Diversification, Size and Risk: the Case of Bank Acquisitions of Nonbank Financial Firms

• DOI: http://doi.org/10.1111/eufm.12061
• Date: 01 March 2016
• Published date: 01 March 2016

Diversification, Size and Risk: the Case

of Bank Acquisitions of Nonbank

Financial Firms

Barbara Casu

Cass Business School, City University, 106 Bunhill Row, London EC1Y 8TZ, UK

E-mail: b.casu@city.ac.uk

Panagiotis Dontis‐Charitos

Westminster Business School, University of Westminster, 35 Marylebone Road, London NW1 5LS, UK

E-mail: p.dontis-charitos@westminster.ac.uk

Sotiris Staikouras

Cass Business School, City University, 106 Bunhill Row, London EC1Y 8TZ, UK

E-mail: sks@city.ac.uk

Jonathan Williams

Bangor Business School, Bangor University, Hen Goleg, College Road, Bangor LL57 2DG, UK

E-mail: jon.williams@bangor.ac.uk

Abstract

We investigate the risk effects of bank acquisitions of insurance companies and

securities firms between 1991 and 2012 using a newly constructed dataset of M&A

deals. We examine risk changes before and after deal announcements by decompos-

ing risk into systematic and idiosyncratic components. Subsequently, we investigate

the relationship between risk and diversification by modelling the determinants of

risks. We find that bank combinations with securities firms yield higher risks than

combinations with insurance companies. Bank size is an important and consistent

determinant of risk whereas diversification is not. Our results inform the continuing

debate on diversification versus functional separation of bank activities.

We thank John Doukas (the editor) and two anonymous referees for their insightful

comments and suggestions. We are also grateful to Dimitrios Andriosopoulos, Elena

Kalotychou, George Kavetsos and Giorgio Di Pietro for helpful comments on early drafts of

this paper. The paper was presented at the 2011 British Accounting and Finance Association

conference; the 2011 International Finance and Banking Society conference; the 2011

Financial Management AssociationEuropean conference and the 2013 Multinational Finance

Society conference. We would like to thank the session participants, in particular, Isil Erel,

Franco Fiordelisi, Philip Gharghori, Bjoern Hagendorff, Jens Hagendorff, Gerhard Kling,

Ornella Ricci, Ioannis Tsalavoutas, Francesco Vallascas and John O.S. Wilson for their

constructive feedback. All errors are our own. Correspondence: Panagiotis Dontis-Charitos.

European Financial Management, Vol. 22, No. 2, 2016, 235–275

doi: 10.1111/eufm.12061

© 2015 John Wiley & Sons Ltd

Keywords: Banks, nonbank financial firms, financial conglomerates, diversification,

risk decomposition, determinants of risk

JEL classification: G21, G22, G32, G34

1. Introduction

This paper contributes to the on-going policy debate on bank diversification versus

functional separation by examining the risk profile of international banks following

acquisition of non-banking activities. It is little over a decade since the Financial Services

Modernization Act (FSMA) of 1999 revoked functional separation to allow US bank

holding companies (BHCs) to operate as financial conglomerates. Permitting the so-called

‘universal banking model’put US banks on equal footing with European banks, which

could operate as universal firms under the Second Banking Directive of 1989.

1

The

response of the financial services industry came in the form of a wave of consolidation,

often via mergers and acquisitions (M&A), through which financial institutions increased

the scale and scope of their activities.

2

Large and complex financial institutions were at the

core of the 2007–09 crisis. This has triggered a new debate on optimal bank size, focusing

either on capital surcharges for large banks (Basel III), or on the range of permissible

activities (Volker rule in the USA, and Vickers and Liikanen proposals in the UK and EU,

respectively).

This reaction has reignited the long-standing debate as to the costs and benefits of

diversification (Herring and Santomero, 1990; Boyd et al., 1998; Flannery, 1999;

Acharya et al., 2006; Herring and Carmassi, 2010; Elsas et al., 2010). At the public policy

level, concerns relate to extended monopoly powers of larger financial firms; conflicts of

interest between financial institutions and consumers; and the possibility that nonbank

financial firms could implicitly benefit from government subsidies targeted at banks via

‘too-big-to-fail’guarantees (Farhi and Tirole, 2012; Molyneux et al., 2014; Laeven et al.,

2014).

The perceived benefits of diversification include synergies from scope economies,

efficiency gains and profit-enhancing cross-selling opportunities (Houston et al., 2001;

Pilloff 1996; Vander Vennet, 2002). Furthermore, diversification may allow financial

1

The Financial Services Modernization Act (FSMA) of 1999 –also known as the Gramm-

Leach-Bliley Act (GLBA) –widened the range of permissible activities for banks. The

process of deregulation in US banking began before 1999 with the first step towards it thought

to have occurred in 1987 when the Federal Reserve allowed Citicorp, Bankers Trust and JP

Morgan to engage in limited underwriting and dealing in a set of securities. Several further

steps gradually eroded the restrictions of the Glass-Steagall Act. The Riegle-Neal Act of 1994

(Interstate Banking and Branching Efficiency Act) let banks expand across states and engage

in geographical diversification. In Europe, the implementation of the Second Banking

Directive by all 15 member states was completed between 1991 and 1994.

2

In addition to financial deregulation, other forces encouraging consolidation in the financial

sector during the 1990s and early 2000s included improved information technology,

globalisation of financial and real markets, and heightened shareholder pressure for financial

performance. In Europe, the introduction of the euro accelerated the speed of financial market

integration and encouraged cross-border activity (Group of Ten, 2001).

© 2015 John Wiley & Sons Ltd

236 Barbara Casu, Panagiotis Dontis-Charitos, Sotiris Staikouras and Jonathan Williams

services firms to reduce insolvency risk due to the imperfect correlation of profits arising

from a broader set of financial activities. Critics, in contrast, perceive no diversification

benefits and instead voice concerns pertaining to the existence of diseconomies of scope

and greater inefficiencies at more diverse financial institutions (Laeven and Levine,

2007), which are deemed as more complex, difficult to regulate and harder to resolve

(Herring and Carmassi, 2010; Chow and Surti, 2011; Gambacorta and van Rixtel, 2013).

Indeed, plentiful evidence shows that substituting interest income with fee-based income

increases earnings volatility (DeYoung and Ronald, 2001; Stiroh 2004; Stiroh and

Rumble, 2006).

Nonetheless, substantial empirical evidence suggests benefits accrue to diversified

institutions relative to more specialised firms (Barth et al., 2000). Although much of the

evidence dates from the late 1990s and early 2000s, policymakers appear to endorse this

view. This paved the way for an unprecedented level of M&A activity in the financial

services industry, which has contributed to the emergence of a number of large and

increasingly complex financial institutions.

3

Following the 2007–09 crisis a growing number of academics and policymakers began

to debate if the size and permissible activities of financial institutions should be re-

constricted because of concerns over systemic risk. New legislation in the USA and

Europe now enforces a functional separation of impermissible investment banking

activities from commercial banking.

4

Whereas the permissible investment banking

activities may differ between the USA and across EU member states, and the mechanisms

to deliver separation range from institutional separation (in the USA) to subsidiarisation

(in the EU) to ring-fencing (in the UK), a common objective of structural bank regulation

is to protect the real economy and bank depositors from exogenous shocks and contagion

3

Most M&A activity during the 1990s in the financial sector involved banking firms.

Acquisitions of banking firms accounted for 60% (70%) of the total number (value) of

financial mergers (Group of Ten, 2001). The asset share of the five largest BHCs in the US

jumped from 21.2% to 48.0% between 1986 and 2006 (Stiroh, 2010). The evolution of the

mean ratio of non-interest income-to-total operating income, to proxy diversification, shows

that the BHCs increasingly diversified over time from 39.0% in 1986 to 53.2% in 2006.

Between these dates, the average BHC operated in more states (21 c.f. 5) and achieved greater

branch penetration (3,118 c.f. 463). Berger et al. (1999) and Berger et al. (2001) discuss the

consolidation process in the US and Europe.

4

The principle of the new legislation is to carve out predefined casino-like trading activities of

banks. A key difference between the US and European approaches is that the Volcker rule in

the US forbids the coexistence of predefined investment banking activities in different

subsidiaries within the same banking group, whereas the European and UK rules allow for

subsidiarisation of such activities in separately capitalised legal entities. In the US, the Dodd-

Frank Wall Street Reform and Consumer Protection Act of 2010 implements the Volcker rule.

In the UK, the Financial Services (Banking Reform) Act of 2013 implements the Vickers

proposals. In January 2014, the European Commission published its proposal for a Volcker-

Vickers style reform, which deviates somewhat from the recommendations of the Liikanen

report of 2012. We should not expect agreement on the final version of the European

legislation until mid-2015, which infers an effective date of mid-2018. Mayer Brown (2014)

review the new European proposal and how it differs from Liikanen and UK and US rulings,

as well as overviewing recent French and German legislation.

© 2015 John Wiley & Sons Ltd

Diversification, Size and Risk 237