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Chapter 19 - Acquisitions and Mergers in Financial- Services Management

CHAPTER 19
ACQUISITIONS AND MERGERS IN FINANCIAL- SERVICES MANAGEMENT
Goal of This Chapter: The purpose of this chapter is to understand why the financial services
industry undertakes so many mergers each year and to determine what legal, regulatory, and
economic factors should be considered when the management of a financial services provider
wants to pursue a merger.
Key Topics in This Chapter

Merger Trends in the United States and Abroad


Motives for Merger
Selecting a Suitable Merger Partner
U.S. and European Merger Rules
Making a Merger Successful
Research on Merger Motives and Outcomes
Chapter Outline

I.
II.
III.

IV.

V.
VI.

VII.

Introduction
Mergers on the Rise
The Motives behind the Rapid Growth of Financial-Service Mergers
A.
Profit Potential
B.
Risk Reduction
C.
Rescue of Failing Institutions
a.
The Credit Crisis: Impact on Mergers
D.
Tax and Market-Positioning Motives
E.
The Cost Savings or Efficiency Motive
F.
Mergers as a Device for Reducing Competition
G.
Mergers as a Device for Maximizing Managements Welfare (An Agency
Problem)
H.
Other Merger Motives
I.
Merger Motives That Executives and Employees Identify
Selecting a Suitable Merger Partner
A.
Merger Premium
B.
Exchange Ratios
C.
Dilution of Ownership
D.
Dilution of Earnings
The Merger and Acquisition Route to Growth
Methods of Consummating Merger Transactions
A.
Pooling of Interests
B.
Purchase Accounting
C.
Purchase-of-Assets Method
D.
Purchase-of-Stock Method
Regulatory Rules for Bank Mergers in the United States

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VIII.
IX.
X.
XI.

A.
Bank Merger Act of 1960
B.
Competitive Effects of Mergers
C.
The Public Benefits Test
D.
Justice Department Guidelines
E.
Herfindahl - Hirschman Index
F.
The Merger Decision-Making Process by U.S. Federal Regulators
Merger Rules in Europe and Asia
Making a Success of a Merger
Research Findings on the Impact of Financial-Service Mergers
A.
The Financial and Economic Impact of Acquisitions and Mergers
B.
Public Benefits from Mergers and Acquisitions
Summary of the Chapter
Concept Checks

19-1. Exactly what is a merger?


Mergers simply mean the financial transactions that result in acquisition of one or more firms by
another institution. Here, the acquired firm (usually the smaller of the two) gives up its charter
and adopts a new name (usually the name of the acquiring organization). The assets and
liabilities of the acquired firm are added to those of the acquiring institution. To affect a proposed
merger, the board of directors must ratify the same. This can be possibly done when shareholders
of all the parties involved approve the merger transaction once it is negotiated among the
management of the parties to the merger. Once the shareholders of each firm involved give
approval to the merger, approval must then be sought from the Department of Justice and the
principal federal regulatory agency of each firm in the merger.
19-2. Why are there so many mergers each year in the financial-services industries?
Many mergers and acquisitions have happened in the entire financial-service sector in recent
years. Many of these mergers have occurred because of lower legal barriers that previously
prohibited or restricted expansion. With several acts like Riegle-Neal Interstate Banking Act of
1994 and Gramm-Leach-Bliley (GLB) Act of 1999 being passed, mergers in financial services
received a legislative boost.
This convergence and consolidation trend has brought banks into common ownership with
security and commodity brokerdealer firms, finance companies, insurance agencies and
underwriters, credit card companies, thrift institutions, and numerous other nonbank service
providers.
19-3. What factors seem to motivate most mergers?
Among the most powerful merger motivations are the belief among the stockholders of the firms
for greater profit potential if a merger is consummated or their expectation of a possible
reduction of cash flow risk or earnings risk. However, from a managements perspective, there is

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Chapter 19 - Acquisitions and Mergers in Financial- Services Management

an expectation to gain higher salaries and employee benefits, greater job security, or greater
prestige from managing a larger firm.
The other various anticipations of merger partners involve the possible rescue of failing
institutions, the gaining of a tax advantage where profits of one merger partner may be offset by
the losses of another merger partner, and the search for market-positioning benefits in new
markets or in superior locations in existing markets. Another motivation is the pursuit of lower
cost and greater efficiency so that the merged institution achieves a greater margin of revenues
over operating expense as well as maximizing the welfare of management.
19-4. What factors should a financial firm consider when choosing a good merger partner?
The following items are the principal factors usually reviewed by the acquiring organization:
1. The firms history, ownership, and management
2. The condition of its balance sheet
3. The firms track record of growth and operating performance
4. The condition of its income statement and cash flow
5. The condition and prospects of the local economy served by the targeted institution
6. The competitive structure of the market in which the firm operates
7. The comparative management styles of the merging organizations
8. The principal customers the targeted institution serves
9. Current personnel and employee benefits
10. Compatibility of accounting and management information systems among the
merging companies
11. Condition of the targeted institutions physical assets
12. Ownership and earnings dilution before and after the proposed merger
It is absolutely essential to thoroughly evaluate the proposed corporate merger before it occurs.
19-5. What factors must the regulatory authorities consider when deciding whether to approve
or deny a merger?
The federal supervisory agencies prefer to approve mergers that will enhance the financial
strength of the institutions involved as they encourage the need for improving management skills
and strengthening equity capital.
Under the terms of the Bank Merger Act, each federal agency must give top priority to the
competitive effects of a proposed merger. This means estimating the probable effects of a merger
on the pricing and availability of financial services in the local community and on the degree of
concentration of deposits or assets in the largest financial institutions in the local market.
Mergers that would significantly damage competition cannot be approved unless there are
mitigating instigating circumstances (e.g., one of the firms involved is failing). Public
convenience must also be weighed by the regulatory agencies to determine if the merger would
improve the supply of needed services that are perhaps currently not being conveniently and
efficiently provided to the public.

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Along with these, the other factors that must be weighed to approve a merger include the
financial history and condition of the merging institutions, the adequacy of their capital, their
earnings prospects, strength of management, and the convenience and needs of the community to
be served.
19-6. When is a market too concentrated to allow a merger to proceed? What could happen if a
merger were approved in an excessively concentrated market area?
The Justice Department guidelines require calculation of the Herfindahl-Hirschman Index (HHI)
as a summary measure of market concentration. HHI reflects the proportion of assets, deposits,
or sales accounted for by each firm serving a given market. HHI may vary from 10,000 (i.e.,
1002)a monopoly position, where the leading firm is the markets sole supplierto near zero
for unconcentrated markets.
As per the Department of Justice guidelines established in 1997, the Federal Reserve merger
policy states that the market area is too concentrated to allow a merger, if the postmerger HHI
increases 200 or more points to a level of 1,800 or more or if the postmerger market share rises
to 35 percent or more. If the Justice Department decides that the resultant merger will make the
banking market too concentrated they are likely to challenge the merger in federal court.
However, merger combinations exceeding these standards often require mitigating factors (such
as greater likelihood of future market entry) in order to gain Federal Reserve approval.
19-7. What steps that management can take appear to contribute to the success of a merger?
Why do you think many mergers produce disappointing results?
There are several steps management can take to improve their chances of success of a merger.

They can know themselves by thoroughly evaluating their own financial condition, track
record of performance, strengths and weaknesses of the markets it already serves, and
strategic objectives.
They can also create a management-shareholder team before any merger to do a detailed
analysis of the potential mergers and new market areas.
Establish a realistic price for the target firm based on a careful assessment of its projected
future earnings discounted by a capital cost rate that fully reflects the risks of the target
market and target firm.
Once a merger is agreed upon, create a combined management team with capable managers
from both acquiring and acquired firms that will direct, control, and continually assess the
quality of progress toward the consolidation of the two organizations into a single effective
unit that satisfies all federal and state rules.
They should also establish lines of communication between senior management, branch and
line management, and staff that promotes rapid two-way communication of operating
problems and ideas for improved technology and procedures.
Create communications channels for both employees and customers to promote (a)
understanding of why the merger was pursued and (b) what the consequences are likely to be

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for both anxious customers and employees who may fear interruption of service, loss of jobs,
higher service fees, the disappearance of familiar faces, and other changes.
Finally they should set up customer advisory panels to comment on the merged institutions
community image, availability of services and helpfulness to customers.

Mergers sometimes produce disappointing results because of ill-prepared management, a


mismatch of corporate cultures, excess prices paid by the acquirer, inattention to customers
feelings and concerns and a general lack of fit between the two firms.
19-8. What does recent research evidence tell us about the impact of most mergers in the
financial sector?
A recent study, which looked at the earnings impact of approximately 600 national bank mergers,
found no significant differences in profitability between merging and comparably sized
nonmerging banks serving the same local markets. However, CEOs at a substantial majority of
the nearly 600 U.S. bank mergers believed their capital base improved and they were now a more
efficient banking organization.
However, as a study by Rose found that there is no guarantee of success in a merger. This study
of 572 banks which purchased nearly 650 other banks found a symmetric distribution of earnings
outcomes for these mergersnearly half displaying negative earnings results.
Finally, a recent study published by the Federal Reserve Board finds that mergers and acquisition
in the financial sector often produce operating cost savings (economies of scale). However, these
are generally for small firms and there is no evidence of cost reductions among large financial
firms or of any improvements in the management quality.
19-9. Does it appear that most mergers serve the public interest?
Most studies that have looked at this issue find few real public benefits. In fact, about one-third
banks changed their pricing policies. The most common change was a price increase following a
merger, particularly in checking account service fees, loan rates, deposit interest rates, and safedeposit box fees.
On the positive side, there is no convincing evidence that the public has suffered a decline in
service quality or availability following most bank mergers. Moreover, mergers may significantly
lower the bank failure rate. Crossing state lines seems to be somewhat effective in helping to
stabilize asset and equity returns, reducing the chances of insolvency and resulting in lower
operating costs. However, some smaller businesses may suffer a bit if their principal bank is
acquired and they dont yet have a relationship with the new owners.
Mergers and acquisitions do tend to stimulate market entry of new competitors. This situation
can have multiple outcomes as some customers quickly look around for new service providers or
can also lead to cost cutting including firing some employees who then start up new financial
firms to challenge their former employers. Hence, mergers and acquisitions usually generate a
mixture of winners and losers.

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Problems and Projects


19-1. Evaluate the impact of the following proposed mergers upon the postmerger earnings per
share of the combined organization:
a.
An acquiring bank reports that the current price of its stock is $25 per share and the bank
earns $6 per share for its stockholders; the acquired banks stock is selling for $18 per share and
that bank is earning $5 per share. The acquiring institution has issued 200,000 shares of
common stock, whereas the acquired institution has 50,000 shares of stock outstanding. Stock
will be exchanged in this merger transaction exactly at its current market price. Most recently,
the acquiring bank turned in net earnings of $1,200,000 and the acquired banking firm reported
net earnings of $250,000. Following this merger, combined earnings of $1,600,000 are
expected.
b.
Suppose everything is the same as described in part a; however, the acquired banks
shares sell for $36.00 per share rather than $18.00. How does this affect the postmerger EPS?
a.

Assuming the acquiring bank as Bank A and the bank being acquired as Bank B, we can
find the individual banks P-E ratios as follows:

As P-E ratio =

$25 per share


4.17
$6 per share

Bs P-E ratio =

$18 per share


3.6
$5 per share

To find the postmerger earnings per share, we first find the total shares of Bank A issued to the
stockholders of Bank B to complete the merger.
If the shareholders of Bank B agree to sell out at Bs current stock price of $18 per share:
They will receive 18 25 of a share of stock in Bank A for each share of Bs stock. Thus, a total
of 36,000 shares of Bank A 50,000 Bank Bshares 18 25 will be issued to the stockholders of
Bank B to complete the merger. The combined organization will then have 236,000 shares
outstanding.

Based on the projected earnings after the merger, stockholders earnings per share will be:
Earnings per share =

Combined earnings
$1,600,000
=
= $ 6.78
Shares of stock outstanding 236,000shares

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b.

If the shareholders of Bank B agree to sell out at Bs current stock price of $36 per share:

They will receive 36 25 of a share of stock in Bank A for each share of Bs stock. Thus, a total
of approximately 72,000 shares of Bank A 50,000 Bank Bshares 36 25 will be issued to the
stockholders of Bank B to complete the merger. The combined organization will then have
272,000 shares outstanding.

Earnings per share =

Combined earnings
$1,600,000
=
= $5.88
Shares of stock outstanding 272,000shares

19-2. Under the following scenarios, calculate the merger premium and the exchange ratio:
a.
The acquired financial firms stock is selling in the market today at $14 per share, while
the acquiring institution's stock is trading at $20 per share. The acquiring firms stockholders
have agreed to extend to shareholders of the target firm a bonus of $5 per share. The acquired
firm has 30,000 shares of common stock outstanding, and the acquiring institution has 50,000
common equity shares. Combined earnings after the merger are expected to remain at their
premerger level of $1,625,000 (where the acquiring firm earned $1,000,000 and the acquired
institution $625,000). What is the postmerger EPS?
b.
The acquiring financial-service provider reports that its common stock is selling in
todays market at $30 per share. In contrast, the acquired institutions equity shares are trading
at $20 per share. To make the merger succeed, the acquired firms shareholders will be given a
bonus of $2.00 per share. The acquiring institution has 120,000 shares of common stock issued
and outstanding, while the acquired firm has issued 40,000 equity shares. The acquiring firm
reported premerger annual earnings of $850,000, and the acquired institution earned $150,000.
After the merger, earnings are expected to decline to $900,000. Is there any evidence of dilution
of ownership or earnings in either merger transaction?
a.

A merger premium will be paid amounting to:

Merger premium (in percent) =


Acquired firm's current stock price per share + Additional amount paid by the acquirer
for each share of the acquired firm's stock
100
Acquired firm's current stock price
$14 + $5
100 =135.714 percent
$14

With an additional $5 per-share bonus the acquired institution's stock will be valued at $19,
slightly lower than the acquiring institution's stock for a $19 $20 or at a 0.95:1 exchange
ratio.

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Hence, the earnings per share from the merger will be:
Earnings per share =

Combined earnings
$1,625,000
=
= $20.70
Shares of stock outstanding 78,500shares

Before the merger, the acquiring institution had an EPS of $20 ($1,000,000 50,000 shares),
whereas a postmerger EPS of $20.70 is reported. This suggests there will not be any earnings
dilution for the shareholders of the acquiring institution.
b.
If the acquiring bank's stock is currently selling for $30 per share and the acquired
institution's shares are trading at $20 per share and also, the acquired firm's shareholders are
offered a $2 per-share bonus to merge, the merger premium will be:
$20 + $2
100 =110 percent
$20

Merger premium (in percent) =

With an additional $2 per-share bonus the acquired institution's stock will be valued at $22,
lower than the acquiring institution's stock for a $22 $30 or at a 0.73:1 exchange ratio.
Post-merger earnings per share =

Combined earnings
$900,000
=
= $6.03
Shares of stock outstanding 149,333shares

Before the merger, the acquiring institution reported an EPS of $7.08 ($850,000 120,000),
whereas the postmerger EPS is $6.03. Hence, the acquiring institution's shareholders will
experience some earnings dilution as well as some decline in their ownership share because of a
considerable reduction in the earnings per share of the acquiring company.
19.3. The Goldford metropolitan area is presently served by five depository institutions with
total deposits as follows:
Goldford National Bank
Goldford County Merchants Bank
Commerce National Bank of Goldford
Rocky Mountain Trust Company
Security National Bank and Trust

Current Deposits
$750 million
500 million
325 million
250 million
175 million

Calculate the Herfindahl-Hirschman Index (HHI) for the Goldford metropolitan area. Suppose
that Rocky Mountain Trust Company and Security National Bank propose to merge. What would
happen to the HHI in the metropolitan area? Would the U.S. Department of Justice be likely to
approve this proposed merger? Would your conclusion change if the Goldford County Merchants
Bank and the Rocky Mountain Trust Company planned to merge?
The Herfindahl-Hirschman Index for the Goldford Metropolitan Area is calculated as follows:

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Bank
Goldford National Bank
Goldford County Merchants Bank
Commerce National Bank of Goldford
Rocky Mountain Trust Company
Security National Bank and Trust
Total

Current
Deposits
$ 750 million
500 million
325 million
250 million
175 million
$2,000 million

Current
Deposit
Market Share
37.50%
25.00%
16.25%
12.50%
8.75%
100.0%

Current Deposit
Market
Share
Squared
1,406.25
625.00
264.06
156.25
76.56
2,528.13

The Goldford market has an HHI above 1,800 and is, therefore, highly concentrated. It would be
difficult for any bank mergers to take place inside the Goldford Metropolitan area because of its
highly concentrated status and because no matter which two of the five banks wish to merge with
each other, the resulting change in HHI would be relatively large.
If Rocky Mountain Trust Co. and Security National Bank merge, their combined market share is
21.25 percent and the HHI climbs to 2,746.875, a change of 218.75 points which may not be
acceptable to the regulatory authorities. Even, if Goldford County Merchants Bank and Rocky
Mountain Trust Company plan to merge, the combined market share of these two banks is 37.5
percent and the HHI rises to 3,153.125, a change of 625 points which will, in all probabilities, be
challenged by the regulatory authorities.
19-4. Gregory Savings Association has just received an offer to merge from Courthouse County
Bank. Gregorys stock is currently selling for $60 per share. The shareholders of Courthouse
County agree to pay Gregorys stockholders a bonus of $5 per share. What is the merger
premium in this case? If Courthouse County's shares are now trading for $85 per share, what is
the exchange ratio between the equity shares of these two institutions? Suppose that Gregory has
20,000 shares and Courthouse County has 30,000 shares outstanding. How many shares in the
merged firm will Gregorys shareholders wind up with after the merger? How many total shares
will the merged company have outstanding?
The merger premium must be:
$60 + $5
100 =108.33percent
$60

Merger premium (in percent) =

The exchange ratio between the respective banks' shares is:


($60 + $5) $85 = 0.7647 to 1.
If Gregory Savings has 20,000 shares outstanding and Courthouse County has 30,000 shares,
Gregorys shareholders will receive 0.7647 20,000 = 15,294 shares from Courthouse County.
The merged firm will have 45,294 shares of stock outstanding.

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19-5. The city of Dryden is served by three banks, which recently reported deposits of $250
million, $200 million, and $45 million, respectively. Calculate the Herfindahl index for the
Dryden market area. If the second and third largest banks merge, what would the postmerger
Herfindahl index be? Under the Department of Justice guidelines discussed in the chapter, would
the Justice Department be likely to challenge this merger?
The banking market in Dryden has the following structure:

Bank 1
Bank 2
Bank 3
Totals

Deposits
$250 million
200 million
45 million
$495 million

Market
Share
50.51%
40.40%
9.09%
100.0%

Squared Market
Share
2,550.76
1,632.49
82.64
4,265.89

Thus, the Herfindahl-Hirschman Index is 4,265.89 in the Dryden market area. This is a highly
concentrated market to begin with. If the second and third largest banks merge, the post-merger
Herfindahl-Hirschman Index climbs to 5,000.51 because the combined share of banks B and C
jumps to over 49 percent. Clearly, the Herfindahl Index rises by more than 700 points and far
exceeds 1,800 in total. This merger would be challenged by the Department of Justice in the
absence of mitigating factors.
19-6. In which of the situations described in the accompanying table do stockholders of both
acquiring and acquired firms experience a gain in earnings per share as a result of a merger?

A.
B.
C.
D.

P-E Ratio of
Acquiring
Firm
5
4
8
12

P-E Ratio of
Acquir
ed
Firm
3
6
7
12

Premerger
Earnings
of
Acquiring
Firm
$750,000
$470,000
$890,000
$1,615,000

Premerger
Earnings
of
Acquired
Firm
$425,000
$490,000
$650,000
$422,000

Combined
Earning
s after
the
Merger
$1,200,000
$850,000
$1,540,000
$2,035,000

The rule is that the stockholders of both acquiring and acquired institution will experience a gain
in earnings per share of stock if an institution with a higher P/E ratio acquired an institution with
a lower P/E ratio and combined earnings do not fall after the merger. Only cases A and C meet
these criteria and the shareholders in these two cases should experience an earnings-per-share
gain.
19-7. Please list the steps you believe should contribute positively to success in a merger
transaction in the financial-services sector. What management decisions and goals should be
pursued? On average, what proportion of mergers among financial firms would you expect
would be likely to achieve the goals of management and/or the owners and what proportion
would likely fall short of the mergers objectives? Why?

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The steps an institution can take that will contribute positively to the success in a merger include
the following:
A.
B.
C.
D.
E.
F.
G.

The institution must first evaluate its own financial condition, understand its own
strengths and weaknesses and its own goals. Mergers can then magnify strengths and
minimize weaknesses.
The institution should form a team to perform a detailed analysis of all potential new
markets and acquisitions.
The institution must establish a realistic price for the acquisition
After the merger, a combined management team should be formed to continually work
towards and assess the progress towards the consolidation of the two firms.
A communication system needs to be formed between senior management and other
managers so everyone feels involved in the merger.
Communication channels need to be formed so customers and employees understand why
the merger took place and what the consequences of the merger are likely to be.
Customer advisory panels need to be formed to evaluate and comment on the banks
image in the community, marketing effectiveness and general helpfulness to customers.

Management decisions and actions which could cause problems for the merger include mergers
where there is a poor understanding of each others culture, where an excessive price is paid for
the merger, where customers feelings and concerns are ignored, where there is poor management,
and where the new firm cannot move forward in a cohesive manner.
According a research by Rose, it appears that roughly half of all mergers achieve the goal of an
increase in earnings (or profitability). The other half of mergers sees a decrease in earnings for
the new firm. Among the institutions that experience gains, lower operating costs, greater
employee productivity, and faster growth appeared to have influenced the greater earnings.

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