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The Effects of Megamergers on Efficiency and Prices: Evidence from a Bank Profit Function

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  • Jalal D. Akhavein
  • Allen N. Berger
  • David B. Humphrey

Abstract

The recent waves of large mergers and acquisitions in both manufacturing and service industries in the United States raise important questions concerning the public policy tradeoffs between possible gains in operating efficiency versus possible social efficiency losses from a greater exercise of market power. The answers largely depend upon the source of increased operating profits (if nay) from consolidation. Mergers and acquisitions could raise profits in any of three major ways. First, they could improve cost efficiency, reducing costs per unit of output for a given set of output quantities and input prices. Consultants and mangers have often justified large mergers on the basis of expected cost efficiency gains. Second, mergers may increase profits through improvements in profit efficiency that involve superior combinations of inputs and outputs. Profit efficiency is a more inclusive concept than cost efficiency, because it takes into account the cost and revenue effects of the choice of the output vector, which is taken as given in the measurement of cost efficiency. Thus, a merger could improve profit efficiency without improving cost efficiency if the reconfiguration of outputs associated with the merger increases revenues more than it increases costs, or if it reduces costs more than it reduces revenues. The authors argue that analysis of profit efficiency is moe appropriate for the evaluation of mergers than cost efficiency because outputs typically do change substantially subsequent to a merger. Third, mergers may improve profits through the exercise of additional market power in setting prices. An increase in market concentration or market share may allow the consolidated firm to charge higher rates for the good or services it products, raising profits by extracting more surplus from consumers, with any improvement in efficiency. The authors believe that the academic literature has made little progress in determining the sources of profitability gains, if any, associated with bank mergers. Of the three main sources of potential profitability gains, the literature has focused primarily on cost efficiency improvements. The empirical evidence suggests that mergers have had very little effect on cost efficiency on average. Moreover, there has also been little progress in divining any ex ante conditions that accurately predict the changes in cost efficiency that do occur for possible use in antitrust policy. Similarly, there are very few academic studies of which the authors are aware of the changes in prices associated with bank mergers. This is surprising, given that a major thrust of current antitrust enforcement is to prevent mergers which are expected to result in prices less favorable to consumers or to require divestitures that accomplish this goal. The authors findings suggest that the banking megamergers of the 1980s did significantly improve profit efficiency on average. The average profit efficiency rank of merging banks increased from the 74th percentile to the 90th percentile of the peer group of large banks with complete data available over the same time intervals, a statistically significant 16 percentage point increase. Use of profit efficiency levels, rather than ranks, indicated similar improvements. This main result also was robust to the alternative 'nonstandard' specification of the profit function which likely removes any scale or merger biases from the analysis. The authors suggest that the reason for the different findings is quite simple. Measured cost efficiency changes do not take into account the effects of the changes in output that occur after the merger, whereas measured profit efficiency changes include all the cost efficiency changes plays the cost and revenue effects of changes in output that typically occur after a merger. The authors suggest that their results may not necessarily generalize to mergers other than the banking megamergers of the 1980s that make up the data set. It is possible that greater cost efficiency gains maybe present in other industries or in bank mergers of the 1990s because of an increased focus on cost savings in the current decade. Similarly, there may be more market power effects on prices in mergers of smaller banks, which tend to occur in more concentrated local markets.

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Bibliographic Info

Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-03.

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Date of creation: Jan 1996
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Handle: RePEc:wop:pennin:96-03

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References

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  1. Demsetz, Harold, 1973. "Industry Structure, Market Rivalry, and Public Policy," Journal of Law and Economics, University of Chicago Press, vol. 16(1), pages 1-9, April.
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  3. Pilloff, Steven J, 1996. "Performance Changes and Shareholder Wealth Creation Associated with Mergers of Publicly Traded Banking Institutions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(3), pages 294-310, August.
  4. Berger, Allen N, 1995. "The Relationship between Capital and Earnings in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 432-56, May.
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  7. Allen N. Berger & Timothy H. Hannan, 1998. "The Efficiency Cost Of Market Power In The Banking Industry: A Test Of The "Quiet Life" And Related Hypotheses," The Review of Economics and Statistics, MIT Press, vol. 80(3), pages 454-465, August.
  8. Ferrier, Gary D. & Lovell, C. A. Knox, 1990. "Measuring cost efficiency in banking : Econometric and linear programming evidence," Journal of Econometrics, Elsevier, vol. 46(1-2), pages 229-245.
  9. Jalal Akhavein & PVBA Swamy & Stephen Taubman, 1994. "A General Method of Deriving the Efficiencies of Banks from a Profit Function," Center for Financial Institutions Working Papers 94-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
  10. Allen N. Berger & Timothy H. Hannan, 1993. "Using efficiency measures to distinguish among alternative explanations of the structure-performance relationship in banking," Finance and Economics Discussion Series 93-18, Board of Governors of the Federal Reserve System (U.S.).
  11. Joseph P. Hughes & William W. Lang & Loretta J. Mester & Choon-Geol Moon, 1996. "Efficient banking under interstate branching," Working Papers 96-9, Federal Reserve Bank of Philadelphia.
  12. Prager, Robin A & Hannan, Timothy H, 1998. "Do Substantial Horizontal Mergers Generate Significant Price Effects? Evidence from the Banking Industry," Journal of Industrial Economics, Wiley Blackwell, vol. 46(4), pages 433-52, December.
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  17. Alden L. Toevs, 1992. "Under what circumstances do bank mergers improve efficiency?," Proceedings 378, Federal Reserve Bank of Chicago.
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  20. Allen N. Berger & J. David Cummins & Mary A. Weiss, 1995. "The Coexistence of Multiple Distributions Systems for Financial Services: The Case of Property-Liability Insurance," Center for Financial Institutions Working Papers 95-13, Wharton School Center for Financial Institutions, University of Pennsylvania.
  21. Schmidt, Peter & Sickles, Robin C, 1984. "Production Frontiers and Panel Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 2(4), pages 367-74, October.
  22. Berger, Allen N. & Hancock, Diana & Humphrey, David B., 1993. "Bank efficiency derived from the profit function," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 317-347, April.
  23. Berger, Allen N. & Hunter, William C. & Timme, Stephen G., 1993. "The efficiency of financial institutions: A review and preview of research past, present and future," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 221-249, April.
  24. Sealey, Calvin W, Jr & Lindley, James T, 1977. "Inputs, Outputs, and a Theory of Production and Cost at Depository Financial Institutions," Journal of Finance, American Finance Association, vol. 32(4), pages 1251-66, September.
  25. Houston, Joel F. & Ryngaert, Michael D., 1994. "The overall gains from large bank mergers," Journal of Banking & Finance, Elsevier, vol. 18(6), pages 1155-1176, December.
  26. Smirlock, Michael & Gilligan, Thomas & Marshall, William, 1984. "Tobin's q and the Structure-Performance Relationship," American Economic Review, American Economic Association, vol. 74(5), pages 1051-60, December.
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