Economics Review

Bright Side and Dark Side of Mergers and Consolidations


Reorganization is one of the key factors in thinking about the structural reform of the Japanese economy. In recent years, moves and attempts toward merger and consolidation seem to be accelerating not only among companies but also among government agencies, universities and municipalities. There is even the shared belief that organizations indifferent to mergers and tie-ups will be left behind. On the other hand, we all witnessed a major debacle in the banking sector following the series of mega-mergers of the past several years. The computer system breakdown at Mizuho Financial Group, the largest banking groups created in a three-way consolidation, disrupted millions of online bank transactions. In Economic Review No.4 (Japanese only), I presented a critical view of integrations among government agencies in the central government reorganization. I believe similar moves within the private sector are also fraught with major potential problems. The Mizuho debacle should not be taken as an isolated example. In this volume, I would like to re-examine the motives and effect of mergers and consolidations among corporate organizations from the perspective of economics, while introducing past analytical works and research results, taking bank mergers as examples. In conclusion, I will evaluate mergers and consolidations taking place in various fields from the viewpoint of structural reform.

Basic analytical point of corporate mergers and consolidations

Mergers and consolidations among companies are basically classified into two types: vertical integration - as seen in a merger between an upstream company producing intermediary goods and a downstream company producing finished products, or between a seller and a buyer - and horizontal integration, in which two or more companies having no input-output relations merge horizontally. Ronald H. Coase (1937) and Oliver E. Williamson (1975) are credited for pioneering the perception that regards firms' decisions to integrate as a matter of choice between doing certain transactions on their own or using the market, and as a question of the boundaries of the firm, while theorization of such perception was done by Sanford J. Grossman and Oliver D. Hart (1986). According to their arguments, the nature of companies is to reduce transaction costs by internalizing transactions. Therefore, should a hold-up problem - a situation in which a seller would be exploited by a buyer even if the seller made a special investment for its transactions with the buyer - it would be more advantageous for the two firms to merge. The arguments concerning firm boundaries, as advocated by Coase, Williamson and Hart, however, primarily explain cases of vertical integration. A distinguished survey by Bengt Holmstrom and John Roberts (1998) also points out: "It seems to us that the theory of the firm, and especially work on what determines the boundaries of the firm, has become too narrowly focused on the hold-up problem and the role of asset specificity."

Horizontal integration
Most mergers and consolidations in recent years, whether they have taken place within or across business borders, are of a horizontal type, rather than vertical integration as in the case of a buyer acquiring a seller. But not much analysis has been done on such horizontal integration. Up until recently, the traditional theory of industrial organization has remained the mainstream approach in analyzing corporate integration. Even the latest textbooks on corporate and management theory, such as those by David A. Besanko, David Dranove and Mark Shanley (2000), explain that the benefits of horizontal integration are in economies of scale when a merger takes place between firms producing the same kinds of products, and in synergies such as economies of scope in case of a merger between firms whose products have little or nothing in common with each other.

Adverse influence on competition of horizontal integration has often been a point of contention. It is particularly so when horizontal integration takes place between two companies, each of which already has a fairly big market share, thus furthering oligopoly in the market. In judging integration, it is insufficient to conduct ex-post assessment based solely on the extent of oligopoly. Horizontal integration may be detrimental to consumers as suggested by a strong conclusion drawn by Joseph Farrell and Carl Shapiro (1990) that the Cournot oligopoly model of horizontal integration without synergies will lead to higher market prices. Whether integration is with or without synergies as well as the scale of synergies provide significant implications not only for the mangers of concerned companies but from the standpoint of competition policy.

Corporate diversification
Corporate diversification, which integrates businesses of different fields, has been a hot topic in economics with a progress made in establishing theory and substantial empirical findings brought (See Jeremy C. Stein (2001) for the latest survey. Tsuru (2000) also conducted a concise survey.) . This field of study sees the impact of corporate diversification as a question of resource distribution within a company (internal capital markets). The core management of a diversified company, having superior information on the profitability of its business segments, is capable of financing them more efficiently than their equivalent independent firms collecting funds from external sources. Indeed, several empirical analyses on American firms in the 1960s to 1970s found that corporate share prices went up significantly following an announcement of a plan to merge for business diversification.

Analyses based on the data about American firms in the 1980s and 1990s, however, found that share prices of a diversified company tend to be lower than the portfolio value of independent companies matching each of its business segments. "Diversification discounts" are observed extensively although some problems unique to empirical analyses (simultaneous bias, etc.) remain. This turn of events corresponds to the history: the United States was in the midst of conglomerate diversification boom in the 1960s and 1970s, which was followed by a major realignment in the 1980s and 1990s in which corporate focus was achieved through takeovers and divestitures. Glenn Hubbard and Darius Palia (1999) explain the changes in the assessment of corporate diversification in relation to the development of capital markets. Their idea is that internal capital markets played a significant role (as a means to solve information asymmetrically) while external capital markets were underdeveloped; thus, the role and significance of internal capital markets declined with the development of capital markets. Diversification discounts have been computed not only for the U.S. but also for other industrialized countries including Japan, Germany, Great Britain, as well as for some Asian countries. The results of such computation show that a diversification discount tends to be greater in a country with developed capital markets (Karl Lins and Henri Servaes (1999, 2000)).

Given the scale of such diversification discounts, however, we need to have theories that can directly explain the demerits of diversification. Inefficient cross-subsidies are one such theory. According to this theory, diversification discounts stem from the "socialism" in internal budgeting that continues to allocate funds to divisions with few investment opportunities while failing to channel funds to those with ample investment opportunities. Business divisions with fewer investment opportunities have both more time and greater incentives to get engaged in rent-seeking activities (such as seeking greater budget and trying to expand private profits for the division), which are totally wasteful for the company. And socialism spreads as companies find it necessary to reduce incentives for rent-seeking activities (Raghuram G. Rajan, Henri Servaes and Luigi Zingales (2000)) or offer direct compensation to inefficient divisions to dissuade them from rent-seeking activities. Indeed, Rajan and others confirmed the presence of inefficient internal subsidies in their survey over diversified American companies, in which they found that companies with greater investment opportunity gaps among divisions have greater tendency to be inefficient in budget allocation.

Assessment of bank mergers and consolidations: Analyses in the U.S. and Europe

In Japan, realignment in the banking sector has been proceeding rapidly with major banks having consolidated into four mega-banking groups. Such financial realignment, however, is not unique to Japan. Rather, it is a global symptom that has been taking place extensively both in the U.S. and Europe although underlying factors may differ. The U.S. removal of restrictions over banks' interstate operations and the financial integration in Europe (a green light for cross-border universal banking) undoubtedly triggered realignment in their respective banking sectors. Studies that explore deeper into the motives and effects of a series of bank mergers and consolidations have been attracting much attention. Empirical analyses hitherto made are mostly on those in the U.S. and Europe. Still, it is worthwhile to summarize the results of such empirical analyses in line with the above-mentioned basic viewpoint on corporate mergers and consolidations (For surveys, see Allen N. Berger (2000), Berger, Rebecca S. Demsetz and Philip E. Strahan (1999), and the Group of Ten (2001).).

As to the impact of bank mergers and consolidations on efficiency, economies of scale work while a merged bank is relatively small in scale. However, it has been concluded that cost reduction through economies of scope and positive announcement effects on share prices are hardly observed. Clear positive effects, if any, are limited to modest improvements in revenue as a result of risk reduction through (product and geographical) diversification. Meanwhile, it has been observed that the rise of oligopoly through bank mergers and consolidations leads to lower deposit interest rates and higher lending rates. Thus, we cannot help but become skeptical about the plus effect of bank mergers and consolidations both for banks themselves and in terms of their implications for competition. It is certainly difficult to attribute banks' motives for mergers and consolidations to a cost-saving effect of scale economies or economies of scope. Rather, it is important to look into their true motives under the light of their strategies. Some studies with such intent have been conducted.

Mergers and consolidations as a means to secure strategic options
A first view is to regard securing strategic options as a motive for expanding business scope (See Arnoud W. A. Boot (1999), Boot, Todd T. Milbourn and Anjan V. Thakor (2001).). Suppose a bank wants to advance into a certain new business field in the future, and assume that it is unknown whether the bank has the organizational capabilities to secure a superior position in this new field of business and that uncertainty remains over future demand for the business. Under such circumstances, the bank has two basic options: It can wait until the uncertainty clears up to decide whether or not to advance into the new field, or it can make an "early entry" into the field (with irreversible investment), accumulate experience and experiment in the field, check its capability of competing in the field, then finally make a drastic decision as to whether or not to expand its operation(For another similar model, refer to J. Matsuzaka (2001) which defines corporate diversification as a process to search for a business segment that best matches the ability and nature of a firm.).

Regarding the above-mentioned case, Boot and others demonstrated that uncertainty concerning the bank's matching ability is large (potential benefits of learning are high) as long as competitions in the new business field is not so fierce, and that an early entry provides greater advantage when competition in conventional businesses are lower (the bank has greater capacity for making an early entry). Banks competing under such a situation would be able to increase their market power through merger and consolidation, thus getting a "deep pocket" for investment on an early entry. This generates incentives for banks to merge or consolidate in their conventional operations first, then advance into a new field. This model seems to capture a good picture of how banks try to utilize mergers and consolidations to set a stage for new businesses and large-scale information technology investment in the face of growing uncertainty and the fast changing environment brought by deregulation, globalization and financial innovation.

"Too-big-to-fail" as a motive for mergers and consolidations
Not all the motives are for profit-maximization as there are selfish motives that should not be ignored. It is unlikely that all bank managers carry out a merger, or a consolidation, in an attempt to build an empire to pursue their own benefits. Most mergers and consolidations that have taken place lately are not of a "big-eat-small" type, but mega-consolidations between or among major banks. The implied intention of this kind of integration may be to become "too big to fail" (TBTF). Such concern was raised when Citicorp and Travelers Group merged into Citigroup in 1998 (Business Week, April 27, 1998). To find TBTF-oriented motives, Maria F. Penas and Haluk Unal (2001) focused on bank bonds, which are not covered by deposit insurance. They found that spreads on bonds issued by banks, or banks' default risks, were substantially lowered following their mergers and consolidations in 38 cases of a total of 65 bank mergers and consolidations analyzed. They insist that TBTF is an important motive for bank mergers and consolidations. Also, in the euro zone, the increasing presence of TBTF banks is making it difficult to address the issue of problem banks (Agnes Belaisch et. al. (2001)). Thus, bank mergers and consolidations are not only about the efficiency of merged banks but have important implications for competition policy and banks' prudence policies.

Assessment of bank mergers and consolidations in Japan

We have to wait for some more years to determine the efficiency and cost-saving effects of Japan's four mega-banking groups. But we do not have to take the U.S. and European cases for example to say that we cannot expect much cost reduction effects deriving from economies of scale and scope. The chances may be greater that their efficiency will be lowered. Referring to corporate merger cases in the U.S., Paul Milgrom and John Roberts (1992) cited a clash of corporate culture and internal political conflicts that lead to rent-seeking activities as demerits of horizontal expansion, in particular, as a result of mergers and consolidations. Such problems, they said, tend to arise in consolidations between or among companies of a similar size (Page 574). In the cases of Japan's four banking groups, major banks - each belonging to different corporate groups of different culture - got together on an equal-footing basis and the scale of clash they are experiencing is beyond our imagination. It is exactly to avoid such a clash by maintaining the dual structure that Japanese merged banks have repeated practice called "tasukigake," alternating the top posts of a merged bank between executives from the two constituent banks.

When Dai-Ichi Kangyo Bank, Fuji Bank and the Industrial Bank of Japan announced a consolidation plan to create Mizuho Financial Group, the then top managers of the banks flatly denied the possibility of the new bank falling into the same rut, saying that the tasukigake (which literally means crossing a sash) is impossible among three. Their remarks were impressive at that time. Mizuho's recent computer glitch was mainly caused by conflicts among the major computer makers responsible for the respective banks' systems as well as the closed and ad-hoc natures of tailored system structures. But it is also clear that the debacle was not a case of insufficient preparation but a natural outcome after the three banks, even in the area of computer systems, tried to push forward their tasukigake mentality, the very idea they had turned down as impossible, to save each other's face. Given the significance of the management's controlling authorities, equal-footing consolidations generate nothing but socialistic inefficiency. Indeed, among the four mega-banking groups, those in which one merging bank has virtually captured ex-post leadership seem to be outperforming the others.

What is more serious in Japan is that mega mergers and consolidations have taken place before their bad loan problems are solved and before they set clear vision for their integration as a means to secure strategic options, as seen in Mizuho's abandonment of a plan to set up an investment bank. These mega mergers and consolidations of banks may result in inefficient internal subsidies as seen in corporate diversification, and further delay bad loan disposal. Obviously, an attempt to prevent further failure of major banks was at work in the integration process of the four respective banking groups. This, however, may result in a greater payment in the future.

Mergers and consolidations' implication for structural reform

Let's take a look at Japan's boom of mergers and consolidations in a greater scope. Not only banks and companies but also universities and municipalities are considering consolidation, basically on an equal-footing basis. They do emphasize intention to get rid of redundant physical and human assets. They seem to believe that consolidation will enable them to carry out otherwise difficult restructuring because redundancy would become apparent once the two get together. As evident in the banks' cases, an equal-footing consolidation tends to result in ill-structured, blurred leadership, which causes major conflicts over whose assets should be disposed. Thus, contrary to their intention, the more likely result is that redundancy will remain and only negative aspects - inefficient information exchange and coordination as a result of an enlarged organizational structure, a clash of organizational culture, etc. - will be highlighted.

Worse, integration in which each participating party has a different dream and counts on the other to fulfill its dream tends to have a domino effect to prompt similar moves among others. Suppose there are a multiple number of organizations in rivalry. None of them have incentives for integration at first. Once the first two organizations decide to integrate, however, the remaining organizations will become less competitive (or so they believe) and their incentives for integration will grow, eventually causing them to jump on the bandwagon (This feature is common to some of regional integration processes, as Richard E. Baldwin (1995) pointed out in "The Domino Theory of Regionalism".). We are experiencing a bubble of mergers and consolidations. But this particular bubble, once formed, will be far more difficult to burst than stock and land price bubbles. The TBTF problem is no longer limited to the banking sector.

When an organization makes life-or-death decisions, it has two basic options. It can either resort to facile solution of integrating with other organization(s), or it can rethink its own raison d'etre, clarify competence and try to demonstrate its unique ability. It would not be an exaggeration to say that the future - not only of each organization but also of Japan's structural reform - hinges on such crucial decisions by organizations.

May 11, 2002

Original text in Japanese

May 11, 2002