U.S. Banker, September 1998

Is Bigger Banking Better?

by Susan Webber

Dollo's theory of evolution is a novelist's invention that rings true. According to Dollo, species develop characteristics that confer competitive advantage, but continue to develop them beyond the point of maximum advantage. Sabertoothed tigers developed massive jaws to be more efficient killers, for instance, but wiped out their natural prey and could not adapt to hunting small mammals.

The banking industry has much to learn from Dollo. Commercial banks are bulking up, assuming that size will make them more successful. Unfortunately, Hugh McColl's battle cry, "Bigger is better," unwittingly evokes the theme of this summer's "Godzilla" film, "Size does matter." Perhaps only in Hollywood and in the checkbooks of Wall Street dealmakers is the pursuit of size for size's sake a good thing. By following a fundamentally flawed strategy, banks that confuse size with strength make themselves vulnerable to more agile competitors.

Examining Conventional Wisdom

Proponents of bank mergers argue that larger institutions will perform better for customers and shareholders. Let us examine three of the most commonly cited reasons.

     • Better/broader product offerings. Larger banks can offer customers a more comprehensive set of products, through cross-selling or its cousin, one-stop shopping. Few have bothered to ask whether consumers really want to buy all their financial products from one source. Consumer banking is a retail business, and the predominant trend in retail has been department stores' loss of market share to specialty retailers and mail-order firms.

Banks customer relationships have been degraded through efforts to minimize costly human interaction. As Keefe, Bruyette & Woods' director of research, David Berry, points out, "A lot of customers are now willing to deal with banks in an impersonal way, with an 800 number and with 24-hour-a-day, 7-day-a-week access."

Another flaw with cross-selling is that for sophisticated consumers, products must be competitive. For example, banks have not had much success with mutual funds because their in-house funds are typically neither stellar performers nor recognized brand names. Similarly, banks are increasingly competing with narrowly focused firms with low selling costs. Many banks have not faced the issue of managing channel conflicts and may be reluctant to match the price of the cheapest provider.

     • Cost savings. In many recent transactions, the combined bank has reduced costs considerably. The assumption that needs to be examined is whether the greater size or scope of the new bank was necessary for the expense cuts, or whether a comparable level of savings could have been achieved by each bank on its own.

The evidence strongly suggests that, beyond a fairly low threshold, greater size does not make for lower operating costs. Numerous analyses have found that the banking industry has a flat to slightly increasing cost curve above the $5 billion level. Indeed, Federal Deposit Insurance Corp. Data show that banks in the $1 billion to $10 billion size range have the best efficiency ratios.

Post-merger cost cuts do not prove that larger banks are more efficient. The flat industry cost curve implies that these costs could have been taken out in the absence of a deal. A transaction merely provides the impetus for drastic action.

     • More efficient technology spending. While technology is part of the cost equation, it merits separate discussion. Just as large banks are not necessarily more cost-efficient than smaller ones, big technology not necessarily cheaper than its small-scale counterpart. For example, many large banks face greater proportional Year 2000 costs. Citicorp expects to spend $600 million (.21% of assets) and Chase Manhattan Corp., $250 million (.07% of assets), compared to under $1 million for Hibernia Corp. (.01% of assets) and $30,000 for National Commerce Bancorp (not a meaningful percentage).

One of the not-widely-recognized culprits is that the popular client/server architecture does not become cheaper with size. While mainframe expenses decline above a threshold level, client/server networks show strong diseconomies. Networks become increasingly difficult and expensive to manage as the number of servers grows, and the costs escalate faster if the bank plans for disaster recovery, which virtually necessitates redundant systems.

Mundane factors can also raise technology costs. Large organizations typically have correspondingly large technology initiatives. Mid-course changes are more likely, and are often more costly.

If the idea that bigger technology is cheaper is a chimera, the notion that large bank mergers can lower technology costs is pure fantasy. "Eighty percent of these bank mergers are going to produce higher technology costs," says Alex Kalpaxis, former chief scientist of Bankers Trust Corp. and head of AstraTek, a software development and consulting firm. "You definitely don't get cost savings as you bring two IT organizations together. If one was more centric, more mainframe-oriented, while the other was more client/server, you will see huge increases in costs."

Beyond a fairly modest threshold, size also produces certain disadvantages. One is lack of flexibility. Less obvious is exposure to increased regulation. Large banks may be subject to greater oversight and control because they are too big to fail, wield too much economic power or become the target of social activists.


The current industry consolidation is in an interim phase. Most banks are simply transplanting the strategy of being all things to all people from protected local markets to a national market. Few have made the tough decisions regarding how they will gain competitive advantage, since size alone does not create a defensible position. Banks need to decide how to focus on customers, products and business processes. The implications of the mismatch between the bank merger phenomenon and the economic fundamentals include:

     • Increased penetration by smaller, new entrants. Banks' share of the financial service industry has declined over the last 20 years and will continue to decline as technology lowers the barriers to entry for nontraditional players. Bank of Montreal COO Tony Comper describes the worst-case scenario:

"With its high-profit customers lost to cherry-pickers, the bank is still faced with supporting an expensive infrastructure and with the fact that most of the customers who remain will be the heaviest users of the costliest distribution channel—that is, the branches. And then, if the bank tries to raise fees or reduce services, more customers will leave, and the cost of providing service will rise once again. This is the 'death spiral' which would be extremely difficult to exit once it is entered."

Large banks may be inclined to ignore specialized competitors and lose valuable time. They may also be distracted by the challenges of integrating acquisitions.

     • Further restructuring as banks begin to develop differentiated approaches. Bank mergers are far from over, and banks will reshuffle assets as they try to develop a defensible competitive position. Certain banks may achieve a cost advantage in specific business, such as the Bank of New York has in securities processing, custody and clearing; the rest must find other ways to compete.

     • Opportunity to differentiate via service. As institutions have grown, banking has become even more impersonal. Most banks define service in modest terms, such as time spent in teller lines. Many industry executives assume that service is not scalable. Yet providers in other service industries, such as Four Seasons Hotels, British Airways and Starbucks have found ways to make the customer feel valued in much more transient relationships.

The headline-grabbing bank mergers favor brawn over brain, when evolution shows that size alone does not afford much protection against predators. Some of today's large banks can emerge as winners, but that will occur only after they have determined how to make their considerable resources work for them and their customers.