Rationale of the Merger: Overview of the Banks History Essay Example

which led to an increase in the average total value of bank equity acquired in acquisitions per year by over 300%. This trend resulted in a consolidation of the U. S. banking industry, in which a few banks were holding a great deal of total bank assets, for instance the top 50 banks now held 65% of the total assets compared to 53% in 1985 (Gilson and Escalle, 1998).

This period of mergers created new competitors. As a result Chemical and Chase were both under pressure to react to the rise in competition for national and international market shares in order to hold their market position. Despite the leading position Chemical had achieved thanks to its merger in 1991, the bank had fallen by late 1994 to fourth place in terms of size (Gilson and Escalle, 1998). Motives behind Merger and Acquisition Transactions As Brealy and Meyers (2005; pp. 55) mentioned mergers can be divided into different categories: horizontal, vertical or conglomerate.

A horizontal merger is defined as a merger between two firms of the same line of business. Hence the merger between Chase and Manhattan would clearly belong to this category as they both are commercial banks. In contrast a vertical merger takes place between companies in different stages of product (Brealy and Meyers, 2005) and conglomerates are mergers or more usually acquisitions where the two firms are engaged in different lines of business (Brealy and Meyers, 2005).

Another kind of distinction, closely related to the above described one, can be made: in-market mergers and market extension mergers. In in-market mergers, as the one between Chase and Chemical would be described, the merging companies do business in

the same markets, the merger rationale is mainly to eliminate overlapping activities and consolidate market positions. In contrast a market extension merger is done to enter new markets and diversify production (Gilson and Escalle, 1998).

M&A often goes along with globalization and deregulation, which increase the competitive situation in world markets and therefore forces companies to react with structural changes. The inability of some companies’ respectively their management to grow under their own power can also lead to M&A transactions (Volkart, 2007; pp. 1083). Although it is worth mentioning that intern growth can be accompanied by high costs (Berger and Humphrey, 1994). Different motives behind Mergers & Acquisition (M&A) exist. Expanding the business is definitely one of them.

However the dominant goal of an M&A activity is the improvement of a firm’s financial performance and efficiency. Volkart (2005; pp. 1084-1086) mentioned numerous theoretical approaches for the explanation of the existence of M&A as there are: Synergy theories: financial, operational and competitive synergies potential. Market power and competition: possibility of eliminating competitors through acquisitions. Corporate taxes: possibility of buying loss makers and thus reducing tax liabilities. Inefficient management: in a merger a weak management can be replaced by a new one.

Diversification: since inefficiency in markets often exists, diversification through acquisition can be achieved (in addition to diversification through securities). Eat or be eaten: especially in markets with a lot of structural changes and diverging sizes of companies the question arises, whether one wants to make an acquisition or be acquired. Nevertheless Shim and Siegel (2006; pp. 230) stated that mergers have several disadvantages as well: Earnings per share: Should be greater or equal as after the merger, which

often is not the case.

Market price per share: should be bigger or equal after the merger, which often is not the case. The culture within the two companies can be totally different, making integration difficult and costly. Need, in order to succeed, of a reduction of the labor force, which potentially can cause reputational damage and lower employee morale for the new company. Numerous econometric studies of bank scale and scope economies, efficiency and mergers in U. S. banking have been conducted (Berger and Humphrey, 1994).

Berger and Humphrey (1994) stated that economies of scale, economies of scope and x-efficiency are generally able to increase the efficiency of a company, whereby x-efficiency is much more important than scale and scope economies. The academic studies have come to the result that economies of scales indeed allow average costs to fall with increases in bank size. Additionally there are minor economies of scope that reduce costs by around 5%. Furthermore the studies have shown that x-efficiency in banking has to potential to lower costs as well (Berger and Humphrey, 1994).

In their empirical study Michtell and Onvural (1995) find that bigger commercial banks often profit from economies of scale and economies of scope and consequently have a high degree of efficiency. While mergers have the potential to improve x-efficiency, this potential is generally not realized (Michtell and Onvurla, 1995). In conclusion we can say that mergers may have the potential to increase the efficiency of a bank. However in most empirical studies, on average, mergers have had no significant, predictable effect on costs and efficiency.

While some mergers have reduced costs, others have raised costs (Berger and Humphrey, 1994). Besides

an increase in efficiency through scale and scope economies can be achieved through many different approaches. Internal organic growth, although cost intensive, gives companies another possibility to expand. In addition further agreements (i. e. joint ventures) can help to improve the efficiency as well Rationale behind the Chase-Chemical Merger Within the trend towards deregulation which had mainly started in the 80s, several non-financial institutions began to offer financial products.

Hence the pressure Chemical and Chase were confronted with further increased. As a consequence of the broader supply from the new players in the market the households changed their allocation of financial assets, whereby the percentage amount of conventional bank deposits (of the financial assets) decreased from 49% in 1980 to 35% in 1994. Under the changed market situation Chemical considered a merger as an option for dealing with the pressure resulting from the new competitors and the trends leading to deregulation.

Another reason for the merger, were the big investment costs in technology that the companies were preparing to sustain in order to stay or emerge as leaders. These investments could only be achieved by big banks. To show how important technological improvements would be in the future, Figure 1 presents the evolution of online banking in the 90’s (Gilson and Escalle, 1998). Figure 1 Projected Growth in Online Banking Source: (Gilson and Escalle, 1998) On merger completion, Chase Manhattan Corporation would create America’s largest- and the world’s fourth largest commercial bank.

In addition the merger would create value in at least two different ways. First of all the banks would save operating and overhead costs. According to an analysis of Chemical the saving potential of a merger

with Manhattan would be $1. 5 billion, as seen in Table 1 (Gilson and Escalle, 1998). Table 1 Estimated Impact of Merger between Chemical and Selected Banks Source: (Gilson and Escalle, 1998). However, 12’000 employees would need to be fired and over 100 branches would have to be closed to achieve the planned cost reductions.

As mentioned before the reduction of the labor force could cause serious reputational problems. Second of all, the leading position of both banks and especially Chemical would help the new company to increase its profit from the higher revenue growth. Furthermore the leading position and a greater equity should enable the bank to enter new markets and better satisfy the individual needs of customers. Since Chase had suffered losses in the past and was under pressure, it needed to increase its efficiency (Gilson and Escalle, 1998).

Chemical however, had a solid financial record and was not under any pressure to immediately cut costs; hence the possibility to wait presented itself, in this case however Chemical incurred the risk of losing attractive merger opportunities. As mentioned before we can say that mergers have the potential to increase the efficiency of a bank trough scale and scope economies and x-efficiency. Relative Merits of a Merger and an Acquisition It is not always simple to distinguish a merger from an acquisition, because in both cases it is possible that a new firm is established.

In case of a merger, the stockholders of the acquiring company will become stockholders of the new company while by contrast they will no longer be stockholders in case of an acquisition (Volkart, 2007; pp. 1069-1079). In practice there are only few

actual “merger of equals”, as usually one of the two companies takes control over the new established company and clearly runs the business. Yet, in the case of Chase Manhattan Corporation and Chemical Banking Corporation a “merger of equals” would be possible, as the needed preconditions are fulfilled.

First, Chase Manhattan is willing to merge and a hostile takeover (acquisition) is therefore not needed. Second, the size of the two companies is similar, thus a joint management and leadership of the new established company could be possible. The choice of a merger over an acquisition could lead to some considerable advantages. First of all, through a joint management a lot of motivational employees’ problems could be solved, as the employees of the acquiring company would not feel so much betrayed and under pressure as in the case of an acquisition and therefore be less hostile.

Second, it seems realistic to assume that the acquiring company (both its management and its stockholders) does prefer a merger over an acquisition (Gilson and Escalle, 1998; pp. 6). With an acquisition, the stockholders of the acquiring company will find themselves with a new management they haven’t really chosen and can’t expect to control. The purchasing price demanded by the acquiring company is therefore likely to be much higher with an acquisition, as the stockholders must be compensated for giving up control of the firm.

Third, in case of an acquisition Chemical Banking Corporation would first have to make sure that its equity is sufficient, because in case of an acquisition the debt to equity ratio is likely to increase significantly, (Volkart, 2007; pp. 1077) leading the new established company to important financial

problems if the initial equity amount were too low. Last, but surely not least, a merger, because of the advantages mentioned above, could be perceived by the market as more valuable and value-adding than an acquisition, leading to an increase in stocks’ price.

Yet, a merger of equals, with none of the companies taking control over one another, can also lead to important problems. In the case of Chase Manhattan Corporation and Chemical Banking Corporation, the presence of strong corporate cultures within both companies could lead to considerable difficulties. A compromise might never take place between the two companies, creating unrest and inefficiency inside the new firm. Moreover, a merger wouldn’t allow Chemical Banking Corporation to avoid redundancy and cut costs by selectively maintaining only the most profitable assets of Chase Manhattan Corporation like in case of an acquisition.

In case of a merger, the integration costs are likely to be higher, as additional effort is needed in order to achieve a joint decision on whom and what to is to maintain inside the two firms and on how the different technologies are to be integrated (Gilson and Escalle, 1998; pp. 9 – 12). To conclude, it must be mentioned, that one of the main dangers of mergers and acquisition is paying too much for the acquiring firm (beside the integration problems, which are anyway present both in the case of an acquisition as well as in the case of a merger) leading to the result that the premium paid is higher than the additional value created.