The impact of state deposit caps on bank merger premiums.

• Author: Hakes, David R.

1. Introduction

   Nineteen states set a ceiling on the percent of total deposits that any one banking organization may hold in that state. This ceiling is known as a deposit cap. Once a bank has reached a state's ceiling, either through growth or merger, it may not acquire additional banks in that state. Thus, the presence of a deposit cap may eliminate potential bidders for a merger target. We argue that fewer bidders for a target bank may reduce the ratio of purchase price to book value, or what has been termed the "merger premium." In this short paper, we empirically address the impact of state deposit caps on bank merger premiums. We find, as expected, that the presence of deposit caps significantly reduces bank merger premiums.

   An analysis of the impact of deposit caps on bank merger premiums is particularly important for the following reason: On September 29, 1994, President Clinton signed into law the Riegle-Neal Interstate Banking and Branching Efficiency Act [6] effectively striking down the McFadden Act of 1927 and its subsequent 1933 amendments. The new interstate banking law, which became effective on September 29, 1995, establishes a uniform state deposit cap of 30 percent for those states with no existing deposit cap and a national deposit cap of 10 percent. Although we cannot yet measure the impact of the new federally imposed deposit caps on merger premiums because limited data has accumulated since their imposition, we can measure the impact of existing state deposit caps. Our results may be useful as an indicator of the expected impact of the new federally imposed caps. In addition, our results may be immediately useful to various state legislatures as they seek to adjust their existing state deposit caps.

   Though previous studies employ financial, market structure, and regulatory data to explain the variation in bank merger premiums, no existing research has included deposit caps as determinants of bank merger premiums. We address the impact of deposit caps by employing them as additional explanatory variables in a model explaining merger premiums for the period of 1989 through 1994. Thus, while our results support many of the conclusions found in the existing literature, we generate several unique results. We find that deposit caps significantly reduce the merger premium paid to target banks. Further, we find that deposit caps cause a greater reduction in the merger premium paid to moderate size target banks when compared to either extremely small or extremely large target banks. We also find that merger premiums are larger when the target banks have larger off-balance sheet income and when targets are purchased with acquirer stock as opposed to cash (i.e., stock swap). Finally, our results refute results found in previous studies which suggest that there is a premium paid by acquirers to enter less concentrated banking markets.

   In section II we identify the literature on the determinants of bank merger premiums and develop the empirical model we use to explain merger premiums. In section III we report the results of our estimations. Section IV contains some concluding remarks.

2. Model and Data

   The empirical procedure we employ draws heavily from research by Palia [8], Cheng, Gup, and Wall [3], Fraser and Kolari [5], Rhoades [10], and Beatty, Santomero, and Smirlock [2]. Specifically, in order to avoid missing-variable bias in our model, we include explanatory variables that these previous studies have shown to be significant determinants of bank merger premiums. Therefore, the following discussion is limited to a brief description of the components of these studies we use to form the general structure of our model. For a recent and more extensive review of the literature on bank merger premiums, see Palia [8, 92-93].

   Bank merger premiums have been defined uniformly in the literature as the ratio of purchase price to book value of the target bank. As in previous studies, we use the ratio of bid price to book value on the date the merger is announced because the final purchase value is uncertain when stock of the acquirer is used to purchase the target bank. The studies mentioned above explain the variation in this ratio with a variety of variables. We can group these explanatory variables into the following categories: financial, market structure, and regulatory.(1) Note that the purpose of the explanatory variables is to capture information that may influence the market value of a target bank beyond that which is captured by its book value.

   Financial Variables

   Previous studies suggest that the financial condition of the target bank influences the merger premium. This effect is captured by the target's profitability, growth, capitalization, portfolio condition, and cost structure. Profitability is proxied by return on assets or return on equity. Growth is proxied by growth in assets or growth in equity. We expect the signs on the above mentioned variables to be positive because higher profits and faster growth are more attractive to the acquirer. Capitalization is represented by the capital to asset ratio. We expect the sign to be negative because a high capital to asset ratio may indicate that the target is using its capital inefficiently and is unusually risk-averse [8]. Alternatively, the lower the capital to asset ratio, the greater the leverage of the institution - more assets per dollar of capital - and the greater the merger premium, ceteris paribus. Portfolio condition is represented by the non-performing assets to assets ratio and cost structure by operating expenses to average assets ratio. We expect the signs on these two variables to be negative.

   To the above list of variables which are found in previous studies, we add an additional variable. Greater fee income, or off-balance-sheet income, should increase the premium paid for a target bank because these sources of income are not captured by book value. Examples of fee income, or what is sometimes called soft money, are income from loan securitization and loan servicing on mortgage origination, credit card services, underwriting, and debt guarantees. We proxy this source of income with the target's non-interest income to asset ratio and we expect the sign to be positive.

   Although most studies that attempt to explain merger premiums utilize the financial characteristics of the target banks as explanatory variables, Palia [8], and, in particular, Cheng, Gup, and Wall [3], include many of the financial variables described above for both the target and the acquirer. They argue that the same characteristics that make a target appealing make an acquirer better able and more anxious to bid for a target bank, thus raising the merger premium. Therefore, we include the above mentioned financial variables for both the target and the acquirer.

   In addition to the financial...