Banks: too big to succeed?

If the financial crisis was made into the Star Wars franchise, we are now at the Empire Strikes Back or, more accurately, the Regulator Strikes Back. However, while the world concentrates on the SEC’s fraud allegations against Goldman Sachs, a potentially more ground breaking event is happening in Europe.

English Prime Minister Gordon Brown and the Labour Party is trailing in the UK election to the Conservative Party. However, the lead suggests minority government which could make the Liberal Democrats, the third major party, the king-makers. The Liberal Democrats are surging in the polls as a viable alternative to “Bollocks to Brown and Labour but damned if I am voting for those wanker Conservatives!”

Bankers are aghast. The Liberal Democrats have run on an anti-banker platform. The center piece is (a) a 10% levy on bank profits; and (b) breaking up the big banks  by separating the deposit taking arm from the investment banking arm (you know what they say about payback…).

The Conservatives are campaigning on the same platform of breaking up the big banks but want international agreements in place before doing so. If Labour is part of a minority government, it will have to play some type of anti-bank card no matter who their coalition partner is.  If this all comes to pass, could the UK be the first domino in the end game for the too big to fail banks?

Recent history suggests too big to fail banks have a negative impact economically and on society as a whole. But, long range studies suggest, even if there was no financial crisis, there is no conclusive evidence big banks created out of numerous mergers are good for the business or the shareholders. In other words, remove subprime and all the toxic assets and big banks created by mergers may still be bad investments.

Since financial de-regulation began in the 1980’s, there have been numerous studies into the effect of bank mergers on performance, efficiency and shareholder return. A study from the Board of Governors of the Federal Reserve (the banker’s bank) summaries the literature  on effect of bank mergers succinctly: “The …studies indicate, with very few exceptions, that bank mergers do not yield improvements in efficiency or profitability….”

Bigger is not always better. Anyone who has ever dealt with a mega-bank can figure this out- the bureaucracy to maintain the infrastructure overwhelms any efficiency or customer service advantages. Large, unwieldy organization, especially one dealing with risk management, generally do not work faster, display innovation or operate more efficiently.

What about shareholder value? Surely, with such economies of scale and the ability to dominate markets, big merged banks return bang for the buck to the shareholder.  Even the evidence is mixed on this level. To quote a 2006 study on bank mergers impacts: “Early event studies revealed some variation in stockholder wealth changes resulting from a bank merger announcement, but one general result seemed to hold: Acquiring bank shareholders suffered wealth losses, acquired bank shareholders experienced significant wealth gains, and the weighted-average stockholder wealth change was nil to slightly positive.” (emphasis is my own).

Later studies do concede that there is wealth creation for shareholders of merged banks but the returns were no greater than normal market returns. One would have succeeded just as much purchasing a broad based equities ETF with diversification as a bonus.

All 4 of the big American banks (Citibank, Bank of America, Wells Fargo, JPMorgan Chase) got to where they were pre financial crisis through large-scale mergers and acquisitions in the 1980’s and 1990’s. Meanwhile, the “Big 5″ Canadian banks were barred from large scale acquisitions  domestically  in the 1990’s (the acquisition of trust companies in the 1990’s notwithstanding). It is interesting to see how banks forced to grow organically have been able to provide greater piece of mind and stable and positive returns over time than those aiming to hit the home run with a merger.

Could it be the only people benefiting from large banks are the executives themselves and the investment bankers who advise them to buy up other banks so they can make fees? The studies are not shy in calling “empire building” as a reason for bank mergers. Perhaps in the long-run, breaking up the banks in smaller units may be good for society and the shareholder.