What's New in Cybertalk?

By Jean Gora
August 2001

Note: CyberTalk is a column that appears monthly in LOMA's Resource, the magazine for insurance and financial services management. To see more contents of the magazine and to see how to subscribe, click on RESOURCE MAGAZINE.

Who Merges and Why—or Why Not?

Despite the apparent increasing consolidation and globalization of the financial industry, the vast majority of financial mergers during the 1990s were domestic and took place within various sectors of the industry, not across them (i.e. a lot more banks bought other banks than bought insurers). Although the banking sector of the industry grew more consolidated, it is far from clear whether the insurance industry did, despite a number of large insurance mergers. There are indications that specialist firms as well as conglomerates remain viable in the insurance business.

The preference of firms for merging with like firms in the same country may result from a realistic assessment of the chances of wresting profits from other kinds of mergers. Computer and communications technology can have the greatest impact on costs when applied to a restricted set of operations that occur in high volume. Domestic within-sector mergers create such operations.

International mergers continue to encounter major regulatory and cultural barriers that add significantly to costs and cannot be overcome by technology. At least some of the impetus to cross-border mergers comes from the global capital markets. Because the markets make money available for mergers, financial firms spend it. The capital markets may or may not value these regulatory and cultural barriers realistically. Several interesting studies have become available recently that shed light on financial industry consolidation. This issue of CyberTalk examines their findings.

The Group of Ten
One study, Report on Consolidation of the Financial Sector, was conducted under the auspices of the Group of Ten, the finance ministers and central bank governors of the leading industrialized countries. Published in January 2001, it examines merger activity between 1990 and 1999. At least one party to the merger had to be in one of the following countries: the United States, Canada, Japan, Australia, Belgium, France, Germany, Italy, Netherlands, Spain, Sweden, Switzerland, or the United Kingdom. The study is the most comprehensive to date regarding global financial industry consolidation. Below are presented some of the study’s key findings.

A total of 7,634 financial industry mergers involving an acquirer within the study area occurred between 1990 and 1999. The merger rate grew dramatically during the first five years of the decade. In 1990, 337 mergers took place; in 1995, the number jumped to 901. The merger rate continued to grow at a slower pace after 1995, moving up to 970 in 1999. Of the acquirers over the ten-year period, 4,423 were banks, 2,029 were securities firms, and 1,182 were insurance companies, making banks the most aggressive acquirers by far during the time frame studied.

Despite the publicity that cross-industry mergers have received, the vast majority of mergers during this period occurred within specific sectors. Banks bought banks, securities firms bought securities firms, and insurers acquired other insurers. Of the 7,634 mergers, fully 6,175 (81 percent) occurred within specific sectors. Similarly, the vast majority of mergers were domestic. Of the total mergers, 6,391 (84 percent) were domestic.

A Path of Least Resistance
These patterns suggest that, at the beginning of the 1990s, the financial industry was structured primarily on a national basis in a manner that allowed a large number of firms to function within each industry sector. Faced with pressure to consolidate, most players chose the path of least resistance—to merge with like players within the same country. Ten years later, as a result of these mergers, "national champions" were emerging within the various sectors.

National location has had a more significant impact on mergers than industry affiliation. If the most common mergers were domestic and within the same sector of the financial industry, the next most common mergers were domestic but across sectors. Thus, if forced to choose between merging with a domestic player in a different industry sector and a foreign player in the same sector, firms tended to prefer the first alternative.

Cross-sector consolidation may be a fallback position that firms adopt when the domestic supply of desirable like firms dries up for one reason or another. The increasing institutionalization of savings in a country that did not traditionally have a large group of institutional investors may be an important factor contributing to domestic cross-sector consolidation. Such institutionalization may create surplus retail distribution capacity that firms attempt to overcome by broadening their product mix. This issue is discussed later in this article.

The study showed significant differences among the various financial sectors with respect to the share of total mergers that were domestic. Ninety percent of bank mergers and 82 percent of securities mergers were domestic, but only 64 percent of insurance mergers were. Almost one-third (31 percent) of insurance mergers were across borders but within the same sector of the financial industry; in contrast, only 11 percent of securities mergers and 7 percent of bank mergers were across borders but within the same sector. On an absolute basis, the number of cross-border bank mergers (451) was approximately equal to the number of cross-border insurance mergers (419). The number of cross-border securities mergers was far higher (715), reflecting the globalization of capital markets.

National and regional factors appear to have affected these differences. The high rate of domestic bank mergers resulted in part from the large number of such mergers in the U.S. as the traditionally fragmented banking industry consolidated. The relatively high level of insurance cross-border mergers resulted largely from cross-border mergers within the European insurance industry. If a European insurance firm was acquired domestically, it tended to be acquired by a firm in another sector of the financial industry—an indicator of the popularity of bancassurance in Europe. These patterns suggest that European insurers, faced with increasing bank consolidation and bancassurance in the domestic markets, responded by merging across borders in an attempt to build scale that would allow them to compete with the large banks.

Comparing Countries and Regions
If figures for all of the European mergers are grouped together and compared to those of the United States and Japan, the United States had by far the largest absolute number of mergers. The U.S. total of 4,094 mergers far outstrips Europe’s 2,736 and Japan’s 246. However, Europe had both the most within-border cross-sector mergers and the most cross-border within-sector mergers both on an absolute and a relative basis. (Within-border European mergers are mergers within a single European country.) Thus, up to now, European financial firms have used mergers to become both more diverse (on an industry sector basis) and more international than firms headquartered in the U.S. or Japan.

The move to unify Europe economically and the long tradition of universal financial institutions within many European countries explain this pattern. The experience of European financial firms with both cross-sector and cross-border mergers gives them an important advantage as they acquire firms in emerging markets. They are skilled at dealing with multiple cultures and at integrating diverse operations in these cultures.

The Group of Ten study found that, during the 1990s, the concentration of the banking industry in all of the countries under study tended to increase. In contrast, the study found no consistent pattern of increasing concentration of the insurance industry of the countries studied and no consistent structural patterns for life and property & casualty firms within the same country.

The Wharton Study
Given the number of insurance mergers, why did the Group of Ten study fail to find increasing consolidation of the insurance industry? A study of the U.S. insurance industry conducted at the Wharton School of the University of Pennsylvania suggests one possible reason. The study, Conglomeration versus Strategic Focus: Evidence from the Insurance Industry, was published by the Wharton Financial Institutions Center in 1999. It focuses on the U.S. insurance industry. One of its co-authors, Allen N. Berger, was a member of the Board of Governors of the Federal Reserve System.

The Wharton study sought to explain why both insurance conglomerates (firms offering both life and P&C insurance) and strategically focused insurance specialists (offering either life or P&C insurance) have survived in the United States over the long term. Using data on insurance company costs, revenue and profits in 1988-1992 NAIC filings, and the A.M. Best database, the Wharton study found that some kinds of insurance firms benefit from profit scope economies while others do not.

Profit scope economies measure the relative efficiency of joint versus specialized production, taking both costs and revenues into account. Large insurers that emphasize personal lines, use vertically integrated distribution systems, and are profit-efficient successfully apply the conglomerate model. Small insurers that emphasize commercial lines, use non-integrated distribution systems and are profit X-inefficient (i.e., relatively unconcerned with maximizing profit) successfully apply the strategic focus model.

In attempting to determine the source of profit scope economies, the Wharton study examined cost and revenue scope economies separately. It found that cost scope economies and revenue scope diseconomies tend to balance each other out (with some variation by type of firm). Cost scope economies arising from the "sharing of inputs may create lower costs for joint producers, especially at small scale." Revenue diseconomies may arise because specialists are more able than conglomerates to tailor products to their customers’ needs and to charge higher prices accordingly. "These findings generally run counter to claims of large benefits from one-stop shopping convenience for customers, and suggest that the benefits from joint production tend to be on the cost side, rather than on the revenue side."¹

Motives for Consolidation
The findings of the Wharton study are particularly interesting in light of the results of the Group of Ten’s survey of 45 representatives of the insurance, banking, and securities sectors in the 13 countries covered by the study. The survey examined motives for consolidation and factors encouraging and discouraging consolidation.

Survey participants were asked to rate the importance of various possible motives for consolidation for both domestic and international mergers both within sectors and across sectors. Because of the limited number of international mergers, most respondents did not address motives for cross-border mergers. The top motive for domestic within-sector mergers was (with the percent of respondents who ranked them very important) the desire to gain economies of scale (80 percent). Second was a desire to gain increased market power (30 percent), and third was a desire for revenue enhancement as a result of increased size (23 percent).

Economies of scale result from sharing the inputs of production. Respondents were significantly more confident of financial firms’ ability to achieve economies of scale than of their ability to generate more revenue as a result of their size. And, as the following survey results pertaining to cross-sector mergers show, these respondents were almost twice as confident of financial firms’ ability to generate economies of scale as of their ability to enhance revenue by offering one-stop shopping through cross-sector mergers. They were more than three times as confident of firms’ ability to generate economies of scale (from within-sector mergers) as of their ability to generate economies of scope (from cross-sector mergers).

The top three motives for domestic cross-sector mergers were revenue enhancement through offering one-stop shopping (46 percent), economies of scope (25 percent), and managerial empire-building (18 percent).

As we saw above, the Wharton study questioned the benefits of offering one-stop shopping in all circumstances. Some market segments may prefer the tailored service of specialists and may be willing to pay more for it.

If the above problems exist in the case of domestic mergers, they are likely to be more pronounced on an international level. Objectives that domestic mergers cannot achieve easily are unlikely to be achieved more easily on a cross-border basis. The reverse is true.

Forces Propelling Mergers
It is interesting, therefore, to examine the forces propelling mergers, according to the respondents to the Group of Ten’s survey. For domestic within-sector mergers, the dominant forces encouraging consolidation are IT and communications. Once a computer or communications system is built, adding additional users or traffic is often trivially cheap. Thus, such systems are major enablers of economies of scale for within-sector mergers. However, they are less important in cross-sector mergers because each sector has many unique systems that cannot be transferred to other sectors. For this reason, it is more difficult for cross-sector mergers to generate economies of scope through the use IT and communications.

As noted earlier, one force encouraging cross-sector domestic mergers is the institutionalization of savings. Countries with large private pension plans institutionalize much savings. The individual does not save through a bank account or an individual insurance policy. Instead, the saving takes place as the individual’s employer contributes to a pension plan—managed by an institution—on his behalf. Financial firms do not need branches on every corner or thousands of sales representatives to sell to institutional clients.

Thus, the institutionalization of savings may mean that both banks and insurers have surplus capacity in their retail distribution networks. However, they have already absorbed the costs of building these networks. Therefore, they can with reason seek to generate economies of scope by selling other products through the networks. Whether mergers allow them to generate greater economies of scope than they can get through distribution agreements remains to be seen.

How did respondents view the leading forces (rated very important) encouraging financial consolidation? For within-sector mergers, IT and communications (62 percent) are the dominant force. Deregulation (36 percent) and globalization of the capital markets (34 percent) are also important, although less so. For cross-sector mergers, IT and communications (36 percent), deregulation (37 percent) and the institutionalization of savings (37 percent) are all equally important.

The way they viewed the leading forces discouraging domestic consolidation is also interesting. When asked about legal and regulatory impediments, within-sector rated 32 percent and cross-sector 25 percent. Twenty-nine percent of respondents saw within-sector cultural constraints, and 40 percent saw cross-sector cultural constraints.

The dominant force behind cross-border mergers, according to survey respondents, is the globalization of the capital markets. A look at how respondents viewed the leading forces (rated very important) encouraging cross-border consolidation is enlightening. For within-sector mergers, 42 percent of respondents said the globalization of the capital market is a very important force, significantly more important than IT and communications (29 percent) and the introduction of the Euro (29 percent). For cross-sector mergers, 36 percent of respondents said the globalization of the capital market is a very important force, significantly more important than market climate (26 percent) and the introduction of the Euro (23 percent).

In effect, because the money is available for international acquisitions, financial firms are spending it in the name of entering new markets, irrespective of whether they have any significant ability to generate economies of scale and scope on cross-border operations. Survey results show that respondents rated legal and regulatory impediments and cultural constraints as far more important barriers to international than domestic mergers. The ratings for cross-border barriers showed 60 percent concerned about legal and regulatory impediments within-sector, and 59 percent concerned about them across sectors. For cultural constraints, 69 percent ranked them as very important within-sector, and 67 percent ranked them as very important cross-sector.

Cultural constraints are even more important deterrents to international mergers than legal and regulatory impediments. The latter can be eliminated relatively easily. The former cannot. The verdict is not yet in on whether financial firms diversifying internationally have the ability to generate economies of scale and scope on their cross-border operations.

In the recent past, the stock market plowed billions of dollars into Internet start-up firms without viable businesses. The capital markets’ enthusiasms are sometimes well-founded; sometimes they are not. Financial firms still have a tremendous amount to learn about operating economically sound international operations. The hurdles to success remain very high. The new cross-border markets must generate enough new business to more than justify the greatly increased cost of doing business.

A final note: in both domestic and international mergers, e-commerce is viewed as a less important force for consolidation than other factors. Among survey respondents, only 25 percent noted it as important for domestic within-sector mergers, 27 percent for domestic cross-sector, 19 percent for cross-border within-sector, and 21 percent for cross-border cross-sector.