8 Addressing the Prudential and Antitrust Aspects of Financial Sector Mergers and Acquisitions

Charles Enoch, Dewitt Marston, and Michael Taylor
Published Date:
September 2002
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Michael Andrews

Mergers and acquisitions involving regulated financial institutions have a prudential dimension that differentiates them from such transactions in other sectors of the economy. While an ill-conceived merger of a manufacturing company may have many undesirable consequences if the merged firm subsequently fails, an unsuccessful financial sector merger is far more significant because of the potential to disrupt key elements of the system upon which all transactions in the real economy are dependent. Further, there is the systemic concern that one failure might destabilize the entire financial sector by triggering subsequent failures of other financial institutions. Thus, a well-defined process is needed to deal with the prudential dimensions of financial sector mergers and acquisitions, in addition to antitrust and other public policy concerns, which are as applicable to the financial sector as to any other merger transaction.1

The generic process for reviewing a financial sector merger presented in Figure 8.1 clearly indicates the primacy of prudential concerns because the entire process will come to an abrupt end if the prudential supervisor objects. In reviewing a merger, the supervisory authority would use an approach similar to that used when considering an application for a new license, because the transaction in effect creates a new institution. The antitrust review would apply the merger enforcement rules that would be applicable to other transactions in the economy. Other public policy issues will undoubtedly influence the decision-making process, and in many countries they are explicitly incorporated into the merger review. A key point illustrated by Figure 8.1 is that there is no provision for these other considerations to lead to completion of transactions where either the prudential or the antitrust authority objects.

While the need for a clearly defined process is evident, the intersection of competition law and banking law may create a number of gaps or uncertainties. In some industrial countries, the process for considering banking mergers and acquisitions has developed over time, and while it is understood by market participants, it may not be formally defined. Developing countries may not have a competition law of general application, so there may not be an established process for considering the antitrust dimensions of a merger.2 In the case of both industrial and developing countries, where there is a competition law, it may not be clear how it interacts with the banking law.3 These issues are of increasing importance given the upward trend in both number and value of financial sector mergers (Figure 8.2), and increasing financial sector concentration levels in countries throughout the world.

Figure 8.1.Reviewing a Financial Sector Merger or Acquisition

Figure 8.2.Worldwide Financial Sector Mergers and Acquisitions

Source: McKinsey and Company (1998).

Note: Includes commercial banks, savings institutions, credit unions, personal and business credit institutions, mortgage brokers, securities dealers and brokers, life insurance companies, and bank holding companies.

The link between prudential issues and macroeconomic stability is well understood; a weak banking system is unable to intermediate savings efficiently, and fragility in the banking system is generally detrimental to economic growth.4 While the antitrust dimension does not immediately affect the macroeconomic framework, it is an important longer-term consideration. A banking industry characterized by a lack of competition will tend to maintain high spreads and fees, and thus will not provide the efficient intermediation of savings necessary for strong growth.5 Thus, failure to consider the potential antitrust implications of a banking merger or to seek alternatives to highly concentrated financial sectors will be detrimental in the long run. Other public policy concerns, such as foreign ownership and the impact on employment, arise from any large merger, but often take on particular significance in the case of financial sector transactions. Consideration of these issues is important, but because of the broader macroeconomic implications their status is eclipsed by the weighting first of prudential concerns, and then by antitrust issues.

Despite a large body of research and practical experience in both prudential regulation and competition law, very little published material addresses the intersection of these two topics.6 In most countries, mergers and acquisitions “fall under the jurisdiction of both the banking regulators and the competition authority, giving rise to a need for some mechanism for resolving possibly conflicting regulatory decisions.”7 This chapter is intended to provide an overview of the principles and best practices that apply in reviewing financial sector mergers and acquisitions, thus ensuring that there are not conflicting regulatory views.8 This guidance will typically be required in one of three instances. The first arises when reviewing or providing drafting assistance for either financial institution legislation or a competition law of general application. A second instance occurs when advising on reviews of mergers or acquisitions involving large financial institutions, which may include privatization transactions. A third instance may arise when dealing with a systemic crisis.

The Policy Approach

This section outlines the policy considerations that apply in financial sector mergers and acquisitions and suggests the key elements for an effective, clear, and transparent review process. Developing an effective, clear, and transparent process for the review of financial sector mergers and acquisitions can involve many kinds of approaches. An effective process provides for due consideration of the relevant public policy issues. Clarity is provided if an enumeration of the role of the various official agencies involved and procedural steps to be followed is readily accessible in the public domain. In a transparent process, the public policy concerns that will be evaluated in reaching a decision and the criteria that will be considered for each relevant issue are publicly identified in advance, and the reasoning for a particular decision is publicized.


Multiple public policy considerations are part of the review of a financial sector merger. The key to an effective process is that lower-order issues cannot take precedence over issues of greater public policy importance. Thus, the most essential element of an effective process for dealing with financial sector mergers and acquisitions is that the prudential supervisory authority has the ability to prohibit a transaction. Otherwise, the entire rationale for prudential supervision would be undermined because a transaction likely to raise systemic concerns could proceed despite the objections of the supervisor. It is not necessary that the prudential authority be the final decision-making body, only that a decision to approve a transaction cannot be made over the objections of the supervisor.

The second most important element of an effective process for dealing with financial sector mergers is an explicit consideration of potential antitrust implications. The reason antitrust issues rank immediately behind prudential concerns is the importance of a competitive market to the development of a vibrant financial sector that will be able to meet the intermediation and transaction needs of the economy. Thus, it is quite possible that a merger, while acceptable from a prudential perspective, should not be allowed because of the long-term detrimental effects that would arise from a significant reduction of competition in the market. Given the prudential regulator’s vested interest in stability, there may be a readiness to tacitly accept less than vigorous competition and thus approve a merger that might lead to oligopolistic behavior. This possibility suggests that there are benefits to an antitrust review that is independent of the prudential review.

Issues beyond prudential and antitrust concerns also have a legitimate place in the public policy debate. In the United States, for example, the banking regulator is explicitly charged with the consideration of the broader needs of the communities served by merging banks. In France, India, the United Kingdom, and a number of countries in Central and Eastern Europe, competition law explicitly addresses issues such as employment, regional development, or other social or political considerations.9 In a number of countries including Australia, Austria, Canada, Ireland, and Norway, the minister responsible for the financial sector has “reserve powers” that might be used to disallow for broad public policy reasons a merger that might be acceptable on both prudential and antitrust grounds.

While it can be argued that prudential and antitrust issues should be the only factors taken into consideration in the merger review process,10 other public policy concerns such as the impact on employment or regional development will inevitably influence the decision-making process. There may be legitimate policy reasons not to permit a merger that is acceptable from a prudential and antitrust perspective. But in an effective merger review process other policy considerations will not result in the approval of a merger or acquisition that is objectionable from a prudential or antitrust perspective. For example, a transaction viewed as desirable to maintain domestic ownership of a large financial institution would not be approved if there were concerns about the soundness of the merged institution, or if there were concerns that the transaction would lead to a significant lessening of competition.

Clarity and Transparency

Ideally, every country should have a well-defined process specifying the sequence of events and the role of each participant involved in the review of a financial sector merger. As a practical matter, though, the intersection of the various policy concerns and the multiple regulatory agencies that may be involved may mean it is not immediately clear how the review should proceed. A clear process could be defined in several ways, including explicit references in banking and competition law. With a well-drafted bank statute and competition law of general application, however, specific legislative provisions dealing with financial sector mergers are not required. A bank statute that meets international best practices will provide supervisors with “the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties.”11 As long as there is no possibility that the competition law could be construed as empowering the antitrust authority to approve a financial sector transaction without the consent of the prudential regulator, the more generally applicable antitrust review of a merger can be applied to a financial sector transaction.

A merger, like an application for a license, results in the creation of a new institution.12 Thus, as discussed in more detail in the next section, the supervisory authority can use a methodology similar to that used to consider the application for a new license to review the prudential aspects of a merger. Provided that licensing criteria are well documented in legislation, regulations, or policy statements, the supervisory authority has only to indicate publicly that it will be guided by its licensing criteria in evaluating a merger proposal. If the criteria are not already well defined in legislation or regulations, it is probably better to address this shortcoming in the context of licensing requirements, rather than through a statement on the process that will be used to evaluate mergers and acquisitions.

An explicit policy statement or administrative guidance on the process for consideration of financial sector mergers is relatively rare, although this step arguably provides the greatest clarity and certainty for market participants. Australia and Canada are among the few countries to have outlined the process clearly, probably because in both countries the highly concentrated financial sector makes the prospect of financial sector mergers even more highly politically charged than is frequently the case in other industrial countries. In Australia and Canada it has been clearly established that a merger would move to the final stage of consideration, where other policy considerations might still prohibit a transaction, only if there were no prudential or antitrust objections.

In the United States, the Bank Merger Act of 1960 establishes the primacy of the bank regulatory agencies in approving a merger, although the antitrust authority may still seek a court order within 30 days of approval to overturn a transaction approved by the relevant banking agency (Box 8.1). The Department of Justice cannot seek approval of a transaction denied by the banking agencies, which are also charged with consideration of a range of nonprudential issues, but these issues do not take precedence over the prudential or antitrust considerations. For example, the Community Reinvestment Act, which requires consideration of the merger proponent’s record of compliance with the act’s provisions, provides only that a merger may be denied. It does not provide that a bank with a strong record in community reinvestment would be permitted to consummate a merger that raised prudential or antitrust concerns.

The increasing number of financial sector mergers in Europe has recently led to increased focus on both the prudential and the antitrust aspects of these transactions. Within the European Union, a merger is subject to specific country requirements, which may pertain to both prudential and competition issues, and also to antitrust review by the Directorate General IV (Competition) of the European Commission. As a practical matter, financial sector transactions have generally led to declarations of “nonopposition” from the European Commission. While in many cases there have been high levels of national concentration, the Commission has generally found either that the relevant geographic market is large, or that even with a narrow geographic market definition there are enough alternatives to ensure no likelihood of a significant lessening of competition. Even the most problematic of the large European bank mergers, the 1997 merger of two of the three largest Swiss banks, was quickly approved with minimal conditions imposed. The Competition Commission had identified as its primary concern the small business loan market, because of the potentially dominant position of the merged Union Bank of Switzerland and Swiss Bank Corporation. These concerns were mitigated by the parties’ agreement to divest a number of branches and subsidiaries, with all the agreed divestitures completed in March 1999.13

Box 8.1.Bank Merger Review in the United States

Until the mid-1960s, the United States had a long history of not applying antitrust legislation to the banking sector. The Bank Merger Act 1960 considered that the banking agencies would receive but not be bound by the views of the Department of Justice, which enforced antitrust provisions.1 However, the landmark Supreme Court Philadelphia decision in 1963,2 and a series of follow-up cases3 established that bank mergers were subject to the Clayton and Sherman antitrust acts. This raised the possibility that the Justice Department might obtain court orders to unwind consummated mergers that had already been approved by the banking regulators. Amendments to the Bank Merger Act in 1966 addressed this uncertainty by immunizing previous transactions and limiting the time period for a challenge by the Justice Department to 30 days after approval by the relevant banking agency.

The Bank Merger Act provides that the regulatory authority (the Federal Reserve, the Office of the Comptroller of the Currency, or the Federal Deposit Insurance Corporation) that would have responsibility for the resulting institution is the agency empowered to provide final regulatory approval of a merger. The responsible agency is required to consider advisory opinions from the other federal banking authorities and the Department of Justice as part of the review process. The criteria to be considered by the responsible agency are:

  • the effect of the transaction on competition;
  • the financial and managerial resources of the existing and proposed institutions;
  • the future prospects of the existing and proposed institutions; and
  • the convenience and needs of the community to be served.

The first point explicitly deals with antitrust concerns, while the second and third deal with prudential concerns. The fourth point takes into account a range of other public policy concerns. The responsible banking agency is not bound by the opinion of the Department of Justice, but clearly would be subject to legal challenge if it approved a merger in spite of objections on antitrust grounds.

1Bernard Shull(1996, p. 257).2 U.S. v. Philadelphia National Bank et al. 374 U.S. 321 (1963).3 Mast notably U.S. v. First National Bank and Trust Company of Lexington, 376 U.S. 665 (1964); and U.S. v. Manufacturers Hanover Trust Co., 240 F. Supp. 867 (S.D.N.Y. 1965).

In most European countries, “the objective of ‘stability’ of the banking sector is placed alongside the objective of enhancing competition.”14 In some countries such as Switzerland, the antitrust law provides that the competition authority makes the final decision and that the input of the banking regulator is simply part of the process. While the primacy of prudential concerns may not be established in law, it is generally clearly understood by market participants that in practice a merger would not be approved over the objections of the prudential regulator. Typically, merger proponents would make an informal approach to the prudential regulator before proposing such a transaction.

Public disclosure is an important element of transparency,15 but public knowledge that a proposed merger had been rejected on prudential grounds might lead to a loss of confidence in the merger proponents. For this reason, merger advocates frequently seek a favorable indication from the supervisor before making a public announcement of their intentions. It would be unusual for a bank to proceed with an attempted acquisition or merger in the face of an unfavorable advance indication from the prudential regulator. But this did take place in 1982 when Hong Kong and Shanghai Banking Corporation proceeded with a bid for Royal Bank of Scotland. The transaction was subsequently denied by the Monopolies and Mergers Commission.

If merger advocates have publicly announced their intention, the prudential supervisor might find it advisable to provide the proponents with an unofficial indication of an unfavorable decision to allow them an opportunity for a face-saving “voluntary” termination of the merger discussions. Should there be an “official” denial of the merger, transparency would dictate that the prudential authority publicize the rationale for its decision. If one or more of the merger entities are publicly traded, an unfavorable decision by the supervisor would be a material event under securities law in many countries, and thus subject to public disclosure by the parties, notwithstanding any decision by the supervisor not to release its decision to the public.

Antitrust authorities frequently have sought to bring greater transparency to the merger review process by providing published guidelines, and in rarer instances specific guidelines have been published for the antitrust analysis of bank mergers. The guidelines provide greater certainty in dealing with financial services products and markets, which differ in a number of aspects from the real sector transactions that constitute the bulk of transactions likely to be subject to antitrust review. As detailed in a later section, though, the issues of financial services product and market definition have become well-enough defined through the merger review process in a number of countries that specific bank merger guidelines are not necessarily required to ensure a well-understood and transparent analytical process. Ensuring that the decisions of antitrust authorities are made public, along with supporting analysis, is an important element of transparency, and thus it is a best practice for countries with a competition law of general application.

Other considerations that might lead to disapproval of a merger or acquisition transaction frequently relate to industrial or regional economic policies. While good practices in transparency dictate that such reasons should be clearly enunciated and disclosed as the basis for a decision, the considerations outlined later in this chapter in the section “Other Considerations” may lead to contravention of multilateral trade agreements. These transgressions should not occur, but in reality they frequently carry great political weight, and it is naive to advocate that they be dealt with transparently.

A recent example of the difficulty in separating true prudential concerns from other issues is the denial of the June 1999 bid by Spain’s Banco Santander Central Hispano for control of Portugal’s Mundial Confiança. The European Union found that Portugal’s refusal to approve the transaction appeared to cloak national protectionism in the guise of prudential concerns, and the issue was referred to the European Court of Justice.16 From a practical perspective, the objective to be achieved in reviewing mergers and acquisitions is to ensure that other policy considerations do not compromise prudential and antitrust concerns.

The section that follows contains a detailed discussion of the relevant prudential, antitrust, and other policy considerations, and makes observations on how these issues can be taken into account during the review process.

Prudential Considerations

The guiding principle of dealing with a merger or acquisition is the same as that applied to any other material change in a regulated financial institution: The resulting regulated entity must comply with all prudential standards. Compliance includes ensuring that the owners have met “fit and proper” standards, that management is qualified and suitable, that all capital requirements are met, and that the entity has a reasonable business plan that provides for continuing compliance with prudential standards. Much as with bank licensing, the onus is on the transaction proponents to provide the supervisory authority with full and complete information to enable completion of a detailed assessment. Information required includes a pro forma balance sheet and income statement, a business plan, and full details on the proposed management team and ownership. In addition to applying analysis similar to that used in considering a new license application, the supervisory authority will focus on prudential issues arising specifically from the merger transaction.

Transactions involving only regulated financial institutions are simplified by the fact that the owners involved should already have been vetted by the supervisory authority and been deemed fit and proper. Also, the quality of management and the financial strength of the institutions should be made known to the regulators. This leads to a presupposition that mergers and acquisitions among regulated institutions would normally not be prohibited on prudential grounds. If the supervisor objects to a proposed merger, the objection indicates either concern over the current risk profile of the merger proponents or concern that the proposed transaction would create an institution with an unacceptable risk profile.

Because activities outside the regulated financial institutions but within a corporate group can affect safety and soundness, a good banking statute will provide a mechanism to ensure prudential review of significant transactions involving the owners or subsidiaries of financial institutions.17 While the issue does not arise in the case of a widely held institution, in the case of majority or significant shareholdings the supervisor will require assurance that after a merger or acquisition, the shareholders would continue to be fit and proper. This is a particular concern if the transaction would result in a major shareholder of a bank also having a major shareholding in a commercial group, because it raises the issue of related party transactions. If the owners of one bank are to become owners of another bank or financial institution, the bank supervisor must be satisfied with the availability of financial information to provide a complete picture of all the institutions having common ownership links.

The prudential risks of subsidiaries of financial institutions are dealt with in several ways. Provided that the banking law contains appropriate provisions, which may include deducting the investment in a subsidiary from the regulatory capital base, limiting the total capital that may be invested in single and all subsidiaries, and establishing a list of permitted subsidiaries, specific prudential provisions to deal with mergers and acquisitions of a financial institution’s subsidiaries are not required. The general banking law will determine whether the specific approval of the prudential supervisor is required for a given transaction, and a competition law of general application will generally provide guidelines to determine readily when a transaction is of enough significance to warrant antitrust review.

Transactional Issues

Mergers and acquisitions are proposed in the expectation of economic gain, which is typically expected to arise from one or more of the following sources:

  • accessing information and proprietary technologies in the target firm;
  • increasing market power to permit widening of margins or acquiring the ability to carry out large transactions that would otherwise require participation by other firms;
  • reducing unit costs and increasing operating efficiency by eliminating redundant facilities and personnel, as well as improving the quality of management;
  • achieving economies of scale or scope;
  • reducing risk through greater diversification; and
  • achieving tax benefits.18

The expectation is that the financial results of the merged firm will exceed the sum of the premerger firms’ results. However, there are many costs associated with completing a merger or acquisition that have to be recouped before any net gain is recorded. In all mergers, there is uncertainty at the outset about the ability of management to complete the merger transaction itself effectively and then to implement the measures required to realize the expected gains. This uncertainty over the attainability of financial projections takes on an additional dimension in the financial sector, and there are also a number of specific regulatory concerns inherent to transactions within the financial sector.

Demands on management

A large merger or acquisition places a major demand on management and staff at all levels in an institution. It is important that both the management proposing a merger and the prudential supervisor recognize that there is an inevitable disruption through the transition period. Significant senior management time will be required for a successful integration of the merging entities. This of course can be a cause of prudential concern if the supervisor has any reservations about the depth and quality of the management team. These concerns will be exacerbated if one or more of the merging institutions have preexisting problems such as a weak loan portfolio, lax internal controls, or poor operational systems. A merger or acquisition is one way in which shareholders of a weak institution can institute a change in management designed to address weaknesses, even when these weaknesses have not yet come to the attention of the regulator.19 The complications of completing the merger transaction itself introduce additional risk elements, though, and these risks increase with the relative size of the weak bank to the strong bank.

The evaluation of the general competence and depth of the management team proposing the merger is a key element in assessing the potential impact of other transactional issues on the strength and soundness of an institution. Greater reliance can be placed on the projections prepared by a team that is favorably viewed and demonstrates an awareness that the probability of achieving all the targets in a merger plan is something less than one. Most of the transaction-related issues that a regulator will have to consider require substantial subjective judgment even though they involve many quantifiable aspects.

Financial projections

The key to most financial sector mergers is anticipated cost-cutting arising from staff reductions, elimination of duplication in headquarters and back-office functions, particularly data processing, and the closure of overlapping branch office locations. Despite numerous empirical studies focusing on bank mergers, and a broader literature addressing mergers in general, there is no certain way to determine in advance which mergers will meet financial projections.20 Although a strong commitment to cutting costs and acquiring firms that are more efficient than (or as efficient as) the target may be important, they apparently are not sufficient to ensure efficiency gains.21 Diseconomies of scale in the management of a larger institution, delays in the realization of expected savings, and unexpectedly large transaction-related issues such as difficulty in integrating computer systems or corporate cultures are among the factors that might result in lower than expected financial performance in a merger.

While historically less important in financial sector mergers, the search for economies of scope by using an existing distribution channel for additional financial products and services has recently become more of a driver for mergers (Table 8.1). Economies of scope are even more elusive than the search for economies of scale, because the melding of diverse cultures and operations is even more difficult than the merging of similar institutions in search of economies of scale.

The prudential regulator is not likely to be able to arrive at better estimates of the financial results than the management team planning the merger. The supervisor should be satisfied, though, that even without achieving all the expected gains, and even considering the costs of the transaction exceed projections, profitability will be maintained and capital will not be impaired. The supervisor necessarily must rely on management, but should carefully question the underlying assumptions and also conduct sensitivity analysis using less favorable assumptions.


One of the most important quantifiable issues is the creation of goodwill, an intangible asset arising from the payment of a premium over book value for an acquisition. Required accounting practices differ among jurisdictions,22 but from a regulatory perspective, the creation of goodwill or revaluation of assets needs to be dealt with conservatively. From a theoretical perspective, the accounting treatment of a transaction should be immaterial because the market would efficiently use whatever accounting information is provided to determine the underlying economics of the transaction. But the basis of prudential requirements is generally “book” or accounting values, and regulatory practice and economic theory deal differently with the element of uncertainty, so the accounting treatment of a merger or acquisition transaction is a material consideration.

Table 8.1.Recent Bank-Insurance Acquisitions
ING (Netherlands)BHF-Bank (Germany)1999
Unibank (Denmark)Tryg-Baltical (Denmark)1999
Storebrand ASA (Norway)Finansbanken (Norway)1999
Citibank (United States)Travelers Group (United States)1998
ING (Netherlands)Banque Brussels Lambert (Belgium)1998
Credit Suisse (Switzerland)Winterthur Group (Switzerland)1998
Sources: U.S. Office of the Comptroller of the Currency (1999); Shutt and Williams (1999).
Sources: U.S. Office of the Comptroller of the Currency (1999); Shutt and Williams (1999).

The regulatory treatment of the difference between a bank’s book value and its market value provides a useful parallel when considering how to account for an acquisition premium. Market value is a reflection of the present value of expected future cash flows, which may well be more than the amount by which the book value of assets exceeds the book value of liabilities. Some portion of this difference reflects assets with book values substantially lower than their market values. The real estate holdings of a bank, for example, may have been acquired many years previously and carried at a book value well below current market value. These real assets typically make up a small proportion of the total assets of a financial services firm, but they may account for a significant portion of capital. Financial assets and liabilities are more likely than real assets to have accounting values that closely approximate their market values. Nevertheless, banks and other financial services firms may be valued at a multiple of their book value, reflecting the net present value of anticipated future cash flows. The multiple of book value captures intangibles such as established customer relationships, the value of branch networks as distribution channels for additional products, and the intellectual resources of the firm.

Market value represents the best current estimate of the expected future cash flows that will be generated by a financial services firm. For publicly traded firms, market value changes constantly, reflecting continually changing views on likely future performance.23 Thus, the premium of market value over book value lacks one of the key elements of capital: It is not permanent. Regulators can take comfort in a high multiple of market value to book value as an indication of positive market sentiment about the likely future performance of the bank, but they continue to rely on book values for the purposes of determining compliance with capital requirements. Similarly, because there is no guarantee that any premium paid for an acquisition will actually be realized in the form of increased future cash flows, for regulatory purposes the goodwill that might arise in an acquisition has no value.

A premium beyond the premerger market value of the target firm introduces a further element of uncertainty. The premium will largely reflect an estimate of the present value of cost savings and revenue increases, net of the costs of the merger, which can be generated by the merged firm relative to the two premerger firms.24 These projections may not be achievable, and the empirical evidence indicates that the majority of mergers fall short of achieving the results projected by the merger proponents.25 Expenses to complete the merger and the time required to achieve cost savings are frequently underestimated, while efficiency gains are frequently overstated. Thus, the valuation arrived at by allowing for increased revenues and reduced costs in the merged firm frequently proves to have been overly optimistic.

The prudent regulatory approach would be to use an accounting method for the business combination that does not write up the value of assets or create goodwill, but generally accepted accounting principles (GAAP) in a given country may mandate another treatment. Executives of a bank involved in an acquisition will generally share the regulator’s preferences for avoiding goodwill if at all permissible under GAAP, although for a different reason. If goodwill is created and has to be subsequently amortized, this has the effect of reducing earnings in future periods. While this is a noncash expense and in theory analysts should see through reported earnings to the underlying economics, executives generally believe that the amortization of goodwill does have a negative impact on analysts’ perception of the value of a stock. If GAAP in a given country does require the creation and amortization of goodwill to account for an acquisition, the goodwill should be deducted from Tier 1 capital for regulatory purposes.

Operational risks

Operational risks are an issue for any merger, but they take on a special significance in financial sector mergers because of the potential threat to both the solvency of the merged firm and the possibility of disruption of the financial system more generally. Accurate and complete information on the assets and liabilities of a financial institution is necessary for risk management. Merging institutions requires dealing with multiple data systems, raising the possibility that vital information such as maturity and yield may be lost or corrupted, with the result that inaccurate or incomplete data are used to manage the liquidity, interest rate, and maturity risk of the institution. Other functions with the potential for high operational risks are the maintenance of customer account data, particularly with regard to assets under management or held in trust. Similar opportunities for confusion and system failure arise in dealing with the links to clearinghouses, depositories, payment systems, and settlement accounts. While the possibility of insolvency of an institution or a systemic threat to the payments system is remote, these are far from academic concerns. The most frequent and serious problem in banking mergers is the unexpected difficulty in integrating data processing and operations.26 Concern over Y2K issues led to the decision in many 1998 and 1999 mergers to run parallel systems until 2000, despite the additional expense.

In addition to ensuring that the merger proponents have appropriately planned to deal with institution-specific operational risks, the prudential supervisor will want to examine the plans for managing the merged institutions’ links to the rest of the financial system. Ensuring uninterrupted transactions processing requires that measures, including contingency plans to deal with possible disruption, be jointly implemented by the merging institutions and the relevant clearinghouses and payment systems.

Hostile bids

Some prudential supervisors discourage or prohibit transactions where an acquirer is attempting to act against the wishes of the management and directors of the target institution. In March 1999, the Italian prudential supervisor blocked proposed acquisitions involving four of the largest Italian banks: a takeover of Banca di Roma by San Paolo IMI and the acquisition of Banca Commerciale Italiana by UniCredito. In both cases, the central bank opposed the hostile bids on the grounds that such takeovers present greater transactional risks than mergers or acquisitions where all parties are willing participants. Regulators in France and Germany have also discouraged hostile takeovers in the financial sector; in North America they do not often take this position. No empirical evidence actually provides a conclusive view, but it is certainly plausible that the difficulties of successfully completing a transaction will be increased by efforts by the target institution to resist a transaction, by the reduced ability to plan the integration in advance of the closing date, and by the likelihood of less than full cooperation from the target’s management team. When considering a hostile takeover, it would be appropriate for the prudential supervisor to take a very conservative view of transactions costs and potential difficulties in successfully integrating the business of the acquired institution.

Mergers to resolve problem banks

Prudential supervisors use mergers as a resolution technique to deal with problem banks, both in the case of individual weak banks in an otherwise healthy system, and to deal with systemic crises. There is no empirical evidence on the general success of such orchestrated mergers, but it is possible to draw some conclusions from the available evidence on mergers generally and the studies of systemic crises.

In resolving a problem bank addressing the underlying weaknesses is essential. This can be achieved through a merger, because the stronger management and better systems of the sound partner can improve the performance of the weak bank. Thus, while it may be necessary for a transaction to be publicly presented as a merger, it should be internally clear that the management of the strong bank is actually taking over the weak bank. It is arithmetically evident that the capital and loan portfolio of a stronger bank will deteriorate, simply because of the negative effect of the weak bank. This impact obviously decreases as the size of the stronger partner relative to the weaker partner increases. Similarly, the ability of management to deal with the transactional risks of the merger will be a function of both the size of the problem bank and the depth of the problems. Thus, the larger the size of the weak bank relative to the strong bank, the more wary a supervisor should be of orchestrating a merger for fear of dragging down the strong bank and ultimately creating a larger problem.

The risks of arranging a merger to resolve a weak bank can be mitigated through provision of financial assistance to the acquiring bank, thus ensuring that it does not have to absorb the capital deficiency. While use of public funds for bank resolution is generally not appropriate in a noncrisis situation, a deposit insurance fund charged with seeking least-cost solutions may determine that an assisted merger is preferable to other possible resolution techniques.27 Even where financial assistance is provided, though, the key to a successful resolution is that the underlying causes of the problem bank have to be addressed. This is highlighted in the study of systemic banking crises, where progress toward successful restructuring is found to be correlated with addressing the management deficiencies that contributed to the systemic crisis.28

As a rule of thumb, the supervisory authority will want to avoid mergers as a resolution technique unless it is satisfied that management will be able to address the underlying causes of the problem banks’ difficulties. Supervisors will further want to be satisfied that the resulting merged entity will be able to maintain acceptable prudential ratios, either because of the relatively small size of the capital deficiencies assumed or through the provision of financial assistance.

Conglomerate Mergers

A transaction involving different types of financial institutions subject to the authority of different prudential authorities, or a regulated institution and a commercial firm, highlights the need for effective consolidated supervision of financial conglomerates. The divergence of regulatory structures throughout the world has hampered the development of an international consensus on anything but the most general principles of supervision of conglomerates.29 Some country authorities such as Australia and the United Kingdom have attempted to deal with the issues of consolidated supervision, at least within their own borders, by creating a single regulatory authority covering multiple sectors of the financial services industry. Notwithstanding the difficulties in achieving international agreement, where there are multiple authorities responsible for regulation of the various parts of the financial sector within a given country, formal agreements are generally viewed as a prerequisite for effective consolidated supervision. At a minimum, such agreements provide for information sharing, ensure that there is groupwide assessment of risks and capital adequacy of a financial conglomerate, and establish a means to coordinate the supervisory activities of the various authorities. Having such agreements in place means that it is not necessary to develop ad hoc procedures to examine the prudential aspects of proposed mergers among different types of financial institutions. To eliminate any uncertainty, these agreements can clearly specify that the regulatory authority having lead responsibility for the merged firm will coordinate the merger review process. Consistent with the Basel Core Principles, the supervisor should be able to prohibit a transaction that would create a structure that would impair effective supervision.

Cross-Border Transactions

The proposed acquisition of a financial institution in another jurisdiction creates the need for a formal relationship between the home- and host-country regulators. For the host-country regulator, the process parallels the one that would be followed if the foreign financial institution had sought to enter the host country by obtaining a new license. At a minimum, the host country would ensure that the foreign institution is supervised by a home-country authority that capably performs consolidated supervision, and would contact the home country to ensure that it consented to the proposed transaction. But the current state of agreement on international best practices on cross-border supervision is at a level of such generality that supervisors will have to rely on bilateral agreements and understandings to ensure that all cross-border operations are, in fact, subject to effective home and host supervision.30 Ideally, the home and host regulators would have a formal agreement on information sharing, ensuring among themselves that there is consolidated or group-wide assessment of capital adequacy and risk, and that regulated activities do not escape the purview of the supervisors, while avoiding duplication. In practice, this ideal will be difficult to attain.

Potentially, a financial sector merger also has a significant cross-border antitrust dimension. Internationally active financial institutions will be subject to merger review in multiple jurisdictions, because most countries will have jurisdiction to deal with competition issues based on the potential domestic effects of a transaction.31 This could conceivably lead to different decisions on the same transaction. An example would be a proposed merger of two internationally active banks that did not raise antitrust concerns in their home countries but did raise concerns in a third country where both happened to have subsidiaries with large shares of the local market. The result could be that the antitrust authority in the third country might require divestitures to address potentially significant lessening of competition, despite the lack of concern on the part of the antitrust authorities in both home countries. A hypothetical example is readily found in New Zealand. A merger between Lloyds TSB and National Australia Bank would not raise competition concerns in either the U.K. or Australia. But because subsidiaries of Lloyds TSB and National Australia Bank are two of the three largest banks in New Zealand, such a hypothetical transaction could raise serious antitrust concerns in New Zealand. Thus, the intended merger of subsidiaries of international institutions will generally be subject to the same competition review as a merger of domestic firms, and remedies such as divestiture in the local market may be required to address antitrust concerns.

Too Big to Fail

A proposed merger or acquisition involving very large institutions raises the possibility of creating an institution that is “too big to fail,” or one that may reduce the options that would be available to deal with the failure of a large institution. Institutions have been viewed as too big to fail when the costs of closure would exceed the costs of extraordinary measures such as the use of public funds to prevent failure. The potential for one failure to trigger other failures, disruption of the payment system, immediate creation of a liquidity crunch, and the longer-term creation of a credit crunch are all arguments used to suggest that particular institutions are so important to an economy that they cannot be allowed to fail. Although never explicitly stated, a possible rationale for owners to propose a merger of large banks is to gain the benefit of an implicit government guarantee. If the market perceives that an institution is too big to fail, its valuation will be somewhat higher than otherwise warranted.32

These will be very difficult issues to address, both because of the reluctance of regulators to officially acknowledge that a bank might be too big to fail and because of the subjective judgments required and their potential implications.33 In considering the possibility of mergers among large Canadian banks, the prudential supervisor noted that “if the mergers were approved and one of the merged banks experienced serious problems, these options [recapitalization, sale of individual businesses, various forms of restructuring, liquidation and piecemeal or en bloc sales of individual assets and business lines, and an outright sale of the bank to another financial institution] would probably remain, but, given the relative size of the institution in relation to potential buyers and investors, some would be more difficult and more time consuming to implement and a ‘least-cost’ resolution could be more difficult to achieve.”34

While the “too-big-to-fail” issue will have to be considered in the case of large mergers, the prudential regulator may be reluctant to cite creation of an institution that would be too big to fail as a reason for objecting to a proposed transaction. Fortunately, such a large transaction is likely to involve antitrust and other public policy considerations that can be taken collectively with the prudential concerns to form a body of evidence to support a decision to reject a very large merger.

Competition Law Issues

The principal objective of competition law is to maintain and encourage competition as a means of promoting economic efficiency and consumer welfare. The primary competition or antitrust concern regarding a proposed merger or acquisition transaction is that it might lead to a lessening of competition in a market (Box 8.2). A reduction of competition in this context does not refer to a diminution in the number of competitors, but rather to a situation where one or more competitors may be able to exercise market power. Market power arises when, in the absence of reasonable alternatives, a purchaser chooses a product or service that permits the seller to earn “extraordinary profits.” Extraordinary profits usually are evident in higher prices than could be sustained in a competitive market, but they may also arise from a lessening of service, quality, variety, or innovation. While market power is a theoretically simple concept, defining and measuring it in practice is fraught with difficulty.

Market Definition

Financial services have traditionally been defined on an institutional basis—the banking market, the insurance market, and securities markets. This approach is not very useful for antitrust analysis, where the appropriate market has both a product and a geographic dimension. Consideration of possible alternative providers of similar products illustrates the pitfalls in an institutional-based market definition. A consumer seeking a basic account to provide transactions services and household savings might, depending on the particular country, be able to turn to cooperative or other nonbank institutions, mutual funds, securities brokers, or insurance companies. Thus, the size of the market would be significantly understated and hence the concentration significantly overstated if only banks were included in the antitrust analysis of a banking merger.35

Box 8.2.Antitrust Review of Mergers

“Merger review is an unusual activity because it requires ex ante judgments on often imponderable questions concerning the medium- or long-term future of markets and enterprises.”1 While the process outlined below varies somewhat from country to country, competition law generally contains these provisions and procedures for the evaluation of mergers. The practice of reducing these theories and principles to numbers that can form the basis of a decision is inevitably open to debate and discussion because of the assumptions and conclusions that have to be made about likely future events and behavior.

  • 1 Pre-notification.There is generally a size threshold, defined in sales or assets, above which the proponents of a merger must notify the competition authority in advance of consummating a merger. The competition authority typically undertakes a quick preliminary review, and if it is immediately clear that there are no antitrust concerns, permission (or non-objection) is provided, permitting the merger to proceed. In other cases, a more detailed review of the likely impact of the merger is undertaken.
  • 2 The Anticompetitive Threshold.A merger will generally be found to lessen or prevent competition if the merged entity would be able to exercise greater market power in all or a substantial part of the market for a significant period after the merger. The focus of determining whether market power can be exercised is usually on the ability to impose and maintain a price increase, but consideration will generally also be given to the possibility of lessening of competition with respect to service, quality, variety, or innovation.
  • 3 Market Definition.Market definition is central to determining if a merger is likely to lessen or prevent competition. A relevant market is generally defined as the smallest group of products and the smallest geographic area in which sellers could impose and maintain price increases above those that would likely exist if the merger did not take place (the “hypothetical monopolist test”). Conclusions have to be reached as to the likelihood of buyers switching to a substitute product or the same product sold in a different area, and a determination made of the probability of entry by new competitors and supply response by existing competitors.
  • 4 Estimating Market Power.Market share (percentage) or concentration measured by the Hirschman-Herfindahl Index (HHI) is generally used as an indicator of the likely effect of competition on a market. There are usually threshold levels below which the presumption is that there will not be competition concerns. For example, the U.S. Bank Merger Screens indicate that a transaction resulting in a post merger HHI of 1800 or less, and an increase in the HHI of 200 or less is unlikely to require further review. This is a rule of thumb, and does not preclude greater examination if circumstances warrant. Even when concentration exceeds the “safe-harbor” levels, the merger may be approved if there is evidence of low barriers to entry, probable future entry of new competitors, or other mitigating factors.
  • 5 Efficiency exemptions.An anti-competitive merger may still result in a net gain to the economy as a whole if there are economies of scale or scope that outweigh the likely losses from decreased competition.
  • 6 Appeal of decisions.Decisions of the antitrust authority are frequently negotiated with the parties, but where agreement cannot be reached there is usually recourse to the courts. In some cases the first recourse is to a special judicial or quasi-judicial body. Decisions of this special competition authority are generally subject to appeal and judicial review.
1Baker (1998).

Market definition has a geographic dimension in addition to the product aspect. A market physically consists of the geographic area within which a purchaser will seek alternative suppliers. Empirical evidence supports the theory that a purchaser will travel further to get a better price on a relatively expensive and infrequently purchased product, with the implication for antitrust analysis in financial services that the geographic size of a market varies significantly for different products.36 This means that the antitrust analysis of a proposed merger of financial sector firms involves potentially hundreds of products in thousands of local markets.

In practice, this potentially overwhelming analytical challenge is dealt with in practice in two ways. First, the number of geographic markets that require analysis can be reduced by use of an initial screening mechanism. In the United States, a somewhat arbitrary market definition and approach to measurement,37 using deposits as a proxy for a cluster of banking services,38 is used as an initial screening mechanism to identify mergers that are not likely to raise competitive concerns. The process has been codified through literally thousands of bank mergers, to the extent that merger proponents typically have already identified likely competition concerns and they propose remedies concurrently with making their application to the regulator for merger approval.39 Despite recent consolidation, the U.S. banking market is still characterized by a significant number of competitors in most local markets, so the use of the bank merger screens serves to immediately eliminate most geographic markets from further antitrust analysis, even in mergers involving the largest banks.40 This results in relatively quick consideration of even the largest mergers because the analytical resources can be concentrated in the markets of most concern.

A variation on this approach is, either arbitrarily or as a result of detailed market analysis, to determine that the relevant geographic market is national. This determination facilitates the collection and analysis of market share data and builds on work done in a number of European countries that have opted to use national markets in the analysis of bank mergers. Finland, France, the Netherlands, Norway, Sweden, and Switzerland41 are among the countries that have relied on a national or even a European geographic market definition in the antitrust analysis of bank mergers. The European Competition Commission has consistently held that banking markets are either national or international.42 Arguments in favor of national markets have included the relative ease of a current competitor expanding its geographic scope, the increasing ease and prevalence of electronic transactions, and the existence of overlapping market areas that effectively discipline all competitors even if all competitors are not active in every sub-market.

These findings from Europe are contrary to recent evidence from Australia, Canada, and the United States indicating that despite innovations in electronic delivery of financial services, individual consumers remain reliant on nearby financial services firms.43 While consumers will shop a wider geographic area for larger purchases such as mortgages and investment products, the majority of consumers still tend to choose a checking account provider in proximity to either their home or work. The need to have a convenient location to deposit cash receipts makes small businesses even more dependent on having a nearby provider of a transactions account. Further, because lenders frequently tie the provision of operating credit (working capital or overdraft facilities) to the provision of a transactions account to monitor account activity, small businesses wishing to borrow are generally limited to choosing from nearby financial services providers.

It is quite plausible, though, that the smaller geographic size of Finland, the Netherlands, Norway, Sweden, and Switzerland relative to Australia, Canada, and the United States makes the national market definition more appropriate. For developing and transition economies, even if there is evidence to suggest that smaller geographic markets than national are appropriate, it may ultimately be necessary to measure concentration on a national basis because of the lack of available data. Reliable market share data on a regional or local basis is seldom readily available, and cost and time considerations may preclude obtaining it as part of the merger review process.

A second approach to reducing the number of markets is to eliminate from further consideration those where a broad range of alternative suppliers and substitute products, or wide geographic markets, exist. This approach draws on available evidence from developed countries and concludes that multinational and large national businesses have many financing alternatives and thus are not likely to be adversely affected by increasing financial sector concentration. More generally, it also finds that there are a range of alternatives, increasing market size, and relative freedom of entry in some consumer products.44 This elimination of some products generally leaves basic consumer transactions and savings accounts, along with financing and transactions accounts for small and medium-sized businesses, as the areas of major concern in bank mergers in developed countries. These same products are likely to be a concern in developing countries as well, especially because well-developed capital markets to meet business-financing needs are less likely to be present.

Estimating Market Power

Having defined the markets of concern in terms of both product and geographic scope, the antitrust analysis turns to the measurement of the likely impact of a merger transaction on market power. Concentration levels are generally used as a proxy for market power, based on empirical evidence of links between concentration and price.45

Increases in concentration

Even though concentration is a less than ideal measure of market power, and other mitigating and exacerbating factors will be included in the analysis, the level of and increase in concentration in the product markets of key concern will be a focal point in antitrust analysis. Two methods are used to measure concentration, one being a simple summation of market shares, and the other being a summation of the square of the market shares. The second approach, the Hirschman-Herfindahl Index (HHI),46 provides greater weighting to larger firms, and thus at least in theory makes greater provision for the potential for collusion and oligopolistic behavior in an industry dominated by a few large competitors. The two differing approaches do not yield remarkably different results in practice. For example, in comparing the “safe-harbor” provisions of the Canadian Merger Enforcement Guidelines, which are based on market share, and the HHI approach in the U.S. Bank Merger Screens, it is virtually impossible to construct a theoretical market structure that would fall within one safe-harbor provision and not another, despite the differing approach.

There are no absolute definitions of the level of concentration that is likely to lead to an unacceptable ability to exercise market power. As a rule of thumb, U.S. banking regulators will not normally have antitrust concerns about a transaction resulting in a post-merger HHI of 1,800 or less and an increase in the HHI of 200 or less. But in non-banking mergers in the United States, the safe-harbor threshold is an HHI of 1,600. The Canadian safe harbor is a resulting industry structure where the merged firm would have less than 35 percent of the market, or the merged entity would have a market share of less than 10 percent and the four largest firms combined have less than 65 percent of the market. The Australia Competition and Consumer Commission uses a slightly more liberal safe-harbor threshold; the presumption is that transactions resulting in the merged firm having less than 40 percent of the market, or less than 15 percent of the market when the four largest firms have less than 75 percent market share, generally will not result in a significant lessening of competition.

An important consideration, however, is that concentration is only an indicator of the likely ability to exercise market power. Should a transaction not fall within the safe-harbor provisions, it still might not have a detrimental effect on competition if there were mitigating factors such as likely new entrants to the market. Conversely, even if the transaction fell within the safe harbor it might be subject to further review, if for instance the industry had a history of collusion or conscious parallelism. It can be argued that the tendency for all competitors to adjust interest rates at the same time, and the unique nature of lending as a “product,”47 mean that a level of concentration acceptable in other industries should not be accepted in banking. An alternative argument is that nonbanks compete with banks, but this competition is not captured in the usual market definition and analysis, so a higher level of concentration might be acceptable in banking than in other industries.48

New entrants

It is at least theoretically possible that even a market dominated by a single seller might still be competitive. If a market is contestable, that is, it has the potential to be entered by vigorous new competitors, the existing players cannot engage in uncompetitive pricing because the excessive profits earned will attract new competitors and drive the prices down. Contestable markets typically have few barriers to entry, while most financial services markets have traditionally been characterized by high barriers to new entrants. Minimum capital requirements, the sunk cost investment in physical infrastructure such as a branch network, and the significant informational advantage of incumbents over new entrants are all significant barriers to entry.49 While the relevance of these barriers is declining as electronic delivery of financial services becomes more prevalent, probable future entry is still generally not viewed as a significant mitigating factor when considering financial sector mergers.

In addressing merger transactions in developing or transition economies, the “doctrine of probable future entry” can be considered as a means of fostering a greater number of competitors. This doctrine, used in merger analysis in the United States, maintains that a merger should be disallowed if there is likelihood of the acquiring party entering the market by way of a start-up rather than by acquisition.50 In the case of a market characterized by a number of weak institutions, however, the authorities might consider a moratorium on new licenses as a means of encouraging stronger foreign competitors to enter the market by acquiring weaker domestic firms. The intent in either case is to bring innovation and financial strength to the market through the entry of new competitors rather than just reforming existing banks on a stand-alone basis.

Empirical evidence indicates that financial sector capacity develops more quickly when a new or parallel private banking system is allowed to emerge than it does when the government tries simply to reform existing state-owned banks.51 One reason is that the new entrants bring new competitive forces to previously stagnant markets. Thus, from a competition perspective it is preferable for foreign banks to enter a country through start-ups or small acquisitions rather than through acquisition of large domestic banks. In many cases, though, the large domestic banks need to obtain the management expertise and financial strength that a foreign parent could provide, making entry by acquisition more attractive from the prudential perspective.

Efficiencies Gains

In considering the impact of concentration on competition, it is important to remember that competition is a means of creating an efficient market rather than an end in itself. This gives rise to the efficiencies defense, whereby transactions likely to result in a significant reduction of competition may still be approved if the benefits such as economies of scale and scope outweigh the detrimental impact.52 The theoretical argument is that the economy as a whole is better off, because consumers would benefit from the lower prices made possible by scale or scope economies. Even if the resulting loss of competition means that the full amount of the efficiencies is not passed on to consumers and that firms earn somewhat higher profits than would be possible in a competitive market, there is still a net efficiency gain from the merger for the economy as a whole.

The efficiencies defense is difficult to substantiate, because it is difficult to show conclusively that economies of scale and scope actually exist, and if they exist that they cannot be realized in some manner that is more conducive to maintaining competition. For example, a consortium of banks might invest in a joint venture to provide a shared automated teller network as an alternative to mergers leading to only one or two retail bank competitors. The empirical evidence in developed countries on the extent to which efficiency benefits are passed on to the public is mixed.53 In developing and transition economies, a number of considerations make it at least as likely that any efficiency gains from an anticompetitive merger would be more than offset by the exercise of market power and actually result in a dead-weight loss to the economy. These economies typically have less mature capital markets and fewer vigorous nonbank competitors, making longer-run emergence of substitute products and new competitors less likely. There may also be weaker institutional structures or corruption, making it less likely that a vigilant competition authority would intervene in the event of collusion and abuse of dominance. Thus, close scrutiny of the efficiencies defense is warranted, particularly in developing and transition economies.

Other Considerations

While many would argue that prudential and antitrust considerations should be the only factors to consider when determining whether to permit financial sector mergers, a number of other broad public interest factors related to the structure of the financial services industry will also influence the decision-making process. Many of these factors involve trade-offs among various policy objectives and may well result in decisions that are suboptimal from an economic efficiency perspective. But industrial policy considerations will no doubt have some effect on the merger review process.54

National Champions and Domestic Control

A desire for “national champions” and maintaining domestic control of the largest financial institutions are two related public policy objectives that frequently come up in discussions of mergers. One of the motivations for both objectives is an element of pride or nationalism associated with having strong domestically owned companies. There are also economic arguments, although they could not be supported in a world of perfect information, complete freedom of movement and fungibility of capital, and frictionless transactions. Because these theoretical conditions are seldom seen in real economies, though, the arguments in favor of national champions and domestic control cannot be dismissed.

The economic argument for national champions is that a national economy will be diminished in the long run if it becomes merely a “branch plant” without the benefits of the headquarters functions of international firms. Investment in research and development, tax revenues, high-quality employment opportunities, and the potential for development of clusters of excellence around successful firms are all viewed as accruing asymmetrically to countries in which international firms are headquartered.55 For the financial sector, an additional argument in support of national champions is that a country’s financial services firms, building on domestic relationships, will provide more favorable and consistent trade financing to the nation’s exporters and importers than will foreign firms.56 Thus, having a strong international financial sector can contribute to the development of other sectors.

Domestic ownership of some of the largest institutions is a necessary condition for national champions. Even without the explicit objective of fostering national champions, benefits are believed to stem from domestic control. In a country without a strong domestically owned financial sector, availability of financial services may be affected by external events. Empirical evidence suggests that a bank facing capital constraints will choose to curtail its activities outside its home country first.57 Domestically owned banks are arguably less likely to favor foreign business over domestic customers if faced with capital constraints, and they are more susceptible to the exercise of moral suasion by government. Similarly, domestic banks cannot withdraw from a market in the same way that a foreign-owned subsidiary might curtail certain activities or even withdraw completely from a country as a result of a change in the strategic focus of the parent bank.

Creation of institutions that will be significant players within the broader market of the EU has been one of the driving forces behind the long-term trend of consolidation evident in many European countries. The trend has intensified over the last few years, with an increasing number of domestic mergers “which can be seen as an effort to increase market power at the domestic level, thus increasing their size from an EU perspective and creating the necessary conditions for future cross-border expansion.”58 Most notably, concentration has continued to increase, even among countries with already highly concentrated financial sectors.

The Netherlands is frequently cited as an example of a country that has facilitated, if not actively encouraged, the emergence of large firms to compete in international markets. In the financial sector, this was reflected in rapid domestic consolidation through mergers among the largest banks and insurance companies between 1989 and 1991. While the Netherlands has one of the world’s highest levels of concentration in its domestic markets, ING, ABM-Amro, and Rabobank are financial conglomerates that provide the Netherlands with a much greater international presence than would be expected based on the relatively small size of the domestic economy. Acceptance of high domestic concentration, despite the potential for a reduction in competition in products generally not subject to international competition such as consumer and small business banking, was a conscious policy decision because the Netherlands viewed home market consolidation as a means of strengthening the position of Netherlands’ banks internationally.

Table 8.2.Assets of the Five Largest Credit Institutions as a Percentage of the Total Assets of Domestic Credit Institutions
United Kingdom27.027.0

Other countries have implicitly accepted similarly high levels of domestic concentration as a cost of fostering national champions (Table 8.2). Portugal, which already has banking sector five-firm concentration in excess of 75 percent, is now considering two proposed mergers that would reduce the banking sector to two large private sector groups and the state-owned savings bank. Similarly, Finland has permitted mergers and increased domestic concentration as a cost of having banks able to compete against other regional and international banks. Although France’s financial sector is much less highly concentrated than those of some other European countries, competition concerns have been considered in recent bank merger discussions involving three large banks, Banque Nationale de Paris (BNP), Paribas, and Societé Générale, which resulted in the acquisition of Paribas by BNP. The competition concerns were not viewed as serious obstacles, however, because the relevant markets were defined as European, thus eliminating from the analysis concerns about domestic concentration.

Few major countries have explicit restrictions on foreign ownership of major financial institutions, but it is notable that most large institutions in developed countries are either by law or simply in practice widely held and domestically headquartered.59 Approval of the regulator is generally required for acquisition of more than 5 or 10 percent of the shares in a major institution, and while these issues tend to be dealt with in a nontransparent manner, it is generally understood that a foreign shareholder would have more difficulty in meeting the “fit-and-proper” test. For example, the proposed 1982 acquisition of the Royal Bank of Scotland by the Hong Kong and Shanghai Banking Corporation was rejected on “national interest grounds,” while the corporation’s acquisition of a larger U.K. bank, Midland, was approved in 1992. A key difference in the two cases is that in 1990 Hong Kong and Shanghai Banking Corporation had established a U.K.-based holding company. Thus, the actual acquirer of Midland was the U.K.-based holding company, parent of Hong Kong and Shanghai Banking Corporation. Not only did this provide the U.K. regulator with the ability to supervise the banking group effectively, acquisition of a large clearing bank by a U.K.-based holding company was seen as more consistent with the national interest than acquisition by a large foreign bank. A further consideration was that Midland was viewed as being in a financially weak condition, and thus acquisition by a stronger bank was viewed favorably.

A desire for national champions and maintenance of domestic ownership of major financial institutions is frequently a factor in efforts to privatize former state-owned banks throughout the developing world, and it can also be a concern of national authorities when dealing with restructuring in the wake of a systemic crisis. Fiscal considerations, with the government understandably wanting to maximize privatization proceeds, may also come into conflict with competition concerns. The issue could arise because obtaining the best price for the monopoly state savings banks may well come from divesting to a single private owner, resulting in the effective replacement of the state savings banking monopoly with a private savings bank monopoly.60 If alternatives such as divesting different parts of the business to different investors are not readily available, then ease of entry for qualified foreign banks or provisions for the establishment of sound new domestic banks can be important aspects of mitigating the dominance of the privatized bank.

The cases of New Zealand and Poland are interesting counterpoints to the national champions argument. In the case of New Zealand, permitting foreign takeover of the largest banks was viewed as a preferable alternative to the option of taxpayer-financed restructuring, with the result that the New Zealand banking industry is dominated by large foreign-owned banks. Poland has a banking sector that is two-thirds (as measured by capital) controlled by foreign-owned banks. Despite a certain amount of political unpopularity, the need to increase capital and gain management expertise so that the banking system can properly contribute to economic growth has taken precedence over nationalism concerns in the privatization of a number of Polish banks.

Essential Services and Employment

The desire to maintain banking services and employment in remote regions will frequently be an issue in the privatization of state-owned institutions as well as in mergers and acquisitions. Pressure to approve a financially questionable transaction if the acquirer is prepared to commit to maintain services and employment can create prudential concerns. Even if a more financially viable and thus prudentially more attractive option exists, there can be strong political pressure to reject such a transaction because of the unpalatable rationalization of branches and employment. If the commitment made by an acquirer to the maintenance of services and employment will foreseeably create losses of a magnitude that would threaten solvency, the prudential supervisor clearly would prohibit such a transaction. In practice, however, the question of whether such commitments render the institution not practicable will not be clear-cut. Even when locations and operations are generating institution-threatening losses, an acquirer will generally have plans for restructuring and rationalization that are intended to improve financial performance while adhering to service and employment commitments. Without conclusive evidence and analysis, the prudential supervisor would not supplant the projections of the management of the financial institution, but would certainly require strong assurances as to the feasibility of turning around loss-making operations. Should solvency subsequently be threatened by ongoing losses, decisive supervisory action would be required, including forcing the closure of unprofitable locations and business lines. If public policy concerns make such closures unacceptable, it is preferable that government explicitly acknowledge the policy objective and appropriately provide for the necessary expenditure to maintain financial services in remote areas.

Antitrust Issues in a Systemic Crisis

Dealing with antitrust issues in two different kinds of systemic crises brings different responses. In one case, a quick decision must be made to deal with the imminent failure of one or a small number of systemically important banks within an otherwise healthy financial sector. In the other case, an entire financial sector must be restructured with significant involvement of public funds following macroeconomic shocks.

In the first instance, competition issues will be a concern because systemically important banks, by definition, will have large shares of various financial services markets. But when faced with the imminent failure of a systemically large bank, merger with another large bank may be the preferable public policy option, even considering the potential decrease in competition. Most competition laws contain a “failing-firm” provision, which would permit an otherwise objectionable transaction as a means of dealing with a firm on the verge of failure. Generally the firm is required to demonstrate that there is no other alternative that results in less reduction in competition. This would require the shopping of the assets to a wide market. Because financial difficulties can develop and reach crisis proportions suddenly, and the act of seeking buyers for the business of a large bank might itself trigger a crisis, it may not be possible to meet the failing-firm provision of a competition law.

This possibility is explicitly contemplated in the competition law of a number of countries including Canada, Italy, and Switzerland. To preserve the stability of the financial system, the competition law contains a provision allowing for dispensing with the usual requirement for approval of a merger or acquisition by the competition authority. In each case, the circumstances where such a provision may be used are limited to dealing with a crisis, and the provision has not yet been used in any of the three countries. This type of provision is not common in competition law, and one of the arguments against such an approach is that it inclines the decision-making process in favor of an arranged merger among large institutions. With the ability to conclude a large merger, despite existing antitrust concerns, prudential regulators and policymakers may not actively pursue solutions that would be less likely to result in a significant reduction in competition such as the sale of various parts of the business of a failing large institution. A further argument against such a provision is that despite the clear intent that it only be used to deal with a crisis, its availability could be misused, leading to political interference. The alternative to such a provision in the competition law is the use of emergency legislation to amend the statute or provide a specific exemption in a time of crisis. While this avoids the pitfalls of having explicit exemptions in the competition law, the need for special legislative measures will certainly complicate dealing with a crisis in a timely manner.

In the second case of broad financial sector restructuring as a result of a systemic crisis, it is desirable to address antitrust issues and the maintenance of competition at the same time as long-term solutions are sought. While it may be necessary, as in the case of Indonesia, for a bank-restructuring agency to assume temporary control of a percentage of the banking sector that would normally give rise to concerns about a decrease in competition, this is clearly an extraordinary situation that should not raise antitrust concerns. But the desirability of ensuring a healthy level of competition can be taken into account in implementing resolution plans for the banks under the control of the restructuring agency. While the prudential objective of ensuring that the market is ultimately made up of sound institutions will take precedence, the emergence of one or two large banks with a majority of the market is less preferable than a sector characterized by a larger number of vital competitors. Entry of well-regarded foreign institutions through new incorporations or small acquisitions is particularly desirable as a means of providing a larger number of vigorous competitors in the marketplace. Thus, it is important that the banking and other laws, and the exercise of discretion and judgment by the authorities, does not create greater barriers to entry for foreign firms than for domestic firms. Development of one or more shared ATM networks may be valuable in encouraging competition in retail banking markets, and liquid capital markets reduce the dependency of businesses on bank financing, limiting the possibility of exertion of market power.

Fostering competition may be an especially difficult challenge in markets historically dominated by a single state-owned bank. The state savings bank typically has the bulk of retail business in the former Soviet countries, and relatively large state-owned banks are common in many other developing and transition economies. Creation of additional retail networks is not likely to be an attractive business, at least in the short run, and the track record of regional institutions that collectively might provide competition for the national network is, at best, uneven. It can be a difficult matter to strike the middle ground between encouraging competition and new entrants and guarding against the possible detrimental effects on the safety and soundness of the system. The objective from a prudential perspective is the maximum amount of competition that is consistent with a sound and stable financial system.


Both the prudential and the antitrust dimensions of financial sector mergers and acquisitions need to be explicitly addressed in a merger review process. In many countries today it is not clear how the events in a merger review process should be sequenced, or how the interaction should take place among the prudential and antitrust authorities and other parties such as government officials. In many cases, a clear understanding has developed over time among market participants, but the greatest clarity is provided by an explicit policy statement that outlines the process and, most important, establishes the ability of the prudential supervisor to prohibit a transaction if soundness and stability are concerns.

In reviewing a merger, the prudential authority will use a methodology similar to that used in reviewing the application for a new license, because a merger or a large acquisition in effect creates a new institution. In addition, the prudential authority will focus on specific transactional issues, primarily by checking that all material transactional risks have been identified and addressed and by performing a sensitivity analysis using less favorable assumptions than those used by the merger proponents.

The antitrust review, which to speed the process can be undertaken concurrently with the prudential review, will apply the merger enforcement rules that would be applicable to other transactions in the economy. Evidence from other jurisdictions can be used to assist in market definition and analysis, enabling more resources to be devoted to those products and markets that are likely to be of greatest competitive concern—for instance, consumer and small business banking.

When dealing with weak financial institutions, the prudential regulator may actively encourage mergers as part of a resolution strategy. It may be desirable to complete such transactions, even at the risk of reducing competition, to maintain stability in the financial system. However, the decision to proceed in spite of antitrust concerns must be taken cautiously in light of the longer-term detrimental impact of reduced competition in the financial sector.

Public policy concerns beyond financial sector stability and antitrust issues will undoubtedly influence the merger review process, and they may even be specifically accommodated in countries where the prudential or antitrust regulator is charged with considering other issues, or where a final governmental approval is required. While arguments of economic efficiency would dictate that these other issues not be considered, they have a practical importance in any country. An appropriate review process ensures that these other issues cannot force completion of a transaction where there is either prudential or antitrust concern, regardless of the other perceived benefits.

When dealing with a systemic crisis, it may be desirable and necessary, for the sake of making immediate decisions, to dispense with the detailed antitrust scrutiny that a large financial sector transaction would ordinarily entail. But because of the importance of competition in fostering a long-term, healthy, and efficient financial sector, even when dealing with a crisis it is desirable to consider alternatives to the creation of one or a few large institutions that dominate the market.


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The author is grateful for helpful comments and suggestions from Claudia Dziobek, Charles Enoch, Huw Evans, Gillian Garcia, Sami Geadah, Garry Goddard, Michael Grant, Peter Hayward, Cem Karacadag, Marina Moretti, Brent Sutton, Jan Willem van der Vossen, Hugh Williams, Delisle Worrell, and the participants in two seminars who discussed earlier drafts of the paper.


This chapter focuses on banks, but the principles are equally applicable to other regulated financial institutions that play key roles in the economy. Accordingly, the terms bank and regulated financial institution are used interchangeably throughout this chapter. Many of the points would also apply to other regulated industries.


This is increasingly less common, however. Since 1990, more than 35 developing and transition economies have enacted or substantially revised competition laws. See Khemani (1997, pp. 23-27).


A recent example of the difficulties that can arise from such a lack of clarity is the attempted hostile takeover of Standard Bank Investment Corporation by South Africa’s Nedcor. In November 1999, Nedcor applied to the prudential authority, the South African Reserve Bank, for approval to acquire control of Standard Bank. The initial view was that only the approval of the prudential regulator was required, but as part of its defense against a hostile takeover. Standard Bank successfully challenged this position in court. This challenge led to the negotiation of a memorandum of understanding between the prudential authority and the Competition Commission on how to consider competition issues as well as concerns over financial stability in the review of bank mergers. On June 21, 2000, the Finance Minister rejected the transaction, citing concerns over systemic risks if the merged entity failed, increased concentration and diminished competition, and job losses.


While the literature contains no conclusive view, empirical evidence supports the widely held position that there is a strong positive link between the functioning of the financial system and long-run economic growth. See Levine (1997, pp. 688-726).


Among the very few publications on the subject are Enhancing the Role of Competition in the Regulation of Banks (OECD, 1998a) and Competition and Related Regulation Issues in the Insurance Industry (OECD, 1998b). While they identify the lack of clarity in many countries over how competition law should he applied to financial sector mergers and acquisitions, neither offers any guidance on principles that might be used to address the issue.


See OECD (1998a, p. 11).


This chapter does not address other key elements of competition law such as collusion, abuse of dominance, and consumer protection. Unlike mergers and acquisitions, there is no prudential dimension to the application of these aspects of competition law to the financial sector. In many countries, though, activities seen to have general benefits, such as the maintenance of a single industry-owned agency for health data to facilitate life underwriting or clearinghouses owned by a consortium of competitors, have been exempted from prohibitions on collusion that normally would preclude such activities.


The differences between a start-up and a merged entity are clear, though. Also, rejection of a merger proposal does not deny the economy of a new competitor, but in fact prevents a reduction in the number of competitors.


Swiss Competition Commission, Competition in Practice, Case RPW 1998/2.


See OECD (1998a, p. 11).


See, for example, the emphasis on open processes and public availability of information in the “Code of Good Practices on Transparency in Monetary and Financial Policies,” available at


European Union, 1999, Competition Policy Newsletter (October), pp. 48-49.


Core Principle 5 of The Basel Core Principles for Effective Banking Supervision requires that supervisors have the ability to judge acquisitions or investments by banks. Core Principle 4 requires that supervisors be able to review and reject proposals to transfer significant ownership or controlling interests in banks.


Smith and Walter (1996, pp. 14-15). Another possible reason for mergers is that the interests of the management of a financial institution may not be compatible with those of the shareholders. Management may derive higher compensation from managing larger institutions and may seek personal gain. Management thus may manage as a large institution. Hence mergers and acquisitions are desirable despite empirical evidence that, beyond a relatively small critical mass, there are no economies of scale and scope in financial services. For a summary of the literature on economies of scale and scope in financial institutions, see Berger, Hunter, and Timme (1993, pp. 221-49).


A succinct summary of the banking merger efficiency studies is found in Berger, Demsetz, and Strahan (1999, pp. 135-94).


Since June 30, 2001 the U.S. approach has required use of the purchase method to account for business combinations rather than the pooling method that previously had been generally applicable. The purchase method results in the creation of goodwill in the amount that the purchase price exceeds the fair value of assets at the date of the acquisition transaction. Due to a concurrent change in the accounting treatment of intangibles, goodwill is no longer amortized but instead is subject to an ongoing impairment test. Goodwill created in an acquisition will only be written down if it becomes evident that there is impairment in its value. In 2001 Canada, which already required use of the purchase method to account for most acquisitions, replaced the requirement to amortize goodwill with an impairment test approach similar to that adopted in the United States. In the United Kingdom and much of the rest of Europe, the write-off of goodwill created in an acquisition is taken immediately as an extraordinary item.


For privately held or state-controlled firms, market value can be difficult to determine because this information is not available on an ongoing basis.


A contributor to a premium may also be the writing up of the book value of assets to reflect their current market value. As noted above, however, the excess of the market value of individual real assets over their hook value is likely to be small, relative to the total assets and liabilities of a financial services firm.


For further detail on the literature evaluating the efficiency gains from bank mergers, see Boyd and Graham (1996); and Rhoades (1994). The literature is largely based on U.S. data, but the findings seem likely to be more widely applicable.


The FDIC provided financial assistance to allow healthy banks to purchase more than 1,000 insolvent U.S. banks between 1984 and 1999. See Berger, Demsetz, and Strahan (1999, p. 148).


Claudia Dziobek and Ceyla Pazarbasioglu, “Lesson and Elements of Best Practice,” in Alexander and others (1997).


See Joint Forum on Financial Conglomerates (1999), available at


Analysts’ reports on banks in developing and transition economies illustrate this market perception. See, for example, Thomson Bank Watch’s August 1, 2000, rating of Bank Turan-Alem (Kazakhstan), which explicitly notes that the bank, a product of a merger of two smaller banks, is large enough “that it is highly likely that the government would support the bank in extremis.”


If there were certainty that some institutions would not be allowed to fail, market incentives to manage those institutions in a prudent manner would be removed. In the event of a crisis, though, regulators would want to preserve the option of taking extraordinary steps to deal with large institutions to preserve systemic integrity. The result is that regulators are generally reluctant to officially discuss or document criteria that might determine whether an institution was “too big to fail” or the measures that might be adopted as an alternative to the failure of such an institution. This so-called doctrine of constructive ambiguity, whereby regulators avoid acknowledging that some institutions are too big to fail by virtue of their systemic importance, serves to reduce moral hazard. It is widely acknowledged, though, that the notion of “too big to fail” is an implicit part of many regulatory regimes. See Hanweck and Shull (1999, pp. 251-284).


For fuller discussion of market definition issues, see Kwast, Starr-McCluer, and Wolken (1997); and Andrews (1993).


Markets are geographically defined as either Federal Reserve markets, Ranally Metropolitan Areas, or, for nonmetropolitan areas, counties. See the joint Department of Justice and banking agencies “Bank Merger Screens” (U.S. Office of the Comptroller of the Currency, 1995). To date, the agencies have not accepted arguments that geographic boundaries on the market are becoming irrelevant, or at least are much larger because of both the increasing prevalence of regional banking networks and the increased use of electronic distribution such as ATMs, telephone, and PC banking. The arguments to consider larger geographic markets are well presented in Radecki (1998); and Smith and Ryan (1997).


The U.S. Federal Reserve uses deposits as a proxy for the cluster of banking services that ate viewed as the relevant product market. The European Competition Commission divides the services provided by a bank into three products: retail banking, corporate banking, and financial market services. Merger analysis in Canada and Australia has used narrower product definitions.


For example, in the merger of NationsBank and BankAmerica in 1998 to create the largest bank in the country, the merger screens identified only 11 local markets with antitrust concerns. This permitted the focus of analytical efforts on these markets, much reducing the time that otherwise would have been required to consider the application. Further, because the U.S. process has been so well established over time, the merger proponents were able to propose remedies at the time of their application with the reasonable expectation that these would be acceptable to the banking agencies. See Federal Reserve Board (1998).


See any of the Commission decisions related to the financial sector, for example, Case No IV/M.1172, Fortis AG/Generale Bank.


The HHI is the sum of the squared market share of all of the firms selling in a particular market, and will equal 10,000 (1002) when one firm has 100 percent market share.


A loan is probably the only product where a seller would not provide as much of the product as desired by a buyer willing to pay a given price. Normally in banking this behavior is evidence of appropriate assessment of default risk by the lender, but it could also be used by banks acting in collusion to ration supply and thus artificially increase the price of credit.


Tangible support for this argument is found in the United States, where the Bank Merger Screens have higher HHI safe harbors than the more broadly applicable Horizontal Merger Guidelines.


For a good discussion of barriers to entry in financial services, see Rhoades (1997).


For a review of the literature, see Amel (1989, pp. 29-68),


Efficiencies considerations are explicitly addressed in merger review in Australia, Canada, New Zealand, the United Kingdom, and the United States. In other jurisdictions, efficiencies considerations enter merger evaluation less directly. See McFetridge (1998, pp. 91-103).


Avkiran (1999, pp. 991-1013).


Industrial policy is shorthand for any economic or social concern, other than competition policy and efficiency, that influences antitrust law enforcement. For a discussion of some of the industrial policy considerations that have influenced recent major merger decisions, see Snyder (1997).


See Peek and Rosengren (1997), who find that Japanese banks facing capital constraints in the late 1980s significantly reduced their loan portfolios in the United States while their domestic portfolios were protected from shrinkage. The observed effect was attributed to a decision to maintain close lending relationships in Japan.


Background Paper No. 2, Organizational Flexibility for Financial Institutions: A Frame-work to Enhance Competition (Ottawa: Task Force on the Future of the Canadian Financial Services Sector, 1998), pp. 19-20.


Baker (1999, p. 517). This conundrum applies in the privatization of any state-owned monopoly.

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