Too big to manage: does the law of diminishing returns apply to synergies? It may when the new giants become too big to manage and improved earnings are not realized

RMA Journal, The, July-August, 2004 by Claude A. Hanley, Jr., Edward E. Furash

Merger mania is gripping banking once more, raising the specter that only a handful of mega-banks will dominate the industry by 2012 and that these banks will all fall into the "too big to fail" basket, creating rigidity in the U.S. economy.

The FDIC's current projection is that there will be 6,000 to 7,000 banks in 2012, down from nearly 15,000 in 1987. Banks at all tier levels will be of larger asset size.

The spate of announcements has included hot only blockbuster mergers like those of JPMorgan Chase & Go. and Bank of America Corp., but also a whole crop of regional banks, such as Citizens and SunTrust. This continues a long-term trend in the U.S. in which the number of institutions has declined steadily since 1980. Collectively, this activity has again given rise to the specter of the industry being dominated by a few dozen mega-banks.

But pay no heed to the Cassandra-like warning that the mega-banks will inevitably stifle competition if left unchecked. We believe that large size in itself brings a number of significant inherent problems. And the ongoing "too big to fail" debate is giving way to a "too big to manage" problem. This corollary holds that as banks merge and expand, effective execution becomes more problematic. To put it more bluntly, size increases complexity to the point where managers lose control of the behemoths they create and accelerate problems that tan drain earnings, sully reputation, and increase overall risk.

One of the themes pursued in The Decline and Fall of the Roman Empire by Edward Gibbon (1737-94) is that centralized Roman administration could not know what was going on in every corner of the Empire, so misdeeds of all kinds flourished, leading to the immediate but unsuccessful solution to split the Empire in two.

It appears that all human enterprises, including banks, can suffer from this problem, mostly through an inability to hold all employees to risk and morality standards. Accounting fraud mysteriously appears, high-risk trading goes unmonitored, and consumers and customers are hurt by institutions' failure to monitor protection compliance. The litany of other failures to manage is expanding, and the response has been to create more rules and procedures that must be monitored--in other words, as we shall see later, activities that makes the situation even worse through bureaucracy.

Merger Economies

Let's review the economic- rationale often used to justify mega-mergers. Conventional wisdom holds that if a bank wants to survive and thrive, it must be one of the biggest players. The implicit assumption is that success in banking necessitates attaining economies of scale in manufacturing, distribution, branding, marketing, and so forth. While this approach reflects the low-cost, low-growth aspects of a commodity business like banking, if overlooks the reality that providers also can and often must differentiate on service and customer interaction when the string of scale economics runs out.

Let's agree that certain economics of scale exist in banking. Recent academic studies have shown that consolidation does generate value through scale economics in processing. The prima facie evidence is embodied in the consolidation among providers of mortgage servicing and credit card processing. Asset size also provides a bank with leverage to extract better prices from vendors and suppliers. But these processing economies also have brought greater difficulty in meeting regulatory and accounting standards.

While economics of scope, defined as the ability to offer a broader product array, also are often cited as a reason to merge, the potential benefit is not supported by strong empirical evidence. Furthermore, it is unclear whether institutions have had significant success in translating additional products into deeper customer relationships. Having scope size and being able to integrate divers products into consumer sales are two different things. Despite representations to the contrary, consumers have not flocked to consolidate their accounts in response to the one-stop-shopping concept of many large institutions.

Nevertheless, the benefits to size extend beyond mere cost savings from suppliers and scale in processing. Large organizations also can afford to invest in expensive information technology systems that facilitate sophisticated customer and marketing analytics. There also are benefits in financial operations, as big balance sheets tan support larger corporate and international loans. JPMorgan Chase & Co. effectively used its large base of equity capital to establish a competitive advantage in loan syndications. Also, large organizations can offer richer compensation packages, which gives them a leg up in executive recruiting. But note that such selective implementation of scale advantages requires new management skills and attitudes.

Limits of Economies

It is unclear that economics extend beyond the narrow areas just mentioned. More importantly, the theoretical existence of these benefits is not the same as their realization. In the case of mergers, through which most mega-banks are formed, financial theory holds that the combined entity must pull certain economic levers, such as reduced production costs, increased volume, or reduced risk. Failure to do so may mean that the merger actually subtracts from shareholder value because it fails to recoup the acquisition premium, merger integration expenses, and transaction costs. In other words, it is one thing to merge and entirely another to manage it successfully.