Overview

2. Overview • This chapter discusses the benefits to geographic diversification available in the domestic market and the reasons underlying the wave of merger activity in the U.S. Evidence on the cost and revenue synergies and other factors affecting geographic expansion are also explored.

3. Attractiveness of Geographic Expansion • Some factors are unique to financial services, but some also apply to industrial sector • Regulation and regulatory framework • Cost and revenue synergies • Firm- or market-specific factors

4. Domestic Expansions • Historically FIs' ability to expand was constrained by regulation. • Banks in particular • Regulations also create potential opportunities for new entrants to exploit existing monopoly rents.

5. Regulatory Factors/Geographic Expansion • Insurance companies • State regulated. • Usually easy to establish subsidiaries • Physical presence in nearly every state • Subsidiary structure can also isolate parent firm from higher risk states such as Florida

6. Regulatory Factors • Thrifts • Branching controlled by Office of Thrift Supervision (prior to 1989, under FHLBB) • Restrictions loosened by Garn-St. Germain Act of 1982, FIRREA 1989 • In 1992, OTS permitted interstate branching for federally chartered savings institutions • Since 1980s, restrictions on expanding across state lines have been loosened considerably. • Eased acquisitions of failing thrifts across state lines

7. Constraints on Domestic Expansion • Commercial Banks • Restrictions on intrastate banking have been liberalized in a piecemeal fashion. • Interstate restrictions: • McFadden Act, 1927 • From 1927 to 1997 relied on establishing subsidiaries rather than branching. • Multibank holding companies (MBHC)

8. Stages in Regulation of BHCs • One-bank holding company loophole in Douglas Amendment 1956. • Growth in one-bank holding companies from 1956 to 1970. • Classic examples of Edward Kane’s “Regulatory dialectic” • 1970 Bank Holding Company Act Amendments. • Permissible activities “closely related to banking”

9. Erosion of Interstate Banking Restrictions • Regional and national banking pacts • Nationwide • Nationwide reciprocal • Regional reciprocal • Purchase of troubled banks across state lines • Nonbank banks • Ended by Competitive Equality Banking Act, 1987 • Tightened further in 2006 • Blocks banking activities by firms such as Walmart and Home Depot

10. Erosion (continued) • Expansion in OBHC activities. • Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 • U.S. and nondomestic banks allowed to branch interstate. • Full interstate banking with exception of de novo branching in 1997 • Wave of consolidation: megamergers • U.S. banking industry moving toward systems such as those in Europe and Canada

11. Consolidation • Megamergers • Mostly in the same or closely related markets • Pure bank merger examples: BancOne/ First Chicago, and NationsBank/Bank of America

12. Synergies: Geographic Expansion • Cost synergies • X-efficiency • Berger and Humphrey: Less evidence of cost savings from economies of scale and scope • Houston, James and Ryngaert / Rhoades: found significant cost savings in megamergers • Berger and DeYoung: positive and negative links between geographic scope and bank efficiency

13. Synergies: Geographic Expansion • Revenue synergies • Enhance revenues by expanding into growing market • Enhance revenues by expanding into less than fully competitive market • More stable revenue stream • Activity or geographically focusing mergers generate higher abnormal returns

14. Monopoly Power Concerns • Regulators concerned with merger activity that could result in monopoly power. • Concentration ratios such as Herfindahl-Herschman Index (HHI) employed to measure the effects of merger. • HHI = sum of squared percentage market shares. • Focus on postmerger concentration ratio as indicator

15. Web Resources • Visit U.S. Department of Justice www.usdoj.gov

16. Other Factors • Solvency and asset quality • leverage, loan loss reserves, NPLs • Attractiveness of bank merger measured in terms of merger premium. • Analysis indicates that highest merger premiums paid for well-managed banks in relatively uncompetitive environments.

17. Success of Geographic Expansion • Investor reaction • Abnormal returns for both acquiring bank and target bank. • Although some contrary results for bidders

18. Success of Geographic Expansion • Postmerger performance • merged banks tended to outperform industry • improved ability to attract loans and deposits, increase employee productivity and enhance asset growth.

19. Global and International Expansions • Three ways for an FI to establish international presence: Sell financial services to foreign customers : • from domestic office • Loan to Brazilian manufacturer originated in New York office of J.P. Morgan Chase for example • via branch, agency, or representative office in the foreign country • through subsidiary company in the foreign country • These are not mutually exclusive.

20. Top global banks • Of the top 30 global banks, no single country dominates. • Canada, Ireland, Netherlands, USA, Austria, Germany, Spain, Switzerland and the U.K. all have significant international banking presence • After a decade of retreat, Japanese banks entering neighboring countries in Asia

21. U.S. Banks Abroad • Some U.S. banks have long history of offices abroad • J.P. Morgan Chase • Overseas Direct Investment Act of 1964 • Created incentives for U.S. banks to establish foreign offices to service U.S. clients • Eventually repealed • Beginning of the Eurodollar market. • Eurodollar transactions: dollar transactions outside the U.S.

22. Factors Encouraging U.S. Bank Expansion Abroad • Originally, restrictions on foreign lending • Dollar as medium of exchange • Weakened by decline in dollar relative to the euro and yen • Political risk concerns • Outflows of dollars from emerging markets to Cayman Islands and the Bahamas • USA Patriot Act of 2001 • “Know your customer” rules • Hudson Bank, Rigg’s Bank

23. Factors Encouraging U.S. Bank Expansion Abroad • Domestic Regulatory Restrictions/ Relaxation of foreign regulation • U.S. banks generally allowed to engage in permitted activities of the foreign host • 2003, Chinese Banking Regulatory Commission shifted toward allowing entry of foreign banks and accommodating competition • Evidence that many of the nonbanking activities of U.S. banks in China yield important revenue-risk diversification benefits (Whalen) • Technology and Communications Improvements • CHIPS and proprietary networks

24. Factors Deterring U.S. Expansions Abroad • Capital Constraints • Basel II reforms of BIS increase risk weights for non-OECD countries rated below B, and for OECD countries rated below AA • Emerging Market Problems • Competition • European banks advantaged by Second Banking Directive • Equivalent to a single EC passport • Wave of mergers • Formation of alliances between European banks

25. Foreign Banks in the U.S. Five organizational forms: • Subsidiary • Branch • Agency • Restricted form • Cannot accept deposits • Edge Act Corporation • Representative Office

26. Trends and Growth • Foreign banks continue to expand in the U.S. • Modest retrenchment in mid 1990s • Introduction of Foreign Bank Supervision and Enhancement Act of 1991 combined with other factors in the U.S. and abroad

27. Regulation of Foreign Banks in the U.S. • Prior to 1978, primarily state level • International Banking Act of 1978 • National treatment as an attempt to level the field • Accelerated foreign bank expansion in the U.S.

28. Foreign Bank Supervision Enhancement Act of 1991 • FBSEA motivated by collapse of BCCI • Features: • Entry requires approval by the Fed • Must have regulation by home country on consolidated basis and requires information to be provided by home country regulator to evaluate application • Fed has examination authority and closure authority • Retail deposit taking only if covered by FDIC • Activities restricted to those permissible for a federal branch • Daiwa Bank ordered to cease operations

29. Advantages of International Expansion • Diversification • Economies of scale • Innovations • Financial innovations can be applied to other markets where there is less competition • Success of U.S. securities firms in Japan attributable to experience with / knowledge of, risk management products • Funds source expansion • Customer relationships • Regulatory avoidance

30. Disadvantages of International Expansion • Information/Monitoring costs • Additional regulatory environments come with need for understanding those environments • Nationalization/Expropriation • Political risks • Fixed costs can be high

31. Pertinent websites Bank for International Settlements www.bis.org Federal Reserve www.federalreserve.gov Department of Justice www.usdoj.gov FDIC www.fdic.gov OCC www.ustreas.gov Office of Thrift Supervision www.ots.treas.gov