Motivation Behind Bank Mergers



AN EXAMINATION OF BANK MERGER ACTIVITY:

A STRATEGIC FRAMEWORK CONTENT ANALYSIS

Cheryl Frohlich, University of North Florida

Cfrohlic@unf.edu

C. Bruce Kavan, University of North Florida

Bkavan@unf.edu

ABSTRACT

Over the last decade, bank mergers and acquisitions have been occurring at an unprecedented rate. The purpose of this study is to determine the underlying and driving forces or causation based upon examination of resent banking merger activity. A content analysis was performed utilizing the FDIC Applications for Merger/Acquisitions from 1996 and 1997. Since previous research has not employed the content analysis approach, this study offers a fresh approach to identifying the driving motivators behind the banking merger activity. The coding scheme adopted for this content analysis was conceptualized in the Porter strategic model (Porter, 1980) as operationalized in a “fishbone” analysis framework (Nolan, Norton & Company, 1986). This approach utilizing the Porter Model worked well in determining the rationale behind the merger/acquisition activity for the banking industry. For the period examined, there are four main paths identified that explains the reasons behind the mergers/acquisitions activity. These four paths are related to (1) creating economies of scales, (2) expanding geographically, (3) increasing the combined capital base (size) and product offerings, and (4) gaining market power. In examining the paths, it appears that, at a much higher level in Porter’s “fishbone” framework, the mergers are driven by cost reductions rather than by increasing gross revenue.

INTRODUCTION

Over the last decade, bank mergers and acquisitions have been occurring at an unprecedented rate. From 1990 through 1998, the number of banks has dropped from 12,347 to 8,774 banks resulting in a 28.9% decline. During this same period, there have been 4,625 unassisted mergers with only 569 failures. Thus the major contributor to the 28.9% decline in the number of banks is likely attributable to the merger activity within the industry.

The perceived motivation drivers for this merger activity are generally considered to be the acquiring banks' desire to increase its return by expanding geographically. This perception is similar to Stewart’s premises of merger motivation. According to Stewart (The Quest for Value, pp375-383), the actual motivating forces behind mergers should be ones that will (1) increase financial performance (net operating profits), (2) financial benefits through borrowing against the seller’s unused debt capacity or against an increase in the consolidated debt capacity (lending capability for banks), and (3) tax benefits derived from expensing the stepped-up basis of assets acquired or from the use of otherwise forfeited tax deductions or credits.

CONTEXT FRAME

Stewart’s merger motivation theory of increasing financial performance (net operating profits) is largely accepted as being a merger motivator within the banking industry. An increase in net operating profits may either be derived from cost savings or increase in revenue. Many of those involved in the bank mergers agree that cost savings are a significant reason for the activity. Downsizing (Craig, 1997) and global consolidation allowing banks to increase size and market capabilities while creating technological efficiencies (Investor’s Chronicle, 1997) are largely responsible for the cost savings of mergers. However, the research results on the financial performance of the merged banks have resulted in conflicting conclusions. While some research has found bank acquisitions are not improving the financial performance of the combined banks (Baradwaj, Dubofshy, and Fraser, 1992; Palia, 1993; Hawawine & Swary, 1990; Toyne & Tripp, 1998; Madura and Wiant, 1994), other research has resulted in opposite conclusions (Cornett & De, 1991; Chong, 1991; Cornett and Tehranian, 1992; Subrahmannyam, Rangan, & Rosenstein, 1997).

A non-financial (at least an immediate non-financial) merger motivator has long been believed to be geographic diversification. The geographic diversification is an attempt to increase the bank’s market, decrease its risk, and in the long run increase profits. Prior to the Riegle-Neal Interstate Banking and Branching (IBBF) Act of 1994, which allowed bank holding companies to acquire banks in any state after September 29, 1995 and allowed mergers between banks located in different states after June 1, 1997, banks were not allowed to expand across state line (with some exceptions). After Riegle-Neale Act, banks have the full freedom to acquire another out-of-state bank in order to expand geographically across state lines and to diversify geographically. The unassisted merger rate has increased since the IBBF Act. This increase in merger rates would seem to lend credence to the geographic motivator behind bank mergers.

Besides geographic diversification benefits, Stewart’s merger motivation theory of financial benefits derived from the consolidated debt capacity of the newly merged banks may be an additional merger motivator. As the banks merge and their capital base enlarges, their combined lending ability increases and they are able to offer larger loans without soliciting additional participation from another bank partner. Thus, the bank is able to possibly increase market share and revenue while decreasing competition.

However, the growth in the asset base of the nation’s banks through this merger activity produces the increased risk of financial harm to the economy. If a large asset based bank should fail, the bank’s failure might bankrupt the banking industry’s insurance fund. The ripple effect of the failure and subsequent bankruptcy of the insurance fund would cause panic throughout the nation. With the crisis involving Continental Illinois National Bank and Trust Company in May 1984, which was and still is the largest resolution in US history, and its subsequent resolution by its regulatory bodies, the government policy of “Too Big to Fail”(TBTF) was born. If banks reached a “magical size, the regulatory bodies would deem them to be too big to liquidate and thus many banks began to earnestly merge or acquire in order to reach the TBTF size. Therefore, an additional merger motivator behind the desire of banks to increase in their capital base may be the notion that regulators would not allow banks of a certain size to fail. Although, after the passage of the Federal Deposit Insurance Corporation Act of 1991, the “TBTF” motivation should have decreased in importance, some researchers still found that the “TBTF” was an important motivator in the larger mergers of the 1990’s (Benston, Hunter, and Wall, 1995; Hunter and Wall, 1989; Boyd and Graham, 1991).

METHODOLGICAL CONSIDERATIONS

To more fully explore the rationale behind the recent merger activity, a content analysis was performed utilizing the FDIC Applications for Merger/Acquisitions from 1996 and 1997. The unit of analysis was each independent merger/acquisition application. The FDIC provided a random sample of the merger/acquisition applications.

The coding scheme adopted for this content analysis was conceptualized in the Porter strategic model (Porter, 1980) as operationalized in a “fishbone” analysis framework (Nolan, Norton & Company, 1986). The coding of the content of application closely approximates the use of a standardized questionnaire. Thus, content analysis has the advantage of both ease and high reliability, but may be more limited in terms of content validity to the extent that the applications closely reflect the underlying stated merger decision rationale. However, since the merger/acquisitions within the banking industry must provide certain data (i.e. Community Reinvestment Act compliance or Herfindahl Indexes) to reinforce the merger/acquisition stated rationale, there may be more validity in the stated rationale for mergers/acquisitions of this industry than in others using this approach. The use of the widely accepted Porter strategic model provides an appropriate framework for both inductive and deductive conclusions. In addition, it provides a tight linkage to the strategy literature for validity of the coding categories. Furthermore, the use of multiple coders and a referee insure a high degree of reliability in coding effort.

For each application, two coders independently coded each paragraph and the results entered into a spreadsheet for data management purposes. The results of the two coders were then compared, and, if there were any disagreement, the referee discussed the differences with each of the coders and made a final determination. For each application, a resultant tabulation was created and overlaid upon the fishbone for visual inspection. Figure 1 contains the total numerical count for the entire sample.

For purposes of these proceedings, we will limit our analysis to an explanation of the results based upon simple description. However, it is our intent to model the data utilizing Categorical Discriminate Analysis

CONCLUSIONS

Although banks have maintained that many frameworks used for analysis of other industries often do not work within the banking industry due to imposed regulatory constraints, Figure 1 reveals that the Porter Model does work well in examining the rationale behind the merger/acquisition activity for the banking industry. It can be seen from the Figure 1 that there are four main paths, for the period examined, that explains the reasons behind the mergers/acquisitions activity. These four paths are related to (1) creating economies of scales, (2) expanding geographically, (3) increasing the combined capital base (size) and product offerings, and (4) gaining market power.

It appears that decreasing costs rather than increasing gross revenue drives much of the merger activity at a higher level in Figure 1. Many of the applications stated the reduction of costs as a reason for the merger. In addition, many of the applications went further than a general statement of cost reduction explaining that the combined institution would create economies of scales that would result in a reduction in costs as justification for their merger/acquisition request. Utilizing the synergies between the two partners is a common phrase found throughout the applications. Often the smaller partner can combine with the larger partner developing economies of scale and, thereby, reducing their combined costs.

The remaining three paths are related to increasing gross revenue but at a much lower level on the fishbone framework. Many of the applications justified the merger either directly or indirectly by referencing the combined institution’s ability to expand geographically into markets that the individual institutions had not previously had a market presence. As a result, through the geographical expansion, the institution would be able to decrease total risk and increase product sales and, thus, increase overall gross revenue.

Many of the merger/acquisition either directly or indirectly justified their mergers through the fact that the combined asset base (size) would be larger and, thus, allowing the combined institutions to make loans to companies that the individual institutions could not have previously serviced due to capital base lending regulatory restrictions. In essence, the larger capital base allowed the merged institutions to offer a new product (jumbo loans) to an existing customer or to gain new customer through the new product offering. In addition, on the same path many of the applications justified the merger through the ability to offer a greater array of products. The smaller partner (usually) would be able to offer products already carried by the larger partner and that previously due to the smaller partner’s size they had not able to offer. In both cases, the merger would allow the combined institution to offer a greater product array increasing their sales and, thereby, increasing gross revenue.

The last path deals with the, often, indirect merger justifications of increasing market power. Through the merger, the merged institution would be better able to compete with institutions within their market, increasing their product sales, and, thus, their gross revenue.

As can be seen, much of our results reinforce the first two motivation theories proposed by Stewart: (1) merging to increase financial performance (net operating profits) and (2) merging to gain financial benefits through increasing the consolidated debt capacity (lending capacity for banks). Further analysis and research in this area will lend even further insight into the motivating reasons behind bank mergers and the resulting strategic benefits derived from the merger activity.

REFERENCES:

___________(1997) Global Custody: Get Big or Get Out-Global Custodians Have Been Consolidating with Gusto over the Year. What is Behind this Battle for Giant Status, and What Does It Mean for Clients? Investor’s Chronicle, (November, 14) n. 155,40.

Baradwaj,B.G, D.A. Dubofsky, & D. R. Fraser. (1992). Bidder Returns in Interstate and Intrastate Bank Acquisitions, Journal of Financial Services Research, 5, 261-273.

Benston, G. J., W.C. Hunter, & L.D. Wall. (1995). Motivations for Bank Mergers and Acquisitions: Enhancing the Deposit Insurance in Put Option versus Earning Diversification. Journal of Money, Credit, and Banking, (August), 777-788.

Boyd, J. & S. Graham. (1991). Investigating the Bank Consolidation Trend. Quarterly Review (Federal Reserve Bank of Minneapolis). (Spring), 3-15.

Chong, B. (1991). The Effects of Interstate Banking on Commercial Banks Risk and Profitability. Review of Economics and Statistics,73, 78-84.

Cornett M. M. & S. De. (1991). Common Stock Returns to Corporate Takeover Bids: Evidence from Interstate Bank Mergers. Journal of Banking and Finance.15, 273-296.

Cornett, M. M. & H. Tehranian. (1992). Changes in Corporate Performance Associated with Bank Acquisitions. Journal of Financial Economics. 31, 211-234.

Craig, B. (1997). Where Have All the Tellers Gone? Economic Commentary (Federal Reserve Bank of Cleveland), 1-4.

Hawawini, D.C. & I Swaey. (1990). Mergers and Acquisitions in the US Banking Industry.New York:Elsevier Science.

Hunter, W. C. & L. Wall. (1989). Bank Mergers Motivations: A Review of the Evidence and Examination of Key Target Bank Characteristics. Economic Review (Federal Reserve Bank of Atlanta). (September), 2-19.

Madura,J. & K.J. Wiant. (1994). Long-Term Valuation Effects of Bank Acquisitions. Journal of Banking and Finance. 18,1135-1154.

Palia, D. (1994). Recent Evidence on Bank Mergers. Financial Markets, Instituions, and Instrument, 3,37-59.

Porter, M. E. (1980). Competitive Strategy: Techniques for Analyzing Industries and Competitors, The Free Press, A Division of Macmillan Publishing Company, Inc., New York.

Nolan, Norton & Company.(1986). Introduction to NNC's Architecture Process, Boston.

Stewart, G. B.(1991). The Quest for Value A Guide for Senior Managers, Harper Business: New York,375-382.

Subrahmanyam, V., N. Rangan, & S. Rosenstein. (1997). The Role of Outside Directors in Bank Acquisitions. Financial Management, 26 (3), 23-26.

Toyne, M.F. & J.D. Tripp. (1998). Interstate Bank Mergers and Their Impact on Shareholder Return: Evidence from the 1990’s. Quarterly Journal of Business and Economics,37 (4),48-58.

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