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.
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
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
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:
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 channelthat 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
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
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.