M&A economics in financial services: the key issues

Mergers and acquisitions (M&A) in the financial services sector accelerated in the 1980s and 1990s. This was a consequence of regulatory and technology changes, together with the search for scale and scope economies on the part of financial firms, in addition to the search for a larger geographical footprint in the case of many firms. The result has been substantial consolidation among financial services firms which can be defined as those operating in commercial banking, insurance, asset management and securities. The process continues in the financial crisis of 2007-09, in many cases encouraged or forced by governments in the course of financial bailouts, and we can expect another M&A boom after the current financial hurricane blows over. 

by Professor Ingo Walter, director of SimCorp StrategyLab

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The M&A data are impressive. Figure 1 shows the total volume of M&A transactions in the financial services industry over two decades, from 1986 to 2008. Much of the volume is in the banking sector, followed by the insurance industry and investment banking. Worldwide, 75.4% of the deal-flow was in-market (similar firms acquiring similar firms) and the balance was crossmarket (for instance, banks acquiring insurance companies). The in-market proportion was higher in the US (83.9%) than in Europe (67.3%) during this period due to regulatory barriers that effectively prohibited US cross-market deals until they were liberalised in 1999. Figure 2 shows the M&A volumes specifically for the asset management industry, much of which involved the acquisition of asset managers by  commercial and universal banks as well as investment banks and insurance companies. The league tables of the world’s largest and most rapidly growing asset managers epicted in figure 3 shows the wide variety of firms involved – banks, insurers, broker-dealers and independent asset managers. Indeed, there are substantial differences in the structure of the asset management industry geographically – for example, figure 4 shows the importance of independent asset managers in the US, which is absent in Europe.

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Several basic questions arise in connection with the use of M&A as a tool for strategic development. Is bigger better? Is broader better? Who wins? Who loses? How does the result affect the stability and efficiency of the financial architecture? What are M&A deals supposed to achieve? The key questions are how a transaction is likely to affect each of the following variables: 

Revenue Gains

The classic motivation for M&A transactions in the financial services sector is ‘market extension’. A firm wants to expand geographically into markets in which it has traditionally been absent or weak. Or it wants to broaden its product range because it sees attractive opportunities that may in addition be complementary to what it is already doing. Or it wants to broaden client coverage for similar reasons. Any of these strategic moves is open to ‘build’ or ‘buy’ alternatives as a matter of strategic execution, and buying may in many cases be considered faster, more effective and/or cheaper than building. Done successfully, such growth through acquisition should be reflected in both the top and bottom lines in terms of the firm’s market share and profitability and maximises what practitioners and analysts commonly call ‘synergies’.

These come in three forms. First, clientdriven linkages may exist when a financial institution serving a particular client or client-group can, as a result, supply financial services either to the same client or to another client in the same group more efficiently in the same or different geographies. Second, geographic linkages are important when an institution can service a particular client or supply a particular service more efficiently in one geography as a result of having an active presence in another geography. Third, product-driven linkages exist when an institution can supply a particular financial service in a more competitive manner because it is already producing the same or a similar financial service in different client or arena dimensions.

Economies of scope attributable to crossselling arise when the all-in cost to the buyer of multiple financial services from a single supplier – including the cost of the service, plus information, search, monitoring, contracting and other transaction costs – is less than the cost of purchasing them from separate suppliers. Revenue-diseconomies of scope could arise, for example, through agency costs that may develop when the multi-product financial firm acts against the interests of the client in the sale of one service in order to facilitate the sale of another, or as a result of internal informationtransfers considered inimical to the client’s interests.

In addition to the strategic search for revenue synergies through M&A transactions, financial services firms will also seek to dominate markets in order to extract economic returns. By focusing on a particular market, merging firms could increase their market power and thereby take advantage of monopolistic or oligopolistic returns. Market power allows them to charge more or pay less for the same service. In many countries however, regulatory constraints tend ultimately to limit increases in market power. The key strategic issue is the likely future competitive structure in the different dimensions of the financial services industry. It is an empirical fact that operating margins tend to be positively associated with higher concentration levels (as are cost-to-income ratios).

Even without the complexities and integration costs that arise in mergers and acquisitions, it is often difficult for major financial firms to accurately forecast the value to shareholders of initiatives to extend markets, build market power, and achieve cross-selling successfully. This is one reason why m&a transactions systematically benefit the seller far more than the buyer in the financial services sector.

Cost Gains

Expected bottom-line gains attributable to M&A transactions are related to lower costs due to economies of scale and scope, or improved operating efficiency, usually reflected in improved cost-to-income ratios.

Whether economies of scale exist in financial services has been at the heart of strategic and regulatory discussions about optimum firm size in the financial services industry. Can increased average size of firms create a more efficient financial sector? Does increased size, however measured, by itself serve to increase shareholder value?

If economies of scale prevail, increased size will help create financial efficiency and shareholder value. If diseconomies prevail, both will be destroyed.

First, scale economies should be directly observable in cost functions of financial services suppliers and in aggregate performance measures. Many studies of economies of scale have been undertaken in the banking, insurance and securities industries over the years, and the consensus seems to be that scale economies and diseconomies generally do not result in more than about 5% difference in unit costs.

Inability to find major economies of scale among large financial services firms is also true of insurance companies and brokerdealers. For most banks and non-bank financial firms, except the very smallest, scale economies seem likely to have relatively little bearing on competitive performance. This is particularly true since smaller institutions are often linked together in cooperatives or other structures that allow harvesting available economies of scale centrally. Alternatively they may be specialists that are not particularly sensitive to the kinds of cost differences usually associated with economies of scale in the financial services industry. Megamergers are unlikely, whatever their other merits may be, to contribute very much in terms of scale economies.

Most serious discussions of scale economies in financial services focus entirely on firmwide scale-effects, although the really important scale issues are encountered at the level of individual financial services. There is ample evidence, for example, that economies of scale are both significant and important for operating economies and competitive performance in areas such as global custody, processing of mass-market credit card transactions and institutional asset management, but are far less important in other areas; in private banking and M&A advisory services, for example.

Unfortunately, empirical data on cost functions that would permit identification of economies of scale at the product level are generally proprietary and therefore unavailable. Still, it seems reasonable that a scale-driven strategy may make a great deal of sense in specific areas of financial activity even in the absence of evidence that there is very much to be gained at the firm-wide level. And the fact that there are some lines of activity that clearly benefit from scale economies while at the same time observations of firm-wide economies of scale are empirically elusive suggests that there must be numerous lines of activity where diseconomies of scale exist.

Second, cost economies of scope mean that the joint production of two or more products or services is accomplished more cheaply than producing them separately. ‘Global’ scope economies become evident on the cost side when the total cost of producing all products is less than producing them individually, while ‘activity-specific’ economies consider the joint production of particular services. On the supply-side, banks can create cost savings through the sharing of transactions systems and other overheads, information and monitoring cost, and the like. Cost diseconomies of scope may arise from such factors as inertia and lack of responsiveness and creativity that may come with increased firm size and bureaucratisation, ‘turf’ and profitattribution conflicts. These can increase costs or erode product quality in meeting client needs, or there can be serious cultural differences across the organisation that inhibit seamless delivery of a broad range of financial services.

Third and most important are operating efficiencies that are not related to either scale or scope. That is, financial firms of roughly the same size and providing roughly the same range of services can have very different cost levels per unit of output. There is ample evidence of such performance differences, for example, in comparative cost-to-income ratios among banks, insurance companies and investment firms of comparable size, both within and between national financialservices markets. The reasons involve differences in production functions, efficiency and effectiveness in the use of labour and capital, sourcing and application of available technology, and acquisition of inputs, organisational design, compensation and incentive systems; in other words, in just plain better management. Empirically, a number of studies have found very large disparities in cost structures among financial firms of similar size, suggesting that the way they are run is more important than their size or the selection of the business that they engage in. The consensus of studies conducted in the United States seems to be that average unit costs in the banking industry, for example, lie some 20% above ‘best practice’ firms producing the same range and volume of services, with most of the difference attributable to operating economies.

Diversification, Bailouts and Conflicts of Interest

One of the arguments for financial-sector M&A deals is that greater diversification of income from multiple products, client groups and geographies creates more stable, safer, and ultimately more valuable institutions. Symptoms should include higher credit quality and lower cost of financing than faced by narrower, more focused firms. Certainly, the failure of any major financial institution that is the product of mergers could cause unacceptable systemic consequences. Therefore the institution is virtually certain to be bailed-out by taxpayers – as has happened in the case of comparatively much smaller institutions in the United States, Switzerland, Norway, Sweden, Finland, and Japan during the 1980s and 1990s and again in the global financial crisis of 2007 - 09. Consequently, too-big-to-fail (TBTF) guarantees create a potentially important public subsidy for the kinds of large financial organisations that often result from mergers.

The potential for conflicts of interest is endemic to multifunctional financial services firms. The conflict of interest issue can seriously limit effective strategic benefits associated with financial services M&A transactions. For example, inside information accessible to a bank as lender to a target firm would almost certainly prevent it from acting as an adviser to a potential acquirer. Entrepreneurs may not want their private banking affairs dominated by a bank that also controls their business financing. A mutual fund investor is unlikely to have easy access to the full menu of available equity funds though a universal bank offering competing in-house products. These issues may be manageable if most of the competition is coming from other universal banks. But if the playing field is also populated by aggressive insurance companies, broker-dealers, asset managers and other specialists, these issues will prove to be a continuing strategic challenge to the management of a bank.

Finally, it can be argued that the shares of multi-product firms and business conglomerates tend to trade at prices lower than shares of more narrowly-focused firms, all other factors being equal. There are two basic reasons why this ‘conglomerate discount’ is alleged to exist. The first is the argument that, on the whole, conglomerates tend to use capital inefficiently due to management discretion to engage in value-reducing projects, cross-subsidisation of marginal or loss-making projects that drain resources from healthy businesses, together with misalignments in incentives between central and divisional managers. A second possible source of a conglomerate discount is that investors in shares of conglomerates find it difficult to ‘take a view’ and add pure sectoral exposures to their portfolios. Investors may avoid such stocks in their efforts to construct efficient asset-allocation profiles. This is especially true of highly performancedriven managers of institutional equity portfolios who are under pressure to outperform cohorts or equity indices. So the portfolio logic of a conglomerate discount may indeed apply in the case of a multifunctional financial firm that is active in retail banking, wholesale commercial banking, middle-market banking, private banking, corporate finance, trading, investment banking, asset management and perhaps other businesses. Shares in a financial conglomerate represent an ownership interest in a broad range of businesses - as do shares in a closed-end mutual fund.

Summing-up

Taken together, the evidence suggests limited prospects for firm-wide cost economies of scale and scope among major financial services firms. Operating efficiency seems to be the principal determinant of observed differences in cost levels among most types of financial institutions. Demand-side economies of scope through cross-selling may well exist but are likely applied very differently to specific client segments and can be vulnerable to erosion due to greater client promiscuity in response to sharper competition and new distribution technologies. And while larger size may make a firm too big to fail or ‘systemic’, recent experience during the financial crisis shows this as hardly an unmixed blessing – quite apart from the conglomerate discount that may adversely affect the share values of large and complex financial firms.

Ingo Walter (Ph.D.) is director of SimCorp StrategyLab, Seymour Milstein Professor of Finance, Corporate Governance and Ethics and serves as the Vice Dean of Faculty at the Stern School of Business, New York University.