazio, 2003).

2.2 Definition of a Bank

Fama (1980) defines banks as “financial intermediaries that issue deposits and use proceeds to purchase securities” (p. 39). While banks perform various financial activities, their key function is to convert short-term liabilities, such as deposits, into longer-term assets, especially loans, which process is referred to as intermediation.

The environment facing banks today differs to a great extent from that of the past. Diversification among sub-industries has increased competition between banks and other financial service companies that provide mutually exclusive products and services to the same customers. Although banks originally obtained most of their revenue from interest income, today fee-based income from investment services and derivatives is also an important position on a bank’s income statement. As finance has become more globalised over the years, a shift from banking to the securities market, known as disintermediation, has taken place in all Western countries since the 1970s. This has further increased competition among financial services companies and required banks to find diversified and new sources of income. Diversification's negative impacts, however, include a tremendous increase in earnings’ volatility, and new types of risks for banks to manage. The next section covers risks that banks are exposed to (Penza & Bansal, 2000; Porter, 2005).

2.3 Risks Faced by Banks

As financial intermediaries, banks are exposed to different types of risks including liquidity risk, credit risk, market risk, and operational risk. As the banking sector has evolved, the types of risks banks face have increased tremendously, necessitating comprehensive risk management practices for banks.

2.3.1 Liquidity Risk

Liquidity risk is a major risk for banks and can be defined as the “risk of loss arising either from the inability either to make payments or to refinance obligations. When referring to negotiable instruments, liquidity risk is the risk of loss incurred due to a lack of potential buyers when the instrument is sold” (Penza & Bansal, 2000, p. 21).

Banks require a certain amount of liquidity in order to meet their routine expenses, such as interest payments and overhead. Banks’ liquidity also needs to cover unexpected “liquidity shocks,” such as heavy loan demand or large money withdrawals. If a bank holds insufficient liquidity to meet those demands, it might have to turn to high-cost sources of funding that reduce its profitability. Assessing a bank's liquidity risk involves the entire balance sheet, along with the off-balance sheet activity. Banks need to ensure that low-cost sources of funding are available to them fast and easily. This might entail holding a portfolio of assets that can easily be sold, or acquiring a large number of stable liabilities. However, liquidity's necessity needs to be balanced against its negative impact on profitability. Generally, more liquid assets earn lower rates of return than less liquid assets, and specific types of stable funding might be more expensive than those that are more volatile. By holding only cash as an asset, a bank can be perfectly liquid but would follow a highly unprofitable strategy because cash earns no income (Federal Reserve Banks of Kansas City and St. Louis, 2004).

2.3.2 Credit Risk

Credit risk is associated with the “risk of the loss arising from the failure of the counterpart to make the promised payment” (Penza & Bansal, 2000, p. 21).

Loans are usually the biggest source of credit risk for banks; however, other sources of credit risk exist throughout a bank's activities, including in the trading and banking book. Banks are increasingly exposed to credit risk in numerous financial instruments other than loans, such as interbank transactions, trade financing, foreign exchange transactions, bonds, swaps, financial futures, equities and options. The adoption of the 1988 Capital Accord, known as Basel I, first established standards for credit risk. The aim of credit risk management is to maximise a bank's risk-adjusted rate of return by maintaining credit risk exposure at a tolerable level. On one hand, banks are required to manage the credit risk inherent in their entire portfolio, and the risk in individual transactions on the other. Effective credit risk management is a significant and critical aspect of comprehensive risk management practice in modern financial markets, and is essential to a bank's long-term success (Bank for International Settlement, 2000; Basel Committee on Banking Supervision, 2005).

2.3.3 Market Risk

Market risk can be defined as the “risk of losses sustained as a result of changes in the value of traded or tradable assets. This risk is due to changes in the prices of market factors and is sometimes referred to as price risk” (Penza & Bansal, 2000, p. 21). It can therefore result from adverse movements of interest rates, exchange rates and equity, as well as commodity prices. In practice, however, interest rate risk is the most important type of market risk that banks face.

Managing market risk is increasingly important for banks owing to the increased complexity of financial instruments; the increase in banks' trading activities; and the increased volatility of interest rates, foreign exchange rates and stock prices caused by the globalisation of financial markets. Therefore, since 1998 US banks with large trading operations have been required to hold a minimum amount of capital intended to cover the market risks in their trading portfolios. This market risk capital standard is based on banks' internal risk measurements models, rather than on standardised regulatory risk weights, and supplements the existing capital standards for credit risk mentioned above. Further steps toward improving banks' risk management practices were taken in 2004, when the Basel Committee on Banking Supervision first published Basel II. Basel II imposed a number of amendments to the minimum regulatory capital standard required for internationally active banks regulated by Basel I. A significant amendment included market discipline as a primary pillar in Basel II in order to ensure that banks operate efficiently and prudently, increase disclosure requirements and promote overall economic stability (Basel Committee on Banking Supervision, 2005; Hirtle, 2003; Penza & Bansal, 2000).

2.3.4 Operational Risk

There is no universally agreed upon definition of “operational risk;” however, for regulatory capital purposes, the Basel Committee adopted one that industry participants had developed. It defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and reputational risk” (Basel Committee on Baking Supervision, 2003, p. 8). Although this definition of operational risk includes legal risk, it excludes the strategic and reputational risks that banks might be exposed to.

Banks and supervisors have increased their focus on measuring and identifying operational risks, such as fraud, terrorism and system failures. Incidents such as terrorist attacks and rogue trading losses at Barings and recently at Société Générale have emphasised the importance of risk management, beyond the scope of credit and market risk. As a result, the Basel Committee on Banking Supervision introduced a capital charge for this type of risk as part of Basel II. This capital charge ensures that banks separate operational risk from credit risk and quantify it apart from credit and market risk (Basel Committee on Banking Supervision, 2005).

2.4 Types of Banking Services

A bank’s activity can be divided into three main types: retail banking, private banking, and investment banking. These types of banking services differ in their functions, the environment in which they operate and their outlook, as the following sections describe.

2.4.1 Retail Banking

Retail banking is the most traditional business of commercial banks and deals directly with individuals and small businesses, rather than large corporations or other banks. In general, retail banking services include savings accounts, debit cards, credit cards, and personal loans. Since the 1990s retail banking has changed significantly because of both technological changes and new competitors. Telephone banking and the advent of e-banking are major technological issues affecting the retail banking business. These innovations have reduced branch networks' importance and made national boundaries irrelevant. Unrelated competitors, such as the United Kingdom’s two biggest retailers, Sainsbury’s and Tesco, entered the retail banking market offering savings accounts and credit cards, among other services, by establishing partnerships with banks. These trends indicate that the retail banking industry is changing and that retail banking will no longer be commercial banks' dominant business. Although this sector remains profitable, concerns about consumer debt and slow economic growth cloud its outlook. Retail banking services seem to have become a specialised niche, with some global banking institutions offering retail banking services and products in addition to a wide spectrum of other banking services and products, such as private banking and investment banking (Bream, 1998; DiVanna, 2004).

2.4.2 Private Banking

Private banking services are designed to suit the requirements of high net worth individuals, whom banks consider worthy of investing a lot of time in. Therefore, banks serve these customers on a more personal and trustworthy basis than mass-market retail banking customers. Private banking comprises a wide range of services, from the basic components of retail banking such as credit cards and deposit accounts, up to wealth management, tax planning, and inheritance. In 2007 assets under management in private banking increased from US$3.4 trillion to US$7.6 trillion, which is an increase of 128%. Therefore, it can be inferred that private banking services are gaining popularity and that it is a fast-growing market. In times of increased competition private banking provides an opportunity for banks to increase their fee income. Banks also can transfer market risk, at least to a certain extent, to these customers. Because private banking is basically an asset management service, financial risk management plays a major role in enabling banks offering these services to limit possible losses (Avery, 2008; Penza & Bansal, 2000; Walbert, 2006).

2.4.3 Investment Banking

Investment banking is the most globalised segment of the financial services industry and is continuously challenged to respond to new developments and innovations in the global financial markets. Investment banking services comprise merger and acquisition advice, issuing and selling securities in the market (both equity and debt), fund management, and lending. The term M&A refers to the consolidation of companies. During a merger a new company is formed, while during an acquisition a company is purchased by another and no new company is formed. The investment banking industry is changing rapidly. Forty years ago it was dominated by a few small partnerships that earned most of their income from the commissions they received floating securities on behalf of their clients. Today’s investment banks are huge full-service firms that earn a substantial proportion of their revenues in technical trading businesses, which started to attain prominence only in the 1980s. This development is a result of technological and regulatory changes that make economies of scale possible. In the future, further technical advances, coupled with increasingly strident regulations, will likely result in more systematisation and more consolidation of the largest investment banks (Morrison & McIntire, 2007; Penza & Bansal, 2000).

2.5 Sector Consolidation

For at least the past decade, all types of business activities have been consolidated in the economic landscape. Especially the financial services industry, which comprises the banking sector, is consolidating both within and across many industrial countries; and mergers and acquisitions among financial institutions occur in record numbers in terms of both their frequency, and the size of the merging institutions. The value of mergers in the financial services industry increased tremendously, from US$79 billion to US$902.5 billion, between 1996 and 2006, as Figure 1 of the Appendixes shows (Berger, Demsetz, & Strahan, 1999).

Generally, the main motivations for consolidation in the banking sector are to maximise shareholder value, to generate cost and revenue synergies, to create opportunities for expansion which provides the benefits of diversification of assets and liabilities, and to widen the scope of products and services. Commercial banks are required to increase in size as a result of ongoing disintermediation and their need for economies of scale. The pace of consolidation is determined mainly by changes in the economic environment, such as technological change, improvements in financial conditions, deregulation of geographic and product restrictions, and international consolidation of markets, which alter the constraints facing banks (Berger et al., 1999; Ferguson, 2003; Group of Ten, 2001; Hughes, Lang, Mester, & Moon, 1999).

Chapter Four discusses consolidation's effects, which include not only the direct effects of increased market power or efficiency, but also some indirect effects. An example of a potential indirect consequence is a reduction in the availability of financial services to small customers. Possible systemic consequences of consolidation include changes in the payments system's efficiency and changes in the financial system's safety and soundness, as are discussed in Chapter Four. Policymakers are required to balance the expected social benefits and costs of these consequences when setting rules on consolidation and approving or disapproving individual mergers in the banking sector. In practice, however, it often proves difficult to quantify the consolidation's benefits and costs. The following chapter investigates the recent takeover of ABN AMRO as an example of ongoing consolidation in the banking sector (Berger et al., 1999; Ferguson, 2003; Group of Ten, 2001; Hughes et al., 1999).

3 Case Study: The Bidder Competition for ABN AMRO

3.1 Situation pre-Takeover of ABN AMRO

Before its takeover, ABN AMRO was among the top banks in Europe, with a wide international presence and a wide range of banking services offered. It followed a mid-market growth strategy and its financial information in fiscal year 2006 revealed improvements in all key banking indicators compared to previous years.

3.1.1 Company Overview and Business Description

The leading international banking group ABN AMRO, whose history dates back to 1824, offers a broad range of banking products and financial services. Its products and services include private banking, consumer banking, commercial banking, investment banking, corporate banking, asset management, and private equity. ABN AMRO operates through 4,532 offices and branches in 56 countries and territories spanning Europe, North America, Latin America and Asia. It is headquartered in Amsterdam and employs more than 100,000 people. As of July 2007, ABN AMRO ranked 12th in the world based on assets and 24th in the world based on Tier 1 capital (ABN AMRO, 2007; Timewell, 2007).

The group is broadly structured into seven client business units (BUs), three product business units, two cross-business unit segments and group functions. The seven client business units consist of five regional business units (the Netherlands, Europe, North America, Latin America and Asia) and two global units, namely private clients and global clients. The regional BUs serve about 20 million consumer clients and small and large businesses worldwide, and the two global client BUs serve about 550 clients with global needs. The three product business units comprise global markets, transaction banking, and asset management, and support the client business units by developing and delivering products. ABN AMRO’s asset management operates from over 20 locations worldwide and manages, as of July 2007, EUR211 billion worth of assets for private investors and institutional clients. The two cross-business unit segments, cross-consumer and cross-commercial clients, bind the group’s client business units (ABN AMRO, 2007).

ABN AMRO operates primarily through nine core business divisions: private equity, the Netherlands, North America, Latin America, Europe, global clients, Asia, private clients and asset management, as well as a group functions division that includes mainly corporate functions. ABN AMRO's group functions division performs services that have been centralized or are shared across the whole group. It comprises value-added support and services including risk, audit, investor relations, legal, compliance, corporate development, communications, and human resources. ABN AMRO’s group functions division also holds the group’s strategic investments and proprietary trading portfolio, and records any related profits or losses (ABN AMRO, 2007).

3.1.2 Strategic Focus

ABN AMRO focuses on consumer, commercial, and private banking activities, and applies a “relationship-based business approach” (ABN AMRO, 2006, p. 14) through its various business units mentioned in the previous section. ABN AMRO aims to build on its strong position with consumer and commercial mid-market clients and to provide them with high-quality and innovative products and services. The consumer mid-market segment includes mass affluent consumers served by the regional client business units and the majority of the private banking clients served by the private client business unit. The commercial mid-market segment comprises a substantial amount of medium-to-large companies and financial institutions that are served by the regional business units. Although ABN AMRO’s growth strategy focuses on the mid-market, it still considers top and bottom clients. Serving top private banking clients develops innovative investments, which later can be offered also to mid-market clients. Serving the top commercial clients, such as multinational corporations, enables ABN AMRO to strengthen its industry knowledge and product innovation, which eventually benefits its mid-market clients. ABN AMRO aims to improve its strategic position by investing further and by acquiring additional clients in its chosen markets and client segments (ABN AMRO, 2006, 2007).

3.1.3 Key Financial Data

ABN AMRO’s most important financial information before the takeover is displayed graphically in Figures 2 to 6 of the Appendixes, and is summarised below.

During fiscal year 2006, ABN AMRO generated revenues of EUR 22,658 million, which is a 16.4% increase over 2005. The Netherlands, ABN AMRO’s largest geographic market, accounted for 20.5% of the group's total revenues. During the same time period, ABN AMRO’s net income increased from EUR 2,207 million to EUR 4,715 million. Regarding its balance sheet, ABN AMRO held assets equal to EUR 987.1 billion at the end of 2006, ranking it 12th in the world among banks, as stated before. At the end of 2002, ABN AMRO’s assets amounted to only EUR 556.0 billion, which reflects a 43.6% decrease in total assets. Shareholders' equity also increased tremendously between 2002 and 2006, totalling EUR 11.1 billion at the end of 2002, and increasing by 53.0% to EUR 23.6 billion by the end of 2006. Looking at ABN AMRO’s financial ratios reveals that it increased its return on equity (ROE) by 0.6% to 20.7% by the end of 2006, thus improving its profitability. Furthermore, ABN AMRO experienced a decline in its efficiency ratio from 71.9% to 69.6% over the same time period. This decrease in its efficiency ratio suggests that ABN AMRO was losing a smaller percentage of its income to expenses than it had been, which is good for the bank and its shareholders. Focusing on ABN AMRO’s share figures shows an increase in the number of shares outstanding from 1,589 million in 2002 to 1,854 in 2006. During that time period, the dividend per share increased by 21.7% to EUR 1.15. Additionally, the group's earnings per share (EPS) increased from EUR 1.39 in 2002 to EUR 2.50 in 2006. ABN AMRO’s share price also increased from EUR 12.32 at the beginning of 2002 to EUR 31.04 at the end of 2006, which is a 251.9% increase (ABN AMRO, 2006).

Overall, the information above shows that ABN AMRO successfully improved its financial performance between 2002 and 2006.

[...]