Bank mergers: a bad idea

MUKESH KHANAL

Recently, during his presentation of mid-term review on monetary policy, Nepal Rastra Bank governor Yubraj Khatiwada suggested to the bankers that they should engage in mergers and acquisitions. He posited that the increase in credit interest, that has been observed, was the result of increase in interest rates on deposits. Therefore, funds for further growth have been difficult to obtain due to the resulting higher costs of obtaining such funds. A merger of banks, the governor believes, will help reduce the costs of operating a financial institution. This according to me is a dangerous suggestion.

Like many other economists, the governor believes that a merger or acquisition will result in an institution that is bigger than its individual parts. This bigger institution will experience lower costs due to economies of scope and scale, increase in market power, diversification, and reduced operational expenses. Thus, the perception is that this consolidation will accrue higher gains than the simple sum of gains from two separate institutions.

The perceived gains arise out of the belief that the newer and larger organization is considered to be efficient in allocating resources—human and capital—to maximize the output gains. The same personnel and infrastructure can deliver different services and products. Thus, redundant operating costs will be minimized. The belief is also that the larger bank, with more resources now at disposal, can even offer more products and services than before. In essence, the larger entity could take the best tools and methods from the pre-merger entities to maximize efficiency and capabilities.

However, these perceived gains do not occur, at least not to the extent that is perceived. Research on mergers and consolidations has shown that there is no conclusive evidence of such gains existing in reality. Hence, the governor’s suggestion to the bankers was based on little factual evidence. While the suggestion might have been genuine and made in earnest, the repercussions could be devastating. In this case, the idea of bank mergers creates risk of underperformance and loss in overall valuation of the banking industry. Therefore, the governor needs to be careful while dispensing his wisdom.

There are many methods for cost-cutting, and numerous austerity measures can be implemented if the banks are in trouble. Mergers should be the last option, and not the first, that should come into the minds of Nepali bankers and the central bank’s governor, when there is trouble.

A prominent effect of bank mergers observed around the world has been the reduced availability of loans to the customer base in the aftermath of the merger. This reduced availability mainly results due to the decline in competitiveness that arises due to the mergers. When a market becomes less competitive, it becomes difficult for people and businesses to obtain loans at reasonable interest rates. The unreasonable interest rates for loans, in turn, results in lower investment in real estate, and devaluation of real estate property prices. If mergers are going to cause similar cascading aftereffects in real estate, which is our fastest growing economic sector, bank mergers are an ill advice for today’s Nepali banks.

Studies have shown, time and again, that diversification, efficiency, enhanced production and service have largely been found missing as results of a merger. Also, whatever the varied intentions provided for mergers, the underlying incentives have always been cost reduction. And, cost reduction is not an issue that is severe enough to grant merger and acquisition rights from the central bank. Our central bank has to be cautious in this regard.

Cost reduction can be done in a variety of ways. Mergers should be advised as the last option, and should only be allowed if one of the merging banks is facing a dire consequence, such as bankruptcy, if not merged. It helps to be cautious because mergers often result in anti-trust issues. Well-meaning intentions before the merger go haywire after the merger. Companies have been observed to be engaged in activities ranging from anti-competitiveness to corruption after the merger.

Also, mergers do not work, most of the time, in achieving the stated objectives. They do not increase efficiency, do not promote diversification, and do not reduce costs in the extent that are touted before the merger. In fact, just the opposite has been the case. Although the results from post-mergers vary from one country to the other, empirical studies have shown that only 14 to 17 percent of mergers result in lower costs. However, the question could then be asked: Could the costs have been lowered by other means before deciding that the merger was the best option? There are many methods for cost-cutting, and numerous austerity measures can be implemented if the banks are in trouble. Mergers should be the last option, and not the first, that should come into the minds of Nepali bankers and the central bank’s governor, when there is trouble.

The main argument that economists and policymakers put forward to support mergers has been the idea of supposed creation of scale economies. In simple terms, it means there are advantages in cost reduction when a company becomes larger. However, there is strong evidence of uncertainty over the very existence of economies of scale. And, in cases where economies of scale have been observed, there is significant uncertainty over how wide the range of the scale is. In addition, in cases where scale economies have been observed, the banks that merged have always been two smaller banks.

However, the gains are very small and likely attributable to technological progress rather than economies of scale. The gain is not observed in instances when two large banks are merged to create an even larger bank. Therefore, in Nepal, if the central bank grants permission for banks to merge, it has to ensure that the banks that are merging are not large. Such precautions have to be taken because those kinds of mergers are seen to have reduced market competition among banks and create unfair market power, anti-trust issues, and corruption.

Another argument policymakers use to support mergers is the creation of scope economies because of subsequent diversifications of the portfolio. It means a large bank is able to utilize more resources to render diverse and wide range of products and services. However, customers that have accounts in the merged banks experience deteriorating customer service, increasing fees, new and unfair account features and structures applied without prior notification. These are not desirable results from a merger.

In addition, in order to prevent closed accounts, banks have practiced activities such as lowering the fees and rates in the short-term. When the competition fades off and the merged banks gain significant market power due to their large size, they have hiked their fees and charges. Economists at the Federal Bank of New York have observed that, even when there was no competition with rivals, the merged banks always lowered the interest rate paid to customers on savings. That is a practice meant to increase shareholders’ profits by harming the customers. It is not a desirable outcome for the market.

The most important question in our case could be whether the Nepali banking industry needs mergers at all. The banking industry in Nepal is still growing, and does not seem to be in much trouble. If the central bank feels that there are too many banks in Nepal, it should stop issuing new permits. Issuing too many permits, and then asking the banks to merge, is a bad way of doing business. It also makes the central bank look like it is run by a group of amateurs. And, that is the last thing you want people to think about the central bank. This type of amateurish activity deteriorates the confidence that the consumers and businesses have in our central bank, and can have devastating economic consequences.

We all saw, in the last few years, that big American and European banks, those created mainly as results of various mergers, all came crashing down while little banks survived. If there’s one lesson we can all learn from recent world-wide financial crisis, it is this: The bigger our banks are, the harder they come crashing down when there is any trouble. The bottom line is this: No more permits to open new banks and no more mergers. If they cannot stand the competition, let them fail and exit the market. That is what capitalism teaches us. That is what should be practiced.

Writer is an Economist at the Institute for Integrated Development Studies (IIDS). He can be reached at mkhanal@iids.org.np