Banks Measuring the Synergy of a Merger

Abstract

 

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As a result of deregulation and increasing corporate globalisation, financial institutions such as banks are looking to consolidate their position within the national and international marketplace. Over the last decade or so, one of the popular routes chosen to achieve this is by way of Mergers and Acquisitions (M&A). We have used the model of a proposed bank-to-bank merger as the focus of this document. However, before such an event takes place the institutions in question need to assure themselves of the synergies achievable. This report studies the ways and methods of measuring the synergies of a proposed merger. We find that there are two main areas of Synergy to be looked at, namely Cost saving and Revenue enhancement. In the course our research on the ‘quantitative’ methods by which synergies can be measured we have looked briefly at their purpose in respect of the corporate market.
Banks

The Synergy of Mergers

Bank ABC Inc is considering a merger with its smaller bank competitor bank DEF Inc. To ascertain where such action is necessary and would be successful the banks need to consider the synergy rational behind the proposed merger and submit these to the business stakeholders for approval. The question before them is therefore how, and by what quantitative methods can they measure the synergy that would be created by such a merger?

In order to deal with this subject effectively we must first understand the definition of synergy as it understood in the business sense. From a corporate point of view, synergy is defined in the dictionary in two ways.

A)                          As an interaction between corporate groups that creates an enhanced combined effect, which are seen as the internal drivers of synergy, or

B)                          More technically the ability of those merged company’s to create greater shareholders wealth than stand alone entities, considered to be the external drivers of synergy.

For the purpose of this study the analysis of synergies in business mergers can be divided into two sub categories.

 

i)               Cost Saving (known as Hard Synergies)

This includes such expense items as staff rationalization (with possible, though in most cases actual, redundancies), the streamlining of administration and back office systems and logistics. In terms of system integration the financial benefits could be quite substantial, especially in cases like usage of the Internet.

In the case of bank-to-bank mergers there is also the saving possibility from the reduction of branches. Most major towns would have at least one branch of each of the of the merger participating banks. Post merger they would only be the need for one. A merger would therefore be cost effective in this instance and bring cash value back into the business and, by default, to its shareholders. Alternatively, in terms of growth and geographical coverage, an acquiring bank may use the merger route as a way of achieving growth at a cost, which would be far less by way of merger than the expenditure necessary to achieve the same level of coverage as a stand alone enterprise. This was the case in the UK and a large part of the rational between Lloyds Bank and the TSB bank. Lloyds bank predominately located in the southern half of England and TSB were predominately concentrated in the northern parts and Scotland. The merger gave the acquiring bank (Lloyds) national coverage, whilst retaining both brand names under the merged public image of Lloyds TSB Plc.

Amalgamation of head offices, joint promotional and marketing programmes, combining technological systems, such as computers and Internet systems, are further examples of hard synergies. All of this reorganization has been recognised as essential to the process of helping to make the merged business better organized and more cost efficient. In his article for Academy of Management Review, M Lubatkin (1983) was one of the first strategists to recognise how important, in terms of Mergers and Acquisitions, were the strategic and organisation elements.

Because of the nature of these synergies, it is a relatively straightforward task to be able to calculate the financial consequences of a successful merger. By their very description there is little difficulty in being able to calculate cost saving element of the merger. There are of course other less easily calculated “hard” synergies such as in the area of training. In a merger both the acquirer acquired, assuming the culture drive was not excessive, would benefit from the fact that, post-merger, they would have access to a larger resource of trained staff, already experienced within the all fields of the business.

The synergies of cost control have historically proven to be one half of a key element in the successful outcome of a merger in the field of bank consolidation. Bank-to-Bank mergers where the strategies of cost control show evidence of high levels of synergy witness a positive performance level. Alternatively there may be a drop in performance if firms with different cost controlling strategies choose to merge (Prahalad and Bettis, 1986).

 

ii)             Revenue Enhancements (known as Soft Synergies)

The area of soft synergies, by their very nature, cannot be calculated or defined in such a positive manner as “hard” synergies. Nevertheless their calculation as part of the overall synergy is just as, in not more important.

The ability for cross selling is an important synergy to reflect upon, though in many instances, in terms of scale, this may be more beneficial for the acquired bank than the acquirer. For example, the acquiring bank sells product Y and the acquired bank sells product Z. Pre merger, the acquired has 500 branches and the acquirer had 2,500. The result of the merger means that the acquirer has increased the branch sales force for their product by five. Even the acquiring bank has increased theirs by 20%.

Staffs themselves are another synergy to consider carefully, especially from the acquirers point of view. There is likely to be an initial resistance to the acquirer from that quarter so it is essential that they be taken into consideration when considering possible changes to the culture and working methods of the acquired company. The lost of highly trained staff soon after the merger could prove to be extremely disruptive and adversely affect the level of synergy considered to be in place prior to the merger.

Strengths and weaknesses. Pre merger there is limited ability for either of the banks to apply themselves to dramatically change the positions of strengths and weaknesses with their own corporation. However the positive would be quite different post merger. In this situation the two banks would be able to draw from one another, using compatible strengths to power growth and achieve added value, whilst at the same time taking the strengths from one to protect against the weakness of the other. Research has shown that improvements to inefficiency could be expected from banking mergers (Humphrey and Vale 2003)

Branding and goodwill are other incidence of “Soft” synergies. For example, pre merger the name TSB was recognised as a relatively minor player in banking circles. Mention the same name today and it conjures up an image of the third largest bank in the country. There is no opportunity to reflect on the balance sheet the real reason why many companies merge, which is to gain the benefits of enhanced brand portfolios or to leverage the corporate brands to produce market or revenue synergies. (John Stokdyk 1999)

 

Although a high number of mergers have failed to produce the desired results, The successes in relation to mergers with high levels of synergies are reflected in both those mergers witnessed within the domestic market and cross border mergers. In terms of performance, bank mergers in the domestic sector tend to see an increase of around 1.2%, only slightly lower than cross border mergers, which return 1.5%. These findings are supported by results by Houston and Ryngaert (2001).

It follows therefore, that to achieve a successful merger the organisations have to measure, and fully evaluate the hard and soft synergies areas between the two businesses, and indeed ensure that they exist in the first place. Furthermore the analysis is a necessary exercise in the decision making process as to whether the institution should proceed with the proposed merger in the first place. Without the existence of synergies between the acquiring and acquired business there would be no added value achievement in the merger and, in fact it could be detrimental to both parties involved with the proposal. As indicated in definition b) above one of the main reasons for a merger is a greater wealth for shareholders than they are enjoying in the pre-merger situation.

Synergies or no synergies are the question? The following logic tree for merger specific efficiencies and synergies may go some way to providing an answer.

Figure 1
http://faculty.haas.berkeley.edu/shapiro/mergers.pdf page 12 of 28

 

There have been a high number of recorded cases of mergers, which despite the pre merger promotion of high levels of synergies between the acquirer and acquired, have not succeeded because the stated objectives of efficiencies could not be met, or at best not within the projected timescale. This may be partly due to the fact that the reasoning behind such mergers was more connected with the desire for growth was a more important determining factor. It also may reflect the fact that, despite the synergy being apparent, there was an inability to be able to convert the theory into fact. The successful mergers occur where the identification of the areas of synergy pre-merger can be turned into facts post-merger. Available evidence supports this premise.

The merger cases involving Bank of America and Chase Manhattan Bank are two such successes. Nouravi, Mahmoud M, Chavis, Betty M (1998) report on the outcome of the merger involving Bank of America found that, “In the case of Bank of America improvement in managing resources helped the company deal with increases in the other non-interest expense items. It appears that BOA has utilized the synergy available to it from the merger with SP in the loan portfolio management, as well as in controlling costs.”

In the case of Chase Manhatten their CEO, Harrison, William B. Jr, (2000) in a letter to shareholders, declared, “We have, in fact, accomplished what many mergers of today strive for – scale and market leadership in core businesses and integrated delivery…”

Referring to merger activities with the European market John Rushton (2002) observed, “Those managers who can deliver operational synergies, and can replicate the process, will create a new paradigm for banking operations, generate superior value for their shareholders, and re-model the European banking arena.”

 

 

So what are the driving forces behind Bank-to-bank synergies and how can these synergies be measured?

 

Drivers of Synergies
As can be seen from the following, there are a variety of factors that are brought into play immediately thoughts of a merger are given credence.

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When a merger takes place the acquirer, almost without exception, is required to pay a premium over and above the value of the business. This and the method of payment have a marked effect initially upon shareholder values, thus the importance of synergy. As has been mentioned in many places, “When you pay six for something worth five, you have to find sufficient synergy to make up the difference.” The risk management are taking is the possibility of achieving these efficiencies. Not only that but they will be expected to achieve them within the timescale set out before the merger, a feat that is very seldom possible, even in the most efficient of businesses.

The strategic relatedness and relative size is also important in terms of the level of synergy it is possible to achieve. In bank-to-bank mergers, the relatedness is not a problem as, generally all the products and services offered are similar if not almost identical. Size is important too because mergers are more effective and efficient if the acquired business is of a smaller size than the acquirers.

Therefore the management has to study the equation in depth to ensure that the required synergies can be achieved from the various internal factors, either on a cost cutting or revenue enhancing basis. Those areas being operational areas for direct cost cutting purposes, which will include the capital assets of the business. In the case of the banks this may include freehold or leasehold commercial property, system integration such as information technology and Internet, strategy and control and culture.

If all of these parts are in place then the management of the acquiring business is then set with the task of measuring the expected synergies.

 

Measuring Synergies – “Soft Synergy”
One of the most important parts of the measuring of “soft” synergies, those dealing with revenue enhancement, is the value generated for shareholders (EPS). The following table shows the effect that paying a premium for the acquired business has on the earnings per share and over how many years the effects of the merger on EPS will take to recover from the cost and be returning value to shareholders comparable with pre merger levels. Table 1 provides details of data for a sample of two companies entering into a merger. Table 2 indicates the effect that different premiums paid will have on the earnings per share, in other words the synergy of earnings on shares.

 

Table 1

 

© Stanley Block 1997

 

 

 

 

Table 2

© Stanley Block 1997

 

As can be seen from the above table, the higher the level of premium paid for the acquired business, the bigger the initial dilution in shareholder value and the longer term it takes in respect of years, to recover the equity position.

 

 

 

One of the most quantifiable tools for measuring synergy is that produced by Denison (1995). It is survey based and is particularly relevant in terms of the synergy of culture.

 

Table 3

It is survey based, with the responses recorded in percentage terms. The results of the survey are then fed into a typical organizational culture circumplex from which is produced a reasonably accurate guide as the levels of adaptability, mission, consistency and involvement in a particular product. Used to measure the cultural aspect of the proposed merger, it could give a fair indication of the flexibility of the workforce and thus the synergy that they would provide upon the execution of the merger.

 

Table 4

 

 

The businesses involved with the merger as, being banks, most of their services are customer based and their staff customer focused in their duties. It is thus extremely important to evaluate any areas of concern that the work force may have at a very early stage in the process.  That is where a tool like the Denision survey based on, and the answers produced, is extremely important.
Disruption because of lack of focus, or a drop in the standard of customer care in the early stages of the merged businesses life, could seriously affect the timescale in which the synergies should be producing results. This in turn would have a negative effect in both shareholders and the financial markets confidence. At the same time the merged businesses need to look realistically at the quality of their staff and the training levels. Customer liaison and care in all areas of the business will be vital for the success of the venture.
Measuring Synergies – “Hard” Synergy
The methods for calculating the effects of a larger branch network and increase in the numbers of trained personnel available to increase sales of products is relatively straightforward to calculate.  It is a matter of analysing historical statistics. Working of the example of size we used earlier, the acquirer with 3,000 branches and the acquired with 500, it is a relatively straightforward exercise to calculate the additional sales opportunities available. Similarly in terms of property assets and disposals of these post merger. These are measured by simple mathematical calculations.

However with regard to branch disposals it would not just simply be a question of the release of capital back to the business. There is also the synergy of Revenue Enhancement to consider. As most of the branches closed are likely to be as a result of duplication, there is a value added element. The majority of the customers from the branch that is closed will transfer to the other branch of the merged entity. Thus the company will end up with the same income as was available to the two pre merged entities, but with substantially reduced costs applicable to that income. This is known as the economies of scale.

When evaluating synergy in relation to mergers, one method of measuring that is always employed is economies of scale.  The following simple example shows the basics of this method. It reveals that, if a cost of a service to a bank was $1,000 and that bank had 100 customers, the Average cost per customer would be $10. If the number of customers doubled, but the costs remained the same, then the cost per customer would halve.

 

Figure 1

 

 

 

 

 

 
Of course in reality the law of diminishing returns is not that simple for the size of organisations we are studying in this report. As Stephen Suranovic (2004) shows in his studies, there is a time when the benefits begin to fall away (see figure 2 and explanation)

Figure 2

 

 

 

 

 

 

Explanation

With a simple adjustment it is possible to show that economies of scale in production is equivalent to increasing returns to scale. Increasing returns to scale in production means that an increase in resource usage, by say x%, results in an increase in output by more than x%. In the adjoining diagram we plot labor productivity in steel production when production exhibits increasing returns to scale. [This graph is derived by plotting the reciprocal of the unit-labor requirement (i.e. 1/aLS) for each output level in the above diagram.]

Note that as output (scale) increases from Q1S to Q2S, labor productivity (given by the reciprocal of the unit-labor requirement) also rises. In other words, output per unit of labor input increases as the scale of production rises, hence increasing returns to scale.

Another way to characterize economies of scale is with a decreasing average cost curve. Average costs, AC, are calculated as the total costs to produce output Q, TC(Q), divided by total output. Thus AC(Q) = TC(Q)/Q. When average costs decline as output increases it means that it becomes cheaper to produce the average unit as the scale of production rises, hence economies of scale.

 

 

 

The principles of economies of scale method is very popular and the general opinion is that, As a result of economies of scale and scope deriving from the combination of similar skills, a firm competing on the basis of low cost and operating efficiency is expected to benefit from merging with another organisation characterized by a set of similar strategies. (Bollenbacher. 1995)

 

Results

The results of our research and studies are that there are several reasonably simple quantitative methods of measuring the synergies relevant in terms of a bank-to-bank merger. However different measuring tools are necessary for different aspects of the project.

For example in terms of revenue enhancement, an particularly shareholder value, one needs to use the model for Earnings Per Share (EPS), as this will give an indication both of the level of premium paid for the acquired business which is acceptable to the shareholders and other stakeholders, and will indicate the lifecycle needed in order to recover the pre-merger EPS levels.

For the Cost-synergy analysis and measurement, some areas will be a question of simple mathematics’, for example the value of the sale proceeds for any freehold property sold, the saving on costs etc as a result of branches closed down and, possibly, redundancies. The same would be true in areas such as system integration, computers and information technology.

The business would also need to measure how far the effect of the law of economies of scale. How achievable it is, what areas it applies to and as what point in the equation does it begin to return to scale.

Finally, and bearing in mind that the study relates to a bank-to-bank merger, which is heavily customer focused, it is critical for the business to study the cultural and customer synergy in some depth. The level of flexibility of staff to the changes, their acceptance or otherwise of the proposed merger, and their customer focus is extremely important, indeed critical to the success of the venture.

To analyse the cultural, employee and customer side of the proposed merger the Denison survey based tool would be of considerable use.

 

 
References

 

Bollenbacher G.M. (1995), The New Business of Banking: Transforming Challenges Into Opportunities in Today’s Financial Services Marketplace, revised edition, New York. Irwin 1995

Denison, D. and Mishra, A., Towards a Theory of Organisational Culture and Effectiveness; Organisational Science/ Vol 6, No 2 March-April 1995

Harrison, William B. Jr. (2000). Commenting in a letter to shareholders, Annual Report Chase Manhatten 1999

Houston, J.H. and M. Ryngaert (1994), The overall gain from large bank mergers, Journal of Banking and Finance 18, 6, pp. 1155-1176

Humphrey, D. and B. Vale (2004), Scale economies, bank mergers, and electronic payments: a spline function approach. Journal of Bank and Finance (forthcoming)

Lubatkin, M (1983), Merger and performance of the acquiring firm, Academy of Management Review 8,2 pp. 218-225

Marek Jindra (October 2002). Synergy in Mergers & Acquisitions – Theory and Practice in Central Europe – Powerpoint presentation 2002

Nouravi, Mahmoud M, Chavis, Betty M (1998) Financial synergy of bank mergers: The case of Bank of America, The Journal of Bank Cost & Management Accounting

Prahalad and Bettis (1986), The Dominant Logic: A new linkage between diversity and performance, Strategic Management Journal 7, pp 485-501

Rushton, John. (2002) European bank shareholders are missing out on cross-border synergy benefits. European Banker 2002

Stokdyk, John. (1999). Article: Brand new look at the goodwill factor, Accountancy Age magazine1999

Suranovic, Steven. M, (2004). Economies of Scale and Returns to Scales, International Trade Theory and Policy Lecture Notes 2004

 

 

 

 

 

 

 

 

 

 

 

 

Figure 2

 

 

 

 

 

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