The evidence on efficiency gains: The role of mergers and the benefits to the public

Abstract

Operating efficiencies, employee productivity, profit performance and average relative efficiency (using Data Envelopment Analysis) were measured for Australian trading banks from 1986 to 1995. Changes in a bank’s market share of deposits is explored as a means of determining the extent to which efficiency gains are passed on to the public. In general, efficiencies rose in the post-deregulation period. Evidence from the merger cases studied supports the reports of others that acquiring banks are more efficient than target banks. However, the acquiring bank does not always maintain its pre-merger efficiency. Decision-makers ought to be more cautious in promoting mergers as a means to enjoying efficiency gains. There is mixed evidence on the extent to which the benefits of efficiency gains are passed on to the public.

Introduction

The three key objectives of this study were to investigate the empirical evidence on the efficiency gains of the Australian trading banks during the deregulated period, examine the role of mergers in efficiency gains, and provide an answer to the perennial question on mergers of `to what extent gains in operating efficiencies are passed on to the public’. The evidence on efficiency gains was examined by measuring overall operating efficiency, employee productivity, profit performance and the industry mean relative efficiency scores. The role of mergers in efficiency gains was probed by comparing relative efficiency scores before and after a merger. The extent to which efficiencies are passed on to the public is measured through the per cent change in bank’s share of deposits in the market.

The main motivation for this study was the Wallis Inquiry¹ which was charged with reporting on the outcomes of the deregulated period, and more importantly, make further recommendations on regulation of mergers. There is no consensus in banking literature about the benefits of mergers to the merging entities or to the public, a situation which is even less clear in Australia due to the small market and the difficulty of conducting empirical research with small sample sizes. Most mergers undertaken are based on perceived economic and political benefits rather than conclusive mathematical calculations. The relative efficiency scores reported in this study can help decision-making by banks intending to take over other banks by providing a comparative performance analysis. Comparison of overall efficiencies and market shares following mergers will contribute to discussions on public benefits of mergers often engaged in by policy makers such as the members of the Federal Treasury, the Reserve Bank of Australia, and the Australian Competition and Consumer Commission (ACCC).²

The beginning of deregulation of the Australian finance sector can be traced to December 1983 when the dollar was floated and exchange controls lifted. Australia entered the deregulated period with 24 banks (excluding merchant banks and foreign banks). Deregulation continued in the following years with lifting of deposit controls, authorisation of savings banks to provide checking facilities, invitation of foreign banks to operate in Australia, changes in ownership of authorised money market dealers, expansion of services by credit unions and building societies, and so on. For example, in 1985–1986 alone, 17 new banks (mostly foreign banks) started business and 55 proposals for the establishment of merchant bank operations were approved. These changes in the composition of the finance sector make it difficult to set up a comparative pre-deregulation and post-deregulation look at banks.³

Major trading banks are facing more competition from local banks, building societies, credit unions and mortgage originators. Particularly in the last few years, there has been a blurring of lines separating the domain of major banks and others. Taking advantage of legislative and technological changes, the so-called state banks and building societies are competing head-on with larger banks both across geographical boundaries and product range. Effectively, the Australian banking sector is experiencing a convergence. For example, major trading banks that traditionally relied on their deposit base to lend are increasingly financing their home loans through securitisation. This has come about as a direct result of mortgage originators' success in providing low-cost home loans. Similarly, non-bank institutions are increasingly packaging their services with products traditionally offered by banks. In the next few years, major banks in particular are expected to undergo further restructuring with emphasis on generating revenue from fees rather than the interest spread.

In a low-growth population, maturing markets are likely to lead to fiercer competition. As banks come to terms with free market conditions, rationalisation of the banking industry will continue. Similarly, the increased scrutiny of the industry by the Federal government, for example, the Martin Inquiry,⁴ has put more pressure on the banks in terms of profitability, effectiveness of competition, product innovation, and information to users (Australian Bankers' Association, 1990). The pressure on banks has also been maintained by the investigation of the former Prices Surveillance Authority (PSA)⁵ into bank fees and charges.

Rationalisation of the existing branch networks is a reflection of each bank's efforts to achieve competitiveness, a process that has also been assisted by technological developments. For example, the Australia and New Zealand Banking Group (ANZ) has been implementing a major restructuring of its branch network to reduce operating costs and increase efficiency. Central to this exercise are staff redundancies, branch closures, and in some cases, re-engineering of retail delivery channels aimed at improving efficiency and customer service. With in-market mergers and takeovers, closing overlapping or non-performing branches can greatly reduce operating costs as well as provide more branches for the combined customers of both banks. In-market mergers are usually justified on the argument that the same number of customers can be served at a lower cost (Houston and Ryngaert, 1994).

“… benefits of in-market consolidation should be at least a 25% cost savings and possibly as much as 75% cost savings, as measured by the reduction of the acquiree's non-interest expenses” (Bowen, 1990, p. 18).

A study by Keefe et al. (1990) reports an average of 35% savings in operations costs of target banks within 6–9 months following a merger. However, these arguments ignore the larger component of total expenses, namely, interest expense.

The Australian Competition and Consumer Commission (ACCC) has been against merging of major trading banks or acquisition of a last substantial regional bank by a major bank. The ACCC’s approach may be in conflict with that of the current Federal Treasurer who appears to be more open to the arguments of the banking industry. This study provides an objective look at the operating efficiencies that are often used as a justification for proceeding with mergers (Berger et al., 1993a). A further aim of the study is to assess the extent to which operating efficiencies are passed on to the public in the form of improved services.

The empirical evidence in this study reveals that there has been a slow but steady rise in bank efficiencies between 1986 and 1995, interrupted briefly in 1990–1991 by the bad debts resulting from the imprudent lending during the late 1980s. By enhancing competition and scrutiny of banking, deregulation has forced banks to better their efficiencies. Ostensibly, mergers have emerged as one method of striving for operating efficiencies, mainly focused on the cost side. While three of the four merger cases studied lend support to the hypothesis that acquiring banks are more efficient, the acquiring bank does not always maintain its pre-merger efficiency. There is also mixed evidence on public benefits of efficiency gains following mergers. A rise (drop) in operating efficiency is not always accompanied by a rise (drop) in market share as one would expect.