The FIG Idea: The urge to merge
Why bank consolidation isn't the slam-dunk it seems to be.
Dubious industry experts Becca Bigger and Frank Mentation aren’t mundane enough to debate whether recent sharp falls in the capital markets indicate a new phase in the economic cycle.
No, they’re hot on the next big boardroom issue: are we about to see renewed rapid bank consolidation?
Despite sharing the same office, Becca and Frank have tended to hold different views on this subject. The FIG Idea listened in to their discussion.
Becca Bigger: There are too many banks in the world. Progress means consolidation. In Europe, there were 8,500 banks a decade ago and now there are only 6,500. That’s still too many.
In the US, the number of banks has gone down 60% in the past quarter-century. But there are still 5,000 of them. And that’s still too many. Banking systems should have a small number of large providers.
That’s in everyone’s interest: customers want a broader, integrated service, plus big banks are better for financial stability and shareholder value.
Frank Mentation: Who’s to say there are too many banks? And you mention customer benefits, but I noticed the other week that the Australian government’s competition review found that concentration leads to “constrained competition”.
Becca Bigger: Yes, I saw that, too, but the point was a bit more nuanced. They also said “concentration is not by itself the calamity it is often made out to be”.
I just think that banks are natural monopolies. The most successful banking industries are controlled oligopolies. Part of this is due to the obvious scale advantages. Fixed costs of things such as compliance and IT investment are increasing, and so smaller banks struggle: their lack of scale leads to higher prices or reduced profits.
Frank Mentation: Ah, scale! That old chestnut. Well, take a look at the official FDIC data from the US. It shows that tiny banks with assets under a billion dollars do have slightly worse efficiency ratios, but above a billion, the ratios for medium-sized banks and large banks are pretty much the same.
I just don’t believe in scale because, beyond a certain point, diseconomies of scale inevitably appear. Scale economies are a mirage.
Becca Bigger: You think? Well, aside from operational efficiency, scale enables diversification. That's essential for good risk management and leads to improved financial stability. To put it another way, monolines are more prone to failure and so have a higher cost-of-capital. Consolidation gives diversification and reduces the cost-of-capital, creating value. Hey presto!
Frank Mentation: I’ve got one word for you: TBTF! You say concentration is good for financial stability due to diversification, I say systemic risk increases as concentration increases.
And, more importantly, Becca, the adoption of new technology changes everything and undermines many of your arguments. Providers of banking services don’t need branch networks or big mainframes any more. Barriers to entry are diminishing as fixed costs are actually falling. Technology-enabled new entrants are piling into financial services.
Becca Bigger: Oh come on Frank, that’s all hype. Few of these startups are viable. Most of them are just a few kids in a garage with a laptop. They're not going to make a real difference to the banking industry.
Frank Mentation: Fine, but a small number of them have genuinely strong offerings and have built sizeable franchises.
My multi-currency credit card is from a company that started three years ago and has a million customers now. Even traditional startups are doing well: branch-based Metro Bank in the UK opened in 2010 and broke even in 2016.
It seems to me that small banks are growing their market share. Another thing is that connectivity means small specialists can pick off discreet stages in the value chain, even if they’re mainly active behind the scenes. The financial services industry is fast becoming a network with nodes and clusters. It’s fragmenting, not consolidating.
Becca Bigger: I hear you, Frank. But I’m still certain there will be in-market consolidation and maybe some cross-border activity too. Leading bank executives are saying the same thing.
For some banks, M&A is a necessary part of their growth strategy. With cost-of-capital so low, it’s an obvious avenue, even if some cynics think acquisition strategies tend to destroy value for the buyer.
Frank Mentation: Becca, I don’t think we disagree. Maybe we’ll see lots of change with a mix of consolidation AND fragmentation.
Becca Bigger: Yeah, maybe. You want another tea?
(Postscript: Becca’s employer, BigBank, has recently become the subject of takeover speculation, while the information aggregation firm that Frank co-founded five years ago is considering multiple offers from potential alliance partners and purchasers.)
The characters in this article are, of course, entirely fictitious.
The FIG Idea is written by a market participant with more than 20 years' experience working with financial institutions.