Efficiency and Market Power Gains in Bank Megamergers: Evidence from Value Line Forecasts

• Author: Erik Devos,Rajesh Narayanan,Srinivasan Krishnamurthy
• Date: 01 December 2016
• DOI: http://doi.org/10.1111/fima.12134
• Published date: 01 December 2016

Efficiency and Market Power Gains

in Bank Megamergers: Evidence

from Value Line Forecasts

Erik Devos, Srinivasan Krishnamurthy, and Rajesh Narayanan∗

This paper examines whether gains in bank megamergers occur due to efficiency improvements

or the exercise of market power using financial statement line item forecasts from Value Line to

infer the effect of the merger on prices and quantities. The average megamerger is associated

with cost-efficiency improvements. In the cross-section, efficiency gains are limited to market

expansion mergers while market overlap mergers and Too-Big-To-Fail (TBTF) mergers exhibit

monopoly gains. Efficiency gains dissipate when the resultingmegabank size exceeds $150 billion

in assets or 1.5% of gross domestic product indicating that banks thought to be TBTF are likely

to be “Too-Big-To-Be-Efficient.”

Over the last three decades, the US banking industry has rapidly consolidated through

megamergers to produce giant institutions. In 1984, the industry asset share of banks with

over $10 billion in assets was 34.5%. By 2013, it had increased to 82.6%. The four largestbanks,

Bank of America, WellsFargo, JPMorgan Chase, and Citigroup, each with assets over $1 trillion,

are, since 1994, the product of 18, 12, 7, and 3 mergers, respectively. These giant institutions

typically rationalize megamergers as efforts aimed at realizing operating efficiencies made pos-

sible by the relaxation of longstanding restrictions on geographic and product market activities.

Nevertheless, a megamerger does eliminate an actual or potential competitor and the enlarged

size of the resulting institution strengthens market perceptions that it is Too-Big-To-Fail (TBTF)

thus improving access to monopoly rents and regulatory subsidies. Understanding the rationale

for megamergers requires tracing whether the gains from the combination arise from efficiency

improvements or enhanced market power.

In this paper, we develop and use a methodology that relies on Value Line forecasts to trace

the gains associated with the largest bank mergers that occurred in the prior three decades

Wethank Marc Lipson (Editor) and especially an anonymous refereefor helpful comments that have significantly improved

the paper.We also thank Viral Acharya,Allen Berger, Lamont Black (FMA discussant), Amit Bubna, Kee Ho Chung, Bill

Elliott, Rob Hansen, Murali Jagannathan, KennethKim, Chuck Knoeber, Anil Makhija, Paige Ouimet, Richard Rosen,

Ramana Sonti, Krishnamurthy Subramanian, Venkat Subramaniam, Sheri Tice,Mark Walker,Richard Warr, and seminar

participants at IIM Ahmedabad, the Indian School of Business, Louisiana State University, SUNY - Buffalo, Tulane,

the University of Texas at El Paso, the University of Texas at San Antonio, and the FMA Annual Meetings for helpful

comments on earlier versions of the paper. We thank Peter Cyriac, Elizabeth Devos, Cheng Fu, Rong Hu, and Dobrina

Koychevafor their help in data collection. We retain responsibility for any errors.

∗Erik Devos holds the J.P. Morgan Chase Bank Professorship in Business Administration and is a Professor in the

Department of Economics and Finance, College of Business Administration at the University of Texas at El Paso in El

Paso, TX. Srinivasan Krishnamurthy is an Associate Professor in the Poole College of Management at North Carolina

State University in Raleigh, NC. Rajesh Narayanan holds the E. Robert Theriot Professorship and is an Associate

Professor in the Department of Finance,E. J. Ourso College of Business at Louisiana State University in Baton Rouge,

LA.

Financial Management •Winter 2016 •pages 1011 – 1039

1012 Financial Management rWinter 2016

(1983–2014).1Value Line issues quarterly forecasts of financial statement line items for stand-

alone banks until the merger is consummated that exclude merger-related effects and for the

combined bank thereafter that include merger-related effects. We use these forecasts to generate

a measure of expected operating cash flows (OCFs), value it, and estimate merger gains as the

difference between the value of the combined entity and the sum of the values of the stand-

alone entities. Using line item forecasts, we decompose these gains into contributing revenue and

cost components, and further into “price” (net interest margins) and “quantity” (loan volume)

components that reflect the impact the merger is expected to have on bank customers. This

decomposition allows us to link revenue and cost changes to favorable or unfavorable price

and quantity changes enabling us to determine whether the megamerger is expected to generate

efficiency improvements (leading to lower prices and/or higher quantity) or permit the exercise

of market power (leading to higher prices and/or lower quantity).

Our analysis reveals that the averagemegamerger from 1983 to 2014 generates a gain of about

$3.1 billion (all dollar figures reported in the paper are in constant 2015 dollars) or roughly

8.4% of the combined premerger market capitalization of the merger partners. The corresponding

median estimates are $755 million and 4.9%, respectively. These gains arise on the cost side

from decreases in noninterest expenses. Furthermore, these cost reductions are accompanied by

decreases in the net interest margin (prices charged to customers) on unchanged loan quantities

indicating that, on average, bank megamerger gains are efficiency related.

In the cross-section, the sources of merger gains vary based on the extent to which the merger

partners’ businesses overlap geographically. In market expansion mergers where the geographic

footprints of the merger partners do not overlap substantially, we find that gains occur on the

revenue side from increases in noninterest income. Furthermore, these revenue improvementsare

accompanied by decreases in net interest margin and increases in loan volume. These findings

indicate the presence of operating efficiencies associated with cross-selling products or services

that result in lower prices and largerbusiness volume in market expansion mergers. In contrast, in

market overlap mergers wherethe geographic overlap between the merger partners is substantial,

we find that gains arise on the cost side from decreases in noninterest expenses. However, these

cost reductions are also accompanied by increases in interest margin and decreases in loan volume.

These findings indicate that the cost reductions in market overlap mergers do not occur from

efficiencies (e.g., elimination of redundancies), but arise from the exercise of market power that

reduces business volume.

Merger gains also vary with the size of the resulting combination. Using (ad hoc) size thresholds

to determine whether the merger produces a candidate for TBTF subsidies, we find that the gains

in TBTF mergers are higher relative to non-TBTF mergers. Furthermore, we confirm that the

gains in TBTF mergers arise on the revenue side from increases in noninterest income. However,

these revenue increases are not accompanied by anychanges in interest margins, loan volumes, or

loan loss provisions. This finding indicates that gains in TBTF mergers are not expected to arise

from efficiency improvements or from the extension of riskier loans. Instead, revenue increases

are expected to stem from riskier, nontraditional activities. Closer examination of the realized

noninterest income in these mergers reveals an increase in income from riskier activities (e.g.,

trading activities). This suggests that when banks achieve a size that renders them TBTF, they

derive benefits from the implicit regulatory insurance that allows them to engage in riskier off

balance sheet activities. As an alternate way to examine how merger gains vary with size, rather

1Valueline is a well-known provider of investment information. According to Graham (1999), the ValueLine Investment

Survey is the best known investment newsletter and can be considered the market leader. Value Line’s use in academic

research dates back at least to Fisher Black’sfamous 1973 letter to the editor of the Financial Analysts Journal.