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Do bank mergers lead to efficiency gains? The Case Study of bank

mergers in Pakistan (working paper)
Mushtaq Ur Rehman
1
, Ali Naseer
2
, Muzamil Khan
3
, Shafiq Ur Rehman
4

1
Research Student, Mohammad Ali J innah University Islamabad
2
Mardan Institute of Management Studies, (MIMS) Mardan,
3
Mardan Institute of Management Studies, (MIMS) Mardan,
4
University of Malakand, (UOM) Chakdara, Dir (L).


Abstract: Pakistani banking industry is under the wave of merger and acquisition. This paper
summarizes two case studies on the efficiency effects of mergers. The bank mergers of year 2006
are selected for study. Twelve ratios are applied on all case studies for the period of 3 years pre
merger and 3 year after merger. Market analysis is used as control variable. The results provide
objective of cost cutting is achieved on average, efficiency effect is marginal and pre merger
efficiency of acquirer and size of bank didnt contribute anything in efficiency gains.

1. Introduction:

Pakistani banking industry transformed from a government dominated sector to a highly
competitive and profitable industry. Major reforms in banking industry have increased its
resilience and developed efficient financial system that brings economic growth. The whole
phenomenon is consistent with different studies e.g. financial development is correlated with
economic growth (Goldsmith, R. W, 1969., Abma, R. C. N et al 2003, Khan and Senhadji 2000).
This industry has been suffering under the wave of merger and acquisition since many years. One
reason of these mergers and acquisitions is duly implementation of Basel Accord II by State Bank
of Pakistan. According to circular issued in October 2005 all banks are required to maintain their
capital gradually to the level of 23 billion till the end of 2013, however now this requirement has
decreased to 10 billion according to market condition but still our focus is on requirement
imposed in 2005 to understand the situation prevailing in our study time period. Banks found it
difficult to raise the capital through equity injection or reinvestment of profits therefore merged
themselves to bring their capital to the required level. This phenomenon is consistent with the
studies of Harford, jarred (2004) that shocks that may be regulatory and technologically causes
industry merger waves. By using the data of USA many bank analyst argued that bank merger
leads to efficiency gains. But recent studies show that no efficiency effects can be attained from
mergers and acquisition. While the studies in Taiwan shows that banks relating to different
cultures can attain cost efficiency.

We can find significant number of mergers in banking industry in a short period of time. Since no
study has focused on this important issue of merger. We have conducted this study with an
objective to find out whether bank mergers leads to efficiency gains or it just achieve cost
reduction due to economics of scale. Further we want to analyze that efficiency of acquirer before
merger has any positive effect on efficiency of merged firm, and impact of size of banks before
merger on efficiency gains, and some information about labor laws in Pakistan. Our study will be
the addition in literature.

Our study analyzed the effects of mergers on efficiency yields in Pakistan using case study
methodology. We will compare the results of financial ratios before and after merger in order to
find out the effects of merger on efficiency while market analysis is used as control variable.
Results of the study provide that cost reduction is achievable on average, efficiency gains are not
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clear or not achievable, Pre merger more efficient acquirer have no effect on efficiency gains and
large banks didnt provide more efficiency gains after merger.

This paper consists of four sections. Section one provides literature review and our hypothesis.
Section two provides methodology. Section three discusses our study frame work and data.
Section four discuss summary of findings and limitations.

2. Literature Review:

J alal D. Akhavein et al (1997) finds that merged banks realized statistically significant increase in
profit efficiency relatively to other banks, and these improvements are high for the banks that are
inefficient prior to merger.
According to Crispi et al (2004) premerge efficiency of merged and acquired bank is relatively
low.

Cornett et al (2006) finds that after merger revenue enhancement and cost reduction improved
performance of banks and these results are more significant for large banks relatively to small
ones.

Facarelli Dario et al (2002) finds that strategic objective of merger is expanding revenues from
financial services. He finds that economies of scale or cutting costs are difficult to implement in
country where labor laws are rigid.

According to Ryngaert D. Michael et al (2001) most of the estimated value gains from bank
mergers stem from the opportunity to cut cost by eliminating overlapping operations and
consolidating backroom operations. For a typical bank merger estimated revenues enhancement
are significantly less important.

According to Peristiani Stavros (1997) banks that participate in a merger realized a small but
significant decline in pro forma X- efficiency 2 to 4 years, and acquiring bank achieves moderate
improvements in scale efficiency. He also finds that profitability and operating cost performance
of surviving banks after merger are greatly influenced by balance sheet attributes and other bank
characteristics.

According to Len, Ping-wen (2005) that banks relating to different cultures can achieve better
results from merger regarding cost efficiency in Taiwan. While banks with same set up cant
explore new business grounds so cant achieve cost efficiencies from merger.
According to Huizinga, H.P. (2001) checked the efficiency effect of 52 horizontal bank mergers
in Europe, the cost efficiency of bank mergers is substantial while profit efficiency is marginal.
According to GARY A. DYMSKI (2002) U.S experience that mergers are efficiency driven is
unique and cant be applicable on all banking industry. In developing countries such mergers are
not efficiency driven but actually due to changes in macro structural changes and due to change in
banking strategies over time.

Rhoades Stephen A. (1998) used case study methodology in order to find out the cost and
efficiency results of merger. Sixteen financial ratios consisted on expense ratios, profitability
ratios, and balance sheet ratios, were applied on nine case studies on USA banking industry. Data
for pre merger and post merger activity were analyzed. Ratios of peer group were used as control
variable, to check the observed changes are due to economic variables or due to combined firm
effect. Results of studies showed that on average mergers reduced cost but not necessarily
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brought efficiency gains. Moreover size of acquiring firm and premerger efficiency of acquiring
firm cant predict the results of merger.

3. Hypothesis:
Literature review provides base for four hypotheses, that Mergers provide efficiency gains,
Mergers decrease cost of doing business due to economics of scale, and better effects of merger
can be attained by the banks operating at large scale and if acquirer is more efficient before
merger.

4. Methodology:

4.1 Case study approach

We have used case study methodology to measure the effects of merger using premerger data, of
acquirer and target firm, and post merger data. The choice of methodology is influenced by two
factors e.g. small number of observation and desire to get information about firms behavior and
performance. (Rhoades, Stephen A. (1998), Facarelli Dario et al (2002).

5. Study framework and data:

The same common financial ratios are used on all case studies in order to judge the efficiency of
merger. Financial ratios include six expense ratios, two profitability ratios, four balance sheet
ratios.

We take data of 3 years preceding the merger and 3 years after the merger. Three year time
period was used because of the almost unanimous agreement among the experts we interviewed
that about half of any efficiency gains should be apparent after one year, and all gains should be
realized within three years. by Rhoades, Stephen A (1998).
Ratios for three years before merger are calculated for both acquirer and for target, and for
industry that provides information about relative efficiency of target and acquirer. Then by
taking the average ratios of acquirer and target we just create a hypothetical firm that shows the
summation of balances of both firms.

For the post merger period we calculate the ratios for combined firm. And premerger data is
compared with post merger data to determine what changes occurred in efficiency, performance,
and balance sheet items. The control group is particularly valuable at this stage because it allow
to judge that observed changes are due to economic factors or due to combined effect.

6. Data:

The mergers analyzed are not selected randomly. Indeed, the mergers are selected on the basis of
recent data. So the activities of year 2006 are considered, as 2007 didnt provide any merger
activity. And activities after 2007 didnt provide the financial statements for three years.

Information about merger activities is taken from web site of Karachi stock exchange which
provides that three mergers activities are acquired in year 2006. Financial data are taken from
publications of state bank of Pakistan and from web sites of merged banks. But we are unable to
gather the required data for atlas investment bank. So our study focused on two merger activities
that are coded as A and B. Case study B shows merger of large banks as compared to case study
A.
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7. Financial ratios:

Twelve financial ratios are analyzed to examine the results of merger. Six are expense ratios
includes, expenses to average assets
1
, expenses to operating revenue, these ratios are best
indicator of efficiency gains and are controlled for shrinkage of firm.
Ratio of non-interest expenses
2
to assets directly affected by cost saving that are routine result of
horizontal merger. So this ratio is of special interest. Total expenses to total revenues and non-
interest expenses to adjusted operating revenues
3
are analyzed as an alternative to the expenses to
assets ratios. Rationale of using revenues in denominator is, expenses are adjusted for interest rate
changes but assets are not. So revenues are used as they are also adjusted for interest rate
changes.

Two profitability ratios include net income
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to average assets. This ratio shows the ability of bank
to generate income from assets at its disposal, and is good indicator of overall banking
performance. However the limitation of ratio is, it is upward biased due to income generated from
off balance sheet items. Second ratio is net income to equity, and it is alternative of profitability
ratio. That measures the return on owners investment. But limitation of this ratio is different
firms used different structure of capital and equity.

Four balance sheet ratios include total capital to total assets that is indicative of risk taking
behavior of firms. Other ratios include total loans
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to total assets and, C and I
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loans to total assets
that would likely shows change in expense ratios. As increase in these ratios increase the cost of
maintaining loan portfolio relative portfolio of government securities with no meaningful
implication for operating efficiency. Finally ratio of core deposit
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to total deposit shows the
choices between non-interest and interest expenses without any implication for operating
efficiency, as increase in this ratio likely result in increase in non-interest expenses and decrease
in interest expenses.

8. Summary of findings:

This section presents a summary of findings of the two case studies.

1
Average assets are calculated by taking the average of opening and year ending balances with a rational
that expenses (income) represent a flow generated through the whole year so average of asserts are more
closely related with these flows.
2
Noninterest expenses include administrative and other expenses that are directly related with managing
business.
3
Adjusted operating revenues=noninterest income+(interest income-interest expenses)
4
Net income is defined as operating income minus applicable income tax minus extraordinary items and
other adjustments.
5
Total loans=lending to financial institution +advances
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C and I loans are defined as advances
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Core deposit according to Richaiu u. Sheehan (2uu4) can be defined as checking accounts and saving
accounts for financial institutions
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Merger
Acquiring
firm more
efficient then
target
Pre to post merger change in performance relative to market
Return on Total expenses noninterest expenses Return on
Assets total total total adj equity
Assets rev. assets ope rev.
A Yes WK
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Imp
9
NC
10
Imp Imp WK

B Yes WK Imp WK WK WK WK


8.1 Main Findings:

Total expenses are increased as compared to assets but such increase in expenses less then market
trend for both case studies. So it can be interpreted as total expense to total asset ratio show
efficiency gains in both case studies. Total expenses to total revenue ratio for first merger didnt
provide any clear information. While for second merger increase in expenses are more as
compared to increase in revenues. Although market trend is consistent for this phenomenon but
for merged firm increase in expenses are more when measured in percentage terms. So this ratio
cant provide any efficiency gains for both studies. Non-interest expenses to total assets and
adjusted operating revenue ratios are used to measure cost efficiency which is achieved in one
case study but for case study B cost efficiency is not achieved.

Both case studies show that return on assets and return on equity are decreasing. But return on
equity for merged firm of case study A is very low.

8.2 Explanation of findings:

Based on information provided in table 1, we can interpret that on average bank mergers can
achieve cost cutting objective. Case study A shows that cost cutting objective that is more famous
result of horizontal merger is achieved. While for other case study it is not achieved. And this
result is supported by Ryngaert D. Michael (2001), Huizinga, H.P. (2001), Rhoades Stephen
A.(1998) studies. Efficiency, that is different from cost cutting on the basis that cost cutting leads
to shrinkage of business or closing of overlapping offices while efficiency leads to achieve more
output from least input, is marginal in both case studies. This result is consistent with the studies
of Ryngaert D. Michael et al (2001), Huizinga, H.P. (2001), Rhoades Stephen A. (1998). Our
hypothesis that if acquirer is more efficient than acquired then efficiency gains are more is not
acceptable. For example in both case studies acquirer is more efficient then acquired firm but this
efficiency didnt provide any special efficiency gains. This result is not supported by literature.
Large Size of the merged firms add efficiency gains also proved wrong as merger B provides no
special gains although it shows merger of large banks relative to merger A. this result is also not
supported by literature.

Both merger decreases return on assets and specially return on equity. That can be interpreted that
mergers In Pakistani banking sector are not the result of achieving more benefits for shareholders
in fact these are result of structural requirements imposed by State Bank of Pakistan.
On checking of balance sheet attributes we find that merger didnt change the risk behavior of
firms. The one common attribute in both studies is that both merged firms didnt increase the

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WK: Weakened
9
Imp: Improved
10
NC: Not clear
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amount of advances that can earn high profits but both firms increased the amount of core
deposits that pays high interest which didnt provide efficiency effect to them however reducing
cost of non-interest/ non-mark up expenses provides merger A cost efficiency.

9. Conclusion:

Objective of our study is to check the efficiency gains, fulfillment of cost cutting objective, also
analyze the role of pre merger efficiency of banks and size of banks to be merged. We have found
that cost cutting is important result of merger while efficiency is marginal result of merger.
Moreover size and pre merger efficiency didnt contribute anything in efficiency. On the basis of
such results we can interpret that these mergers are due to requirements of minimum capital and
minimum no of branches imposed by state bank of Pakistan. So the banks that are unable to
increase their capital by equity injection go for mergers. This result is consistent with studies of
DYMSKI GARY A.

10. Limitations:

Results of study cant be generalized as it covers activity of one particular year. We cant analyze
some proposed ratios of Rhoades Stephen A. (1998) studies, like personnel, occupancy, other
non-interest expenses to assets ratios, off balance sheet items to assets ratio due to availability of
data on such grounds. Our research aims include that we want to interpret the labor laws are also
not achievable as we are not able to find out true staff cost. However this is an ongoing research
and we will try to remove the problem of generality in our full research paper by taking data from
different years and also check the results by taking peer group as control variable.

References:

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efficiency and price: evidence from a bank profit function. Review of industrial organization 12
(1997) 95-139

Abma, R.C.N., Fase, M.M.G., Financial environment and economic growth in selected Asian
countries. J ournal of Asian economics 14(2003) pp 11-21

Crespi, Rafel., Garcia- ustona., Miguel A., Salas, Vicete., Governance Mechanisms in Spanish
bank. Does ownership matter? J ournal of banking and finance28 (2004) 2311-2330

Cornett, Marcia Millon., McNutt, J amies J ohn., Tehranian, Hassan. Performance changes around
bank mergers: Revenue enhancement versus cost reduction. J ournal of Money, credit and
banking 38 (june,2006)

DYMSKI, GARY A. the global bank merger wave: implications for developing countries. The
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Musleh-ud Din., Ghani, Ejaz., Qureshi, Sarfraz. Scale and Scope Economies in Banking: A Case
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(1996) pp. 203213

Facarelli, Dario., Panetta, Fabio., Salleo, Carmelo. Why do bank mergers? journal of Money,
Credit and Banking 34 (2002) 1047-1066
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