FRBSF Economic Letter
99-25; August 20, 1999
 Economic
Letter Index
A New View on Cost Savings in Bank Mergers
Over the past decade, the banking industry has undergone rapid consolidation.
Before the 1990s, most bank mergers involved banks with less than $1 billion
in assets; more recently, even the very largest banks have merged with
other banks and with nonbank financial firms.
Globalization, technological advances, and more regulatory flexibility
are often cited as factors that have stimulated and allowed more banks
to merge. Banking organizations involved in mergers almost always point
to cost savings and diversification as motives for merging. Mergers may
reduce costs if banks can close redundant branches or consolidate back-office
functions. Mergers may also further diversify bank portfolios and thereby
reduce the probability of insolvency, thus allowing merged banks to cut
costs further, because their borrowing costs and capital-asset ratios
are lower.
One of the most striking aspects of the recent wave of bank mergers has
been the split between bankers and economists about the practical importance
of these cost advantages to merged banks on average. The managements of
merging banks and industry analysts often project sizeable cost reductions,
typically to be achieved by reducing labor and physical capital inputs.
Economists in universities and in bank regulatory agencies have been hard-pressed,
however, to identify systematic merger-related gains in bank productivity.
For example, Berger (1998) concurred with the results and views of many
economists that bank mergers on balance have had little effect on banks'
total noninterest costs. Pilloff and Santomero (1998) surveyed both the
statistical and case study literature on bank mergers. Based on their
reading of the enormous empirical literature on bank costs, they concluded
that on average the market valued the combined firm no higher than it
did the separate components. Had merging cut costs, higher total market
value would have been anticipated.
This Economic Letter reports on our study (Kwan and Wilcox 1999),
which takes a new look into the cost savings argument. Our view is that
the conventional analyses typically have underestimated a number of sizeable
and long-lasting cost reductions that merged banks have achieved. Underestimates
of cost reductions stem from merger accounting rules that trigger accounting
adjustments that bias reported costs upward. The rules of purchase
accounting require marking the purchased bank's assets to market, often
resulting in increases in the accounting values of both physical and intangible
bank assets. As a result, post-merger banks report higher depreciation
and amortization charges on their larger asset bases, even if they own
and operate the same buildings and equipment after a merger as they did
before a merger.
Accounting issues
Currently, according to Generally Accepted Accounting Principles (GAAP),
there are two methods to account for business combinations: purchase accounting
and pooling-of-interests. In purchase accounting, all the assets of the
target bank are marked to market before they are combined with the acquiring
bank's assets, including the target bank's premises and equipment. The
difference between the purchase price and the revised book value of target
bank's equity, after marking all the target bank's assets to market, are
recorded as goodwill, an intangible asset, in the surviving bank's book.
All intangible assets then must be amortized and expensed per GAAP. Hence,
in purchase accounting mergers, both the stock value of bank premises
and the stock value of intangible assets for the surviving bank would
likely be higher than those of the combined total of the acquirer and
target before the merger due solely to purchase accounting. If the recorded
bank premises and intangible assets are marked up due to the use of purchase
accounting, the surviving bank's reported depreciation charge and amortization
expense will rise instantly, even if the surviving bank changes nothing
after the merger.
In pooling-of-interests, the target bank's assets, liabilities, and owners'
equities are combined with those of the acquiring bank at book value as
though the two companies had always been commonly owned. Thus, the reported
assets of the merged bank would be equal to the sum of the reported assets
of the two merging banks, absent any real changes in bank assets after
the merger. Hence, unlike purchase accounting, pooling-of-interests would
not trigger additional depreciation expenses or goodwill charges. However,
the merging banks must satisfy all the conditions for pooling, including
certain pre-merger attributes, such as comparable size, and post-merger
activities limiting assets sales or stock repurchase; otherwise, the purchase
accounting method must be used.
Figure 1 shows that the
percentage of purchase accounting bank mergers was rising during our study
period, and Figure 2 indicates
that the average ratio of market value to book value equity for banking
companies also was rising. Both of these trends are likely to raise the
reported expenses more during the latter part of the study period than
during the earlier part. To minimize the distortions and obtain a more
accurate measure of the change in genuine operating performance of a merged
bank that used the purchase accounting method, we adjust the merged bank's
reported premises expenses and other noninterest expenses by the amount
that is attributable to the purchase accounting revaluations.
Findings
We compile data for a sample of over 1,000 of the bank mergers that occurred
between 1985 and 1997. We then compare the post-merger ability of merged
banks to cut costs with the cost-cutting achieved over the same period
by banks that did not merge. About one-third of the sample mergers used
purchase accounting.
Without first adjusting the data for the purchase accounting effects,
we find that merged banks (relative to non-merged banks) cut their total
noninterest expenses by economically small and statistically insignificant
amounts. Of the three operating cost components, labor costs, which are
not affected by purchase accounting revaluations, registered the largest
drop after the merger, falling an average annual amount of 0.02% of total
assets. Unadjusted premises expenses and other noninterest expense, however,
on average went up after mergers.
Purchase accounting triggered significant incremental premises expenses
and incremental intangible expenses. Adjusting premises expenses and intangible
expenses shows that merged banks on average did cut occupancy and other
noninterest costs, suggesting that bank mergers have produced operating
cost savings. On average, merged banks cut annual total noninterest expense
by 0.04%. So, for a merged bank that earns, say, a 1% return on assets
(ROA), these average cost savings translate into a 4% increase in ROA.
The adjustment for amortization expense rose over time and was largest
in recent years. This reflects the fact that purchase premia over the
book values of target banks were rising over time (see Figure 2). After
adjusting for accounting revaluations, bank mergers in 1993-95 shaved
adjusted total noninterest expense by 0.1% of total assets, which is equivalent
to a 10% boost in an ROA of 1 percentage point.
More recent bank mergers were found to cut operating costs more than
earlier bank mergers. However, mergers involving large banks cut costs
neither more nor less than mergers among smaller banks. Nevertheless,
the evidence weakly supported the idea that the operating performance
of large mergers, relative to their smaller counterparts, seemed to be
improving over time.
Conclusions
Do bank mergers lead to operating cost savings? While the majority of
past research did not find significant cost reduction after banks merged,
bank managers and banking consultants cite improving operating cost efficiency
as a primary motivation for bank mergers.
The purchase accounting method can trigger additional reported occupancy
expense and amortization expense by the surviving bank that have nothing
to do with actual costs. Hence, to measure the changes in performance
before and after the merger more accurately, our study adjusts the reported
data to eliminate the pure accounting effects on reported costs. In addition,
we also include more recent data in our analysis, so that we cover a period
when the banking industry was financially much stronger and the pace of
banking consolidation was rapid.
We find evidence that bank mergers have reduced operating costs.
Both labor costs and occupancy expense are found to decline significantly
after the merger. However, some of these findings are evident only after
we remove the pure accounting effects on reported expense data, confirming
that merger accounting can hide a significant portion of cost cuts. While
the evidence is stronger for the more recent time period, we also find
that the size of the merger did not have a significant effect on the amount
of cost savings.
Simon H. Kwan
Senior Economist
James A. Wilcox
Professor of Finance,
UC Berkeley, and
Visiting Scholar, FRBSF
References
Berger, Allen N. 1998. "The Efficiency Effects of Bank Mergers and Acquisition:
A Preliminary Look at the 1990s Data." In Bank Mergers & Acquisitions,
eds. Yakov Amihud and Geoffrey Miller. Kluwer Academic Publishers.
Kwan, Simon H., and James A. Wilcox. 1999. "Hidden Cost Reductions in
Bank Mergers: Accounting for More Productive Banks." Federal Reserve Bank
of San Francisco Working Paper
99-10.
Pilloff, Steven J., and Anthony M. Santomero. 1998. "The Value Effects
of Bank Mergers and Acquisitions." In Bank Mergers & Acquisitions,
eds. Yakov Amihud and Geoffrey Miller. Kluwer Academic Publishers.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
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