Are Fewer Banks Better?

First it was REITs. Then loans to Latin American governments. Then commercial real estate. Now, the buzzword among America's fad-ridden big banks is "consolidation." Bankers see mergers, especially combinations of banks with shared markets, as the key to making the industry stronger, more efficient, and better able to fight domestic and foreign competitors. And bankers have gone at consolidation with a vengeance. In 1991, banks announced more than 500 mergers, capped by three megadeals involving $443 billion in assets.

While the merger boom, unlike the industry's lending fads of the recent past, won't bring the banking system to its knees, it may fall far short of solving banking's troubles. Washington's top regulators are cheering consolidation on, but their research staffs report that past mergers haven't produced the efficiency gains promised by the dealmakers. The economists' findings: The average bank merger in the 1980s didn't cut costs, didn't raise productivity, and actually made the combined bank slightly less profitable. "We all believe that consolidation ought to work," says a Federal Reserve official, "but that hasn't been supported by the numbers yet."

Those disappointing numbers are contained in two recent Fed studies, which challenge the conventional wisdom in the industry that mergers make economic sense. In one, economist Aruna Srinivasan of the Atlanta Fed followed all bank mergers from 1982 through 1986--a period when many states opened their doors to out-of-state banks. In the four years after the deals were consummated, Srinivasan found, noninterest expenses, mostly salaries and other overhead costs, fell by 4.8% in merged banks. But those savings were easily matched by banks that remained independent. The reason: Savings on salaries and branch costs in the merged banks were offset by increases in such expenses as advertising and amortization of goodwill acquired in the takeover.

ASSUMPTIONS BELIED. A similar study by economists Allen N. Berger of the Fed's Washington staff and David B. Humphrey of Florida State University concluded that mergers didn't lead to bigger and better banks. After focusing on 114 deals during the 1980s involving banks with $1 billion or more in assets, the study found that big mergers "were about a wash" for cost savings and "slightly negative" for the merged banks' profits, says Humphrey.

Both Fed studies undercut another cherished theory of pro-merger bankers: that merging banks with overlapping markets would yield bigger cost savings, as the combined bank closed redundant branches and back-office operations. While Srinivasan found slightly better gains for banks serving roughly the same market, Berger and Humphrey couldn't find any correlation between the degree of market overlap and success at cutting costs. An unpublished Fed study also casts doubt on the savings potential of branch closings. Completing every possible in-state, big-bank merger and closing half the overlapping branches would eliminate only 2.7% of the nation's 58,603 bank offices, researchers found.

The economists' results have spurred a counterattack by bankers and the consultants who broker mergers. "The academics are looking at an era when banks were interested in expansion, not efficiency," says H. Rodgin Cohen, a New York banking attorney. In the rush to leap over state lines, many banks paid high prices, then failed to follow through with cost-cutting. Analysts point to the defunct Bank of New England Corp. as an example of '80s-style agglomeration. After New England states approved regionwide banking, BNE swallowed 32 banks. But the bank never could keep up with the acquisition binge. Back-office operations remained independent. BNE even ran seven different systems for recording deposits.

SHARED MARKETS. Bankers, consultants, and regulators argue that the industry is more focused nowadays on cutting costs and filling in gaps in banks' markets to get the best return on overhead. Last year's big dealmakers claim to be meeting ambitious savings goals. BankAmerica Corp. has cut 3,700 jobs since it took over Security Pacific Corp. in April, even before starting to close excess branches. Chemical Banking Corp. says it has reduced its payroll by 4,500 since announcing its merger with Manufacturers Hanover Corp. last year.

Even so, many banks that have remained independent are racking up similar cost savings. For example, analysts expect Midlantic Corp. in Edison, N.J., to reduce operating costs by $100 million, thanks in part to staff reductions. But regulators see another benefit to consolidation: "You've got to have something major--a takeover or a big threat of one--to shake most of these bankers out of their complacency," says a top Fed official. That psychological boost--and the chance that it can force efficiencies banks have resisted for decades--is enough for officials. They're willing to bet that the merger boom will be more than just another banking fad.

      Banks that merged in the '80s showed no significant gains in operating 
      efficiency. Fed researchers say the industry would gain more by improving 
      operations at inefficient banks than by combining banks to cut overlap and costs
      Fed researchers found that even efficient banks had a hard time generating cost 
      savings after buying another bank. Eliminating market overlap through mergers 
      didn't produce bigger savings, either
      Banks don't get more efficient as they get larger. The big banks that are now 
      merging are already larger than the most cost-efficient size, say researchers
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