U.S. Banker, November 1995

Merger Boom's Big Lie

by Susan Webber

Tell a Scot about a new idea and he is likely to reply, "The case is not proven." The banking industry would benefit from a healthy dose of Scottish skepticism right now, for the rationale underlying the current merger boom — that bigger is better — has little hard evidence to support it.

Pro-merger sentiment and activity run strong nowadays. According to Securities Data Co., through the end of August U.S. banks had completed 277 deals worth $34.2 billion in 1995, easily topping the previous peak of $24 billion for all of 1991. As one deal maker puts it, "There isn't a bank under $100 billion in assets that isn't thinking about who to tie up with." But is this enthusiasm warranted? Or is it, like the discredited third world, leveraged buyout and real estate lending of the 1980s, another case of bankers looking to their peers to justify a misuided impulse?

Despite the enthusiasm of the stock market, odds are the current urge to merge will not deliver improved competitiveness, more efficient operations or better customer penetration. That's not to say mergers never work but that many of the current transactions are based on false premises. Preoccupation with deal-making also distgracts management from taking concrete measures to improve performance now. Finally, as they chase one another around the sofa, their focus remains inward when bankers need to think and act outside traditional industry boundaries.

The big lie of the current acquisition vogue is that the largest banks will ultimately win. True, some financial services businesses like mutual funds, custody and mortgage servicing, show powerful scale economies. But for banking companies, the connection between size and performance is tenuous. Beyond a certain size threshold, there is not much correlation between efficiency ratios and asset size. Indeed, some bank analysts project that regional banks will become more efficient than their larger money center brethren.

What about the notion that bigger, newly-merged banks can strip out more costs than either bank could separately? A Standard & Poor's study has confirmed that bank mergers can result in lower costs, but others have been able to achieve similar levels of costs savings with less disruption and without paying acquisition premiums. The cost-cutting of newly combined banks focuses on processes and business practices and does not appear to take advantgage of scale economies, perhaps because there are few to expoit. Running larger organizations requires more reporting and a greater span of control, which increases costs and reduces agility.

Technology Now Affordable

Another false idea is that technology favors the large. Systems costs have dropped greatly, and the speed of commoditization of once-advanced technologies has quickened to the point that very small trading firms can afford state-of-the-art derivatives packages. The reason banks find technogy expensive is that they need to integrate and update old systems. A merger only makes this task more difficult and costly since more systems are involved.

The truth is that bank executives seek safety in size. They hear about consolidation and industry-wide excess capacity on almost a daily basis. But what drives them to do deals is not a reading of industry trends but concern about their future. They are afraid of aggressive acquirers and being outflanked by banking behemoths. The fear factor outweighs cold-blooded calculation. In its recent merger with Chemical Banking Corp., Chase Manhattan Corp. succumbed to the pressure of activist investor Michael Price. Even though Price owned 6.1% of the bank, he could not buy it since control could only pass to another bank.

Some executives sense a market top and figure it is better to cash in, exit with a strong record and try to influence their destiny through favorable "social" arrangements with buyers rather than fight it out in the coming lean years. As Daniel Nelson, chairman of Boise's West One Bancorp, said his decision to sell: "Timing is everything. Our board had been considering whether to sell for several years. We decided our earnings were not going to get any better than they had been."

Bank managements are more eager to sell than before and are accepting lower prices. Over the last 12 years, bank prices have held remarkably constant at 15 times trailing earnings. This year, bank transactions have averaged 14 times earnings. While this may not seem like much of a change, in the current environment it fuels transactions by producing little or no earnings dilution for buyers. Never at a loss for a catchy phrase, Wall Street pros have labelled some of these bank deals "takeunders."

Sellers can rationalize deals in terms of the benefits to shareholders or greater scope for the combined organizations. Buyers make a more straightforward case for heft. In the words of Chemical's Walter Shipley, who will be the chairman and chief executive of the new Chase: "Well-managed size is a strength for our customers."

The siren song of adulation is undeniably a motivating factor as well. NationsBank Corp. CEO Hugh McColl, portrayed as a feared and savvy deal maker, becomes a gun-toting, macho man on a recent cover of "Fortune" magazine. Yet his predatory bent has done nothing for the stock price, which has stayed essentially flat for the last five years, during one of the greatest bull markets for bank stocks. (It is worth noting that the article did give the shares a lift.)

For more conservative managements, transactions have other appeals, like prescribing the course of action for the next few years. The Chemical/Chase deal may offer abundant opportunities for synergies, but it also comes at a particularly opportune time for Chemical. CS First Boston Corp. bank analyst Thomas Hanley notes that the easy operating improvements have largely been squeezed out of the MHT acquisition, and the key test of generating productivity gains and EPS growth lay ahead. Another big deal gives the new Chase at least a couple of years of digestion before it has to address those difficult questions again.

Yes, the environment is tough. The steep yield curve of the early 1990s, which subsidized bank profits, is gone. Competition for consumer and commercial loans is fierce and spreads over cost of funding are at cyclical, and in some cases, historic lows. Some bank analysts believe that banks are taking on greater risks and under-reserving, thus overstating current profits and setting the foundation for future credit losses.

Securities firms, insurance companies and mutual funds all continue to attract bank customers with banklike services, and the advent of electronic banking and electronic money has positioned Microsoft and the Internet as competitive threats. But banks, because they look to other banks for examples and ideas, sell themselves short.

The Efficiency Problem

Banks are very inefficient—but the problem lies principally on the revenue rather than the cost side. A 1993 study in the "Journal of Finance" concluded that banks can achieve ROAs between 2.6% and 3.7% based primarily on output improvements. Too many banks fail to fully achieve their revenue-producing potential.

The danger of the current merger environment is that both the contemplation and the execution of transactions diverts management from taking concrete steps to improve performance. There is plenty bank executives can do if they want to. Some examples:

     • While most banks recognize the potential of cross-selling, very few do it well. Efforts tyically fade as the initial enthusiasm wanes. Even relatively successful efforts generally fail to generate ongoing referrals between organizationally remote areas, like retail and asset management, or treasury and corporate lending. A well-designed program involves all sales forces and includes a formal process for screening, qualifying, and managing referrals, meaningful financial rewards and education. Equally important, it requires strong, visible and continuing senior management support.

     • Salesmen, whether corporate lenders, small business account officers or private bankers, are often overwhelmed by the number and complexity of new products. They either avoid them or bring in a product specialist at the earliest possible juncture, which is costly and generally unproductive. Companies like IBM, PepsiCo, and Charles Schwab & Co. use an approach called "just-in-time learning," which recognizes that selling is much like teaching. The sales staff gets laptop based tools with product information that they can use not only to prep themselves, but also to explain product features to customers—thus making them more productive and turning what would normally be a training cost into a marketing tool.

     • Most banks lack the management information they need. A recent Ernst and Young study showed that only 24% of all banks can analyze proditability by customer, 32% by product, 37% by branch and 43% by line of business. Far fewer banks can determine the risk-adjusted profitability of their activities. It is difficult to see how managements can make informed decisions about where to invest resources if they do not know where they are making money.

     • Probably the biggest reason that banks don't generate more revenues is that there are few incentives for employees to be more productive. Even though banks have gotten better about cutting deadwood, they do not pay stars much more than average players. Moreover, at most banks managing is held in higher esteem than producing and it is a very exceptional boss that pays an underling more than he or she earns. Banks can learn a lot from how LBO companies and aggressive companies like General Electric Capital Corp. measure performance and reward managers.

Another danger of the merger fad is that it keeps bankers' horizons small. Even though banks are beginning to pursue differentiated strategies, most still sell a broad array of products to a broad cross-section of customers. And this makes them vulnerable to narrowly focused competitors who target attractive customers and products, especially branch-based services where semi-fixed costs absorb a large percentage of revenues. But banks are defending their traditional high-cost channels, for example, by pricing electronic access at a premium to prevent cannibalization of branch business.

It is similarly surprising that no U.S. bank has replicated U.K.-based Midland Bank's First Direct venture, a stand-alone telephone bank that has already attracted over 500,000 customers. If banks are to do deals, better to do one that changes a bank's outlook. A compelling example is Swiss Bank's acquisition of U.S. derivatives player O'Connor & Associates. That deal not only brought new technology, it energized the stodgy SBC culture, facilitated a reorganization of business units along global lines of business and is turning out to be an extremely attractive investment.

Banks need to start looking not just to other financial service firms but to other service businesses for models of how to compete more effectively. A catalog marketer, for example, would make very profitable use of the information banks possess about how much their customers spend and where they spend it. Similarly, retailers think much more about format and store productivity than banks ever have, and are obsessed with factors such as sales per square foot, service productivity, defection rates and sales closure rates.

Bank executives need to make certain they are not using mergers as a way to avoid the tough challenges before them. While combining organizations and cutting costs is not easy, it is far more difficult for bankers to do what they really need to do, which is radically reshape their outlook, their way of doing business and their culture. The industry needs more thrifty Scots and fewer profitgate dealmakers.