Chapter 19

Chapter Nineteen
Acquisitions and Mergers in FinancialServices Management

Copyright 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
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Key Topics
Merger Trends in the United States and Abroad

Motives for Merger
Selecting a Suitable Merger Partner
U.S. and European Merger Rules
Making a Merger Successful
Research on Merger Motives and Outcomes
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Introduction
A globe wave of mergers involving banks, securities
firms, insurance companies, and other financialservice providers has been under way
Reflects the great forces of consolidation and
convergence that are dramatically reshaping the
financial-services industry
This trend is driven by
Intense competition
Deregulation
The search for the optimal size financial-services
organization
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Mergers on the Rise

Many of the mergers sweeping through the banking
industry reflect lower legal barriers that previously
prohibited or restricted expansion
For example, in the U.S., the Riegle-Neal Interstate
Banking Act of 1994 and the Gramm-Leach-Bliley (GLB)
Act of 1999
The GLB law opened wide the arena for bank

nonbank financial-service combinations
Permits banks, insurance companies, and security firms to

acquire each other
Critics of the GLB law argue that while GLB may result in
reducing U.S. financial firms risk exposure, it does not
appear to hold great promise for major improvements in
operating efficiency
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Mergers on the Rise (continued)

Competition among European financial firms is
becoming more intense, leading to continuing mergers
and acquisitions
Financial-service mergers in Europe have slowed from
time to time due to a slowing economy and European
governments attempts to protect their home banks from
acquisition by outsiders
Asia and Japan also have experienced a growing

number of mergers
Due to an effort to shore up credit quality problems, fend
off the ravages of deflation and sluggish economies, and
compete with powerful U.S. and European banks
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TABLE 191 Recent Leading International Financial-Service

Mergers and Acquisitions
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TABLE 192 Some of the Largest Financial-Service Mergers

and Acquisitions in American History
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The Motives Behind the Rapid Growth of

Financial-Service Mergers
Mergers usually occur because
1. The stockholders involved expect to increase their
wealth or reduce their risk exposure
2. Management expects to gain higher salaries and
employee benefits, greater job security, or greater
prestige from managing a larger firm
3. Both stockholders and management may reap
benefits from a merger
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Financial-Service Mergers (continued)
Profit Potential
Some argue that the recent increase in financial-service
mergers reflects the expectation of stockholders that profit
potential will increase once a merger is completed
If the acquiring organization has more skillful management
than the firm it acquires, revenues and earnings may rise
Especially true of interstate or international mergers where
many new markets are entered
If the acquiring firms management is better trained than

the management of the acquired institution, the efficiency
of the merged organization may increase
May result in more control over operating expenses
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Risk Reduction
Many merger partners anticipate reduced cash flow risk
and reduced earnings risk
The lower risk may arise because
Mergers increase the overall size and prestige of an
organization
Open up new markets with different economic characteristics
from markets already served
Make possible the offering of new services whose cash flows
are different in timing from cash flows generated by existing
services
Mergers can result in a more stable financial firm, able to

withstand fluctuations in economic conditions
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Rescue of Failing Institutions
The failure of a company is often a motive for merger
Many bank mergers have been encouraged by the FDIC as
a way to conserve federal deposit insurance reserves and
avoid an interruption of customer service when a
depository institution is about to fail
The great credit crunch of 20072009 resulted in numerous
financial firms either failing or in real trouble for which
mergers and acquisitions were often the only option
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Rescue of Failing Institutions
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Tax and Market-Positioning Motive
Many mergers arise from expected tax benefits
Especially where the acquired firm has earnings losses that
can be used to offset taxable profits of the acquirer
There may also be market-positioning benefits

A merger will permit the acquiring institution to acquire a
base in a completely new market
Examples of U.S. market-positioning acquisitions:

Bank of America Corp. acquiring FleetBoston Financial Corp.
Wachovia Corp. acquiring Golden West
Capital One Corp. acquiring North Fork Bancorp and
Hibernia Corp.
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The Cost Savings or Efficiency Motive
Large-scale staff reductions and savings from eliminating
duplicate facilities have followed in the wake of some of the
largest mergers in the financial-services sector
Research has shown that sometimes the single most
important merger motivation was the desire to reduce
operating costs followed by a plan to diversify into new
markets
Many mergers are of the market extension type
Means that the merging institutions do not overlap much or at
all in terms of geographic area served
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Mergers as a Device for Reducing Competition
When two competitors are allowed to merge, the public is
served by fewer rivals for their business
Service quality may diminish and prices and profits may
rise
More aggressive prosecution of the antitrust laws may
need to be considered
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Mergers as a Device for Maximizing
Managements Welfare (An Agency Problem)
Management may view a prospective acquisition as a way
to increase salaries and employee benefits, lower the risk of
being fired, and enhance managers reputation in the labor
market from working for a bigger firm
If managers reap these benefits at the expense of company
stockholders, an agency problem emerges
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Other Merger Motives
Increased growth capacity
Enables a lending institution to expand its loan limit to
better accommodate large and growing corporate
customers
This is particularly important in markets where the lenders
principal business customers may be growing more rapidly
than the lending institution itself
Give smaller institutions access to capable new

management and costly new electronic technology
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How can management and the owners of a financial firm
decide if a proposed merger is good for the organization?
Measure both the costs and benefits of a proposed merger (not
easy to do)
A merger is beneficial to the stockholders in the long run if it

increases the stock price per share
The price of a financial firms stock depends upon
The expected stream of future dividends flowing to the
stockholders
The discount factor applied to the future stock dividend stream,
based on the rate of return required by investments of
comparable risk
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(continued)
In order to maximize stockholder value, the proposed merger
should
Improve Operating Efficiency (reduce operating cost per unit of
output)
Consolidate operations and eliminate duplication
Geographic Diversification
Product Line Diversification
Find an acquisition target whose earnings or cash flow are negatively
correlated (or have a low positive correlation) with the acquiring
organizations cash flows
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(continued)
A major consideration in any proposed merger is its probable
impact on the earnings per share (EPS) of the surviving firm
Stockholders of both acquiring and acquired institutions will
experience a gain in earnings per share of stock if both of the
following occur
A company with a higher price-to-earnings (P-E) ratio acquires
a company with a lower P-E ratio
Combined earnings do not fall after the merger
In this instance, EPS will rise even if the acquired institutions
stockholders are paid a reasonable premium for their shares
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(continued)
As long as the acquiring institutions P-E ratio is larger than
the acquired firms P-E ratio, there is room for paying the
acquired companys shareholders a merger premium
High-premium deals often yield disappointing results for the

stockholders of the acquiring firm
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(continued)
Exchange Ratio
The number of shares of stock offered by an acquiring bank for
each share of stock of the acquired bank
Dilution of Ownership
Spreading the firms ownership over more stockholders so that

the average shareholders proportion of firm ownership declines
Results from offering the acquired firms stockholders an
excessive number of new shares relative to the value of their old
shares
Dilution of Earnings
Spreading a fixed amount of earnings over more shares of stock

so that the EPS of the combined firm declines
Will occur if the P-E of the firm to be acquired is greater than the
P-E of the acquiring firm
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The Merger and Acquisition Route to Growth

The acquired firm (usually the smaller of the two) gives up its
charter and adopts a new name (usually the name of the
acquiring organization)
The assets and liabilities of the acquired firm are added to
those of the acquiring institution
A merger normally occurs after managements of the
acquiring and acquired organizations have struck a deal
Proposed transaction must then be ratified by the board of
directors of each organization and possibly by a vote of each
firms common stockholders.
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(continued)
If the stockholders approve (usually by at least a two-thirds
majority), the unit of government that issued the original
charter of incorporation must be notified, along with any
regulatory agencies that have supervisory authority over the
institutions involved
In the U.S., the federal banking agencies have 30 days to comment
on the merger of two federally supervised banks
There is a 30-day period for public comments as well
Public notice that a merger application has been filed must appear
in a newspaper of general circulation serving the communities
where the main offices of the banks involved are located
The U.S. Justice Department can bring suit if it believes
competition would be significantly reduced after the proposed
merger
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(continued)
The principal characteristics of the targeted institution that
are examined by the potential acquirer fall into six broad
categories
1.
2.
3.
4.
5.
The firms history, ownership, and management

The condition of its balance sheet
The firms track record of growth and operating performance
The condition of its income statement and cash flow
The condition and prospects of the local economy served by
the targeted institution
6. The competitive structure of the market in which the firm
operates (as indicated by any barriers to entry, market shares,
and degree of market concentration)
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(continued)
In addition, potential acquirers will look at these factors as
well
1. The comparative management styles of the merging
organizations
2. The principal customers the targeted institution serves
3. Current personnel and employee benefits
4. Compatibility of accounting and management information
systems among the merging companies
5. Condition of the targeted institutions physical assets
6. Ownership and earnings dilution before and after the
proposed merger
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Methods of Consummating Merger

Transactions
Mergers usually take place employing one of two
methods
1. Pooling of interests
2. Purchase accounting
For mergers begun before July 1, 2001, the Financial

Accounting Standards Board (FASB) permitted use of
the pooling of interests
Merger partners merely sum the volume of their assets,

liabilities, and equity in the amounts recorded just before
their merger takes place
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Transactions (continued)
In contrast, under purchase accounting the firm to be
acquired is valued at its purchase price and that price is
added to the total assets of the acquirer
The acquirer records the acquisition at the price paid but
must value the acquired firm at market value plus goodwill (if
the acquisition price and market value are different)
No goodwill is figured in when using the pooling of

interests approach
After 2001, the pooling of interest method for merger
accounting was eliminated for U.S. financial firms
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Another way to view the merger process is to determine
exactly what the acquirer is buying in the transaction
Assets or shares of stock
Purchase-of-assets method
The acquiring institution buys all or a portion of the assets of
the acquired institution, using either cash or its own stock
The acquired institution usually distributes the cash or stock
to its shareholders in the form of a liquidating dividend and
the acquired organization is then dissolved
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Purchase-of-stock method
The acquiring firm assumes all of the acquired firms assets
and liabilities and the acquired firm ceases to exist
While cash may be used to settle either type of merger
transaction, in the case of commercial banks, regulations
require that all but the smallest mergers and acquisitions be
paid for by issuing additional stock of the acquirer
A stock transaction has the advantage of not being subject to
taxation until the stock is sold, while cash payments are
usually subject to immediate taxation
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The most frequent kind of merger among depository
institutions involves wholesale banks merging with
smaller retail banks
Lets money center banks gain access to relatively low-cost,
less interest-sensitive consumer accounts and channel those
deposited funds into profitable corporate loans
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Regulatory Rules for Bank Mergers in the

United States
Two sets of rules generally govern the mergers of banks and
other financial firms:
1. Decisions by courts of law
2. Statutes enacted by legislators, reinforced by regulations
For example, the Sherman Antitrust Act of 1890 and the Clayton
Act of 1914 forbid mergers that would result in monopolies or
significantly lessen competition in any industry
Whenever any such merger is proposed, it must be

challenged in court by the U.S. Department of Justice
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United States (continued)
The Bank Merger Act of 1960
Requires each merging bank to request approval from its
principal federal regulatory agency before a merger can take
place
National Banks Comptroller of the Currency
State Member Banks Federal Reserve
State Insured Banks FDIC
Each federal agency must give top priority to the competitive

effects of a proposed merger
Mergers with anti-competitive effects may be approved if it can
be shown that there are significant public benefits
For example, providing convenient services or rescuing a failing bank
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The degree of concentration in a market is measured by the
proportion of assets or deposits controlled by the largest
institutions serving that market
The Justice Department guidelines require calculation of the
Herfindahl-Hirschman Index (HHI) as a summary measure
of market concentration
It is the sum of the squared market share for all banks in a
specific market area
where Ai represents the percentage of market-area deposits,
assets, or sales controlled by the ith financial firm in the
market, and there are k financial firms in total serving the
market
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Under the latest Department of Justice (DOJ) Guidelines
If a market has a postmerger HHI below 1,000 points, then the
market is unconcentrated; no further DOJ review
A market is considered moderately concentrated if its postmerger
HHI is 1,000 to 1,800 points and as a result of the proposed
merger the change in the HHI is less than 100 points; usually no
further DOJ review (unless the change in the HHI > 100 points)
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Under the latest Department of Justice (DOJ) Guidelines
A market is considered highly concentrated if the postmerger
HHI lies above 1,800 points and the postmerger change in the
HHI exceeds 50 points; usually no further DOJ review (unless
the change in the HHI > 50 points)
If the change in the HHI > 100 points in a highly concentrated
market, significant competitive issues will be raised and a suit to
block the proposed merger may be filed by the DOJ
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The Merger Rules in Europe and Asia

The European Commission an executive body of the European
Community currently based in Brussels has emerged as a key
mediator of mergers involving European businesses
Because the European Commission cannot break apart a merger
after that combination has occurred, the Brussels commission has
been somewhat more aggressive in denying some companies
permission to merge
The doctrine of collective dominance suggests that if a significant
European market would become so concentrated as a result of a
proposed merger that only about four firms would come to
dominate that market, then the European Commission may vote to
block any further market concentration
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The Merger Rules in Europe and Asia

(continued)
In Asia, merger rules are in a state of flux as leading nations seek to
modernize their merger review process and develop more definitive
guidelines for merging firms
In assessing a proposed mergers, Asian authorities emphasize
Market share
Availability of alternative sources of supply for the consumer
Whether foreign firms are involved that will significantly impact
domestic institutions in a dangerous way
Mergers that appear to rescue losing domestic companies, protect
jobs, and bring new technologies and managerial talent into the
host country often receive favorable rulings
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Making a Success of a Merger

Many mergers simply do not work
A variety of factors often get in the way
Poor management
Mismatch of corporate cultures and styles
Excessive prices paid by the acquirer for the acquired firm
Failure to take into account the customers feelings and
concerns
Lack of strategic fit between the combining companies
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Making a Success of a Merger (continued)

Helpful steps that improve the chances for a desirable merger
outcome
1. Acquirer must start by evaluating its own financial
condition
2. Must have detailed analysis of possible new markets
3. Must establish a realistic price for target firm
4. After merger, combined team must direct progress towards
consolidation
5. Must establish communication between senior management
and all employees
6. Must create communication channels for customers and
employees to understand why merger took place
7. Should create customer advisory panels to evaluate and
comment on merged banks image and products
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Research Findings on the Impact of

Financial-Service Mergers
The Financial and Economic Impact of Acquisitions and
Mergers
Merger-active financial companies tend to grow faster than
nonmerging firms
Generally, acquiring financial firms, on average, are not more
profitable than the firms they buy
This suggests that management of the acquiring firm hopes to buy
into success
Acquired companies are often significantly less profitable than

the firms they compete with
Acquirers pay sizable premiums for target firms
Thus, stockholders of acquired companies often gain a financial
advantage, while acquirers often wind up with mixed results
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Research Findings on the Impact of

Public Benefits from Mergers and Acquisitions
Research has found few real benefits from the publics perspective
On the positive side, there is no convincing evidence that the public
has suffered from a decline in service quality or in service
availability
There is also some evidence that bank failure rates decline in the
wake of merger activity
Mergers and acquisitions usually have multiple outcomes and
generate a mixture of winners and losers
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Quick Quiz
What factors should a financial firm consider when
choosing a good merger partner?
What factors must the regulatory authorities consider
when deciding whether to approve or deny a merger?
When is a market too concentrated to allow a merger to
proceed?
Does it appear that most mergers serve the public
interest?
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Chapter Nineteen

Acquisitions and Mergers in FinancialServices Management

Merger Trends in the United States and Abroad

2008 The McGraw-Hill Companies, Inc., All Rights

2008 The McGraw-Hill Companies, Inc., All Rights

Mergers on the Rise

The GLB law opened wide the arena for bank

Permits banks, insurance companies, and security firms to

2008 The McGraw-Hill Companies, Inc., All Rights

Mergers on the Rise (continued)

Asia and Japan also have experienced a growing

2008 The McGraw-Hill Companies, Inc., All Rights

TABLE 191 Recent Leading International Financial-Service

2008 The McGraw-Hill Companies, Inc., All Rights

TABLE 192 Some of the Largest Financial-Service Mergers

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

If the acquiring firms management is better trained than

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

Mergers can result in a more stable financial firm, able to

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

There may also be market-positioning benefits

Examples of U.S. market-positioning acquisitions:

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

2008 The McGraw-Hill Companies, Inc., All Rights

The Motives Behind the Rapid Growth of

Give smaller institutions access to capable new

2008 The McGraw-Hill Companies, Inc., All Rights

Selecting a Suitable Merger Partner

A merger is beneficial to the stockholders in the long run if it

2008 The McGraw-Hill Companies, Inc., All Rights

Selecting a Suitable Merger Partner

2008 The McGraw-Hill Companies, Inc., All Rights

Selecting a Suitable Merger Partner

2008 The McGraw-Hill Companies, Inc., All Rights

Selecting a Suitable Merger Partner

High-premium deals often yield disappointing results for the

2008 The McGraw-Hill Companies, Inc., All Rights

Selecting a Suitable Merger Partner

Spreading the firms ownership over more stockholders so that

Spreading a fixed amount of earnings over more shares of stock

2008 The McGraw-Hill Companies, Inc., All Rights

The Merger and Acquisition Route to Growth

2008 The McGraw-Hill Companies, Inc., All Rights

The Merger and Acquisition Route to Growth

2008 The McGraw-Hill Companies, Inc., All Rights

The Merger and Acquisition Route to Growth

The firms history, ownership, and management

2008 The McGraw-Hill Companies, Inc., All Rights

The Merger and Acquisition Route to Growth

2008 The McGraw-Hill Companies, Inc., All Rights