The Economics of Bank Mergers in the European Union, a Review of the Public Policy Issues

INSEAD Working Paper No. 99/35/FIN

52 Pages Posted: 13 Jul 1999

Multiple version iconThere are 3 versions of this paper

Date Written: May 1999

Abstract

A very large merger wave in the banking sector has taken place in Europe and the United States over the last ten years. This raises a set of questions to different parties. Banks' shareholders and managers need to identify the potential sources of economic gain derived from a merger or an acquisition. As concerns public policy makers, they need to assess how bank mergers--be they domestic intra-industry, across-industry, or cross-border--affect their mission of protecting investors and ensuring financial stability, an appropriate level of competition, and the competitiveness of national firms in international financial markets. Moreover, as the banking world is becoming increasingly international, there is a need to reassess the structure of bank regulation and supervision which has been historically assumed by each nation State.

In European countries, mergers have allowed banks to increase efficiency by facilitating the coordination of the closing of branches. This raises a fear of excessive concentration in some banking markets. An alternative way to decrease the excessive size of the distribution network could have been a cooperative agreement among banks or a State-led reduction of capacity as was done in the steel industry. However, if scale or scope economies do prevail, mergers would be a better way to achieve both efficiency and appropriate scale. But the very large empirical literature on the many potential sources of scale or scope economies identified in the report raises some doubt as to the significance of these benefits, in particular for banks larger than euro 100 billion. A legitimate question concerns the existence of economies of scale and scope in the future as both new technology and the single currency are transforming rapidly the banking industry. There is clear evidence that size and international coverage are important to operate on several segments of the capital markets (such as bond and equity underwriting, or custodian activities). On the retail markets, it is the author's opinion that European coverage will be important to diversify credit risk and that size will facilitate international expansion and brand recognition. In view of these potential gains to be achieved by mergers, policy makers have to consider the potential social cost of these mergers.

Mergers & Acquisitions in banking are raising policy issues for three major reasons. The first one is concentration, market power and too large interest margins which hurt the real economy. Since many financial services are contestable, the worry about concentration should focus on lending to individuals and small & medium size firms and on the supply of payments services. As concerns the latter, payment services could be opened to new financial players, such as mutual funds or insurance companies. Moreover, competition from the co-operative mutual banking sector can mitigate the effects of concentration in some countries. Secondly, there is a concern that large banks will devote less attention to lending to small &medium size firms. Recent US evidence puts this argument into doubt by showing that, if larger banks focus less on the retail sector, this opens opportunities to other financial services providers. The third and more significant issue in the author's view is systemic stability, in particular in small countries that have generated very large institutions, namely the Netherlands and Switzerland. Under the premise that the default of a large bank would be costly (or that a costly bail out would be necessary), it would appear that small countries are facing a comparative disadvantage, as the cost of public bailout will be spread among a smaller population. For instance, the book value of equity of the United Bank of Switzerland represents 9 percent of Swiss Gross Domestic Product, while the equity of Deutsche Bank-BT represents one percent of the GDP of Germany. With a similar degree of risk aversion, one would find it more efficient to spread the bailing cost across a larger European population base. Moreover, since the default of a large international bank could affect many countries, the decision of a bail out should be taken jointly by these countries. These two arguments suggest the need for both a European bail out authority and a European banking supervisor. However, this state of the world cannot be reached as long as nations want to retail full control of their public spending.

In this second best world, smaller countries will have to carefully balance the benefits of large and competitive financial groups with low probability costly default. To improve the odds, they will need to develop superior supervisory systems in three directions. The first will be to check the ability of financial institutions to control risk ex ante. Secondly, they will need to be able to value frequently and conservatively the solvency of financial institutions to be able to step in before a large shortfall arises. Finally, they will need to improve their bankruptcy proceedings to facilitate the closing of financial institutions in those very rare cases of insolvency.

JEL Classification: G21

Suggested Citation

Dermine, Jean, The Economics of Bank Mergers in the European Union, a Review of the Public Policy Issues (May 1999). INSEAD Working Paper No. 99/35/FIN, Available at SSRN: https://ssrn.com/abstract=168808 or http://dx.doi.org/10.2139/ssrn.168808

Jean Dermine (Contact Author)

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France
+33 1 60 72 41 33 (Phone)

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