New View of Bank Consolidation


Fred Furlong

FRBSF Economic Letter 1998-23 | July 24, 1998

Consolidation has dramatically altered the structure of banking in the U.S. Since the mid-1980s, the number of banks has plummeted, and larger banks spanning ever wider geographic areas have become more prevalent.

Western Banking Quarterly is a review of banking developments in the Twelfth Federal Reserve District, and includes FRBSF’s Regional Banking Tables. It is published in the Economic Letter on the fourth Friday of January, April, July, and October.

Consolidation has dramatically altered the structure of banking in the U.S. Since the mid-1980s, the number of banks has plummeted, and larger banks spanning ever wider geographic areas have become more prevalent. Given the epic dimensions of this structural change, it is surprising that research finds little evidence that bank consolidation results in systematic improvements in cost efficiency.

This Letter reviews the research on cost efficiency and consolidation, and also examines a somewhat new view, in which consolidation is not just a process for adjusting costs in banking but also an avenue for enhancing revenues. According to this line of research, bank mergers are associated with improved performance, in part because merged banks achieve higher valued output mixes.

Impact on structure

Consolidation in banking is distinct from “convergence.” Consolidation refers to mergers and acquisitions of banks by banks. Convergence refers to the mixing of banking and other types of financial services like securities and insurance, through acquisitions or other means.

The most dramatic effect of consolidation has been the disappearance of thousands of banks. Figure 1 shows the number of banks declining steadily since the mid-1980s, with little if any sign of abatement. Through the end of 1998, the net contraction was about 37%.

The onset of this trend corresponds roughly with legislation passed in several states that relaxed restrictions on intrastate branching. For example, Illinois, a state that had restricted intrastate branching, had 1,234 banks in 1985; in contrast, California, with its longstanding tradition of intrastate branching and its larger population, had only 453 banks. With the change in laws, the number of banks in Illinois has dropped to 784 (-36%). But consolidation is more than just an adjustment to changes in laws on intrastate branching. Even in California the number of banks is down to 336 (-25%), indicating that the restructuring of banking is being influenced by other factors as well, such as advances in technology.

Another dimension of the structural change in banking is the rise of the so-called megabanks. This development also has been helped along by the easing of geographic restrictions on banking, particularly the lifting of interstate branching restrictions in recent years. Measured in 1997 dollars, the average asset size of the top ten banks has increased from about $100 billion to close to $170 billion between 1985 and 1997. Moreover, if the proposed mergers announced in the last few months are consummated, the largest U.S. bank (not largest financial institution) would be more than twice the size of the largest bank in 1985 (measured in 1997 dollars).

With the attention given to the megamergers, it may be somewhat surprising that the share of banking activity accounted for by the top five or ten largest banks in the U.S. has not jumped appreciably. This is shown in Figure 2, which measures banking activity by value added (net interest income plus noninterest income). Nevertheless, with some 9,000 banks in the U.S., it is notable that the share of the top 100 banks has risen to over two-thirds.

Cost efficiency

An early view of consolidation in banking was that it makes banking more cost efficient because larger banks can eliminate excess capacity in areas like data processing, marketing, or overlapping branch networks. Cost efficiency also could increase if more efficient banks acquired less efficient ones. Though studies on efficiency in banking raised doubts about the extent of overcapacity, they did point to considerable potential for improvement in cost efficiency through mergers.

Whatever the potential, the research so far on the effects of bank mergers has not found strong evidence that, on balance, merged banks improve cost efficiency relative to other banks. This does not mean that many mergers, including those of some large banks, have failed to lead to significant gains in cost efficiency. It just means that the outcomes for those banks tend to be offset by problems encountered in other mergers, and that many banks have improved cost efficiency without merging.

New view

More definitive results can be found in other recent research that has taken what might be called the “new view” on consolidation. Under this view, bank mergers are not just about adjusting inputs to affect costs; rather, they also involve adjusting output (product) mixes to enhance revenues. Two research efforts taking this approach are Akhavein, et al. (1997), covering mergers in the 1980s, and Berger (1998), covering mergers in the 1990s. These studies find that bank mergers do tend to be associated with improvements in overall performance, in part because banks achieve higher valued output mixes. While these studies do not track all of the channels through which bank mergers affect the value of output, they suggest that one channel has been banks’ shift toward higher yielding loans and away from securities.

This channel is particularly interesting given the other results in these studies. They find that merged banks also tend to experience a lowering of their cost of borrowed funds without needing to increase capital ratios. The lower cost of funds is consistent with a decline in the overall risk of the combined bank compared to that of the merger partners taken separately. This apparently occurs even though a shift to loans by itself might be expected to increase risk. One interpretation of these results, then, is that a merger can result in a reduction in some dimensions of risk, which then affords the post-merger bank more latitude to shift to a higher return, though perhaps higher risk, output mix. The sources of diversification could be differences in the range of services, the portfolio mixes, or the regions served by the merging banks.


The impact of consolidation on bank structure has been obvious, while its impact on bank performance has been harder to discern. The connection to cost efficiency, in particular, remains tenuous. However, recent studies accounting for the combined effects of adjustments affecting costs and revenues suggest that mergers have had a positive effect on bank performance.

Fred Furlong
Vice President
Banking, Finance, and Regional Studies


Akhavein, Jalai D., Allen N. Berger, and David Humphrey. 1997. “The Effects of Megamergers on Efficiency and Prices: Evidence from a Bank Profit Function.” Review of Industrial Organization 12.

Berger, N. Allen. 1998. “The Efficiency Effects of Bank Mergers and Acquisition: A Preliminary Look at the 1990s Data.” In Bank Mergers & Acquisitions, eds. Y. Amihud and G. Miller. Amsterdam: Kluwer Academic Publishers.

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