Chapter 3
The economics of bank mergers
3.1
There are essentially four main views about the motivations for bank
mergers.[1]
-
The first is that it is about improving the efficiency of banking
by realising economies of scale and economies of scope or allowing banks to
meet the borrowing needs of increasingly large corporations.
-
The second is that it is motivated by increasing market power
(and hence profits), which will be reflected in lower interest rates on
deposits and/or higher interest rates on loans.
-
The third motivation is that banks may seek to merge in order to
reach a size at which they are 'too-big-to-(be-allowed-to)-fail'. There is
evidence that ratings agencies and markets believe that large banks are more
likely to be assisted in a crisis than small banks.[2]
-
The final view is that mergers are largely ego‑driven, with
bank management seeking the greater prestige and salaries that come from
running a larger organisation.[3]
(There are also defensive advantages in getting larger. It makes the bank less
likely to become a takeover target itself, thereby protecting the CEO's
position.)
3.2
It is only if the first reason is dominant that mergers may be in the
public interest rather than just in the interests of the bankers. This chapter
therefore concentrates on the evidence for economies of scale and scope in the
international economics literature. The latter part of it addresses the
question of whether a 'contestable' banking market allows greater concentration
without banks increasing their margins.
Economies of scale in banking
3.3
Very small independent banks may well be inefficient. In terms of costs,
it would not be desirable for every suburb or town to have its own bank
developing bespoke computer systems (including for internet banking),
advertising, training staff and so forth. One response would be for the
individual banks to buy these services from specialist providers or form
syndicates to provide some of them.[4]
But in most cases the model adopted has been for banks to spread these costs
across a number of branches around the country. This also has the advantage
that if a particular town is struck by a specific problem – a natural disaster
or the closure of a large factory – the soundness of its bank will not be
affected. Further diversification across different types of banking activity
may be a further advantage.
3.4
It is also argued that, especially with prudential rules limiting large
exposures to set proportions of capital, making large loans is only open to
large banks. A variant of this argument is that large banks can be 'national
champions' able to compete in international commercial markets, or develop a
significant retail presence in emerging banking markets such as China. This
view has been put by the four major banks in arguing that no restrictions
should be placed on their ability to undertake further mergers:
To put it bluntly, the Australian majors need scale to compete
with global banks...But the four pillars policy materially constrains us, both
domestically and offshore...Westpac often finds itself competing against
organisations 10 times our size. So no one should be too surprised when we do
not feature in the “mega-deals”. Size does matter when it comes to lead bank
roles and taking on the exposures involved.[5]
If Australian banks are to compete internationally, they will
need to grow substantially. Scalability is important for operating in global
markets, in which Australian banks are relative minnows.[6]
3.5
The four major Australian banks ranked between around 40th
and 60th in the world by size of assets and capital in The Banker's
2009 survey.[7]
While this is well up on the 75th to 105th places they
held a quarter-century ago, it still leaves them well short of the world's
leading banks. A merger between two of the major Australian banks would not
create a bank in the global top twenty. Indeed a merger of all four majors, giving
virtually a domestic monopoly, would be needed to create a bank in the global
top ten, or with a capital base comparable to that of the leading Chinese banks.[8]
3.6
Nor is it obvious that domestic mergers would make Australian banks more
effective global competitors:
It has been convincingly argued that, in many cases, domestic
rivalry rather than national dominance is more likely to breed businesses that
are internationally competitive.[9]
3.7
As Professor Davis points out:
...the ability of a much smaller local bank (Macquarie) to
compete in international investment banking, securities and wholesale markets
would appear to weaken the argument, and suggest that ‘culture’ may be a more
important issue than domestic commercial banking scale.[10]
3.8
Moreover, there are also disadvantages from banks becoming too large.
Many customers believe that large banks lose touch with their communities.
Local managers may be transferred interstate and not know their customers and
their business. The perception that larger organisations give poorer, or less
personal, service may be one reason why there is often a loss of a smaller
bank's customers when it is taken over by a larger bank.[11]
An industry rule of thumb is that typically about 5 per cent of the target
bank's retail customers will transfer their business elsewhere as a result of a
takeover.[12]
This accords with the experiences of some local bank workers:
Every takeover I have been subjected to has lost
business...When Trust Bank was bought out by Colonial, then CBA, we had an
enormous amount of clients say, ‘Well, if I wanted to bank with the CBA, I
would already have been with them,’ and they leave—over a period of time,
because it takes a fair bit of effort to change banks.[13]
3.9
As banks become larger and more complex, it becomes much harder for head
office management to keep control of the risks being undertaken. There have
been high profile cases of 'rogue traders' from large banks operating in
complex derivatives markets causing huge losses.
3.10
Furthermore, even when mergers offer the potential to reduce
costs, these gains may be hard to realise. Incompatibilities in computer
systems are a common problem but there can also be significant challenges in
reorganising management and dismissing excess staff while maintaining focus and
morale, and merging institutional cultures.[14]
One Japanese bank, some years after forming from a merger, had three HR
departments, one for those staff from one of the constituent banks, one for
those from the other and a third looking after staff who had joined since the
merger.
3.11
The Australian Bankers' Association suggest 'a merger is assumed to
offer benefits in terms of economic scale efficiency'.[15]
But the available evidence questions this assumption.
Evidence on economies of scale
3.12
An indication of the extent of economies of scale is given in Chart 3.1,
which summarises data from Australian banks, building societies and credit
unions. The horizontal axis shows the size of institutions (measured by assets,
on a log-scale so that small credit unions and the large banks both fit) and
the vertical axis shows operating (ie excluding interest and write-offs) costs
as a percentage to assets. If the operations of financial institutions were
dominated by economies of scale the observations should lie around a
downward-sloping curve. For the credit unions, this seems to be the case. But
for the larger banks, the curve flattens: St George's operating costs were
already a similar proportion to assets as the four major banks, even before its
merger with Westpac. The chart does not therefore suggest that mergers of large
banks are likely to generate significant gains in efficiency.[16]
Chart 3.1:
Australian financial intermediaries: size vs efficiency
Source: Secretariat, based on
data in KPMG, Financial Institutions Performance Survey 2008.
3.13
This result is consistent with empirical studies which have attempted to
ascertain at what point the advantages of increasing the size of banks start to
become outweighed by the disadvantages. A study by two BIS economists found
that in some parts of the world, the average large bank had lower operating
costs relative to assets than did the average small bank, but in other regions
the small banks actually had lower average costs. However, despite these
general results, there were many small banks with costs/assets ratios which
compared favourably with the average large bank. In terms of profitability:
...smaller rather than larger banks were more profitable [on
average]...mainly because larger banks...included a greater number of loss‑making
institutions (especially in Asia). Larger banks, however, have an advantage in
returns on capital, because they are generally able to operate with smaller
capital relative to the size of assets.[17]
3.14
Surveying the literature, they observe:
Recent econometric evidence on gains from mergers is therefore
often weaker than the claims of the merging institutions. Some empirical
studies found... economies of scale could be exhausted at relatively low levels.[18]
3.15
Subsequent studies continue to give at best very weak support to the
efficiency gains from mergers, other than those between small banks. Some
recent surveys of the literature found:
...findings of previous studies are consistently pessimistic.
There is generally a lack of improvement in firm performance as a result of
mergers.[19]
...little evidence that there are significant economies
of scale or scope in banking at the institutional level.[20]
...the evidence for such cost economies arising from mergers in
the financial services sector is at best ambivalent. Most studies of financial
intermediaries, especially banks, show constant returns to scale over large
ranges of output. The evidence for economies of scope is more encouraging but
only slightly.[21]
...the bulk of empirical research shows no evidence of
efficiency gains from bank mergers.[22]
...although some consolidations improve cost efficiency, others
worsen the performance of the combined institutions. The net effect across all
institutions is no significant gain in cost performance...many studies conclude
that substantial economies of scale exist, but only up to a relatively small
size. While there is a wide variation in the exact size of this cut-off point,
the largest Australian banks are clearly above this point.[23]
...the available research literature seems to suggest that
increasing bank market concentration and consolidation tend to drive loan rates
up...[24]
Overall, there appears to be little evidence...that very large
banks gain substantial cost savings from increased scale or product
diversification...[25]
In general, most studies find only small economies of scale
in a [financial] firm’s cost structure. In those studies that find evidence of
increasing returns to scale, the measured economies of scale seem to be
stronger in small to medium-sized firms than for large firms.[26]
...consolidation in the financial sector is beneficial up to a
relatively small size in order to reap economies of scale, but there is little
evidence that mergers yield economies of scope or gains in managerial
efficiency.[27]
3.16
Similar results were obtained in two recent econometric studies of Australian
banks:
For those four major banks that are found to operate over the
range of diseconomies of scale, mergers among them will inevitably result in
much lower efficiency in the consolidated banks and the overall banking sector.[28]
Decreasing returns to scale set in very quickly at less than
$10,000 million: almost all medium size and large banks exhibit decreasing
returns to scale. This suggests a question mark over the economies of scale
claimed at times by the proponents of mergers between the largest banks.[29]
3.17
Another reason why mergers may lead to reduced efficiency is that they
may lead to banks that are too big to be allowed to fail. This reduces
discipline on the banks. As one regional bank put it:
It is always the case that any institution considered too big
to fail will lose internal discipline whilst parties dealing with that
institution act as if that institution has a guarantee from the government.
This becomes a self‑fulfilling prophecy, with that institution gaining an
unfair advantage in the risk-return tradeoffs, while its internal disciplines
deteriorate until we have a situation like the recent US or UK experience.[30]
3.18
Another indication that bank mergers often fail to generate improved
efficiency is the reaction of stock market valuations to them. Here most
studies fail to find the market rewarding banks, either at the time the
takeover is announced or after it has been realised. For example, Buckley and Rayna (2001) examined Westpac's takeover of Bank of Melbourne and found that
while the takeover led to increased returns on Bank of Melbourne shares, it led
to decreased returns on Westpac shares. Surveys of other studies of bank
mergers conclude:
The main finding of the event studies looking at share prices
around the time that a deal is announced is that, on average, total shareholder
value (ie the combined value of the bidder and the target) is not affected
by the announcement of the deal, since, on average, the bidder suffers a loss
that offsets the gains of the target.[31]
...traditional studies fail to find conclusive evidence that
bank mergers create value.[32]
...[study] finds a strong negative share price reaction
following the acquisition.[33]
Economies of scope
3.19
Merging banks with differing foci, or merging a bank with another type
of financial institution, may allow cross-selling of products; such as selling
insurance to customers with bank accounts. It may allow a reputable brand name
to be used to sell more products (albeit at the risk of diluting the value of
the brand). A humble bank branch may become a 'one stop financial shop'.
3.20
However, bringing together different types of financial institutions
involves more difficulties in blending corporate cultures. It creates
organisations which are harder to manage and harder to assess, and may give
rise to conflicts of interest which 'Chinese walls' may not always effectively
address (e.g. a bank simultaneously lending to a company, underwriting its
securities and investing its customers' superannuation in the company's
shares). Empirical studies have generally found economies of scope to be
relatively small.[34]
3.21
The impact of the formation of financial conglomerates on financial
stability is unclear, reflecting conflicting forces:
These are diversification, which will reduce the probability
of individual bank failure, and contamination, which can lead to contagion
flowing from failures in non-core banking activities.[35]
Concentration, contestability and interest margins
3.22
The empirical literature on the relationship between concentration and
interest margins is surveyed in Northcott (2004). There are many studies which
suggest that more concentrated banking systems are associated with higher
interest rates being charged for loans and lower rates being paid on deposits.
In some cases, the results are not robust after controlling for other factors.
In particular, low barriers to entry reduce the impact of concentration on
interest margins. There do not seem to be any studies arguing that interest
margins are narrower in more concentrated systems. The survey also refers
to studies showing that more competitive banking systems tend to be more
efficient.
3.23
Concentration ratios are only one aspect of assessing the competition
within the banking market. The similarity of interest rates is not a good
guide: while banks generally charge very similar rates for housing loans, this
could be a sign either of a cartel or of very strong competition. Looking at
how changes in interest rates charged move with the banks' costs of funds might
suggest that the housing market is reasonably competitive but not the credit
card market. One way the market can be made more competitive is by making it
easier for customers to move between banks, and the Government is currently
addressing this.[36]
3.24
Bank mergers, even if they lead to high concentration, will not harm
consumers if it is easy for new banks to enter the market in response to any
high profits observed. This is known as a 'contestable' market, and will mean
that high concentration will not be associated with excessive profitability.
3.25
One factor that has made the Australian banking market more contestable
is that the authorities no longer artificially restrict the number of banking
licences. As Valentine and Ford (2001, p 42) put it, banking licences used to
be like taxi licences but are now more like driver's licences.
3.26
Another change is that the rise of internet banking means there is less
need to establish a physical 'bricks and mortar' network of branches in order
to compete in the retail market. ING Direct is an example of a new bank that
primarily operates in Australia via the internet:
Apart from Government obligations, banking is now a much more
contestable market. In the past, banks derived considerable advantage from
having extensive branch networks that made it expensive for new entrants to
duplicate. The emergence of the Internet, electronic banking and emergence of
the loan and equipment finance broking industry has eroded this advantage.[37]
3.27
Nonetheless, generally the most successful banks have had both branches and
an online presence – the 'clicks and mortar' model. This is illustrated by the
way the major banks, having reduced their branch networks in the 1990s, are now
expanding them again.[38]
3.28
The ACCC's view is that:
...the barriers to large scale national entry for all retail
banking products are high and are particularly significant for branch-centric
products...current credit conditions have had the effect of raising barriers to
entry for lenders. In particular, the closure of securitisation markets and the
increase in the cost of credit has meant that many non-bank players have exited
lending markets...the high degree of customer ‘stickiness’ for many retail
banking products may further increase entry barriers...it is often difficult and
time‑consuming for a customer to compare one product with another. In
addition,...the inconvenience and, in some cases financial cost
(e.g. mortgage exit fees), may deter switching.[39]
3.29
Choice does not regard the Australian banking market as very
contestable:
The structure of the Australian banking market is such that
there are significant hurdles for new entrants. This includes incumbents’
branch network size, a payments system based on bilateral relations and the
obstacles to consumer switching only partly alleviated by reforms instigated by
the Treasurer in 2008. By its own admission BankWest was only able to enter the
market because of the backing of a very powerful parent company (HBOS) and
because pricing in the Australian market was uncompetitive. But BankWest has also
acknowledged that complex and cumbersome switching procedures make it difficult
to gain market share.[40]
3.30
Dr Jones characterises the experience of the foreign bank entrants in
the 1980s as illustrating the barriers to entry in Australian retail banking:
The entrants were sizeable entities, but all found entry into
retail (and small business/family farming) banking hampered by the expenses of
duplicating the extensive branch network (recently compounded by the added
capital expense of ATM installation) that characterises trading bank operations
in Australia. Most of the entrants declined the prospect and the few who did
were burnt.[41]
3.31
A contrasting view is put by the Australian Bankers' Association:
While banking has long been viewed as an industry
characterised by high barriers to entry, evidence now shows that these barriers
have fallen considerably... In the past, banks derived considerable advantage
from having extensive branch networks that made it expensive for new entrants
to duplicate. The emergence of the Internet, electronic banking and emergence
of the loan and equipment finance broking industry has eroded this advantage.
There is clear evidence in the banking market that some foreign-owned
subsidiaries with a retail presence have managed to build large deposit and
lending books without extensive branch networks...new entrants can purchase
off-the-shelf credit scoring software that will enable them to accurately
assess credit risk without needing extensive historical information.[42]
3.32
The ABA claims repeatedly in their submission that:
...academic studies have shown that there is no correlation
between bank concentration and competition...[43]
3.33
However, there is a distinction between saying that concentration is not
the only factor that determines competition in a market, and that increasing
concentration will not reduce competition in that market.
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