Motivations for Bank Mergers and Acquisitions: Enhancing the Deposit Insurance Put Option

versus Earnings Diversification

Author(s): George J. Benston, William C. Hunter and Larry D. Wall
Source: Journal of Money, Credit and Banking, Vol. 27, No. 3 (Aug., 1995), pp. 777-788
Published by: Ohio State University Press
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GEORGE J. BENSTON
WILLIAM C. HUNTER
LARRY D. WALL

Motivationsfor Bank Mergersand Acquisitions:

Enhancingthe Deposit InsurancePut Option
versus EarningsDiversification
THE PACEOF MERGERS
AND ACQUISITIONS
among U .S .
commercialbanks has increaseddramaticallyover the past several years. From an
annualaverageof 170 mergersduringthe 1960 to 1979 period, the annualaverage
increasedto about498 duringthe 1980 to 1989 period.l Of the many factorsleading
to this increase in merger activity, the weakening of regulatoryrestrictionsagainst
interstatebankingwas a significantcontributingfactor. Priorto the 1980s, the prohibition againstinterstatebankingand state-levelrestrictionson branchbankingand
multiplebankownershiplargely limited where and how bankscould compete. With
the weakening of these geographic restrictions, mergers and acquisitions were a
means for banks to penetratenew markets,realize potentialeconomies, and acquire
financialpower and prestige associatedwith largersize.
An importantissue is whetherbanks used their increasedfreedomto merge in a
way intendedto increasethe value to them of deposit insurance.An acquisitionpolicy designed to maximize the value of deposit insurancemay be shareholder-wealth

The views expressed here are those of the authorsand not necessarily those of the FederalKeserve
Bank of Atlanta, the Federal Reserve Bank of Chicago, or the Federal Reserve System. The authors
thankthe anonymousreferees for their comments.
1. For a review of recent U.S. bank mergerand acquisitionactivity, see Rhoades (1985) or LaWare
(1991). Hereafter,the terms mergersand acquisitionsare used synonymously.Our model and empirical
tests do not distinguishtakeoverswhere the targetis mergedinto the acquirerfrom those where the target
retainsa separatebankingcharter.

GEORGE
J. BENSTON
is John H. HarlandProfessorof Finance, Accounting,and Economics, EmoryBusiness School, EmoryUniversity.WILLIAM
C. HUNTER
is Senior VicePresident
and Director of Research, Federal Reserve Bank of Chicago. LARRYD. WALLis research
officer, Federal Reserve Bank of Atlanta, and adjunct professor of finance at Emory
University.
Journal of Money, Credit, and Banking, Vol.27, No. 3 (August1995)

Copyright1995by TheOhioStateUniversityPress
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778 : MONEY, CREDIT,AND BANKING

maximizing if an increase in the value of deposit insuranceincreases shareholder

wealth. Hunterand-Wall(1989) and Boyd and Graham(1991) raise the possibility
thatbanks seek to become largerto increasethe probabilitythatthe FDIC will cover
100 percent of the bank's deposits (that is, become "too big or too importantto
fail"). This "depositinsuranceput-option-enhancing"hypothesisis not the only hypothesis to suggest that banks might pursuegrowtheven if it is socially suboptimal.
Bank managersmay also be interestedin pursuinggrowth to enhance their salary,
perquisites, and personal prestige. However, the deposit insurance put-optionenhancinghypothesisdiffersin one importantway from hypothesesrelatedto managerial interests. The deposit-insurancehypothesisalso suggests thatacquirerswould
be willing to pay more for riskier, more profitableorganizationswhose returnsare
highly correlatedwith the acquirer'sreturns.23 The managerial-interesthypothesis
would be consistent with no relationship(or possibly a negative relationship)between purchaseprice and ex post risk.
Alternatively, banks may find that maximizing risk does not maximize shareholder wealth. The regulatorsmay not permit increased risk exposure, or the increased risk of failure may impose costs that exceed the value of the deposit
insurance put option.4 In this case, shareholderwealth may be maximized by
mergers that diversify earnings. This "earningsdiversification"hypothesis posits
that acquiringbanks seek earningsdiversificationin an effortto generatehigherlevels of cash flow for the same levels of total risk. That is, reductionsin business risk
are offset by increases in financial risk. Kim and McConnell (1977) suggest that
acquiringfirms can offset the reductionin equity value by issuing additionaldebt,
returningthe probabilityof bankruptcyto original levels. They and Asquith and
Kim (1983) provide strong empirical evidence showing that leverage indeed is increased following mergers between nonfinancialfirms. Indirectempirical support
for banks' offsetting the risk reductionassociatedwith merger-inducedearningsdiversification appears in the literaturethat examines the performanceof acquired
banks. Heggestad and Mingo (1975), Piper (1971), and Piperand Weiss (1971) find
that banks acquiredby bank holding companies tend to reduce their capital ratios
significantlyafteracquisition.This increasedleverageincreasesthe tax shield due to

2. The deposit insuranceput-optionhypothesis differs from the other hypotheses in anotherway as

well. The deposit insurance put-option hypothesis, while consistent with management'smaximizing
shareholderwealth, may not be optimal from society's perspective. The other hypotheses, for example,
the maximization of salaries, perquisites, and personal prestige, while serving to maximize management's utility, do not necessarily maximize shareholderwealth or society's welfare.
3. This does not necessarilymean that all acquirerswill pay more for risky targetsthan for less-risky
targetsof the same size. This will dependon the extent to which the acquirerseeks to maximize the value
of the deposit insuranceput option. Thatis, once an acquirerbecomes too big to fail, theremay still be an
incentive to furthermaximize the value of the deposit insuranceput option by acquiringriskier banks.
Both actions, that is, acquiringtargetsto become too big to fail and paying more for more-riskytargets,
are consistent with the "depositinsuranceput-option-enhancinghypothesis."
4. For example, banksand their customersmake long-lived investmentsin areassuch as lending relationships, informationprocessing technologies, and off-balance-sheetactivities that would not be positive net presentvalue projectsif the bank had a high probabilityof failure.

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GEORGEJ. BENSTON, WILLIAMC. HUNTER, AND LARRY D. WALL :

779

debt (see Lewellen 1971) and, hence, after-taxnet cash flow. Beatty, Santomero,
and Smirlock (1987), Hobson, Maston, and Severiens (1978), Rose (1975), Talley
(1972), and Ware(1973) find that acquiredbanks tend to reduce significantlytheir
holdings of low-risk securities while simultaneously increasing their holdings of
loans, thereby raising earnings. Similarly, Cornettand Tehranian(1992) find that
both interstateand intrastatebank mergersproducesignificantincreases in the cash
flow returnsto stockholders.Thus, there is evidence that diversificationof a bank's
net earnings through merger increases the cash flow available to stockholders. A
merger also might increase net cash flows from savings due to economies of scale
and scope and from efficiencies resultingfrom more effective management.5
An empirical evaluation of these competing hypotheses should be of interest to
both bank managers and policymakers. Empirical evidence on which factors are
most highly valued by acquiringbanks should allow target bank managementsto
assess mergerproposalsbetterand to structurethemselves to maximize their acquisition value. Similarly,such evidence can providepolicymakerswith a betterunderstanding of the effects that fixed rate deposit insurance had on bank merger
motivations during the merger wave of the 1980s and can provide additionalevidence useful in evaluatingthe potentialbenefitsof relaxingrestrictionson geographic expansion by banks.6
We test these alternativehypothesesby developing and estimatinga simple model
of the price bid by banksfor banks. Althoughseveral studiesof bankmergersexamine key determinantsof the prices paid in bank mergers(see, for example, Varaiya,
Hempel, and Lam 1984; Beatty, Santomero,and Smirlock 1987; Gup, Cheng, and
Wall 1989; Rhoades 1987; Rogowski and Simonson 1987; Liang and Rhoades 1988;
Adkisson and Fraser 1990; and Rose and Wolken 1990), surprisinglynone explicitly
examines the impactof the targetbank'searningsdiversificationpotentialon acquisition premiumsor purchaseprices.7
Ourtests are conductedusing a sample of bids made by U. S . commercialbanking
organizationsduringthe period from December 1981 throughJuly 1986. In the following section we present our empirical model and outline our data sources and
definitions. The empiricalresultsare discussed in section 2. A conclusion follows in
section 3.

5. Recent researchexamining scale and scope economies in banking[see Berger, Hunter,and Timme
(1993) for a comprehensivereview] suggests thatthe potentialgains resultingfrom scale and scope economies are dominatedby those available throughthe eliminationof managerialX-inefficiencies. For example, research to date suggests that differences in managerial ability to control costs or maximize
revenues account for as much as 20 percent of costs in banking, while scale and scope inefficiencies
account for only about S percentof costs.
6. Proponentsof changes in federal interstatebranchinglaws arguethatthe risk of bankfailurewould
decrease if existing restrictionswere relaxed. Implicit in this argumentis the belief that acquiringbanking organizationsattemptto engage in risk-reducingmergersbecause they are unable to diversify adequately in their existing geographicmarkets.
7. Liang and Rhoades (1988) study the impact of geographicdiversificationon bank risk. They find
that, while geographic diversification(intrastate)can reduce composite measuresof bank risk, the variance of individualcomponentsof these measuresmay actually increase.

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780

: MONEY, CREDIT,AND BANKING

1. THE EMPIRICALMODEL AND DATA

The price bid for any asset should be positively related to and no more than the
presentvalue of the change in the bidder'sexpected net cash flows. As postulated,a
bank merger may increase the net cash flows expected from operations or from
higher-valueddeposit insurance. Because, at a minimum, the price bid should reflect the stand-alonevalue of the net assets acquired,we reduce the purchaseprice
and expected net cash flows by the marketvalue of the targetbank before the consolidation was known to the market.Thus,
PPT =

A (CNCF, CDIP),

( 1)

where
PPT

= the purchase premium of a target bank (purchase price less precon-

solidation marketvalue),
CNCF = change in the net cash flows of the combined (targetpIus acquirer)organization, and
CDIP = change in deposit insuranceput-optionvalue to the combinedorganization.
I a. Change in Net Cash Flows
This section develops proxies for the impact of a merger on the riskiness of the
post-mergerbanks and, thus, indirectlyproxying for the increase in net cash flow.
The combined organizationmight be less risky than the acquirerpriorto portfolio
changes, both because of diversificationgains from less-than-perfectlycorrelated
returnsat the two banks and because the target is low risk. We measurethe covariance of the target's and acquirer'sreturnsusing their respective returnson assets
Similarly,the varianceof the tarover the four years prior to the merger, COVAT.8
get's earnings is proxied by the variance in its returnon assets over the four years
prior to the merger, VART. If acquirersseek to exploit diversificationgains, both
COVAT
and VARTshould be inversely relatedto PPT. If the owners of the targetbank
were not adequatelydiversified, theirreservationprice might be inversely relatedto

8. The choice of a four-yearhorizon reflects a compromise between using a longer time period to
obtain more data and using a shortertime period to estimate more accuratelythe currentvalue of the
variance. The choice of returnon assets instead of variance in net income eliminates the scale factor of
the acquirer'stotal assets. The importanceof eliminating this scale factor may be demonstratedby an
example. Considertwo targets(A and B) thathave the same asset size and distributionof returnsand two
acquirers(C and D) that are also identical except that the assets and distributionof returnsof acquirerC
are five times larger than those of acquirerD. If covariances are calculated using returnon assets, the
covarianceof A and C is identicalto the covarianceof B and D. Thus, using returnon assets suggests that
the two potentialmergerswill produceapproximatelyequal changes in the target'sasset portfolioto fully
exploit the diversificationor deposit insuranceput-optiongains. However, if covariancesare calculated
using net income, the covariance of A and C is five times that of B and D. Thus, use of net income
produces the anomalous result that the diversificationor put-optiongains from a mergerof A and C are
five times the gains from a mergerof B and D. (We recognize thatthe use of ratios, includingROA,fails
to account for differencesin the relative size of the targets, and adjustthe variablesappropriatelybelow.)

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GEORGEJ. BENSTON! WILLIAMC. HUNTER AND LARRYD. WA1L : 7X1

VAR7.Hence, a negative sign on the coefficientof this variablealso would be consistent with this situation.9
The value of CNCF also might depend in parton the acquirer'sability to reduce
the costs of producingthe combinedorganization'sexisting productmix by achieving economies of scale. We measure this possibility with the relative asset ratio,
TArITAA,where TA is total asset size and the subscriptidentifies the target (T) or
acquiring(A) banks. We hypothesize that the larger is the relative asset ratio, the
greateris the opportunityfor merger-relatedefficiencies to be realized. Hence, if the
mergers were expected to produce economies of scale, WATITAA should be significantly positiveiy relatedto PP7-.
An alternativehypothesis is that the short-runcosts of merging two banks are a
positive functionof their relative size. Accordingto organizationtheorists, melding
culturesin a mergeris more difficultand costly when the targetis more equal in size
to the acquirer.If short-runcosts are a positive functionoiSsize and these costs outweigh the presentvalue of economies of scale, an inverserelationshipbetween relative size and purchasepremiumis expected.
An inverse relationship also is suggested by Rogowski and Simonson (1987).
They hypothesize that relatively large targetsoffer acquirersifeweropportunitiesto
introducenew and presumablymore profitableproducts,as the targetwould already
be offeringproductssimilarto those offeredby the acquirers.lOHence, in these situations, acquirerswould offer less to the targets'owners, otherthings equal.
Managersof acquiringbanks may be superiorto managersof targetbanksin producing shareholdervalue. This superioritymay be manifestin lower costs or greater
revenues.l ' We proxy the efficiency of the acquirerwith the ratio of its marketto
on the assumptionthat the
book value of equity (a variantof Tobin'sQ), MVAIBVA,
stock marketvalues a bank at more or less than its book (presumedreplacement)
value if the bank's managersare betteror worse thannormal. Similarly,the efficienIf acquiringbanks typically poscy of the target is proxied by the ratio MVTIBVT.
sess the superiormanagement(as wollld be predictedby models of the marketfor
is expected to be positively relatedto the bid premicorporatecontrol), MVAIBVA
to
ums. MVTIBVT is expected have a negative sign because bad targetmanagement
implies greateropportunitiesfor the acquiringbankto improvethe target'sefficiency, ceteris paribus. 12

9. The covarianceand variallcesof the target'sand acquirer'srevurnsare also measuredusing the rate
of returnon equity and the net interestmargin.The resultsobtainedusing these alternativemeasuresare
noted in footnote 14 below.
10. Ideally, a direct measureof these new productopportunitieswould be employed. However, the
financial statementsof banks lack sufficientdetail for the calculationof a direct measure. For example,
all types of commerciallending appearunderthe single headingof commercialand industrialloans.
11. Several studies suggest the potential for lower costs; including Berger and Humphrey(1991),
Elyasiani and Mehdian (1990), Evanoff, Israilevich, and MerTis(1990), and FelTierand Lovell (1990).
However, Srinivasan and Wall (1992) suggest that mergers of larger organizationsbetween 1982 and
1986 did not producelower noninterestexpenses, ex post.
12. Since market-to-bookvalue ratios might be affected significantlyby geographiclocation, we include regional dummy variables in the empirical model to control for the possibility of regional differences in the ratio.

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782

: MONEY, CREDIT,AND BANKING

Finally, the marketin which a prospectivetargetbank operatesmay enhance its

value to an acquirer.Such marketconditions might include the size of the market,
expected marketgrowth, and the degree of concentration.These variableswere included in a large-scale study of the determinantsof bankmergersbetween 1978 and
1983. Amel and Rhoades (1989) found thatrapidgrowthof the targetbank was not
a determinant.They found thathigh marketsharereducesthe probabilityof a bank's
being acquiredin a horizontalmerger, but increases its acquisitionprobabilityin a
market-extensionmerger. Market concentrationalso reduces the probabilityof a
horizontal acquisition and is not a significant determinantof market extension
mergers. Although we do not include marketshare and concentrationvariables in
our model, from the Amel-Rhoades (1989) study, we expect that the omission of
these variables tends to bias the results weakly against the earningsdiversification
hypothesis.

Ib. Changein the Valueof theDepositInsurancePutOption

A mergermay increasethe value of deposit insurancein two ways: (1) by increasing the size of the bankingorganizationso it may be eonsideredtoo big or too importantto fail, and (2) by increasing the variance of the acquiringorganization's
returns. Risky acquirersmay bid more than low-risk acquirersfor targetsbecause
the value of becoming too-big-to-fail is greaterfor banksthatare more likely to fail.
We measurethis risk by the variancein acquirer'sreturnon assets, VARA,and by its
book-value capital-to-assetratio, BVAITAA.
Underthe deposit insuranceput-option
hypothesis, VARAshould have a positive relationshipand BVAITAA
an inverse relationship to PPT. The hypothesis also predictsa positive relationshipbetween VART
and COVAT
to PPTHowever, the regulatoryagencies may rejectmergersthatpose too great a risk to
the FDIC. Should this have oceurredand if acquirersdo not seek mergersto reduce
risk, the signs of the coefficients of VART,
COVAT,
VARA,
and BVAITAA
should be
insignificant.

I c. TheEmpiricalModel
The expected relationshipbetween each of the variablesand the price bid for the
target is summarizedin Table 1. One problem remains before we can develop an
empirically estimable model: the dependentvariable, purchaseprice premium, is
stated in dollar terms, but all of the explanatoryvariablesare ratios. Therefore, to
scale all of the independentvariables, we multiply each by the target'stotal assets,
TAT.To account for possible regional diifferencesin purchase premiums paid in
mergers, we also include regional dummy variablesbased on FDIC regions in the
empiriealspecifieation. The estimationmodel is then writtenas
PPT

= bo + b1 VART*TA
T + b2 COVA T*TA
T + b3VARA
*TAT
+ b4(BVA/TAA)*TAT + b5 (TATITAA)*TAT
+ b6 (MVA/BVA)*TAT
12
+ b7(MVT/BVT)*TAT + E bj*RDj+ e,
(2)
j=8

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GEORGE
J. BENSTON,
WILLIAM
C. HUNTER,ANDLARRYD. WALL : 783

TABLE 1
RELATIONSHIPS
EXPECTED
BETWEEN
EXPLANATORY
VARIABLES
ANDPURCHASE
PREMIUM
(PPT)
BYTHEALTERNATIVE
HYPOTHESES
ExplanatoryVariable
VART

EarningsDiversification
Hypothesis
-

COVAT
VARA
BVAITAA
TATITAA

acquiringbank
target bank
total assets
variance or returnon assets

+
not significant
not significant
+ if economies of scale
- if mergercost dominates
or if fewer opportunities
for new products

MVAIBVA
MVTIBVT
A
=
T
=
TA =
VAR =

Deposit Insurance
Put-OptionHypothesis

+
not significant

not significant
not significant
COV = covariance or returnson assets
BV = book value of equity
MV = marketvalue of equity

where
PPT = purchasepremiumpaid for the targetbank measuredas the difference

TA =
VAR =
COV

BV =
MV =
RD =

between the price paid for the targetbank less the marketprice of the
targetapproximatelyone monthpriorto the announcementof the
merger,
total assets of target(D or acquiring(A) bank,
varianceof returnon assets,
covarianceof targetand acquirer'sreturnon assets,
book value of equity,
marketvalue of equity,
regional dummy variables, that is,
RD8 = total targetassets for Northeast, 0 otherwise
RD9 = total targetassets for Southeast, 0 otherwise
RDlo = total targetassets for Midwest,
0 otherwise
RDll = total targetassets for Southwest, 0 otherwise
RD12 = total targetassets for West,
0 otherwise, and
zero mean errorterm.

In equation (2) the dummy variablesmeasuredifferencesin the purchasepremium paid relativeto targetslocated in the Centralregion of the UnitedStates. Table 1
shows the relationshipbetween the explanatoryvariablesand the purchasepremium
expected by the alternativehypotheses.
I d. The Data
The observationsincluded in the sample were obtained from the Cates Merger
Watchfor the period from December 1981 throughJuly 1986. To be includedin this
data base the acquiringbank's total assets must exceed $100 million and the target
bank's assets must exceed $25 million. The data include bids made for targetsand
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784

: MONEY, CREDIT,AND BANKING

TABLE 2
SAMPLE
SUMMARY
STATISTICS
Variable

Standard
Deviation

Mean

Purchase premium (PPT) (millions)

Acquirer total assets (TAA)(millions)
Target marketvalue (MVT) (millions)
Target total assets (TAT) (mi11iOnS)
Target variance of returnon assets (VART)
Covariance of returnson assets (COVAT)
Acquirervariance of returnon assets (VARA)
Acquirer book-value of equity-to-totalassets

$21.397
$5,337,100,000
$53.948
$748
.00000391

-.00t)00651
.00000058
.065

(BVA/TAA)

Target TA to acquirerTA (TATITAA)

Acquirer market-value-to-book-valueof equity

32.373
10,348
100.060
1,310
.00001283
.00001408
.00000110
.014

1.051

.237
.387

.964

.432

.213

(MVA IB VA)

Target market-value-to-book-valueof equity

(MVT/B

VT)

are not restrictedto mergersthat were consummated.Ourstudy requiresstock price

inforrnation,which also is available from Cates. The final sample contains 302
mergers. 13
All of the financial statementvariableswere obtainedfrom the Reportof Condition and Reportof Income filed by bankswith theirrespectivefederalbankregulator
and the Bank Holding CompanyFinancialSupplement(FR Y-9) filed by bankholding companies with the FederalReserve. The mergerprice, premergermarketprice,
and premerger market-to-bookratios were obtained from Cates MergerWatch.
Summarysample statistics are presentedin Table2.
2. EMPIRICALFINDINGS

tEable3 reportsthe results obtained using returnon assets (ROA)to measure returns.14 As can be seen in this table, the empiricalmodel is statisticallysignificant
and 81 percent (adjustedR2)of the variationin the purchasepremiumis explained
by the model. Excluding the regional dummy variables, five of the seven estimated
coefficients are statisticallysignificant. A comparisonof the actualsigns of the estimated coefficients with their expected signs underalternativehypotheses (see Table
1) shows that the data are strongly consistent with the earningsdiversificationhypothesis, marginallyconsistent with the managerialinteresthypothesis, and inconsistent with the deposit insuranceput-optionhypothesis.15
13. Our initial sample consisted of 340 mergercases. However, in 4 of these cases the acquiringbank
was a foreign bank, in 8 cases multiplechanges in the mergerterms were observed, in 1 case the merger
was a federally assisted transaction, 19 cases presentedincomplete financialdata, and the predecessor
bank (for purposesof computingvariances and covariances)could not be identifiedin 6 cases.
14. The model also was estimated using the returnon equity and the net interestmarginto calculate
the variances and the covariance measures. The empirical results obtained using these alternativemeasures of returnwere not significantlydifferentfrom those presentedin Table3.
15. It should be noted thateven thoughthe firstpublic confirmationof the too-big-to-faildoctrinewas

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GEORGEJ. BENSTON WILLIAMC. HUNTER AND LARRYD. WALL : 785

TABLE 3
ESTIMATIONOF PURCHASEPRICEBID PREMIUM(PP7-)

All ExplanatoryVariables (except Regional Dummies) Multipliedby the Target's Total Assets (TA7)
Intiepcntiellt
Variable

VART
COVAT
VARA

BVAITAA
TA7lTAA
MVAiBVA

MV-rlBV7
Northeast
Southeast
Midwest
Southwest
West
Intercept
F-Statistic
R-Square

Coefficient

-580.5
-331.2
-2764.3

.421600
-.025400
.012500

-.000854
- .004500
.001930
.015083
.003508
.011489
2189.0
109.15
.81

White's
StandardError

Explanatory
Powera

141.4***
228.6
1378.0*
.096134*t
.00349**3
.00521*t
.005921
.003087
.005120
.003676*2 *
.002589
.007930
812.18 *

-0.538
-0.122
-0.118
-0.967
-0.907
-0.669
-0.042
-0.105
0.049
0.099
0.051
0.219

White-s test tor model specification 150. 13

(Under the null hypotllesi.s.the errorsare homoscedastic. T he test statistic follows a chi-scluaredistributionwith 79 degrees of freedom;its
probabilityvalue is .0001.)
* * = coefficient significant at I percent level, two-tail test
B = coefficient significant at 5 percent level. two-tail test
-coefficient significant at 10 percent level two-tail test
change in the explanatoryvariabledivided by
dExplanatorypower equals the estinlated coefficient multipliedby a one-standarti-deviatioll
the ptlrehasepriee bid premium.

The significantly negative sign on the coefficient of the variance of the target's
is consistent with the diversification/managerialinterestexreturnon assets, VART,
planationfor mergersand inconsistentwith the deposit insuranceput-optionhypothis consistent with
esis. Similarly,the negative sign on the covarianceterm, COVAT,
the diversification/managerialinterest explanation for mergers, although it is of
marginalsignificance. The significantlynegative coefficient of the varianceof the
acquirers'returns,VARA,and significantlypositive coeifficientof the acquirers'book
are also inconsistentwith the deposit insurvalue equity to assets ratio, BVAITAA,
ance put-optionhypothesis. However, to the extent that these variablesare indicators of the quality of management, the results are consistent with the joint
hypothesis that higher-qualitymanagementscan benefit more from acquisitionsand
hence will tend to bid more than lower-qualitymanagements.For example, banks
with lower variances may serve more stable marketsor are better able to manage
made by the Comptrollerol the Currencyfor the largestbanks in the countryin 1984, there were widespreadperceptionspriorto 1984 thatcertainbankswould not be allowed to fail. Forexample, in his 1986
book, Bailoat: An Insider'sAccoant of BankFailaresand Rescaes, IrvineSpraguedescribesfour bailouts
which he handled while Chairmanand Directorof the FDIC. These bailouts were (1) Unity Bank (Roxbury, Mass.) in 1971, (2) Bank of the Commonwealth(Detroit) in 1972, (3) First PennsylvaniaBank
(Philadelphia)in 1980, and (4) ContinentalIllinois (Chicago) in 1984. At the time of theirbailouts, these
institutionshad total assets of $11.4 million, $1.26 billion, $8.4 billion, and $41 billion, respectively.
Thus, a bailout could result from a bank being deemed too importantto its communityas well as from
being too big to fail. While we have no way of assessing the subjectiveprobabilitiesassigned by market
participantsthat a given bank would receive governmentprotectionif it became insolvent and the exact
form this protection would take, the collapse of ContinentalIllinois and the comptroller'ssubsequent
public statements in 1984 made the doctrine explicit. An analysis of the 1981-83 and 1984-86 subperiods indicate that the earningsdiversificationmotive became dominantduringthe post-1983 period.

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786

MONEY, CREDIT,AND BANKING

theirearnings. Banks with highercapitalratiosmay have been moreprofitablein the

past and expect to have more profitablefutureopportunitiesand, hence, retainmore
earnings. An alternativeexplanationis thatthe regulatorswere effective in blocking
takeoversby financiallyweak acquirers.
The coefficient of relative size, TATITAA,
is significantlynegative. This findingis
consistent with the hypothesisthatthe cost of consummatingthe mergerexceeds the
potential savings due to economies of scale and with the notion that large targets
offer fewer opportunitiesfor new productintroduction.The coefficienton the proxy
for the efficiency of the acquirer'smanagement,MVAIBVA,is positive and statistically significant. The positive sign is consistentwith more efficientacquirers'bidding higher premiumsfor targets. Although the negative sign on the targetbank's
managementefficiency proxy, MVTIBVT,indicates that acquirersbid less for more
efficient targets, the coefficient is not statisticallysignificant.These results are consistent with the predictionsof the "marketfor corporatecontrol"hypothesis.
The only regional dummy variable with a statistically significant coefficient is
that representingthe Midwest region. Thus, target banks located in the Midwest
region commandeda higher purchasepremiumthan did targetslocated in the Central regions of the United States, ceteris paribus.
A measureof the relative explanatorypower of the differentvariablesis provided
in the last column of Table3. This measureis the estimatedcoefficientmultipliedby
a one-standard-deviationchange in the explanatoryvariabledividedby the purchase
price bid premium. By this measure, four variablesstandout. The two most important explanatoryvariablesby this measureare the acquirer'sbook value capital-toasset ratio, BVAITAA,
and relativesize, TATITAA.
The quantitativeimportanceof the
covariance of the two banks' returnon assets and the variance of the acquiring
bank'sreturnon assets, COVAT
and VARA,appearsmall by this measureof explanatory power. However, the varianceof the targetbank'sreturnon assets, VART,is the
fourth most importantvariable. The measureof the quality of the acquiringbank's
management,MVAIBVA,is in thirdplace.
3. CONCLUSION

This study examines the prices bid to acquire target banks in the early to
mid-1980s. In particular,the study examines two contrastinghypotheses on the
pricing of risk considerationsin these mergers.The earningsdiversificationhypothesis holds that banks would bid more for mergerpartnersthat offered the potential
for cash flow enhancementsas a result of earningsdiversification,whereas the deposit insuranceput-optionhypothesis holds that acquirerswould bid more for targets thatofferedopportunitiesto increaserisk and/orto become too big or important
to fail. The empiricalresults are consistentwith the earningsdiversificationhypothesis and inconsistent with the deposit insuranceput-optionhypothesis. The signs
and relative importanceof the variables are consistent with mergers having netcash-flow advantages. Contraryto the predictions of the deposit insurance putoption hypothesis, the coefficient on the varianceof the target'sreturnon assets is
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GEORGEJ. BENSTONnWILLIAMC. HUNTER, AND LARRY D. WALL :

787

negative and the coefficient on the acquirersebook value equity to assets ratio is
positive. Moreover,the coefficienton the variablemeasuringthe relativesize of the
targetto the acquireris negative which is consistent with the desire of the acquirer
to increaseits risk and/or enhancingthe target'soperationsby addingnew products.
These results should not be interpretedto imply thatno mergershave been undertaken in an attempt to increase the value of deposit insurance. As suggested by
Hunterand Wall (1989) and Boyd and Graham(1991), deposit insuranceconsiderations may have been importantin some recent mergers including some of the
megamergersof the early 1990s. However, our results stronglysuggest thatmost of
the mergersbetween publicly tradedbanksin the early and mid-1980s were not due
to attemptsto exploit deposit insurance.

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