Do Merger and Acquisition of Banks Lead to Value Creation: US and EU Firms - Dissertation Example

?Executive Summary The current financial crisis has put a lot of question marks over the ability of the banks to perform effectively. A decline in performance of the banks therefore can make them an effective target for takeover and mergers. Evidence from US and EU suggest that mergers and acquisition activity has been on the rise since last few decades however, despite such an increase in the rise of activity, firms are not being able to reap the required benefits. Mergers and Acquisitions are often done on the promise that they will result into improvement in efficiency as well as increase in market power. Both of them therefore can translate into value creation for the firms. Literature however, suggests mix results as mergers and acquisitions in EU and US wide level may not have been able to provide desired results. This proposal is about exploring whether the EU and US banks have gained the benefits of mergers and acquisitions in terms of value creations. Contents Executive Summary 1 Contents 1 Introduction 2 Literature Review 4 Methodology 11 Data & Sampling 13 Chapter Headings & Subheadings 14 Conclusion 15 References 16 Introduction The current financial crisis engulfing the whole developed world has made financial institutions specially banks more vulnerable to takeovers and mergers. The constant decline in the performance of banks and resulting negative attitude of investors has made banks a lucrative target for acquiring. Banks work in a highly regulated and supervised environment therefore the number of stakeholders is generally higher as compared to other industries. The failure of the banks therefore can create significant political as well as economic issues. It is because of this reason that the banks are often put through the phase of consolidation in order to strengthen their equity base so that they can sustain external shocks. The implementation of regulatory environments such as Basel II and III is also considered as a step ahead in highlighting the importance of protecting the banks from complete failure. The current crisis resulted into the acquisition of banks not only by the respective governments but by the private equity firms also. This tendency therefore outlines that the merger and acquisitions within the banking industry can be one of the healthiest signs as the same can allow banks to strengthen their equity base and become more responsive towards external shocks. Consolidation either through the mergers or acquisitions is often done with the purpose of achieving greater market power, expense reduction as well as scope and scale economies. These gains therefore also believed to be translated into the value creation proposition for the firms. As such there are two important implications of the bank mergers in terms of value creation i.e. whether the merger will create value for the shareholders of the banks or whether it will fail to translate those gains into credible and sustained value creation for the shareholders of the banks. This proposal will therefore outline the proposed research study on the performance of banks after their consolidation in Europe and US and how it has translated into value creation. Primarily, the proposed research will focus upon performance of banks in their post consolidation phase and whether such efforts actually result into improvement in performance. Literature Review Banks are considered as one of the highly regulated industries with multiple supervisors supervising different aspects of the banks. Since failure of the banks has a direct impact on the overall financial system of a country, it is therefore always considered as desirable to have stable and strong banking sector. There are different reasons as to why banks merge with each other and some of them are also similar to other industries. One of the key reasons as to why banks merge with each other is to increase their efficiency, achieve economies or expand into new and existing markets. These motives therefore allow banks to look for opportunities to consolidate and become bigger in size to effectively challenge the competition. One of the key assumptions or arguments therefore put forward by the banks while merging or consolidation is based upon the argument that by reducing the expenditure and laying off the staff, they can reduce the expenditure and increase profitability. This promise seems to be more attractive for the shareholders as they tend to view it more favorably despite the fact that such promises often disappoint capital market expectations. (Akhavein, et al. 1997) Another important reason as to why banks merge with each other and look for consolidation is the creation of synergies. Through consolidation, it is generally believed that the banks by creating synergies can actually leverage them through financial production innovation which can ultimately increase their revenue and profitability. Bank consolidation can also take place due to regulatory acquiescence as it is generally argued that the different regulators view the industry differently. One hypothesis which is common among the regulators is that the banking industry is already overbanked. This notion therefore outlines that it is more prudent to consolidate the banking sector rather than leaving the vulnerable banks to market forces. Such policy initiative therefore forces regulators to advocate for the consolidation of the banking industry at the domestic as well as international level. After the creation of single market within EU and globalization effects, banks become the center of attention because the capital mostly flew through the banks. Such free movement of funds through banks also resulted into drastic increase in the profitability of the firms. These trends therefore also increased the pace of mergers and acquisitions within the European Banking sector despite the fact that monetary policy of EU was consolidated through the creation of European Monetary Union or EMU. (Molyneux, et. al, 1994) It has been argued that the banking sector in EU has changed a lot owing to structural changes taking place since 1980s. The rapid changes in the banking industry of Europe have mostly been due to the improvement in technology, de-regulation as well as harmonization of the financial institutions at the EU wide level. The focus on creating a central monetary union as well as the implementation of risk accords such as Basel II has made it important for banks to actually look for ways to meet such challenges. The overall mergers and acquisition drive in EU remained at high level during past few decades as 18 of the 30 large banking institutions in EU developed as a result of M&A activity. This drive has been mostly due to focus on universal banking and hence megabanks were created to ensure that banks successfully meet the universal banking requirements of their customers. The academic emphasis on studying the mergers and acquisition of banks has almost come from US. Most of the studies on the topic are based upon US banks with little or no evidence of academic work on the mergers and acquisition activities of European Banks. (Calomiris & Karenski,1996) There are three different approaches which have been utilized in order to study the mergers and acquisition strategies. These studies are most events based studies and consider M&A as dynamic events. These three studies include dynamic efficiency studies, operating performance studies as well as the event studies. The approach also has been focused upon tracing the pre and post merger performance of the banks. Traditional view of the value creation of the mergers and acquisition strategy is based upon the notion that value can be created if the value of the post-merger firm is more than just the simple arithmetic sum of the values of two pre-merger firms. This traditional view is therefore based upon outlining as to how value can be actually measured and quantified in terms of evaluating the pre and post merger scenario. This traditional view is based upon the notion that there will be improvement in performance after the merger and hence the improvement in performance will lead to the creation of value. There are two important scenarios which have been discussed in the literature regarding the value creation process after M&A activity. It has been argued that value can be created either through the enhanced market power or through cost efficiency. The source of value gains in a post merger scenario therefore may stem different reasons and each individual firm may be focusing upon one or different aspects of the sources as the valid claims for going into mergers and acquisitions strategy. One of the common sources which can translate into value creation is the cost efficiency to be achieved in a post merger scenario. Value creation in a post-merger scenario can occur on the assumption of greater efficiency. Cost efficiency can be achieved through cost synergies or reduction of the cost which can occur better combination of production factors. Cost efficiencies can be achieved through the cost complementarities, economies of scope as well as scale. Banks when merge with each other often gain cost efficiencies either through the transfer of technology, skills as well as procedures which can allow banks to become more effective in achieving the cost efficiency. (Peristiani, 1997), Market power is defined as the ability of the firms to decide on the price and increased market power therefore make the firms dominating enough to set the prices in the market. Literature also suggests that there is a positive correlation between prices and the local market shares however there is a little significance of same in international market. Value creation through enhanced market power therefore is often limited to the mergers and acquisition activity taking place at the domestic level rather than at the international level. Banks can influence the prices after merger either through reducing the prices to force the exit of non-competitive players from the market or increase the prices if market is relatively non-competitive in nature. In both the cases, M&A activity, theoretically, can allow a bank to dominate or circumvent the prices at the domestic level. (Berger A., et al., 1993) Some studies also suggested that despite consolidation of the sector and increase in the concentration ratio of the industry, banking firms are losing their ability to influence the market. This has been due to expansion of the market and systematic opening up of international markets thus diluting the overall market influencing power of banks gained after mergers and acquisition. Studies on measuring the impact of M&A on stock market values track the changes in the stock market value of the acquiring and target firms. These values are subsequently adjusted for the changes in the overall market value of the stocks after the announcement of merger. This approach therefore is also focused upon identifying the present value of the expected changes in the cost efficiency as well as the market power of the firm. Though theoretically, it may be not possible to separate the impact of each on the market prices however, it is generally assumed that M&A activity can always result into an increase in the market power of the firm. Studies performed in M&A taking place in US during 1980s however, do not show encouraging results as there was no increase in the shareholder value for the acquiring as well as target firm. Since in a merger the loss of target firm’s shareholders is a gain of acquiring firm’s shareholders therefore there only occurs transfer of wealth. This transfer of wealth therefore may not result into an exact increase in the shareholder value. Studies conducted during 1990s however, show favorable results as abnormal gains have been recorded for the shareholders of both the target as well as acquiring firm. Some studies also attempted to study the stock market reaction to the announcement of M&A. it has been suggested that the significant value increase can be observed if the M&A is taking place between overlapping firms or where the bidding firm is highly profitable in nature. Studies conducted by Zhang (1995) outline that the M&A activity taking place out of the market tend to generate more shareholder value as compared to the activities which are carried out within the market. Higher market concentration acquired through merger and acquisition however, can only result into increase in value for retail financial services firms. This therefore highlights that the universal banks may not gain substantial increase in their value if they acquire other firms. Zhang’s studies also suggested that geographical diversification at the time of M&A may result into an increase in shareholders value. Some of the studies conducted on M&A in European banking sector show mixed results. Van Beenk & Rad (1997) outlined that returns in a post merger scenario were not significant. Later studies however, confirmed the existence of the abnormal returns however, they were observed in domestic bank to bank deals and where banks actually merged with insurance companies. These studies however, also outlined that the increase in abnormal gains in European markets may be due to the weaker enforcement of the anti-trust laws as compared to the same enforcement in US market. (DeYoung, 1993) Most of the studies carried out either in US or EU however; do suggest that mergers and acquisitions may not result into significant increase in the value creation. However, banks may experience efficiency gains as well as increase in their market power. This does not necessarily means that there will be an increase in the value of the firm after M&A activity. (Haynes, and Thompson1999), It is also important to understand that M&A activity does not necessarily result into an increase in efficiency of banks also. Studies conducted during 1980s on the US banks suggest no or very little improvement in the efficiency of banks. Studies conducted during 1990s however do suggest a positive link between the improvements in efficiency after M&A activity. These efficiencies were low or virtually absent where two larger banks merged with each other. This phenomenon however, has been associated with the organizational diseconomies and disruptions caused by the M&A activity. Some studies however, do suggest improvement in efficiency for large US firms.( Palia, 1993), EU wide level studies also suggest the same results and indicate that mergers and acquisition taking place between banks of same size can result into increase in efficiency for the acquiring firm. It has also been argued that the countries with rigid labor markets may not be able to transform the gains in efficiency as a result of merger activity. This has been associated with the assumption that one of the key sources of cost savings for firms is the laying off their employees. However, the countries where labor markets are rigid may not prove as attractive as it may be difficult for the firms to lay off the employees after merger and acquisition. Some studies also indicated the improvement in profit efficiency of the banks after their merger or acquisition. However, these studies also suggest that there may be little or no cost efficiencies for banks in post merger scenario. Methodology Methodology is considered as the systematic use of different statistical methods to explore and understand questions under review. A good research design and methodology therefore allows researcher to understand as to what is theoretically possible to achieve and what can be different obstacles towards the overall process of conducting the research successfully. To successfully accomplish the task of performing this research, researcher aims to use a mix of different qualitative as well as quantitative methods. This is considered as necessary in order to gain necessary flexibility in achieving the overall aim of the research. In order to assess the impact of consolidation on banks and trace their value creation ability, there are two traditional methodologies used. The first approach is straight forward approach of measuring the impacts in the pre and post merger scenario. This approach uses accounting data to measure and track the changes in the cost, profitability as well as increase in stock values of the firm in both the pre and post merger events. One of the key strengths of this approach is based upon the fact that accounting data is easily obtained and can be relied for the purpose of performing this study. Another important strength of this approach is due to the fact that accounting data measures actual performance and hence the analysis is not just limited to measuring the investor expectations. It is also because of this reason that most of the studies have been conducted by using this statistical methodology. The second approach which can be utilized to measure the impact of M&A and their value creation capability is based upon measuring the stock market reaction to the merger announcements. One of the key strengths of this approach is therefore based upon the fact that data will be based upon market values rather than on the accounting data. It is maintained that the accounting data can be unreliable therefore it is only through the market data that the true economic impact of M&A activity can be measured. Since value creation is directly related with measuring the impact of M&A on stock market values therefore this approach is also considered as one of the valid approaches to perform such studies. Another approach which has recently emerged in the literature is based upon finding a correlation between the accounting data and abnormal returns. This approach is specifically more accurate when focus of research is based upon tracing the reaction of the market towards the merger and acquisition announcements. This approach is also based upon the assumption of whether the markets have the ability to distinguish mergers which achieve better results and those which ultimately fail. For the purpose of this research, researcher will attempt to utilize the first approach of using the accounting data. Researcher aims to identify the improvements in profitability, reduction in costs as well as increase market share and will trace their impact on the market values of the banking firms in both pre and post merger scenario. Researcher aims to use correlation and regression analysis to track the changes in the stock market along with the announcement dates for mergers and acquisition. Correlation and regression analysis will allow the researcher to explore as to what variables actually result into increase in value for the banking firms in pre and post merger scenario. Variables such as increase in interest income as well as reduction in non-interest expenses will be considered to measure the impact of M&A activity on the profitability and cost efficiency of the firms. Three important variables of net profit ration, increase in net interest income as well as returns on assets will be evaluated to assess whether the M&A has actually resulted into any improvement in the bank performance. These variables however, will be traced on yearly basis i.e. 2 years before merger and 2 years after the merger took place. Researcher will also compute concentration ratios of each firm in their pre and post merger scenario. The calculation of concentration ratios will allow the researcher to explore the market power of the firms in their pre and post merger scenario. Assessment of concentration ratio will be used to measure as to whether increase in market power could actually result into an increase in the market share of the firm or not. Data & Sampling For the purpose of performing this research, researcher will be using selective sampling and will use only those banking firms which have been successfully merged during last 20 years. Data for the purpose of this research will be based upon the merger and acquisition activity taking place in US and EU market from 1990 till 2010. Researcher will identify the mergers and acquisition activity taking place both in US and EU market during this period and will track the differences which might have emerged in each market. The overall aim therefore is to identify as to what are the particular factors which may be causing the increase in the market value of the banking firms after their firms. In order to further narrow down the scope of the research, researcher aims to use the data from UK, France and Germany as the test case from EU. Since EU is a geographically diverse region therefore limiting the choices only to these three countries will allow researcher to develop focus and narrow down the choices. To effectively perform the study, researcher aims to obtain the market values in four different phases i.e. 1 year prior to the date of announcement of merger, four days before the announcement of proposed merger and one year and five years after the merger. The period of 1 year and 5 years is considered as sufficient to efficiently track the performance improvement and increase in the shareholder value. The period ending 1 year after the announcement of merger would be used to assess the ability of the market to trace whether mergers have lived to the expectations of the investors or not. To further narrow down the research, only firms having more than $1 billion dollars of asset base will be taken into consideration. This will help the researcher to narrow down the search for the data and besides reducing the probability of error in data compilation. Chapter Headings & Subheadings 1. Introduction 2. Literature Review 1.1.1. Mergers and Acquisitions- a general review M&A in Banks Evidence from US Evidence from EU 3. Methodology Sampling Methods 4. Data 5. Analysis 6. Discussion 7. Conclusion Conclusion Merger and acquisition is considered as one of the effective ways through which firms can actually expand into existing and new markets. The de-regulation of the banking industry in both the US and EU has resulted into large scale merger and acquisition drive. The traditional arguments in favor mergers and acquisition are based on the assumption that M&A activity results into increase in market power and cost efficiencies. Both of them however, are also believed to be translating themselves into increase in value of the banking firms. Existing literature on the topic suggest that there may be no gains from the merger and acquisition strategy. The available studies show conflicting results regarding the impact of M&A on the increase in value for the firm in pre and post merger scenario. In this proposal, a comprehensive literature review and statistical methodology has been outlined to explore as to whether M&A can result into an increase in the value of the stocks of such firms. By using the accounting data and finding its correlation with the stock market prices, the researcher aims to understand and explore as to whether stock market react to the merger and acquisition drive and whether such drive can increase the value for the firms. References 1. Akhavein, J. et al. (1997) The Effects of Megamergers on Efficiency and Prices: Evidence from a Bank Profit Function,, Review of Industrial Organization, 12(0). 2. Beatty, R., et al (1988) Bank Merger Premiums: Analysis and Evidence, Monographs in Finance and Economics, Salomon Brothers Center, New York University, 3. Berger A., et al., (1993) Bank Efficiency Derived from the Profit Function, Journal of Banking and Finance 17, p317-47 4. Calomiris, C. and J. Karenski, (1996) The Bank Merger Wave of the 1990s: Nine Case Studies, University of Illinois, 5. DeYoung, Robert, (1993) Determinants of Cost Efficiences in Bank Mergers, Working Paper 93-1, Office of the Comptroller of the Currency, 6. Evidence from the 80s”, Journal of Money, Credit and Banking, 29(3), p. 326-337. 7. Haynes, M. and S. Thompson (1999), The productivity effects of bank mergers: Evidence from the UK building societies, Journal of Banking and Finance,. 23(5), p. 825-846. 8. KPMG (2001), Insights into creating shareholder value through M&A, KPMG survey 9. Molyneux, P. et. Al (1994) Competitive conditions in European banking, Journal of Money, Credit and Banking, 18 (3), p. 445-459. 10. Palia, D. (1993), Recent evidence on bank mergers, Financial Markets, Institutions, and Instruments, December, p. 36-59. 11. Peristiani, S. (1997), Do mergers improve the X-efficiency and scale efficiency of US banks? 12. Zhang, H (1995), Wealth Effects of U.S. B and Takeovers, Applied Financial Economics , 5, p. 329-336 Read More