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Mergers, Acquisitions, and the

Financial Architecture

Merger and acquisitions activity in the financial sector has been one of

the major vehicles in the transformation of a key set of economic activi￾ties that stand at the center of the national and global capital allocation

and payments system. It can therefore be argued that the outcome of

the M&A process in terms of the structure, conduct, and performance of

the financial sector has a disproportionate impact on the economy as a

whole.

There are three issues here. The first relates to how well the financial

system contributes to economic efficiency in the allocation of resources,

thereby promoting a maximum level of income and output. The second

relates to how it affects the rate of growth of income and output by influ￾encing the various components of economic growth—the labor force, the

capital stock, the contribution of national resources to growth, as well as

efficiency in the use of the factors of production. The third issue concerns

the safety and stability of the financial system, notably systemic risk as￾sociated with crises among financial institutions and their propagation to

the financial system as a whole and the real sector of the economy.

A financial structure that maximizes income and wealth, and promotes

the rate of economic growth together with continuous market-driven eco￾nomic reconfiguration, and achieves both of these with a tolerable level

of institutional and systemic stability would have to be considered a

“benchmark” system.

The condition and evolution of the financial sector is therefore a matter

of public interest. Outcomes of the financial-sector restructuring process

through M&A activity or in other ways that detract from its contribution

to efficiency, growth, and stability can therefore be expected to attract the

attention of policymakers. For example, nobody seriously believes that a

dynamic market-driven economy that hopes to be competitive on a global

scale can long afford a financial services industry that is dominated by

202 Mergers and Acquisitions in Banking and Finance

one or two mega-conglomerates that are able to extract monopoly rents

from their clients and shield themselves from competition by new en￾trants. Long before that happens, the high political profile of the financial

industry and its institutions would trigger a backlash felt in legislative

initiatives, judicial decisions, and regulatory changes, reflecting efforts to

restore higher levels of competitive discipline to the industry.

This chapter examines the public policy issues affecting the structure

of the financial system and therefore the M&A process, and vice versa.

The issues range from competition policy to the design of the financial

safety net and the potentially intractable problems of assuring the safety

and soundness of massive financial conglomerates that are active in a

wide range of financial businesses and sometimes extend across the

world.

IMPACT ON THE STRUCTURE OF THE FINANCIAL SYSTEM

One way to calibrate the so-called “static” efficiency properties of a finan￾cial system is to use the all-in, weighted average spread (differential)

between (1) rates of return provided to ultimate savers and investors and

(2) the cost of funds to the ultimate users of finance. This stylized gross

spread can be viewed as a measure of the total cost of financial interme￾diation, and is reflected in the monetary value of resources consumed in

the financial intermediation process. In particular, it reflects direct costs

of financial intermediation (operating costs, cost of capital, and so on). It

also reflects losses incurred in the financial process that may ultimately

be passed on to end users, as well as liquidity premiums and any excess

profits earned. In this framework, financial processes that are considered

statically inefficient are usually characterized by high all-in margins due to

high overhead costs, high losses not ultimately borne by shareholders of

the financial intermediaries themselves, excess profits due to concentrated

markets and barriers to entry, and the like.

Dynamic efficiency is characterized by high rates of financial product

and process innovation through time. Product innovations usually in￾volve creation of new financial instruments along with the ability to rep￾licate certain financial instruments by bundling or rebundling existing

ones (synthetics). There are also new approaches to contract pricing, new

investment techniques, and other innovations that fall under this rubric.

Process innovations include contract design and methods of trading,

clearance and settlement, transactions processing, custody, techniques for

efficient margin calculation, application of new distribution and client￾interface technologies such as the Internet, and so on. Successful product

and process innovation broadens the menu of financial information and

services available to ultimate borrowers and issuers, ultimate savers, and

various other participants in the financial system.

A healthy financial system exerts continuous pressure on all kinds of

financial intermediaries for improved static and dynamic efficiency. Struc-

Mergers, Acquisitions, and the Financial Architecture 203

tures better able to deliver these attributes eventually supplant those

that do not, and this is how financial markets and institutions have

evolved and converged through time. For example, global financial mar￾kets for foreign exchange, debt instruments, and to a lesser extent equities

have already developed various degrees of “seamlessness.” It is arguable

that the most advanced of the world’s financial markets are approaching

a theoretical, “complete” optimum where there are sufficient financial

instruments and markets, and combinations, thereof, to span the whole

state-space of risk and return outcomes. Conversely, financial systems

that are deemed inefficient or incomplete tend to be characterized by

a high degree of fragmentation and incompleteness that takes the form

of a limited range of financial services and obsolescent financial pro￾cesses.

Both static and dynamic efficiency in financial intermediation are of

obvious importance from the standpoint of national and global resource

allocation. That is, since many kinds of financial services can be viewed

as “inputs” into real economic processes, the level of national output and

income—as well as its rate of economic growth—are directly or indirectly

affected, so that a “retarded” financial services sector can represent a

major impediment to an economy’s overall economic performance. Finan￾cial system retardation represents a burden on the final consumers of

financial services and potentially reduces the level of private and social

welfare; it reduces what economists call consumer surplus, an accepted

measure of consumer welfare.1 It also represents a burden on producers

by raising their cost of capital and eroding their competitive performance

in domestic and global markets. These inefficiencies ultimately distort the

allocation of labor as well as capital and affect both the level of income

and output, as well as the rate of economic growth, by impeding capital

formation and other elements of the growth process.

As noted in earlier chapters, in retail financial services extensive bank￾ing overcapacity in many countries has led to substantial consolidation—

often involving the kind of M&A activity detailed in the tables found in

the Appendix 1. Excess retail production and distribution capacity in

banking has been slimmed down in ways that usually release redundant

labor and capital. This is a key objective of consolidation in financial

services generally, as it is in any industry. If effective, surviving firms tend

to be more efficient and innovative than those that do not survive. In

some cases this process is retarded by restrictive regulation, by cartels, or

by large-scale involvement of public sector financial institutions that op￾erate under less rigorous financial discipline or are beneficiaries of public

subsidies.

Also at the retail level, commercial banking activity has been linked

1. Consumer surplus is the difference between what consumers would have paid for a given product

or service according to the relevant demand function and what they actually have to pay at the prevailing

market price. The higher that price, the lower will be consumer surplus.

204 Mergers and Acquisitions in Banking and Finance

strategically to retail brokerage, retail insurance (especially life insurance),

and retail asset management through mutual funds, retirement products,

and private-client relationships. At the same time, relatively small and

focused firms have sometimes continued to prosper in each of the retail

businesses, especially where they have been able to provide superior

service or client proximity while taking advantage of outsourcing and

strategic alliances where appropriate. Competitive market economics

should be free to separate the winners and the losers. Significant depar￾tures from this logic need to be carefully watched and, if necessary, re￾dressed by public policy.

In wholesale financial services, similar links have emerged. Wholesale

commercial banking activities such as syndicated lending and project

financing have often been shifted toward a greater investment banking

focus, whereas investment banking firms have placed growing emphasis

on developing institutional asset management businesses in part to benefit

from vertical integration and in part to gain some degree of stability in a

notoriously volatile industry. Vigorous debates have raged about the need

to lend in order to obtain valuable advisory business and whether spe￾cialized “monoline” investment banks will eventually be driven from the

market by financial conglomerates with massive capital and risk-bearing

ability. Here the jury is still out, and there is ample evidence that can be

cited on both sides of the argument.

The United States is a good case in point. Financial intermediation was

long distorted by regulation. Banks and bank holding companies were

prohibited from expanding geographically and from moving into insur￾ance businesses and into large areas of the securities business under the

Glass-Steagall provisions of the Banking Act of 1933. Consequently banks

half a century ago dominated classic banking functions, independent

broker-dealers dominated capital market services, and insurance compa￾nies dominated most of the generic risk management functions, as shown

in Figure 7-1. Cross-penetration between different types of financial in￾termediaries existed mainly in the realm of retail savings products.

A half century later this functional segmentation had changed almost

beyond recognition, despite the fact that full de jure deregulation was not

fully implemented until the end of the period with passage of the Gramm￾Leach-Bliley Act of 1999. Figure 7-2 shows a virtual doubling of strategic

groups competing for the various financial intermediation functions. To￾day there is vigorous cross-penetration among all kinds of strategic

groups in the U.S. financial system. Most financial services can be obtained

in one form or another from virtually every strategic group, each of which

is, in turn, involved in a broad array of financial intermediation services.

The system is populated by mega-banks, financial conglomerates, credit

unions, savings banks, saving and loan institutions, community banks,

life insurers, general insurers, property and casualty insurers, insurance

brokers, securities broker-dealers, asset managers, and financial advisers

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Figure 7-1. The U.S. Financial Services Sector, 1950. Figures 7-1 and 7-2 courtesy of

Richard Herring, The Wharton School, University of Pennsylvania.

Figure 7-2. The U.S. Financial Services Sector, 2003.

206 Mergers and Acquisitions in Banking and Finance

mixing and matching capabilities in ways the market seems to demand.

It remains a highly heterogeneous system today, confounding earlier con￾ventional wisdom that the early part of the twenty-first century would

herald the dominance of the European style universal bank or financial

conglomerate in the United States. Evidently their time has not yet come,

if it ever will.

If cross-competition among strategic groups promotes both static and

dynamic efficiencies in the financial system, the evolutionary path of the

U.S. financial structure has probably served macroeconomic objectives—

particularly growth and continuous economic restructuring—very well

indeed. Paradoxically, the Glass-Steagall limits in force from 1933 to 1999

may have contributed, as an unintended consequence, to a much more

heterogeneous financial system than otherwise might have existed—cer￾tainly more heterogeneous than prevailed in the United States of the 1920s

or that prevail in most other countries today.

Specifically, Glass-Steagall provisions of the Banking Act of 1933 were

justified for three reasons: (1) the 8,000-plus bank failures of 1930–1933

had much to do with the collapse in aggregate demand (depression) and

asset deflation that took hold during this period, (2) the financial-sector

failures were related to inappropriate activities of major banks, notably

underwriting and dealing in corporate stocks, corporate bonds, and mu￾nicipal revenue bonds, and (3) these failures were in turn related to the

severity of the 1929 stock market crash, which, through asset deflation,

helped trigger the devastating economic collapse of the 1930s. The avail￾able empirical evidence generally rejects the second of these arguments,

and so financial economists today usually conclude that the Glass-Steagall

legislation was a mistake—the wrong remedy implemented for the wrong

reasons.

Political economists tend to be more forgiving, observing that Congress

only knew what it thought it understood at the time and had to do

something dramatic to deal with a major national crisis. The argumenta￾tion presented in the 1930s seemed compelling. So the Glass-Steagall

provisions became part of the legislative response to the crisis, along with

the 1933 and 1934 Securities Acts, the advent of deposit insurance, and

other very positive dimensions of the regulatory system that continue to

evolve today.

The Glass-Steagall legislation remained on the books for 66 years, re￾configuring the structure of the financial system into functional separation

between investment banking and securities, commercial banking, and

“commerce” (which included insurance) was later cemented in the Bank

Holding Company Act of 1956. European-type universal banking became

impossible, although some restrictions were later eased by allowing

Section-20 investment banking banking subsidiaries of commercial bank

holding companies to be created with progressively broader underwriting

and dealing powers and 10% (later 25%) “illegal-activity” revenue limits.

Mergers, Acquisitions, and the Financial Architecture 207

Very few financial institutions actually took advantage of this liberaliza￾tion, however.

What happened next? Independent securities firms obtained a long￾lasting monopoly on Glass-Steagall-restricted financial intermediation ac￾tivities—mainly underwriting and dealing in corporate debt and equity

securities and municipal revenue bonds—which they fought to retain

through the 1990s via a wide range of vigorous rear-guard political lob￾bying and legal tactics. Firms in the securities industry included legacy

players like Lehman Brothers and Goldman Sachs, as well as firms forcibly

spun off from what had been universal banks, such as Morgan Stanley.

All of the U.S. securities firms were long organized as partnerships,

initially with unlimited liability—thus fusing their ownership and man￾agement. This did not change until almost a half-century later, when many

converted to limited liability companies and later incorporated them￾selves—the last being Goldman Sachs in 1999. Arguably, the industry’s

legacy ownership-management structure caused these firms to pay ex￾traordinary attention to revenue generation, risk control, cost control, and

financial innovation under high levels of teamwork and discipline. Some

of this may have been lost after their incorporation, which the majority

of the partners ultimately deemed necessary in order to gain access to

permanent capital and strategic flexibility.

Unlike banks, independent U.S. securities firms operate under rela￾tively transparent mark-to-market accounting rules, a fact that placed

management under strict market discipline and constant threat of capital

impairment. There was also in many firms a focus on “light” strategic

commitments and opportunism and equally “light” management struc￾tures that made them highly adaptable and efficient. This was combined

with the regulatory authorities’ presumed reluctance to bail out “com￾mercial enterprises” whose failure (unlike banks) did not pose an imme￾diate threat to the financial system.

When Drexel Burnham Lambert failed in 1990 it was the seventh largest

financial firm in the United States in terms of assets. The Federal Reserve

supplied liquidity to the market to help limit the systemic effects but did

nothing to save Drexel Burnham. When Continental Illinois failed in 1984

it was immediately bailed out by the Federal Deposit Insurance Corpo￾ration—including all uninsured depositors. In effect, the bank was na￾tionalized and relaunched after restructuring under government auspices.

Shareholders, the board, managers, and employees lost out, but depositors

were made whole. The lack of a safety net for U.S. securities firms argu￾ably reinforced large management ownership stakes in their traditional

attention to risk control.

The abrupt shake-out of the securities industry started in 1974. The

independent securities firms themselves were profoundly affected by de￾regulation (notably elimination of fixed commissions, intended to im￾prove the efficiency of the U.S. equity market). Surviving firms in the end

208 Mergers and Acquisitions in Banking and Finance

proved to be highly efficient and creative under extreme competitive

pressure (despite lack of capital market competition from commercial

banks), dominating their home market (which accounted for around 60%

of global capital-raising volume and on average about the same percent￾age of M&A activity) and later pushing that home-court advantage into

the international arena as well. Alongside the independent securities firms

grew a broad array of independent retail and institutional fund managers,

both generalists and specialists, and brokers with strong franchises that

were not full-service investment banks, such as like Charles Schwab and

A.G. Edwards, as well as custodians such as State Street, Bank of New

York, and Northern Trust Company.

The regulation-driven structure of independent U.S. capital market

intermediaries may have had something to do with limiting conflict of

interest and other problems associated with involvement of financial firms

in multiple parts of the financial services business. There was also a

general absence of investment bankers (but not commercial bankers) on

corporate boards. There were few long-term holdings of corporate shares

by financial intermediaries. That is, there were few of the hallmarks of

universal banking relationships that existed elsewhere in the world.

The structure also had much to do with the process of U.S. financial

disintermediation on the borrower-issuer side as well as the savings and

asset management side of the flow of funds, with financial flows through

the capital markets showing better static and dynamic efficiency proper￾ties and drawing off financial activities from banks and thrifts. Nonethe￾less, many small community banks and thrifts continued to thrive by

virtue of client proximity, better information, better service, or some com￾bination of these.

Finally, legacy effects of the Glass-Steagall provisions, through the re￾sulting financial intermediation structure, also had much to do with U.S.

reliance in matters of corporate governance on a highly contestable market

for corporate control. For better or worse, in the absence of Glass-Steagall

the U.S. economic performance story though the end of the twentieth

century might have been very different from what it actually was. It

proved to be very good at producing sustained economic dynamism com￾pared with most other parts of the world. It did not, however, prove to

be a good guardian against the kinds of fiduciary violations, corporate

governance failures, and outright fraud that emerged in the U.S. financial

scandals in 2002.

Still, consolidation has proceeded apace in the United States, although

the 1999 deregulation did not in fact produce a near-term collapse of the

highly diversified financial structure depicted in Figure 7-2. However,

consolidation has been accompanied in recent years by higher concentra￾tion ratios in various types of financial services, except in retail banking,

where concentration ratios have actually fallen. None of these concentra￾tions seem troublesome yet in terms of preserving vigorous competition

and avoiding monopoly pricing, as suggested in Figure 3-9 in Chapter 3.

Mergers, Acquisitions, and the Financial Architecture 209

Figure 7-3. The European Financial Services Sector, 2003.

A similar framework for discussing the financial structure of Europe is

not particularly credible because of the wide structural variations among

countries. One common thread, however, given the long history of uni￾versal banking, is that banks dominate most financial intermediation func￾tions in much of Europe. Insurance is an exception, but given European

bancassurance initiatives that seem to be reasonably successful in many

cases, some observers still think a broad-gauge banking-insurance con￾vergence is likely.

Except for the penetration of continental Europe by U.K. and U.S.

specialists in the investment banking and fund management businesses,

many of the relatively narrowly focused continental financial firms seem

to have found themselves sooner or later acquired by major banking

groups. Examples include Banque Indosuez and Banque Paribas in

France, MeesPierson and Robeco in the Netherlands, Consors in Germany,

and Schroders, Flemings, Warburgs, and Gartmore in the United King￾dom. Figure 7-3 may be a reasonable approximation of the European

financial services industry structure, with substantially less “density” of

functional coverage by specific strategic groups than in the United States

and correspondingly greater dominance of major financial firms that in￾clude commercial banking as a core business.

It is interesting to speculate what the European financial services

industry-structure matrix in Figure 7-3 will look like in ten or twenty

years. Some argue that the impact of size and scope is so powerful that

the financial industry will be dominated by large, complex financial in￾stitutions in Europe, especially in the euro-zone. Others argue that a rich

array of players, stretching across a broad spectrum of strategic groups,

210 Mergers and Acquisitions in Banking and Finance

will serve the European financial system and its economic future better

than a strategic monoculture based on massive universal banking orga￾nizations and financial conglomerates. Consolidation is often to the good,

but it has its limits.

Besides the United States and Europe, there is the perennial issue of

the role of Japan’s financial system. Like the United States, it was long

distorted by competitive barriers such as Article 65 of the Japan Financial

Law, promulgated during U.S. occupation after World War II. But it also

had distinctive Japanese attributes, such as the equity crossholdings be￾tween banks and industrial companies in keiretsu structures. Major Japa￾nese City banks such as Sumitomo and Bank of Tokyo existed alongside

four major and numerous minor securities firms, trust companies, finance

companies, and the like. Competitive dynamics were hardly transparent,

and government ministries—notably the Ministry of Finance and the Min￾istry of International Trade and Industry—wielded extraordinary influ￾ence.

The good years of the 1970s and 1980s covered up myriad inefficiencies

and inequities in Japan’s financial system until they ended abruptly in

the early 1990s. The required Japanese financial-sector reconfiguration

was not impossible to figure out (see for example Walter and Hiraki 1994).

Mustering the political will to carry it out was another matter altogether,

so that a decade later the failed Japanese system still awaited a new,

permanent structural footing. Meanwhile, life goes on, and some of the

key Japanese financial business in investment banking, private banking,

and institutional fund management have seen substantial incursions by

foreign firms. In other sectors, such as retail brokerage, foreign firms have

had a much more difficult time.

Structural discussions of Canada, Australia, and the emerging market

economies, as well as the transition economies of eastern Europe, have

been intensive over the years, particularly focusing on eastern Europe in

the 1990s and the Asian economies after the debt crisis of 1997–1998 (see

Claessens 2000; Smith and Walter 2000). Regardless of the geographic

venue, some argue that the disappearance of small local banks, indepen￾dent insurance companies in both the life and nonlife sectors, and a broad

array of financial specialists is probably not in the public interest, espe￾cially if, at the end of the day, there are serious antitrust concerns in this

key sector of the economy. And as suggested in Figure 7-4, the disap￾pearance of competitors can have significant transactions cost and liquid￾ity consequences for financial markets—in this case non-investment grade

securities.

At the top of the financial industry food-chain, at least so far, the most

valuable financial services franchises in the United States and Europe in

terms of market capitalization seem far removed from a financial￾intermediation monoculture (see Tables 2-12 and 2-13 in Chapter 2). In

fact, each presents a rich mixture of banks, asset managers, insurance

companies, and specialized players.