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

AuthorJonathan Williams,Barbara Casu,Panagiotis Dontis‐Charitos,Sotiris Staikouras
Date01 March 2016
Published date01 March 2016
Diversication, 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 DontisCharitos
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
We investigate the risk effects of bank acquisitions of insurance companies and
securities rms 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 diversication by modelling the determinants of
risks. We nd that bank combinations with securities rms yield higher risks than
combinations with insurance companies. Bank size is an important and consistent
determinant of risk whereas diversication is not. Our results inform the continuing
debate on diversication 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, 235275
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 diversication versus
functional separation by examining the risk prole 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 nancial conglomerates. Permitting the so-called
universal banking modelput US banks on equal footing with European banks, which
could operate as universal rms under the Second Banking Directive of 1989.
response of the nancial services industry came in the form of a wave of consolidation,
often via mergers and acquisitions (M&A), through which nancial institutions increased
the scale and scope of their activities.
Large and complex nancial institutions were at the
core of the 200709 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,
This reaction has reignited the long-standing debate as to the costs and benets of
diversication (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 nancial rms; conicts of
interest between nancial institutions and consumers; and the possibility that nonbank
nancial rms could implicitly benet from government subsidies targeted at banks via
too-big-to-failguarantees (Farhi and Tirole, 2012; Molyneux et al., 2014; Laeven et al.,
The perceived benets of diversication include synergies from scope economies,
efciency gains and prot-enhancing cross-selling opportunities (Houston et al., 2001;
Pilloff 1996; Vander Vennet, 2002). Furthermore, diversication may allow nancial
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 rst 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 Efciency Act) let banks expand across states and engage
in geographical diversication. In Europe, the implementation of the Second Banking
Directive by all 15 member states was completed between 1991 and 1994.
In addition to nancial deregulation, other forces encouraging consolidation in the nancial
sector during the 1990s and early 2000s included improved information technology,
globalisation of nancial and real markets, and heightened shareholder pressure for nancial
performance. In Europe, the introduction of the euro accelerated the speed of nancial 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 rms to reduce insolvency risk due to the imperfect correlation of prots arising
from a broader set of nancial activities. Critics, in contrast, perceive no diversication
benets and instead voice concerns pertaining to the existence of diseconomies of scope
and greater inefciencies at more diverse nancial institutions (Laeven and Levine,
2007), which are deemed as more complex, difcult 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 benets accrue to diversied
institutions relative to more specialised rms (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 nancial
services industry, which has contributed to the emergence of a number of large and
increasingly complex nancial institutions.
Following the 200709 crisis a growing number of academics and policymakers began
to debate if the size and permissible activities of nancial 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.
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
Most M&A activity during the 1990s in the nancial sector involved banking rms.
Acquisitions of banking rms accounted for 60% (70%) of the total number (value) of
nancial mergers (Group of Ten, 2001). The asset share of the ve 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 diversication, shows
that the BHCs increasingly diversied 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.
The principle of the new legislation is to carve out predened 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 predened 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 nal 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
Diversication, Size and Risk 237

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