1. How do limitations on geographic diversification affect an FI’s profitability?

 

Limitations on geographic diversification increase FI profitability by creating locally uncompetitive markets.  FIs in these markets earn monopoly rents that are protected by limitations on geographic expansion by potential competitors.  Limitations on geographic diversification reduce FI profitability by preventing the FI from exploiting any economies of scale and/or scope or revenue synergies that may be available.

 

2. How are insurance companies able to offer services in states beyond their state of incorporation?

 

Insurance companies are state-regulated firms that are not prohibited from establishing subsidiaries and offices in other states.  Further, the capital requirements are kept low by state regulators.

 

3. In what way did the Garn-St Germain Act and FIRREA provide incentives for the expansion of interstate branching?

 

Both legislative acts provided for sound banks and thrifts to acquire failing banks and thrifts across state lines.  These acquisitions could be operated either as separate subsidiaries or as branches of the acquiring institution.

 

4. Why were unit and money center banks opposed to bank branching in the early 1900s?

 

Smaller unit banks were afraid of losing retail business to the larger branching banks, and the larger money center banks were afraid of losing correspondent business such as check clearing and other payment services.

 

5. In what ways did the banking industry continuously succeed in maintaining interstate banking activities during the 50-year period beginning in the early 1930s? What legislative efforts did regulators use to respond to each foray by banks into previously prohibited banking and commercial activities?

 

The McFadden Act of 1927 restricted the branching activity of nationally chartered banks to the same extent allowed for state-chartered banks that generally were disallowed from such activity. As a result, the banking industry attempted to circumvent the prohibition of interstate banking by establishing subsidiaries rather than branches under the holding company organizational form.  The Douglas Amendment to the Bank Holding Company Act restricted the acquisition of banking units to the state-allowed activities.  However, the law did not prohibit one-bank holding companies from acquiring nonbank subsidiaries that sold financial products.  Thus the path to geographic expansion continued as banks searched for loopholes to circumvent the legislative restrictions placed on their activities.

 

6. What is the difference between an MBHC and an OBHC?

A multibank holding company is a parent organization that owns more than one bank subsidiary, and a one-bank holding company is a parent organization that owns only one bank subsidiary.  Each organization may own other subsidiaries that provide services closely related to banking as allowed by regulatory authorities.

 

7. What is an interstate banking pact? How did the three general types of interstate banking pacts differ in their encouragement of interstate banking?

 

An interstate banking pact is an agreement between states defining the conditions under which out-of-state banks can acquire in-state subsidiaries.  A major feature of these pacts normally was the reciprocity conditions awarded each state involved.  A nationwide pact allowed out-of-state banks to purchase target banks even if the acquirer’s state did not allow such activity.  A nationwide reciprocal pact allowed purchase only if the acquirer’s state allowed the same activity.  Third, a regional pact allowed out-of-state acquisitions within a small number of states only under conditions of reciprocity.

 

8. What significant economic events during the 1980s provided the incentive for the Garn-St Germain Act and FIRREA to allow further expansion of interstate banking?

 

The bankruptcy of the FSLIC and the depletion of the FDIC’s insurance reserves provided incentives to allow out-of-state acquisitions to resolve bank failures.  The Garn-St Germain Act allowed banks to acquire failing thrifts across state lines.  Finally, FIRREA allows for the purchase across state lines of healthy thrifts.

 

9. What is a nonbank bank? What legislation allowed the creation of nonbank banks?  What role did nonbank banks play in the further development of interstate banking activities?

 

A nonbank bank is a financial institution that did not meet the requirement of (1) making commercial loans and (2) accepting demand deposits as defined in the 1956 Bank Holding Company Act. By purchasing an out-of-state bank and divesting its commercial loans, a large bank or bank holding company could create a nonbank bank that could be used to provide retail or consumer finance banking activities.  This loophole was not closed until the Competitive Equality Banking Act of 1987.

 

10. How did the development of the nonbank bank competitive strategy further clarify the meaning of the term activities closely related to banking? In a more general sense, how has this strategy assisted the banking industry in their attempts to provide services and products outside the strictly banking environment?

 

The Bank Holding Company Amendments of 1970 specified that nonbank activities had to be closely related to banking.  As the growth rate of nonbank acquisitions increased, so too did the pressure on the Federal Reserve to expand the list of these acceptable activities.  The nonbank subsidiaries eventually were allowed to provide more than 60 different types of financial products.  Thus banks learned how to replicate full-scale (or nearly) banking institutions without having a legally defined bank.

 

11. How did the provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allow for full interstate banking? What are the expected profit performance effects of interstate banking?  What has been the impact on the structure of the banking and financial services industry?

 

The main feature of the Riegle-Neal Act of 1995 is the removal of barriers to interstate banking. In September 1995, bank holding companies were allowed to acquire banks in other states.  In 1997, banks were allowed to convert out-of-state subsidiaries into branches of a single interstate bank. The act has resulted in significant consolidations and acquisitions, with the emergence of very large banks with branches all over the country, as currently practiced in the rest of the world. The law, as of now, does not allow the establishment of de novo branches unless allowed by the individual states.  As expected, profit performance of the largest banks has been very good over the period 1995 to 1999.

 

12. Bank mergers often produce hard to quantify benefits called X efficiencies and costs called X inefficiencies. Give an example of each.

 

An X efficiency is a cost saving that is difficult to measure and whose source is difficult to identify.  One common example is the reduction in expenses thought to be derived from greater managerial efficiency of an acquiring bank.  X inefficiencies occur when a merger results in cost increases that are usually attributed to management’s inability to control costs.

 

13. What does the Berger and Humphrey study reveal about the cost savings from bank mergers? What differing results are revealed by the Rhoades study?

 

Berger and Humphrey found that (1) the managerial efficiency of the acquirer is greater than that of the acquiree, (2) the X efficiency gains were small, and (3) the cost savings of mergers with geographic overlap were no greater than those for mergers with no geographic or market share overlap.  Rhoades reviewed nine megamergers and found large cost savings.  In those cases where cost efficiency gains were not realized, the problems were from integrating data processing and operating systems.

 

14. What are the three revenue synergies that may be obtained by an FI from expanding geographically?

 

The three revenue synergies that an FI may obtain by expanding geographically are as follows:

(a)     Opportunities to increase revenue because of growing market share.

(b)     Different credit risk, interest rate risk and other risks that allow for diversification benefits and the stabilization of revenues.

(c)     Expansion into less-than-competitive markets, which provides opportunities to reap some economic rents that may not be available in competitive markets.

 

15. What is the Herfindahl-Hirschman Index? How is it calculated and interpreted?

 

The Herfindahl-Hirschman Index (HHI) is a measure of market concentration whose value can be 0 to 10,000.  The index is measured by adding the squares of the percentage market share of the individual firms in the market.  An index value greater than 1,800 indicates a concentrated market, a value between 1,000 and 1,800 indicates a moderately concentrated market, and an unconcentrated market would have a value less than 1,000.

 

16. City Bank currently has 60 percent market share in banking services, followed by NationsBank with 20 percent and State Bank with 20 percent.

 

1. What is the concentration ratio as measured by the Herfindahl-Hirschman Index (HHI)?

 

HHI = (60)² + (20)² + (20)² = 4,400

 

1. If City Bank acquires State Bank, what will be the new HHI?

 

HHI = (80)² + (20)²  = 6,800

 

400. Assume the Justice department will allow mergers as long as the changes in HHI do not exceed 1,400.  What is the minimum amount of assets that City Bank will have to divest after it merges with State Bank?

 

This is a little tricky. For City Bank to complete the merger, its maximum HHI should be such that when it disposes of part of its assets, the HHI will be X² + Y² + Z²  = 5,800.  Since Z = 20 percent, we need to solve the following: X² + Y² = 5,400; that is, 5,800 less the share of Z² which is 20² or 400.

 

If the merger stands with no adjustment, then X = 80 and Y = 0. But some portion of X must be liquidated. Therefore we need to solve the equation (80 – Q)² + Q² = 5,400 where Q is the amount of disinvestment.  This requires solving the quadratic equation of the form:  Q² + (80 – Q)² = 5,400 which expands and simplifies to 2Q² – 160Q + 1,000 = 0.

Using the formula: Q = , we get Q = 73.1662 percent, which means City Bank has to dispose of 6.8338 percent of total banking assets.  To verify, we can check the total relationship: (73.1662)² + (6.8338)² + (20)² = 5,800.

 

17. The Justice Department has been asked to review a merger request for a market with the following four FI’s.

                                                            Bank                                        Assets

A                                   $12 million

B                                    $25 million

C                                  $102 million

D                                      $3 million

 

1. What is the HHI for the existing market?

 

Bank                Assets              Market Share

A                   $12 m                   8.45 %

B                   $25 m                  17.61%

C                $102 m                  71.83%

D                     $3 m                   2.11%

100.00%

 

The HHI = (8.45)² + (17.61)² + (71.83)² + (2.11)²  = 5,545.5

 

1. If Bank A acquires Bank D, what will be the impact on the market’s level of concentration?

 

Bank                Assets              Market Share

A                   $12 m                  10.56%

B                   $25 m                  17.61%

C                $102 m                  71.83%

100.00%

 

The HHI = (10.56)² + (17.61)² + (71.83)²  = 5,581

 

1. If Bank C acquires Bank D, what will be the impact on the market’s level of concentration?

 

Bank                Assets              Market Share

A                   $12 m                   8.45 %

B                   $25 m                  17.61%

C                $102 m                  73.94%

100.00%

 

The HHI = (8.45)² + (17.61)² + (73.94)² + (2.11)²  = 5,848.6

 

1. What is likely to be the Justice Department’s response to the two merger applications?

 

The Justice Department may challenge Bank C’s application to acquire Bank D since it significantly increases market concentration (HHI = 5,848.6).  On the other hand, the Justice Department would most likely approve Bank A’s application since the merger causes only a small increase in market concentration (HHI = 5,581).

 

18. The Justice Department measures market concentration using the HHI of market share. What problems does this measure have for (a) multiproduct FIs and (b) FIs with global operations?

 

(a)     The Herfindahl-Hirschman Index (HHI) for multiproduct firms is calculated either on the basis of total assets or one particular product (say, deposits). Neither solution is entirely appropriate.  Use of total assets distorts market share calculations since different FIs have different product mixes.  Moreover, an HHI based on total assets will not be accurate if there are different market concentration levels in each product market.

 

(b)     Since the calculation of the Herfindahl-Hirschman Index specifies a market area, results are dependent upon the assumption of the appropriate geographic market.  Global FIs will undoubtedly have activities outside of the specified market area.  If these are omitted in the calculation of market shares, the FIs’ market share may be understated.  However, if they are included, this may overstate the global FIs’ market share and make the market appear to be more concentrated than it is in actuality.

 

19. What factors, other than market concentration, does the Justice Department consider in determining the acceptability of a merger?

 

Other factors considered by the Justice Department include ease of entry, the nature of the product, the terms of sale of the product, market information about specific transactions, buyer market characteristics, conduct of firms in the market, and market performance.

 

20. What are some plausible reasons for the percentage of assets of small banks decreasing and the percentage of assets of large banks increasing while the percentage of assets of intermediate banks has stayed constant since 1984?

 

One reason for the decreasing share of small bank assets is the wave of mergers that has taken place over the 13 year time period.  If two small banks merge, the merged bank may have assets that move it into the next higher asset category. The changes in the interstate banking laws have encouraged this wave of mergers.  Finally, the growth of the national economy has been unprecedented during this time, which has caused the entire banking industry to perform well since the late 1980s.

 

21. According to empirical studies, what factors have the highest impact on merger premiums as defined by the ratio of a target bank’s purchase price to book value?

 

Premiums appear to be higher in states with the most restrictive regulations and for target banks with high-quality loan portfolios.  Interestingly, the growth rate of the target bank seems to have little effect on bid premiums, and profitability and capital adequacy give mixed signals of importance.

 

22. What are the results of studies that have examined the mergers of banks, including post-merger performance? How do they differ from the studies examining mergers of nonbanks?

 

Most studies examining mergers between banks show that both bidding and target banks realize an increase in market value. These results contrast with those of nonbanks studies where only target firms benefit by an increase in stock prices (market value). Bidding firms experience either no gains or in some cases, a decline in market value declines. In addition, studies have also shown that post-merger banks increase their efficiency through reduced operating costs, increased productivity, and enhanced asset growth.

 

23. What are some of the important firm-specific financial factors that influence the acquisition of an FI?

 

Some of the important factors are the leverage ratio, the amount of loss reserves, the loan to deposit ratio, and the amount of nonperforming loans.

 

24. How has the performance of merged banks compared to that of bank industry averages?

 

Cornett and Tehranian found that merged banks tend to outperform the industry with significant improvements in the ability to attract loans and deposits, increased employee productivity, and enhanced asset growth.  Spong and Shoenhair found that acquired banks maintain or increase profits and become more active lenders.  Boyd and Graham found that banks formed from the merger of small banks also outperformed the industry.

 

25. What are some of the benefits for banks engaging in geographic expansion?

 

The benefits to geographic diversification are:

 

(a)     Economies of scale: If there are efficiency gains to growth, geographic diversification can reduce costs and increase profitability.

 

(b)     Risk reduction: Overall risk reduction via diversification.

 

(c)     Survival: As nonbank financial firms have increasingly eroded banks’ market share, banks’ campaign to expand geographically can be viewed as a competitive response.  That is, as global FIs dominate the financial environment, larger institutions with presence in many regions may better position the FI to compete.

 

(d)    Managerial welfare maximization: Empirical evidence suggests that larger institutions offer more lucrative compensation packages with greater amounts of perquisites for managers.  Growth via geographic diversification may therefore be in the interests of managers, but not in the interests of stockholders unless the activities increase firm value.