FRBSF Economic Letter
2004-15; June 18, 2004
Until this year,
Citigroup was the only $1 trillion banking organization in the
U.S. Now, there are two more—Bank of America has merged
with FleetBoston, and J.P. Morgan Chase is about to complete its
merger with Bank One. These megamergers are notable not only for
their size but also for the geographic scope that the new institutions
will serve. Indeed, they may signal the beginning of a process
for building a truly national banking franchise. As mergers continue
to shape the structure of the banking industry in the U.S., this
Economic Letter looks at the economic drivers behind them and highlights
some important policy implications.
Background on recent consolidation
The Riegle-Neal Act allowed
interstate branch banking beginning in 1997, and, since then, the
number of large bank mergers has
increased significantly. Figure 1 plots this trend along with another
noteworthy trend, namely, that most of the large bank mergers in
recent years involved institutions headquartered in different states;
the latter point suggests that these are market-expansion mergers,
where the acquirer and the target have few overlapping operations
in their respective banking markets. Although the markets they
serve are much bigger, so far none of these three megabanks has
come close to having a banking franchise that spans all 50 states,
which is now legally possible.
Another noteworthy fact about the recently announced megamergers
is that the target banking companies are healthy institutions that
are likely to survive as independent organizations. This is in
stark contrast both to the late 1980s and early 1990s in the U.S.,
when many bank mergers involved relatively weak banking companies
being acquired by somewhat stronger organizations, as well as to
some large bank mergers abroad, most notably in Japan. Today the
U.S. banking sector is in good shape, with record profits and relatively
low volumes of problem loans. For example, the return on average
assets in 2003 for the two merger targets, Bank One and FleetBoston,
were 1.27% and 1.34%, respectively, while the top 50 bank holding
companies averaged 1.28%. This suggests that the recent megamergers
are not motivated by economic weakness but rather by other economic
Economic forces driving megamergers
We can identify four economic
forces that may be driving large bank mergers. First is economies
of scale—the relationship between
the average production cost per unit of output and production volume.
A firm that produces a higher volume of output can see its unit
cost of production decline because the costs of some of the inputs
are fixed, such as administrative and overhead expenses. However,
diseconomies of scale also are possible. The average production
cost may start to rise when output exceeds a certain volume because
it may be more costly to manage a very large firm; these costs
may stem from corporate governance issues, difficulties in coordination
and execution, and diminished flexibility in responding quickly
to changing markets.
While banking researchers generally agree
that economies of scale do exist in the industry at low levels
of output, there is less
agreement about whether diseconomies of scale emerge at high levels
of output. Earlier studies found evidence that diseconomies of
scale did occur when total banking assets exceeded roughly $10
billion; however, those results were based on banking data prior
to the passage of the Riegle-Neal Act, when banking companies operating
in multiple states had to maintain separately capitalized, individually
chartered bank subsidiaries in those states. The passage of Riegle-Neal
allows these banking organizations to consolidate the individual
state charters into a single charter, thus greatly streamlining
management and operations. On the cost side, it is apparent that
the cost structure of running a network of bank branches across
multiple states should be more efficient than running a group of
individually capitalized bank subsidiaries. On the revenue side,
research on megamergers suggests that merged banks experienced
higher profit efficiency from increased revenues than did a group
of individual banks, because they provided customers with higher
value-added products and services (Akhavein, Berger, and Humphrey
1997). Moreover, a banking organization of a certain scale may
even earn a "too-big-to-fail" subsidy due to the market's
perception of de facto government backing of a megabank in times
of crisis. While the combination of all these factors could raise
the optimal scale of large banking organizations today, it remains
to be seen whether a $1 trillion bank is the "right" size.
second economic force is economies of scope—a situation where
the joint costs of producing two complementary outputs are less
than the combined costs of producing the two outputs separately.
This may arise when the production processes of both outputs share
some common inputs, including both capital (such as the actual
building the bank occupies) and labor (such as bank management).
The passage of the Gramm-Leach-Bliley Act (GLB) in 1999 changed
the scope of permissible financial activities for banking organizations.
In the past, banking organizations were not allowed to engage in
securities activities except on a limited, case-by-case basis through
their so-called Section 20 subsidiaries. Also, general insurance
activities were not permitted for banking firms, except in very
small towns with fewer than 5,000 residents. GLB allows banking
organizations to expand into securities and insurance activities
in a much more straightforward way (see Furlong 2000 for more details).
Although the two recently announced megamergers mainly involve
combining banking activities, the potential of scope economies
among banking, securities, and insurance could further increase
the optimal size of a large banking organization today compared
to pre-GLB days.
The third economic force is the potential for risk
diversification. Research suggests that geographic expansion would
benefits to a banking organization not only by reducing its portfolio
risk on the asset side, but also by lowering its funding risk on
the liability side, as it spreads funding activities over a larger
geographic area (Hughes, Lang, Mester, and Moon 1999). Furthermore,
research suggests that product expansion could yield diversification
benefits, most notably between banking and securities activities,
while less so between banking and insurance (see the survey article
by Kwan and Laderman 1999). Thus, a bigger bank is expected to
be less vulnerable to economic shocks, and that alone could reduce
its cost of capital, further compounding the benefits of scale
and scope economies that come only from the production process.
The fourth economic force involves the bank managements' personal
incentives. These may include the desire to run a larger firm and
the desire to maximize their own personal welfare. Empirical research
has shown that managerial compensation and perquisite consumption
tend to rise with firm size. Research on stock market reactions
to megamerger announcements in the 1990s suggests that, on average,
the market did not view mergers of publicly owned banking companies
as providing a significant gain to total shareholders' wealth of
the combined company (Kwan and Eisenbeis 1999). The muted market
response to merger announcements raises questions about the true
magnitude of the net economic benefits underlying large bank mergers.
First and foremost, bank mergers have the potential to raise
antitrust concerns, which must be resolved satisfactorily before
Because bank mergers can alter banking market structure and because
market structure influences banking competition and hence the price
of banking services to customers, all bank merger applications
are scrutinized by banking regulators. In addition, the Department
of Justice has the authority to challenge any mergers that are
deemed harmful to competition. Research suggests that the markets
for many banking products and services remain local in nature,
despite the advances in information technology and electronic commerce
(Rhoades 2000). In fact, the recent market-expansion megamergers
themselves are testimony to the importance these large banking
organizations attach to maintaining a local market presence. Thus,
the current regulatory practices of defining banking markets locally
in evaluating the effects of proposed mergers on competition seem
justified. When a proposed merger is found to result in an unacceptably
high level of concentration in local banking markets, divestitures
in those markets are often required as a condition for regulatory
approval in order to preserve meaningful competition. Looking at
western states, Laderman (2003) found that changes in concentration
of local banking markets were quite modest despite the large degree
of consolidation in banking over the past 20 years.
In addition to concerns about banking concentration effects on
local market competition, existing banking legislation also limits
banking concentration at the national level. Perhaps motivated
by the fear of concentration of banking power, the Riegle-Neal
Act prohibits any merger or acquisition that results in a combined
banking organization controlling more than 10% of the total amount
of deposits of insured depository institutions in the U.S. A banking
organization could exceed the deposit cap through internal growth,
but it would not be allowed to engage in any more mergers or acquisitions.
While the combined Bank of America and FleetBoston organization
would control about 9.9% of the national deposit share, it is still
not yet close to being a truly national bank. Thus, the drive toward
building a truly nationwide franchise could be severely constrained
by current law. As banking organizations get closer to the cap,
policymakers will face growing pressure to reconsider both the
merits of the deposit cap and the best way to accomplish the associated
public policy goals.
The creation of megabanks also heightens concerns
about systemic risk. When banking activities are concentrated in
a few very large
banking companies, shocks to these individual companies could have
repercussions to the financial system and the real economy. The
desire to limit systemic risk may lead policymakers to maintain
some kind of cap on banking concentration at the national level.
increased potential of systemic risk created by megabanks also
intensifies concerns about these banks being considered "too-big-to-fail" (TBTF).
In the early 1990s, the FDIC Improvement Act (FDICIA) included
measures to limit the extension of TBTF to failing banks. Specifically,
it mandated that the FDIC use the least cost resolution method
to handle bank failures, thus greatly raising uninsured bank creditors'
exposure to default risk. It appears to have led market participants
to revise their views towards TBTF. This, in conjunction with the
National Depositor Preference law (1993), which put depositors
ahead of subordinated debt holders, may explain the research findings
showing a significant increase in the sensitivity of the default
risk premium of bank subordinated debt to banking organizations'
underlying risks after FDICIA. However, there is still an exception
in FDICIA—which can be invoked only in extraordinary circumstances—that
permits the FDIC to pay off a failing bank's uninsured creditors
if the use of least cost resolution would have serious adverse
effects on economic conditions or financial stability. Megamergers
create more such potentially systemically important banks and put
a higher premium on credible policies for the orderly resolution
of troubled large banking organizations—policies that limit the
potential for moral hazard while containing their adverse impacts
on financial markets.
There are a number of possible economic drivers for
megamergers, from economic efficiency to the self-interest of
Due to the profound changes in banking laws in the 1990s, earlier
research on bank mergers may not be applicable to today's environment;
therefore, it remains to be seen whether the current bank megamergers
result in any measurable efficiency gains. Nevertheless, the
ever-growing scale of bank mergers raises challenging policy
banking concentration at the national level and systemic risk
concerns, that must be addressed by policymakers in the course
economic efficiency while safeguarding the nation's financial
Vice President, Financial Research
Akhavein, J.D., A.N. Berger, and D.B. Humphrey. 1997. "The
Effects of Megamergers on Efficiency and Prices: Evidence from
a Bank Profit Function." Review of Industrial Organization 12, pp. 95-139.
Furlong, F. 2000. "The
Gramm-Leach-Bliley Act and Financial Integration." FRBSF
Economic Letter 2000-10.
Kwan, S.H., and R.A. Eisenbeis. 1999. "Mergers
of Publicly Traded Banking Organizations Revisited." Federal
Reserve Bank of Atlanta Economic Review 84(4), pp. 26-37.
S.H., and E. Laderman. 1999. "On
the Portfolio Effects of Financial Convergence: A Review of the
Economic Review 2, pp. 18-31.
Laderman, E. 2003. "Good
News on Twelfth District Banking Market Concentration." FRBSF
Economic Letter 2003-31.
Hughes, J.P., W. Lang, L.J. Mester, and C.G.
Moon. 1999. "The
Dollars and Sense of Bank Consolidation." Journal of Banking
and Finance 23, pp. 291-324.
Rhoades, S.A. 2000. "Bank Mergers
and Banking Structure in the United States, 1980-98." Federal
Reserve Staff Study 174.