Crossborder Mergers A Regulatory Challenge

Five public policy issues are raised by bank mergers in Europe. These include protection of investors, safety and soundness (systemic stability), concentration, impact on lending to small and medium-sized enterprises (SMEs), and international competitiveness of financial firms.

Investor Protection

A first potential source of public concern is investor protection in the case of the acquisition of a domestic bank (let us say a Dutch institution) by a foreign bank. A problem could arise if the Dutch component becomes integrated as a branch of the new group. Indeed, it could be that the new entity supervised by the foreign regulator (home-country control) does not meet the Dutch prudential standards. Such a case would provide an argument for the Dutch regulator to step in to protect 'uninformed' investors (public interest argument). Because regulations on conduct of business (such as disclosure of information, liquidity ratios, application of contract law, marketing practices and so on) are controlled by host countries, the issue concerns essentially the solvency of branches of foreign banks.

Systemic Risk

Systemic risk could occur because a single bank is deemed too large to fail. Fears of contagion to other banks or fear of negative impact on consumption or investment could create an argument for a bail-out. In the specific context of bank mergers and acquisitions, three separate cases need to be analysed.

First, a Dutch bank becomes very large with a significant portfolio of risks located abroad. This situation raises the difficulty of supervising and assessing the solvency of this international bank. Second, in the case of bank failure and partial or complete bail-out, this could entail a very large cost to the Dutch Treasury or the Dutch deposit insurance. To assess the potential cost of a bail-out, we report in Table 4.7 the level of equity (book value) of the 15 largest European banks as a percentage of the GDP of the home country. Not surprisingly, the highest figures are found in Switzerland and the Netherlands. The equity to GDP ratio is 8.02 per cent for the recently merged United Bank of Switzerland, 4.6 per cent for ABN-AMRO, as compared to 0.89 per cent for Deutsche Bank. For the sake of comparison, the equity of Bank of America and Citigroup represents 0.55 per cent and 0.48 per cent of US GDP. Taking as a reference point that the bail-out of Crédit Lyonnais will cost French taxpayers twice the book value of its 1993 equity (admittedly an arbitrary case), the cost of bailing out the largest Swiss bank could amount to 16 per cent of Swiss GDP, as compared to 1.8 per cent of GDP in the case of the Deutsche Bank.

The second case is the creation of a Dutch financial conglomerate as a bank decides to expand domestically into a set of other financial services. Financial conglomerates of this type create potentially two problems. The first one is that if there is a bail-out, this could again entail considerable cost to the Dutch Treasury. The second is that it can distort competition if the newly acquired business benefits from the implicit bailing-out guarantee. In principle, these effects can be mitigated by creating effective firewalls between the entities, through for instance the creation of separate legal units owned by a holding company. However, this type of separation could prove difficult to implement if one of the subsidiaries fails since, in a world

Table 4.7 Bank rankings

Country

Bank

Equity (book value) €m, 1998

Equity/GDP (%)

UK

HSBC

29,352

2.12

France

Crédit Agricole

25,930

1.81

France

BNP-Paribas

23,471

1.64

Switzerland

UBS

20,525

8.02

Germany

Deutsche Bank

18,680

0.89

Switzerland

Crédit Suisse

17,579

6.87

Netherlands

ABN-AMRO

17,471

4.60

Germany

Bayerische Hypo

15,195

0.72

Netherlands

Rabobank

14,688

3.88

Spain

Santander-BCH

14,919

2.59

UK

Barclays

13,495

0.98

UK

NatWest

13,389

0.97

Germany

Dresdner

13,042

0.62

Netherlands

ING Bank

12,961

3.42

France

Société Générale

12,521

0.88

USA

Bank of America

47,030

0.55

USA

Citigroup

40,794

0.48

Source: The Banker (1999), author's calculations.

Source: The Banker (1999), author's calculations.

of imperfect information, a reputation effect could lead to a run on other parts of the group, forcing the bailing out of the entire group.

In the first two cases discussed above - cross-border expansion and domestic across-sector move - diversification of risks could reduce the probability of a (costly) bail-out as long as the level of equity is not reduced and the efficiency of management is not hampered by complexity. Adequate control of risk-management systems (ex ante supervision) and frequent and conservative valuation of the equity of the group (ex post supervision) would facilitate early intervention and minimize the cost of a bail-out.

The third case involves one large foreign bank buying a Dutch bank. The Dutch Treasury could be forced to bail out for internal stability reasons, but would not have the right to supervise the branch of a foreign bank because of home-country control. Since the Dutch Treasury would retain financial responsibility, it should be able to retain some supervisory control. That is to say, home-country control or even ECB control has to be complemented by some form of host control as long as the cost of bailing out remains domestic. In this last case, since the default of a large international bank could affect many countries, the decision to bail out would demand coordination among these countries. These arguments - the decision to bail out and the sharing of the cost of a bail-out - suggest the need for further fiscal and supervisory measures, a state of the world that cannot be reached as long as nations want to retain full control of their public spending.

Concentration

The third public policy issue concerns concentration and the fear of a lack of competition. Data on market shares for deposits and loans are reported in Table 4.8. Not surprisingly, they show relatively high concentration in small countries such as Sweden and the Netherlands, with the five largest banks capturing more than 80 per cent of the market, as compared to 14 per cent for the case of Germany. However, concentration figures should be treated with caution as they might not be a good predictor of market power and large interest margins. Finland is an interesting test case as concentration has increased substantially over the last ten years due to domestic mergers. Margins on deposits have decreased from 8 per cent in 1986 to 1.4

Table 4.8 Market concentration (C5, five largest firms)

Loan

Deposit

1985

1990

1997

1985

1990

1997

Sweden

62.65

64.89

87.84

Sweden

57.9

61.4

86.90

Netherlands

67.10

76.70

80.60

Netherlands

85.0

80.0

84.20

Greece

93.16

80.75

76.90

Greece

89.2

87.6

79.60

Denmark

71.00

82.00

75.00

Portugal

64.0

76.0

79.00

Portugal

60.00

73.00

75.00

Denmark

70.0

82.0

72.00

Belgium

54.00

58.00

66.00

France

46.0

58.7

68.60

Finland

49.70

49.70

56.20

Belgium

62.0

67.0

64.00

France

48.70

44.70

48.30

Finland

54.2

64.2

63.10

Ireland

47.70

47.50

46.80

Ireland

62.6

52.6

50.20

Spain

35.10

43.10

42.10

Austria

32.0

36.4

39.00

Austria

28.90

34.00

39.30

Spain

35.1

39.2

38.20

Luxembourg

-

-

28.60

Italy

19.9

18.6

36.70

UK

-

-

26.00

Luxembourg

-

-

28.02

Italy

16.60

15.10

25.90

UK

-

-

26.00

Germany

-

13.50

13.70

Germany

-

11.6

14.20

EU

-

-

52.60

EU

-

55.0

55.00

per cent in 2000, while margins on household loans have increased from 0 per cent in 1990 to 2.7 per cent (Vesala, 1998).

To assess the impact of concentration on margins, we have to analyse the degree of contestability, that is, the ease with which a new player can enter a profitable market segment. For instance, the creation of money market funds has reduced the ability of banks to raise margins on deposits. Similarly, access by large firms to the capital markets with commercial paper or bond issues also reduces the potential impact of concentration on loan margins. However, some specific financial services appear to be less open to contestability. The review of the financial services sector in Canada (MacKay, 1998) points out that the demand for cash and payment services and the access to credit by SMEs is primarily served by local branches of banks. Moreover, although diminishing, there is evidence of 'clustering', that is, consumers acquire products in a bundle rather than individually (for instance, 70 per cent of Canadians buy mortgage and credit cards from the institution in which they do their primary banking services). Vesala (1998) reaches similar conclusions in the case of the highly concentrated market of Finland. An interesting corollary of this analysis (and a proposal in the Canadian MacKay review) is the suggestion to open payment services not only to banks but also to insurance firms and fund managers as a way to reduce concentration and increase competition. Such a move would blur the remaining differences between banks and other providers of financial services.

Lending to SMEs

Several countries, such as the United States, Canada and Australia, have feared that the creation of large banks would have a negative impact on the access to bank credit. Although the argument runs against common economic logic, according to which any profitable services would be provided by the market, the perception is that large banks would concentrate their activities on large corporate firms at the expense of SMEs. Peek and Rosengren (1999) and Strahan and Weston (1999) use a 1993-96 data set of mergers to demonstrate that in many mergers the level of small business lending actually increases. In view of this empirical evidence, with competitive products offered by non-bank financial companies or simply trade credit, and in view of the fact that more and more banks are using credit scoring models to evaluate small-business loans (69 per cent of US banks in 1997), is is likely that the impact of bank mergers on small-business lending will not be so significant. To the best of our knowledge, no such study exists in Europe, and a task of central banks should be to monitor both the quantities and prices of services to the retail trade and to SMEs.

Competitiveness

A final role for public authorities is to facilitate the creation of competitive domestic firms. The banking literature (Berger et al., 1999 and Dermine, 1999) has reviewed the various arguments for bank mergers. If economies of scale do seem significant in specific segments of the investment banking industry (such as bond and equity underwriting, or custodian activities), scope economies resulting from financial diversification or the search for efficiency through the closure of branches appear relevant in retail banking. Moreover, there is the untested argument that the future with e-banking will demand banks of a larger size. To foster competitiveness, policy makers will want domestic firms to reach an optimal size and European coverage. In this case, there appears to be a trade-off between the benefits of large successful domestic firms and the 'low-probability' event of a very costly bail-out. As discussed above, this trade-off appears particularly acute in smaller countries.

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