Wednesday, 18 September 2013

One of the Real Motivations Behind Bank Mergers and Acquisitions

In the first quarter of 1984 there were 14,388 commercial banks in the U.S. As of the second quarter this year, the number had dropped to only 5,887. During the course of about 29 years, the number of banks in the U.S. hence declined by 8,501 or 59.1%.

During the same period, total assets for all U.S. commercial banks increased from USD 2.0259 trillion to USD 13.4386 trillion, an increase of 563.3%. As a result, total assets under management for the average bank increased from USD 0.14 billion to 2.28 billion, or 1,528.6%, during the 1984 to Q2 2013 period.

There are obviously many logical reasons the banking industry in the U.S. has consolidated, as is the case for most other industries, such as economies of scale, expanding the range of products/services, synergies, bankruptcies etc. But there is another fundamental and powerful reason banks merge and make acquisitions. This reason is directly related to fractional reserve banking which lies at the heart of the U.S. monetary system. 

Simply put, a commercial bank attempts to make a profit through issuing loans, accepting deposits and through providing a range of financial services. As such, the extent to which it can create loans (credit) is an important factor deciding the level of profits. Many banks will therefore normally seek opportunities that expand their loan portfolios (ceteris paribus) in order to increase profits.

At first glance, two banks merging will end up with a larger loan portfolio, but can only make an incremental profit from it if there is a gain from synergies. Right? The answer is no. Banks are nothing like other corporations and therefore are not as dependent on the (potential) gain from synergies in order to make an incremental profit from a merger or acquisition. The reason for this can be found in this simple formula in the book Money, Bank Credit and Economic Cycles, 2nd ed by J.H. de Soto, p. 202): 

The formula shows what the maximum credit expansion possible for a single bank would be, where, 
d: the money originally deposited in the bank’s vault
x: the bank’s maximum possible credit expansion starting from d 
c: the cash or reserves ratio maintained by the bank, in keeping with the banker’s experience and his careful judgment on how much money he needs to honor his commitments; and
k: the proportion of loans granted which, on average, remain unused by borrowers at any given time.
As commercial banks are able create money "out of thin air", meaning they don't need a corresponding amount of actual savings backing the loans granted (this is an integral part of "fractional reserve banking"), the key motivator for bank mergers and acquisitions in the above formula is k. The k is the amount of the loan which, since it is not used, is just sitting on the bank balance sheet as a deposit (a deposit is created when a loan is granted). Therefore, the larger the bank's market share is, the more loans and deposits it is able to create and make money from. I'll let de Soto explain:
The fewer the banks operating in the market, the higher k will be; the higher k is, the less money will leave the bank; the less money leaves the bank, the greater the bank’s capacity for expanding loans. One of the strongest motivations behind the trend toward bank mergers and acquisitions which has always been obvious in fractional-reserve banking systems is precisely the desire to increase k. In fact, the more banks merge and the larger their subsequent market share, the greater the possibility that the citizens who receive the banks’ fiduciary media will be their own customers. Therefore both k and the corresponding capacity to create loans and deposits from nothing will be increased and the resulting profit much greater. The value of k is also increased when monetary deposits are made in other banks, which in turn expand their loans, and their borrowers ultimately deposit in the original bank a significant portion of the new money they receive. This phenomenon also causes an increase in the bank’s monetary reserves and therefore in its capacity for credit expansion.
So, there we have it: the larger the bank is the less deposits leave the bank. The less deposits leave the bank, the less money and reserves leave the bank and the more the bank is able to expand its loans and deposits:

d1 = (1 – k)x

d1: the money or reserves which leave the bank as a result of loans it grants
x: loans granted 
In conclusion, the desire to increase loans and deposits through increasing k has been a strong motivation for banks to merge and grow through acquisitions. As a result, two banks that have merged are able to expand their loan portfolio and deposits by a larger multiple than the two combined as stand alone companies. And as long as the current fractional reserve system survives in the U.S. (and many, many more countries), bank mergers and acquisitions will continue unabated in the future as well as any "prudent" bank would seek to increase k in order to increase profits. In theory, this could continue until there is only one bank left standing and regulation is perhaps the only way to end it (other than unreasonably high stock prices of target banks). This is yet another good reason (besides the current system being responsible for the business cycle) to end or fundamentally change fractional reserve banking backed by a central bank (the tax payer that is).