Expansion of Banking Scale and Scope: Don't Banks Know the Value of Focus?

London Business School WP No. LBS-IFA 275-1998

29 Pages Posted: 13 Aug 1998

See all articles by Arnoud W. A. Boot

Arnoud W. A. Boot

University of Amsterdam - Amsterdam Business School; Centre for Economic Policy Research (CEPR); Tinbergen Institute

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School

Date Written: June 1998

Abstract

This paper provides an explanation for the urge of banks to merge and expand scope. We build a model where bank activities evolve over time. Due to deregulation and technological advances, new opportunities become available, but the skill needed to exploit them effectively may be unknown. Early entry into these scope-expanding activities may have learning benefits that are manifested in discovery of the skill needed to operate effectively. This discovery permits more efficient production decisions and thus has value that is increasing in the strategic uncertainty about future skill that exists in the scope-expanding activity.

Scope expansion, however, may not always be optimal. The reason is that scope expansion requires irreversible investments before actual demand is known. This demand uncertainty means that losses are incurred when demand does not materialize and the irreversible investment is forsaken. To offset these losses, two conditions must be met. First, sufficiently high strategic uncertainty about future skills is necessary. Second, the existing commercial banking operations must be sufficiently profitable to give the bank the necessary "deep pockets" to absorb these losses. The latter suggests that banking may not be too competitive and could point to a benefit of merging insofar as mergers reduce competition and deepen the banks' pockets. Moreover, a merged entity may acquire the necessary skill for the future opportunity with higher probability than either of the merging partners on their own. This may elevate the benefits of merging further.

JEL Classification: G21, G24, G31, G34

Suggested Citation

Boot, Arnoud W. A. and Thakor, Anjan V. and Milbourn, Todd T., Expansion of Banking Scale and Scope: Don't Banks Know the Value of Focus? (June 1998). London Business School WP No. LBS-IFA 275-1998, Available at SSRN: https://ssrn.com/abstract=103129 or http://dx.doi.org/10.2139/ssrn.103129

Arnoud W. A. Boot

University of Amsterdam - Amsterdam Business School ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4162 (Phone)
+31 20 525 5318 (Fax)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Todd T. Milbourn (Contact Author)

Washington University in Saint Louis - Olin Business School ( email )

1 Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6392 (Phone)
314-935-6359 (Fax)

HOME PAGE: http://www.olin.wustl.edu/faculty/milbourn/

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