Bank Consolidation and Stability: The Canadian Experience - Essay Example

Referee Report Bank consolidation and stability: The Canadian Experience, 1867-1935 Table of Contents Table of Contents 2 Summary 3 Evaluation 5 Positives 5 Negatives 9 List the major shortcomings of the paper 10 Is the argument robust? 12 Is the methodology correct? 13 Interpretation of the results 14 Summary and final recommendation 15 Bibliography 16 Summary In this article the estimated results of the merger and acquisitions of banks Canada, during 1867-1935 have been studied. It is stated that this activity supports the concentration-stability hypothesis and it is analysed. It is noted that the systemic stability contributes to the risk reduction. This is achieved through geographic diversification and this is analysed by the two/three of the cross-province merger and acquisitions. The empirical findings have been derived by applying a probabilistic theoretical model. This has supported the efficiency hypothesis rather than the imminent failure hypothesis. Thus journal contributes value to the readers as it not only shed light on the debate in the literature but also has policy implications for the merger and acquisitions today. These policy implications hold great importance as the economists and policymakers need to have a good look at them and follow them in all the policies that design. Economists and policymakers’ grave concerns about megabank failures and their consequences on financial markets and the economy are reinforced by empirical evidence on the concentration-fragility hypothesis. It is noted that the consolidation and systemic risk are positively related, although other factors also contributed to the increased risk. Moreover, it is stated that banking crises are less likely in more concentrated banking systems among 70 countries over 1980-97. However, this is not a hard and fast rule and there is a probability of concentration- fragility hypothesis which need to be analysed as well. This is because there are few examples that also find a weaker stabilizing effect at higher levels of concentration. It is shown graphically that the mergers and acquisitions and the size of the financial institutions have shown an increasing trend over the years. The potential benefits from the mergers and acquisitions are the possibilities of risk diversification and synergy, etc. New megabanks like the Citibank are also emerging. Thus, there is more concentration of banks thereby increasing the systemic banking risk. The importance of competitiveness is well known throughout the land but the Minister of Finance of the Canadian Government proposed bank mergers in 1998. However, there is a mixed result found after the mergers and acquisitions of the financial institutions have taken place. Moreover, the public policy implications are also very essential to be noted because they influence the allocation of the total amount of money available from the merged banks. This may involve conflicts of interests and the of objectives of the many stakeholders could be at stake. These regulations could be very different from commercial bankers’. They emphasize more on post-merger systemic risk than bankers. This is because of the costly banking crises; for example the financial tsunami of 2007. Thus these policies are given great importance by the economists and policymakers. There is a need to closely study the megabank failures, their consequences on financial markets and the economy and they must be supported by empirical evidence on the concentration. The scope of mergers and acquisitions has been manageable. The focus of this paper is on the relationship between banking consolidation and stability by examining the stability. The financial institutions under study are of the Canadian banking system. The time period under study is 1867-1935; from Confederation to the formation of the Bank of Canada. Hypothesis one says that these mergers and acquisitions are driven by market forces. They later become more efficient and stable banking system. The other hypothesis says that mergers and acquisitions have been government’s policy response to maintain banking stability through which insolvent banks were arranged to be absorbed by solvent banks This study goes beyond empirical verification of the concentration-stability hypothesis versus the concentration-fragility hypothesis only. The empirical verification of the efficiency hypothesis versus the imminent failure hypothesis is also studied and for this matter the historical and institutional background of the period and region under study is thoroughly studied. This enables in accepting or rejecting the hypothesis. The model aids in analysing how risk reduction can be achieved as a result of diversification through mergers and acquisitions. It is described how the imminent failure hypothesis can be distinguished from the efficiency hypothesis based on this model. Assumptions are taken about the Canadian economy as it is the area under study. Evaluation Positives I personally liked the way the author has used different scenarios in the methodology section. Each case, the profit earning and loss incurring state has been discussed in detail. Complete empirical evidence has been provided regarding the systemic stability, probability of Bank to fail, net cash flow generated from the bank’s total assets and the bank’s capital. Chebyshev Inequality has been applied which is supported in the prior studies. Thus this model holds significant authenticity. In order to evaluate the bank merger it has been noted that it affects the probability of bank failure and hence systemic stability. For this matter the author has in detail explained and compared the pre- and post-merger stability of the banks. All the scenarios have been discussed; if both the banks fail, if both the banks are successful if either of the banks are successful The results have been used in the standardized normal distribution, that aid in comparing the pre-and post-merger probabilities numerically. Thus a complete comparison of the pre and post-merger is provided which further helped in the evaluation of the bank’s financial stability position. In depth analysis on the hypothesis statements have been done. The hypothesis has been empirically proved by applying a significant model. It has been further discussed with assumptions if the net cash flow is not held constant in both the banks. This is one of the assumptions of the model applied. This has been done to empirically distinguish between the two hypotheses by examining the actual changes in systemic risk following mergers and acquisitions during the period under study. In the other section the entire background of the Canadian economy is provided in great detail so the readers who don’t even come from the Canadian background can easily relate the situation and various scenarios. This is again a positive aspect of the paper. Different sub-headings with sufficient details regarding the Bank Mergers and Stability have been covered in greater detail. It is sated that the Canadian banking system has enjoyed a reputation for its solvency and stability, although bank failures occur occasionally as compared to other countries, namely the united stated. The reasons of stability in the Canadian banking system according to the experts have been defined and it is proved that the major reason is the risk diversification through branching. And the way the stability could be achieved in the Canadian banking system have so been noted so that the people from other countries can be educated with all the possible options. It has been sated that the stability could be achieved by geographic diversification which could be achieved by (i) opening new branches or (ii) acquiring other banks, or (iii) both. A comparison has been provided with other states, United States. It is found that the failure rate of the Canada’s branch banking system is lesser as compared to that of the united states and therefore it outperforms the United States’ banking system in terms of stability. Statistics have been provided in an organized manner with proper citation and they are completely backed by the prior literature, the views and a complete theoretical background about the concepts and a complete evaluation has been done about the followed activities. For example in the paper the defunct Home Bank of Canada; an acquiring bank, have been provided with statistics and simultaneously it has been evaluated if the failure was a result of higher post-merger risk. In addition to it sufficient relevant examples that support the original title have also been provided and the examples also support either of the two criteria’s; the firm size or the industry size. In the case, the prominent feature of these mergers and acquisitions that are the two-thirds cross-province acquisitions. Complete statistics have been provided. It is supported in the later paper that the cross-province acquisitions should theoretically have facilitated banks’ portfolio risk diversification. The hypothesis is supported with a complete recent research that is done on the mergers and acquisitions. It is found that out of the 36 off-diagonal correlation coefficients of government expenditure growth, 13 are negative and 4 are positive but low in value (less than 0.1). This pattern of growth and development also suggests that there were opportunities for banks to expand geographically through M&As to reduce risk through diversification, to achieve market extension, and to gain cost and profit efficiencies It has been backed by the statistics and a complete research has been carried out which is represented in a line chart. It is proved that the higher the total number of acquisitions (both direct and indirect), the higher was a bank’s gain in market shares over the years 1900-40. Contingency table analysis is applied to test the null hypothesis that the two groups have the same failure rates. A very in-depth analysis is taken and the chartered banks are first categorized into two groups – those involved in consolidation and those not. These two groups are then further classified into two sub-groups according to whether they had failed or not by 1935. Footnotes have been inserted where it is expected that the reader must know the background of the topic. This is when the author has highlighted something according to the prior studies. For example the losses to depositors have been provided in the footnotes. Also, the empirical findings and historical evidence support the efficiency hypothesis more than the imminent failure hypothesis. Both the hypothesis has been empirically supported by the Z-score value. This provides more essence and numerical backings have been provided to the theoretical parts to prove the hypothesis. A set value is defined according to other related studies and it is followed. This gives more authenticity of the paper proposed because it keeps up with the norms and standards of other related journals in this field, The impact of bank mergers on systemic risk is estimated by a transfer function based on the industry-based Z-score specification. It is determined that the Z-score is a proxy of banking stability by considering together accounting measures of profitability, leverage and insolvency. The industry Z score has also been calculated in precise terms and the two equations have been linked very professionally. After the evaluation of one equation, the second equation is explained with the same details. This is enables the paper to achieve coherence in the explanations and justifications. The paper is focusing on the role of the merger wave, and show how it was related to geographic diversification and the oligopolistic industry that resulted in systemic stability. Thus all the statistics and mergers examples of the similar aspects have been quoted for analysis purposes. Moreover, the selected area, the Canadian banking system provides ample examples for this matter. Moreover, the concepts like ‘Too big to fail’ and ‘great depression’ have not been ignored. Thus, in the ending it has been stated that the government needs to be the lender of the last resort so the risk of failure of these activities could be prevented if not completely eliminated. This would eventually prevent the unforeseen events like the great depression. Besides verifying the empirical validity of the concentration-stability hypothesis versus the concentration -fragility hypothesis, the analysis also proves the debate between the efficiency hypothesis and the imminent failure hypothesis in the literature The findings of this paper have policy implications for bank mergers today. For this very reason two mega-mergers have been studied. Numerous graphs, tables, line charts have been derived in the appendix to support the explanations and the real life trends of the banking market have been supported. Negatives However, a comprehensive data on national income at the provincial level are not available for the years before 1926. Therefore, expenditures on goods and services by provincial governments over the years 1870-1923 are used as proxies for the levels of aggregate economic activity in each province. This can have a slight level of error because exact values of the national income could not be determined any ways. Some of the data I likely to suffer from a sample selection bias simply because it excluded all failed banks. The contingency table analysis results and the relationship between bank consolidation and failures are quite conspicuous even without going through the formal statistical testing procedure. And these contingency table analyses do not depict the causality in the banking sector. For the estimation, the annual data at the industry level is used for the period 1893-1929 to estimate the aggregate Z-score. Data on individual banks like the prior studies have done is not supported because comprehensive data for individual banks are unavailable. However the findings have not supported the imminent failure hypothesis completely with good explanations and statistical evidences. This could be worked on as it is accepted that there was at least one case in which a failed bank was arranged to be absorbed by a solvent bank. List the major shortcomings of the paper This topic is by no means entirely novel in view of some earlier studies. This paper emphasizes the relationship between mergers and acquisitions and the stability. It has used both a theoretical and empirical approach in order to increase the accuracy of the paper and this could help prove the hypothesis in a greater detail. Thus this paper provides value to the literature by resolving the debate between the efficiency hypothesis and the imminent failure hypothesis. Canadian banking system has been selected for analysing the hypothesis because during the period under study, Canadian banking system serves as a natural laboratory to examine the relationship between banking consolidation and stability because it went through a wave of bank mergers, notably during 1900-31. In these years it evolved into a highly concentrated banking system. This study goes beyond empirical verification of the concentration-stability hypothesis versus the concentration-fragility hypothesis only. And after the hypothesis is satisfied, a further question that remains is also analyzed: hypothesis one: does consolidation lead to stability Hypothesis two: the need to maintain stability induces consolidation? However, there is difficulty in calculating the second hypothesis because during the period under study, neither central bank nor financial safety net was present and the banking system was not highly or over-regulated, though not totally free. On the one hand, the banking system evolved under more or less unfettered market forces. The required government intervention was very occasional and it was required when there was banking instability due to market forces. This government invention took the shape of the lender-of-last-resort support or arranging bank mergers and acquisitions: as remedial measures. Assumptions about the Canadian economy are studied in depth. There is a complete section that is donated to this aspect and it is explained prior to the hypothesis because it also aids in the explanation. Thus, the Canadian experience during 1867-1935 has also been closely examined. This support the concentration-stability hypothesis and significant statistics that are represented by graphs and tabular forms. The conclusion depicts that the results of transfer-function estimation indicate a positive impact of mergers and acquisitions on systemic risk. Also, the empirical findings and historical evidence support the efficiency hypothesis more than the imminent failure hypothesis. Both the hypothesis have been empirically supported by the Z-score value. The policy implications for bank M&As today are discussed thoroughly in the ending section. Examples have been taken of the two mega-bank mergers in the 1920s. Evaluation has been done according to the Herfindahl-Hirshman Index and it has been argued that undue reliance on merger guidelines can prevent banks from reducing risk exposure through mergers and acquisitions. Is the argument robust? However the results derived from the empirical evidence are not so straightforward because there is no guarantee that an acquiring bank can always sustain its market share over time. Furthermore, there is the possibility of increased post-merger risk exposure that may hamper a merged bank’s profitability and erode its capital base. For this matter the recent mega-mergers have been studied but no hypothesis have been built on this aspect. Thus, this is a lag in the study. A small deviation in the data can prove to have significant impact on the results derived from the formula. For this matter it has been clearly stated in the paper that it would expect no statistical difference between the failure rates of these two groups of banks. However, numerous possibilities are attached to this. Thus, these mergers and acquisitions could attain a different degree of risk exposure than simply branching. If so, these two groups’ failure rates should be statistically different. For this matter in order to test the null hypothesis that the two groups have the same failure rates, contingency table analysis is applied. The chartered banks are first categorized into two groups – those involved in consolidation and those not. These two groups are then further classified into two sub-groups according to whether they had failed or not by 1935. Is the methodology correct? There is no possible measure as to how to measure financial stability. There are numerous measures that have been described up till now but this paper has restricted its scope by analysing according to two indicators. The selected ones are; the firm level and the industry level. There are numerous other indicators as well. But these have been picked out by analysing the prior literature. It has been searched that the most effective indicator is the level of the firm, especially when studying the concept of mergers and acquisitions. This is because the level of the firm would directly be related to the performance of the company. If it is performing up to mark and it has met the required standards, so this would lead to an increase in the net profit ratio and the gross profit ratio as well. This is majorly because the sales volumes have been increasing over the years. The company will have excess amount of money that could be utilized for various purposes. Firstly, the efficiency of the company would be improved by installation of latest technology and by providing training programs to the employees. The proper know how of operating various machineries would be given to the employees and they would feel an integral part of the company. Later, the money could be used for the extension of the business. New premises could be acquired if more capacity is required. Moreover, other companies and businesses could be merged or acquired to the original company. This would lead to an increase in the originating firm’s level. A higher probability of financial stability, lower would be the probability of failure. The lower probabilities of failure, the likelihood of having contagious bank runs or systemic crises is expected to be reduced. Moreover, the level of the industry is also a good measure of financial stability. If the industry is at a growth stage, it is likely that the sales of the business would be higher as compared to other business in different industries. This is majorly because of the rules, regulations and policies set by the government. If there are easy policies with tax benefits and subsidies so they businesses would benefit in terms of financial stability. This study goes beyond empirical verification of the concentration-stability hypothesis versus the concentration-fragility hypothesis only. And after the hypothesis is satisfied, a further question that remains is also analysed: hypothesis one: does consolidation lead to stability Hypothesis two: the need to maintain stability induces consolidation? However, there is difficulty in calculating the second hypothesis because during the period under study, neither central bank nor financial safety net was present and the banking system was not highly or over-regulated, though not totally free. On the one hand, the banking system evolved under more or less unfettered market forces. The required government intervention was very occasional and it was required when there was banking instability due to market forces. This government invention took the shape of the lender-of-last-resort support or arranging bank mergers and acquisitions: as remedial measures. Interpretation of the results It is explained that the huge size of a merged bank could result in higher operating risk. This is majorly due to a looser organization, increased difficulty in adequate oversight, and potentially larger losses from lending and investment operations. It has later been evaluated and a consensus has been reached via prior research that the serious mistakes made by a megabank after merger could increase systemic risk of the banking system. The results derived from the empirical evidence are not so straightforward because there is no guarantee that an acquiring bank can always sustain its market share over time. Furthermore, there is the possibility of increased post-merger risk exposure that may hamper a merged bank’s profitability and erode its capital base. For this matter the recent mega-mergers have been studied but no hypothesis have been built on this aspect. Thus, this is a lag in the study. A small deviation in the data can prove to have significant impact on the results derived from the formula. The various possibilities of Risk Diversification through mergers and acquisitions have been described. And two Cases of Megabank Mergers have also been evaluated. The levels and changes in the HHI have been explained and this is theoretically supported by prior literature. In assessing whether the Canadian merger wave was in the interest of the public, the insight, analysis and judgment of Beckhart, a leading expert of banking at that time has been done. This is again supported by the prior literature and an in depth evaluation is provided in this paper by studying various hypothesis. For the estimation, the annual data at the industry level is used for the period 1893-1929 to estimate the aggregate Z-score. Data on individual banks like the prior studies have done is not supported because comprehensive data for individual banks are unavailable. Summary and final recommendation It is noted that the consolidation and systemic risk are positively related, although other factors also contributed to the increased risk. Moreover, it is stated that banking crises are less likely in more concentrated banking systems among 70 countries over 1980-97. However, this is not a hard and fast rule and there is a probability of concentration- fragility hypothesis which need to be analysed as well. This is because there are few examples that also find a weaker stabilizing effect at higher levels of concentration. This study goes beyond empirical verification of the concentration-stability hypothesis versus the concentration-fragility hypothesis only. The empirical findings have been derived by applying a probabilistic theoretical model. This has supported the efficiency hypothesis rather than the imminent failure hypothesis. The findings of this paper have policy implications for bank mergers today. For this very reason two mega-mergers have been studied. They provide the possible options that could have been achieved and the possibilities that could be derived if they are rejected by the regulators for exceeding the HHI thresholds according to the US DoJ’s merger guidelines. Thus great importance has been provided to the HHI as a decision criterion alone may hinder banks’ risk reduction through consolidation. Thus it is recommended that the regulators should incorporate risk factors into their bank merger guidelines so as to achieve a balance between competition and stability. The conclusion depicts that the results of transfer-function estimation indicate a positive impact of mergers and acquisitions on systemic risk. Also, the empirical findings and historical evidence support the efficiency hypothesis more than the imminent failure hypothesis. Both the hypothesis have been empirically supported by the Z-score value. However, more details could be provided on how the events like great depression could be prevented. It was a hypothetical statement that was passed by the author. An in depth analysis needs to be done on it. Moreover, other indications could also be studied. 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Bank Concentration and Competition: An Evolution in the Making. JOURNAL OF MONEY CREDIT AND BANKING. 36, 433-452. Top of Form ALLEN, F., & GALE, D. (2007). Understanding financial crises. Oxford, Oxford University Press.http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=191608. Read More