The World Financial Industry

1.0 Introduction

The number of bank mergers in 1990s has increased 215%. (Becher, D.A., 1999) From 1987 to 1997, the value of mergers and acquisitions in the world financial industry has reached nearly 1.4 trillions of US dollars. (Cybo-Ottone, MurgiaSince, 2000) Since bank mergers become popular, there has a controversy about whether bank acquisitions create value for target and bidder shareholders. This paper gives a literature review about this paradox and it is divided by four parts. First part is the reasons for bank mergers. Second part shows the literatures before 1990. Third part recent studies, which examine this paradox from two different methods-studies on announcement and studies on sub-sampling the population of merging banks.

2.1 Reasons for bank mergers

Houston, James and Ryngaert (2001) demonstrate the main reason for bank mergers. Bank mergers can reduce costs and/or increase revenues. Cost reductions can be achieved by eliminating redundant managerial positions, closing overlapping bank branches, vacating redundant headquarters facilities, and consolidating back office functions like check clearing. Cost cutting potential may be greater when merging banks have geographic overlap. Bank executives frequently claim that mergers with considerable operations overlap can result in cost savings equal to 30% of the target's non-interest expenses. Revenue enhancements can come from a variety of sources. The most frequently cited source is cross-selling of bank services. However, this reason does not mean bank mergers can create value for shareholders. There have some empirical evidences to show the limited of cost saving. In U.S bank market, intrastate mergers are more likely to generate cost synergies than interstate bank mergers, because over-lapping branch networks do not exist across states. (Shaffer 1992; Holder 1993; LaWare 1991). In the European Union market, Altunbas, Molyneux and Thornton (1997) find that the mergers between German and Italian bank and between French and German banks will limited the cost saving.

2.2 Researches before 1990

To examine the paradox that whether bank mergers can bring values to target and/or bidder shareholders. In early studies, James and Wier (1987) try to examine the effect of other potential bidders and alternative target firms on the returns to acquirers' shares. They find that there has a positive relationship between gain to acquirers and number of alternative target firms available, in contrast, a negative relation with the number of other potential bidders. Similarly, by studying 26 acquisitions during 1979~1985, Neely (1987) find bidder firms gain significant positive returns. However, difference from James and Wier (1987), who did not study the returns which gained by target firms, Neely also find target firms gain significant returns for the entire sample of banking firms during the announcement week and during the weeks before and after announcement. In addition, Becher (1999) points out the some weakness in previous study. He says that, first in some researches of bank merger activities only use short time period and relatively small size, for example, James and Wier (1987) study 60 out of 265 potential banking mergers over 9 years, while Neely (1987) focuses on a-7 year period data , and Trifts and Scanlon (1987) examine 21 acquisitions over 4 years. Furthermore, a lot of studies do not examine combined firms' returns, instead they focus on bidder and target firms separately. Hawawini and Swary (1990), by examining a sample of mergers from 1972 to 1987, they simply use a weighted average of the average gains (losses) to bidder and target firms. The formula they used to measure of total revaluation is: (Vt/Vb ) In the formula (Vt/Vb )is the average target book to bidder book equity ratio before mergers, is the target firms' average abnormal return and is the bidders' average abnormal return. They find that their results only provide tentative evidence that bank mergers can create values.

2.3 Studies on announcement

There are majority of studies focus on changes in stock market prices by considering the period of the announcement during the merger. The aim of these studies is trying to find out whether the announcement of a bank acquisition brings shareholder value (normally in the form of cumulated abnormal stock market returns) (Altunbas and Marques, 2006) Previous research on the stock market reaction to bank merger announcements concentrates on the stock market revaluation of bidders and/or targets but does not consider the revaluation of the combined bidder and target. While Houston and Ryngaert (1994) says all existing bank merger studies find positive target bank stock returns at the announcement of a merger, many recent studies find negative bidder returns. Thus, it is unclear whether the combined revaluation of the two firms is positive or negative. Houston and Ryngaert (1994) points out the study of Hawawini and Swary (1990) need a more complete analysis, which should calculate the gain from each merger and then aggregate across all mergers instead of a weighted average of the average gains. Also, their research does not consider the post-1987 mergers. Thus, in Houston and Ryngaert's study (1994) they extend their study past 1986 and examine the stock market's perception of bank mergers in the period 1985-1991. In order to properly measure the returns of each merger and get the “information leakage” relative to each deal, they also identify the leakage date and the agreement date. The leakage date is the first announcement when the target firm became a merger candidate. The agreement date is the initial day that the merger agreement reported in the WSJ or NYT. (Houston and Ryngaert, 1994) Event study methodology also is used in their study to estimate the abnormal returns for the target and bidder. As a result, they most important finding is that when the combined bidder and target values together at the announcement of these mergers there are no apparent positive value are created. Targets have positive returns, which are offset by negative returns to bidders. This finding is similar with accounting studies that no apparent cost savings from the average large bank merger. They also find that in recent years, total returns have been higher. Houston and Ryngaert (1994) speculate there are three reasons to explain their finding. First, explanation is that they do not create real synergies. Alternatively, while in our sample there do have a number of good acquisitions, which means after the merger the bank has great opportunities for cost savings, however the returns to these good acquisitions are canceled out by a large number of bad acquisitions. The second explanation they mentioned in their paper is that the probability of a firm being a target may be better recognized than the probability of a firm being a bidder. Thus, target firm prices are bid up in advance of a merger bid, but bidder returns are not bid down. Third, since most takeover bids are stock financed, the acquisition announcement of a bidding bank may be sending out the signal that the firm's stock is overvalued. Undervalued bidders may tend to refrain from making an acquisition. This suggests that estimated total returns may be a downward biased estimate of the synergies resulting from bank mergers. Houston, James and Ryngaert (2001) point that most studies show a bank acquisition can not create value when the value, which was combined of the bidder and the target, increases on the announcement of the acquisition. They give three reasons to explain this. First, merger announcements contain the information refer to the proposed acquisition with information about the acquisition's financing. Bank acquisitions tend to be financed by stock issuance. Stock offerings are generally interpreted as signals of the issuer's “overvaluation.” Thus, bidding firms' negative announcement returns may be caused by negative signaling, which is unrelated to the value created by the acquisition. Similarly with this view, Houston and Ryngaert (1997) conclude that the returns to bidders are significantly less in bank acquisitions financed with stock than financed with cash. Second, Houston, James and Ryngaert (2001) say that mergers are largely anticipated. As a result, the positive merger effects on bank value do not appear in announcement-date stock returns. They use Dow Jones News Service as an example. This service in July 17, 1995 gave a report in Barron's that there are five bank stocks thought most likely to be acquired. In the next year, four of these five banks were acquired. Third reason is that bidding firms' negative announcement return will cause disappointment, which means the bidding firm is less likely to be acquired in the future. Houston uses an example that PNC's acquisition of Meridian Bancorp destroyed value because the likelihood that PNC would be a takeover candidate decrease. These problems suggest that the combined stock returns of the bidder and target on the announcement of an acquisition can understate any value gains associated with a merger.

2.4 Studies on sub-sampling the population of merging banks

After the study of Houston and Ryngaert (1994), US studies have pay attention to sub-sampling the population of banks acquisitions according to their product or market-relatedness. (Altunbas and Marques, 2006) The aim of such studies is to estimate whether certain shared characteristics between targets and bidders could bring or destroy shareholders' value. Mergers of banking firms are classified according to their activity and geographic similarity or dissimilarity. (Delong, 2001) The findings of these studies also separate to two groups. Some empirical results from the United States illustrate that mergers of banks showing in terms of geographical or product strategies could destroy the combined of target and bidder shareholders' value. Amihud, De Long and Saunders (2002) examine cross-border (geographical) bank mergers' effect on the risk and (abnormal) returns of acquiring banks. The abnormal returns in their study are measured through the world, home, and host bank indexes, which are used by bank equity investors. They consider the event window, which is the 12-day period surrounding the announcement of the acquisition, from 10 days before the merger announcement to 1 day after it was announced. Amihud, De Long and Saunders (2002) also examine the changes in total risk of investor reaction and the changes in systematic risk. They get the result that overall the acquirers' risk neither increases nor decreases and there has the negative and significant abnormal returns to acquirers, however there are higher abnormal returns when in the acquirer's home country risk increases relative to banks. Houston, James and Ryngaert (2001) point another interpretation about value destruction for acquiring firm shareholders is managerial hubris and corporate control problem. Similarly, Ryan (1999) argues that most bank mergers are not consider shareholders' interests. Morck et al. (1990) find the similar conclusion that bidding firms' values may reduce because of managerial objectives. Because of their own interests, managers may overpay for acquisition that provide them with the private benefit of diversification. (Amihud and Lev, 1981) Gorton and Rosen (1995) argue that the primary motivation for bank acquisitions is empire building by bank managers who are insulated from the market for corporate control. Houston, James and Ryngaert (2001) also show an interpretation that the operating efficiency of the banking industry has been improved by consolidation, but previous large sample studies have not fully capture the corresponding benefits. Considering managerial hubris and corporate control problem, Houston, James and Ryngaert's (2001) study has two different from previous studies of bank acquisitions. First, their research contains the analysis of only large bank acquisitions over a longer period of time and also includes more recent mergers. Because of using only large mergers, their sample can help them to detect valuation consequences more readily than a sample including smaller transactions. Furthermore, analyzing transactions over a period of 12 years from 1985 to 1996, they are able to study whether the bank mergers can create value for shareholders of both targets and bidders. Second, basing on 41 acquisitions they get management's projections of the merger's estimated cost savings and revenue enhancements. These projections help them to identify the primary reason of management for these acquisitions and also enable them to quantify the likely valuation consequences of the mergers. Houston, James and Ryngaert's (2001) estimate the present value of the incremental earnings that management expects from the merger. We then investigate the relation between these estimated gains and the change in the market value of the stock of the bidder and the target. This analysis indicates the extent to which investors agree with management's projections of cost savings and revenue enhancements, which in turn provides important insights into what the market is looking for when it values bank mergers. Their results are the opportunity to cut costs can bring estimated value gains to shareholders from bank mergers, because bank acquisitions can eliminate overlapping operations and consolidating backroom operations. Cutting cost is more important than estimated revenue enhancements. Furthermore, there is a strong and positive relation between bidder and target bank merger announcement returns and managers' estimated cost savings. In addition, Houston, James and Ryngaert (2001) find bank mergers during recent years (those occurring in the 1990s) are more likely to be accompanied by management's projections of cost savings, and generate higher abnormal returns than acquisitions prior to 1990. Banking mergers can create value to shareholders Mergers are classified according to whether they focus or diversify along geographic and activity areas. (Delong, 2001) Morck, Shleifer, and Vishny (1990) provide evidence that diversifying mergers destroy values. However, their study only focuses on returns to bidders. Pilloff and Santomero (1998) point out that the value and the number new bank acquisitions in the US continues to grow unabated even though academic studies find that bank mergers can not bring significant gains in value or performance. Delong (2001) demonstrates that he use different methods on examining whether diversifying bank mergers destroy or create value for both target and bidder shareholders. First, Delong examines diversification both in terms of geography and in terms of activity. It is very important to examine geographic diversification in the United States, because at the state both the market for corporate control but and the activities in which banks may participate are influenced by the regulation level. Morck, Shleifer, and Vishny's findings are not immediately applicable to banking because of the regulation. Regulation will influence corporate control. For example, Cornett et al. (1998) find that during the time of their study, interstate bank mergers were highly regulated and destroy the value for bidders upon announcement. While, intrastate bank mergers did not destroy bidder value because there had few or no restrictions. Another example we can see in Palia's study. Palia (1993) find that the merger premium, which was paid by the bidder to the target, was influence by regulatory restrictions. The targets will be made more appealing in the States which have restricted branching, and therefore the premium will be increased. Second, Delong (2001) finds that industry specific factors can influence returns, so he focuses on the banking industry and provides a control for these factors. The market return is the on of usual control. Sweeney and Warga (1986) find that risk is another factor to influence returns, because investors ask a premium if there has a high interest rate risk. Thus, in Delong's finding, he study corrects for interest rate and other risks related on bank. Third, Delong examines intra-industry mergers in order to minimize the impact of inter-industry effect. Himmelberg et al. (1999) show the impact of inter-industry that firm performance will be influence, because inter-industry may make spurious results in analyzing the relation between performance and ownership. Since I focus on the banking industry, the results can be considered robust and immune to inter-industry differences. Finally, differ from previous studies. Delong (2001) uses cluster analysis to examine stock returns and to determine activity focus. Therefore, his study presents a new dimension of diversifying versus focusing bank acquisitions and examines the effects of these types of mergers on the total value. Delong's sample is consisted of domestic U.S. bank acquisitions, which were announced during 1988 to 1995 and the mergers between publicly traded firms where at least one is a banking firm, as reported by the Securities Data Company. The result of Delong (2001) is diversifying either activities or geography, or both, do not bring value to shareholders in the acquisitions. Overall, mergers of banking industry neither destroy nor create shareholders' value. However, in Delong's study acquisitions that focus both activities and geography can bring a positive 3.0% return. Bidders in the mergers, which focus both activities and geography, do not destroy value, while bidders in the other merger groups do destroy shareholders' wealth. The earnings do not have large difference between targets, which enter into focusing mergers and targets in the other groups. Therefore, the findings of Morck et al. (1990) for the banking industry are proved by Delong's study. In addition, Delong enhance the study, which is difference from most previous study, that mergers focus on both activities and geography can crate value to both target and bidder shareholders. In consistent with Delong, Cornett et al. (2003) argue that bidders focus on both product-relatedness and geography do not destroy shareholders' wealth.

Conclusion

This paper tries to review the literature about the paradox that whether banking mergers can create value to the target and bidder shareholders. The selected papers, ranging from 1987 to 2006, encompass most aspects of the study. This review covers a substantial bulk of literatures, which can represent the main stream research in this field. First part is the researches before 1990. The representative of this part is James and Wier (1987), Neely (1987). This part also points the weakness of these studies. The weakness is examining the returns for targets and bidders separately. Second part of this paper reviews the latter literatures, which combining value the targets and bidders. In these empirical literatures, they analysis whether bank mergers create values following two main empirical methods. The first is whether the announcement of a bank acquisition brings shareholder value. Most of literatures about this aspect, such as Houston and Ryngaert (1997) find that banking mergers destroy shareholders' wealth. Another method sub-sampling the population of banks acquisitions according to their product or market-relatedness. Empirical evidences from the U.S demonstrate that acquisitions of banks showing shareholders' value are decreased after banking mergers. (eg. Amihud, De Long and Saunders 2002, Houston and Ryngaert 1994) Finally, Delong (2001) argue that only acquisitions that focus both activities and geography do not destroy value. bi Amihud, Y., Lev, B., 1981. “Risk reduction as a managerial motive for conglomerate mergers.” The Bell Journal of Economics 12, 605-617. AltunbasA¸ Y. and Marques, D. 2006, “Mergers and acquisitions and bank performance in Europe: The role of strategic similarities”, Journal of Economics and Business 60, 204-222 Altunbas, Y., Molyneux, P., & Thornton, J. 1997 “Big-bank mergers in Europe: An analysis of the cost implications.” Economica, 64, 317-329. Amihud, Y., De Long, G., & Saunders, A. 2002. “The effects of cross-border bank mergers on bank risk and value. ”Journal of International Money and Finance, 21, 857-877. Becher, D.A., 1999. “The valuation e!ects of bank mergers.” Penn State Working Paper Cornett, M., Hovakimian, G., Palia, D., Tehranian, H., 1998. “The impact of the manager-shareholder conflict on acquiring bank returns.” Unpublished working paper. Boston College, MA. Cornett, M.., Hovakimian, G., Palia, D., & Tehranian, H. 2003. “The impact of the manager-shareholder conflict on acquiring bank returns.” Journal of Banking and Finance, 27, 103-131. Cybo-Ottone, A., & Murgia, M. 2000 “Mergers and shareholder wealth in European banking.” Journal of Banking and Finance, 24, 831-859. DeLong, G. (2001). “Stockholder gains from focusing versus diversifying bank mergers.” Journal of Financial Economics, 59, 221-252. James, C.M., Weir, P., 1987. “Returns to acquirers and competition in the acquisition market: the case of banking.” Journal of Political Economy 95 (2), 355}370 Himmelberg, C., Hubbard, R., Palia, D., 1999. “Understanding the determinants of managerial ownership and the link between ownership and performance.” Journal of Financial Economics 53, 353-384. HOLDER, C. L. 1993 “Competitive considerations in bank mergers and acquisitions: economic theory, legal foundations, and the Fed.” Economic Review (Federal Reserve Bank of Atlanta), 78, 23-36 Houston, J. H., & Ryngaert, M. 1994. “The overall gains from large bank mergers.” Journal of Banking and Finance, 18, 1155-1176. Houston, J. H., James, C., & Ryngaert, M. 2001. “Where do merger gains come from? Bank mergers from the perspective of insiders and outsiders.” Journal of Financial Economics, 60, 285-331. LAWARE, J. P. 1991 “Testimony before the Committee on Banking” Finance and Urban Affairs of the US House of Representatives, September 24, 1991; reprinted in Federal Reserve Bulletin, 77, 932-48. Morck, R., Shleifer, A., Vishny, R., 1990. “Do managerial objectives drive bad acquisitions?” The Journal of Finance 45, 31-48. Palia, D., 1993. “The managerial, regulatory, and financial determinants of bank merger premiums.” The Journal of Industrial Economics 41, 91-102. Pilloff S.J. and A. M. Santomero, 1998, “The value effects of bank mergers and acquisitions” in Y. Amihud and G. Miller (Editors), Bank Mergers and Acquisitions. Ryan, S.J., 1999. “Finding value in bank mergers.” Presentation, Federal Reserve Bank of Chicago Bank Structure Conference, May 5, Chicago. SHAFFER, S. 1992 “Can mergers reduce bank costs?” Working Paper no. 91-17/R. Federal Reserve Bank of Philidelphia. Sweeney, R., Warga, A., 1986. “The pricing of interest-rate risk: evidence from the stock market.” The Journal of Finance 61, 393-410. Trifts, J.W., Scanlon, K.P., 1987, “Interstate bank merger: the early evidence.” The Journal of Financial Research 10, 305-311.

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