A story in Thursday’s Financial Times, “,” by Peter Thal Larsen describes why most bank mergers fail to live up to their promise.
Even though the srticle was prompted by the possible Barclays-ABN Amro merger, its logic applies to much smaller deals. Most advocates of banking deals tout greater economies of scale as their main advantage. Yet these efficiencies are seldom achieved in practice. Indeed, look at Citigroup itself: it has announced a planned staff reduction of 15,000 because its expenses are out of line.
The FT article focuses on big, international banking mergers, which are understandably suspect (it’s hard to imagine how efficient one could become dealing with multiple regulatory regimes and national differences in product demand and marketing approaches). Surprisingly, the FT story fails to note that bigger banks appear to be no more efficient even in homogeneous markets.
It has been well known within the US banking industry for quite some time (see for an example) that it exhibits a slightly increasing cost curve once a certain threshold is surpassed. That means that bigger banks have higher costs per unit of output.This finding has been confirmed repeatedly in academic studies; the only difference among them is the level at which the cost inefficiencies start, but no study had found it to be higher than $5 billion in assets.
There has been some speculation as to why larger banks are not as efficient as their smaller brethren. One theory is that credit decisions, like small business lending and mortgages, are done perhaps a bit better by branch staff who know their communities rather than by credit scoring systems and multi-level reviews. Another argument is that there really are economies of scale within various products, but they are offset by diseconomies of scope. In essence, bigger banks are in more products than smaller banks, and the cost of being in so many businesses offsets the advantage of being “big” in any one business.
Proponents of bank acquisitions, particularly in the US, may still take exception. Haven’t those big bank mergers taken out a lot of costs, and in particular, closed a lot of branches? Ah, yes, but the process of integrating two banks in and of itself is costly, meaning there are offsets (like IT integration) for the more visible sackings. And the increasing cost curve for the industry says any cost reduction could have been achieved without a merger. But for some reason, managers find it easier to cut heads in the wake of a deal.
So what is the real impetus for these deals? I see at least three causes. One, per the Barclay’s example, there is almost a romantic attachment to size as a proxy for leadership or quality. This view may be even stronger in the banking industry than in others, because in banking, one’s power is based on the span of operations one oversees (unlike investment banking, where power is based on revenue generation).
Second is Wall Street’s pressure for growth. Now if you are as big as Citigroup, growth beyond a very modest rate is an unrealistic expectation. If Citigroup were to exhibit high growth, it would very soon be bigger than world GDP. Very large companies inherently can’t exhibit much growth. But an acquisition does make even very large companies bigger, and you have at least two years of the analysts focusing as much on how the acquisition as on top line growth.
Third is that CEO pay in the banking industry is correlated with the size of the bank. So acquirers get to pay themselves more, and the CEO of the target gets a golden parachute. A win-win for everyone but the shareholders.
From the FT:
Shortly after John Varley took over as chief executive of Barclays in 2004, the bank’s top managers started using a new term to describe the scale of its ambitions. The idea, which they dubbed T5, was that Barclays should think and compete as if it were one of the top five banks in the world….
But if Barclays succeeds in buying ABN Amro of the Netherlands, Mr Varley and his team will need a new target. Based on current share prices, the combined group would be worth around $177bn (£90bn, €132bn) and would displace JPMorgan Chase as the fifth largest bank in the world…
The question, however, is whether this is a good idea. Many banking executives argue that large institutions benefit from economies of scale, especially in their use of information technology; have larger balance sheets that allow them to take on more risk; and produce an earnings stream that is more diverse and therefore more stable. But that case is unproven. Despite a decade of banking mergers, there is no evidence that big banks are any more efficient or profitable than their smaller rivals.
This is reflected in their share prices. In the past few years, the world’s largest banks have tended to trade on lower earnings multiples than smaller institutions. “When it comes to asking the stock market whether bigger banks are better, the current answer is a resounding ‘no’,” analysts at Citigroup wrote in a study published last year.
A prime example of the argument that big banks do not necessarily outperform is Citigroup itself. When Citicorp and Travelers combined in 1998, the merger seemed to herald the era of giant financial institutions that could offer a full range of financial services products anywhere on earth….
Nine years on, the reality has fallen some way short of the original vision. Citigroup’s idea of selling insurance products to banking customers failed to take off and it eventually spun off its insurance arm. Regulatory setbacks in the US, Europe and Japan rattled investors and raised questions about the ability of the bank’s management team to keep tabs on such a broad and diverse business…
The history of ABN Amro also offers a cautionary example that building a universal bank does not always work. Ever since it was created through a domestic merger in 1991, the Dutch lender has been eagerly expanding outside its home market, buying banks in the US, Brazil andItaly, while also building up its investment banking, private banking and asset management businesses.
But despite assembling this array of assets, it has failed to deliver any sustained growth in profits in recent years. It was not until The Children’s Investment Fund (TCI), the activist hedge fund, last month launched its campaign to shake up ABN Amro that the bank’s shares rose above the level they stood at in the spring of 2000.
ABN Amro’s performance is often blamed on poor management – and there seems little question that the bank could be better run. Stuart Graham, an analyst at Merrill Lynch, calculates that if ABN Amro’s ratio of cost to income were in line with that of its peers, profits would be 37 per cent higher.
Barclays’ management team would be likely to improve performance. But an alternative argument is that ABN Amro does not make sense in its current form and should be broken up, with its various subsidiaries sold to banks that could manage them better. Investment bankers are trying to assemble consortia that could offer to buy the whole of ABN Amro and, if successful, carve up the businesses among themselves.
In this context, Barclays’ talks with ABN Amro mark a critical moment in the development of the industry. If the deal goes ahead and is a success, it could transform the banking landscape, triggering a string of similar deals among European institutions as they rush to bulk up.
Yet if Barclays is outbid by a rival that splits ABN Amro into different parts, investors could rethink the value of large banks – and increase the pressure on those institutions that havedone big deals in the past to prove they really are worthmore than the sum of their parts.
Until a few years ago, most banking executives agreed that cross-border economies of scale in banking were limited to a handful of areas. The first of those is investment banking, because the corporations and institutional investors that are their main clients are likely to operate across borders. The second is in areas such as asset management, where the skills of fund managers can be centralised in “factories” and the products can be distributed to clients in different countries. The third is in mass retail products, including credit cards, which require huge investments in information technology but where the product is similar in different countries.
More recently, however, European banks have also begun to maintain that cross-border deals can make sense in retail banking. The first bank to explicitly make this case was Spain’s Santander, which bought Abbey National of the UK in 2004. Santander executives argued that they could cut Abbey’s costs by switching its IT systems to the Spanish bank’s proprietary platform, called Partenon. This suggested that big banks, which have the resources to develop state-of-the-art IT systems, would have an advantage when buying up smaller rivals, even in another country.
Other banks promptly followed suit. In several cross-border European deals, executives were proclaiming that – among other factors – the switch to a common IT platform could help to justify the costs of the acquisition. This argument is still unproven. Though Santander has cut costs at Abbey, it has done so largely through a greater than expected level of redundancies. Santander still expects to reap further benefits by introducing Partenon in the UK but it is not yet clear that this will make operations more efficient.
Another factor that could work in large banks’ favour is the introduction of new global rules for measuring banks’ capital. The framework, known as Basel II, allows banks to determine how much capital they need based on their internal risk management models. Over time this should allow big banks, which can afford to spend heavily on developing risk management systems, to operate with proportionately less capital than smaller rivals.
Yet all these benefits may also be available to medium-sized banks. While it seems clear that a bank with a market value of $10bn has access to capital and systems that a bank with assets of just $1bn does not, it does not necessarily follow that a bank valued at $100bn has the same kind of advantage over the $10bn bank.
Indeed, while size may offer some benefits, it can also introduce complexity into a business that makes it harder to manage effectively. HSBC is widely regarded as one of the world’s best-run banks, with operations in more than 80 countries. But even it was caught by surprise by the sudden decline in the US subprime mortgage market.
Whatever the arguments, the data suggest there is no evidence that big banks are better. Last year analysts at Citigroup measured the efficiency and profitability of a large group of banks relative to revenues and the size of their balance sheets and concluded there was no relationship between the two. They also calculated that big banks’ earnings were no less volatile and that, while they were better able to diversify risk, this applied to any bank with a market capitalisation of more than $20bn…
A key question is how the stock market values large banks. At the moment they generally trade at a discount to smaller institutions, suggesting that really big mergers are less attractive. However, this may be due to takeover speculation as well as to the growing influence of hedge funds, which tend to steer clear of large-cap companies in favour of smaller businesses that have a better chance of outperforming the index. If credit conditions were to tighten, investors would probably rush back to big banks as a safer place to put their money.
Others argue that the poor share price performance of Citigroup and HSBC in recent years is a reflection of specific problems at those banks that have nothing to do with their size. “Why do investors not like HSBC? It’s because they had a surprise and their earnings growth was disappointing,” says one executive. “It’s got nothing to do with whether they are big or small.”
Yet the longer the discount persists, the more pressure big banks will face to find a way to realise their true value. It is hard to pick apart a complex, regulated institution like a big bank – particularly if it does not particularly want to be broken up. But TCI’s campaign for change at ABN Amro has paid off handsomely. It is not too far-fetched to imagine TCI, or another activist, seeking to put similar pressure on other big institutions