Borrowing and lending has become a fairly well-understood line of business, and a fairly well-managed one most of the time in most of the world. It is the banks themselves that are volatile, shifting shapes and strategies as furiously as their regulators will allow them in their efforts to win markets and market share. In China they are escaping state captivity by selling shares to foreigners and stockmarket investors. In Russia they are running wild, with balance sheets growing by 30-40% a year. In Japan three new “megabanks” have eaten 11 old banks and are now digesting them. In central Europe foreigners have bought or built 80% of the top local banks since the fall of communism.
In America the ten biggest commercial banks control 49% of the country's banking assets, up from 29% a decade ago. They are pausing for breath now, after a long merger binge encouraged by the deregulation of interstate banking and the removal of barriers between banks, insurance companies and securities firms. Non-financial companies are not meant to own banks, but even that is now being tested by America's biggest retailer, Wal-Mart, which wants a restricted banking licence.
This survey of commercial banking around the world is much preoccupied by questions of size and of ownership. Almost everywhere, big banks have been getting bigger through mergers and acquisitions as well as through organic growth. Is there a natural limit to this process of bank-eat-bank? Could the biggest bank of tomorrow be two or three or even ten times the size of a Citibank or an HSBC today, and if not, why not? And who benefits? It is not always the surviving bank's shareholders. One-half of recent bank mergers around the world have destroyed shareholder value, says Philippe De Backer, a partner in Bain & Co, a consulting firm. In America it is medium-sized banks that are prized most highly by the stockmarkets, partly because investors expect them to be bought dearly by the big banks.
One argument commonly used in favour of mergers, in banking as in many other industries, is the pursuit of economies of scale in areas such as procurement, systems, operations, research and marketing. But the gains from that in the mass production of financial services, though not necessarily illusory, can be elusive. There is a sizeable literature of academic papers claiming that economies of scale can be exhausted by the time a bank reaches a relatively modest size. A study of European banks in the 1990s, published by the European Investment Bank, put the figure for savings banks as low as €600m ($760m) in assets. More recent studies suggest far higher thresholds, up to $25 billion.
Big banks might even dispute that there is a limit at all. But at some point diseconomies of scale will also start creeping in. Management will find it harder and harder to aggregate and summarise everything that is going on in the bank, opening the way to the duplication of expense, the neglect of concealed risks and the failure of internal controls. Something of that last problem afflicted the world's biggest bank holding company, Citigroup, in 2002-05, when it was rocked by a string of compliance problems. America's Federal Reserve reacted by telling Citigroup to suspend large acquisitions, but lifted the order in April this year when it judged that the company had got better controls in place.
Another argument commonly made for mergers is based on economies of scope, the proposition that related lines of business under the same ownership or management can share resources and create opportunities for one another. The basic economy of scope common to almost all banks is the taking of deposits on one hand and the making of loans on the other. The bank gets to re-use its depositors' money profitably. The skills and information useful on one side of the business tend to be useful on the other side too.
But does the same hold good when a retail bank is paired with, say, a corporate bank, an investment-banking division, a credit-card processor, an asset-management operation, private banking (for rich people), an insurance business or a foreign branch network? These businesses all overlap with one another to some degree, but so do lots of other businesses. The fashion for industrial conglomerates came and went 30 years ago. Will financial conglomerates be any more enduring? The bank holding companies that are building them clearly believe so.
A third reason for banks to pursue growth through mergers and acquisitions is one that is never used as an argument at the time, but is universally recognised as a factor. It is managerial ambition (which includes managerial error). Chief executives want the gratification of running a bigger company, or they fear that their own company will be taken over unless they grab another one first.
Managers can argue that the business environment is changing rapidly and that banks must seize the new market opportunities created by new technology or national deregulation or economic globalisation. Thus there is much talk in Europe now of a fresh wave of cross-border mergers and acquisitions within the 25 countries of the European Union, encouraged by the single European currency, the deepening Single European Market and the enlargement of the EU into central and eastern Europe. Shareholders may be the more easily persuaded because a takeover tends to look good at the time. The buyer books the new revenues immediately and cuts some overlapping costs. The acquisition premium goes straight to goodwill. It is only later that you find out whether the businesses are a good long-term fit.
And perhaps growth-hungry CEOs are wiser than their students and their critics know. The very big banks created in America over the past ten years have not been stellar stockmarket performers recently, but they may just be taking time to bed down and knit their management and computer systems more closely together. Their future results may transform the current wisdom about economies of scale.
Bigness may also have benefits not easily captured in studies of financial performance. One is the ability to place strategic bets on future markets, such as China, without putting the whole bank at risk. Another is regulatory capture, or the ability of the regulatee to influence the regulator. The bigger the bank, the more likely its home-country regulators and legislators will be to take its interests into account when drafting new rules, and the more likely they will be to judge it “too big to fail” in the event of a crisis.
Not, of course, that banks these days fold as often as they used to, which is another reason why strong banks go shopping. Weak banks no longer fall into their laps, at least in Europe and America. Banks fail less often, partly because external conditions have been kinder. Developed economies around the world have become more stable over the past 20-30 years, save for Japan in the 1990s. Big shocks in the financial markets have become rarer and better managed. Recent medium-sized shocks, such as the downgrading of General Motors' credit rating last year, have been relatively easily absorbed. The financial markets have moved, you might say, from being a source of shocks to being shock absorbers too.
Such stability may engender its own instability if it encourages everyone to take on more risk in the belief that disasters are less likely to happen. But give credit, until then, where credit is due. Benign economic conditions have encouraged stable banks, and vice versa. Bankers and regulators in much of the world have arrived together at a pretty good model of how commercial banks ought to be run. Pressured by the demands of the capital markets for efficiency and predictability, they have also been pretty good about sticking to the rules and so avoiding catastrophic mistakes.
A version of that modern banking model is enshrined in a new set of rules, running to about 700 pages, that tell banks how they should weigh their risks, and how much capital they should keep on hand in case things go wrong. Big banks in most developed banking markets will be adopting the new rules, known as Basel 2, starting with the European Union next year. But America is hesitating. Some critics there think that the Basel 2 rules are at once too lax and too complicated; others think they discriminate too much between big and small banks.
One safe prediction is that Basel 2 and its risk-modelling methods will make banks even harder to understand than they are already. Ask a banker to explain risk management or credit derivatives or capital allocation to you, and the algebra will soon be spilling off the blackboard. The opacity of banks may count against them with investors. Mercer Oliver Wyman, a strategic and risk-management consultancy, says that publicly listed financial-services companies around the world were valued last year at an average of 14 times their profits, against a multiple of 18 for non-financial companies. But the discount has been shrinking, suggesting both that investors have got more optimistic about relative growth prospects for financial services, and that they think bankers have got better at banking, turning it into a generally less risky business.
This survey broadly agrees on both points. It considers the state of competition and consolidation in the developed markets of America, Europe and Japan. It looks at the big emerging markets of China, India and Russia, where the global winners and losers of the future may be decided. (China alone may account for over 25% of new global demand for financial services in the coming five years, says Alain LeCouedic, a partner at Boston Consulting Group.) It pauses to consider the intricacies of Basel 2, the virtues of pure investment banks and the cost of a Brazilian overdraft before drawing a conclusion which can be briefly summarised here: better banks tend to get bigger, but bigger banks are not necessarily better.
