Changes in regulations that allowed bank holding companies to acquire institutions in states outside their home territory have had a significant impact on the rate of mergers and acquisitions within the U.S. banking industry. Between 1960 and 1979; there had been slightly more than 3,400 U.S. bank mergers and acquisitions. From 1980 to 1994, bank mergers swelled to more than 6,300.

Consolidation reduces a bank’s costs and increases its revenues. It also increases a bank’s complexity, however, and, theoretically, could make it harder to manage, ultimately raising costs. The important question for the banking industry and stockholders, then, is this: Are bigger banks necessarily better?

Following up on their own earlier studies as well as work by Federal Reserve System staff, a group of researchers has found that mergers and acquisitions do have a favorable impact on the financial strength of the acquiring bank. Joseph P. Hughes of Rutgers University, William Lang of the Office of the Comptroller of the Currency, Loretta J. Mester of the Federal Reserve Bank in Philadelphia and the University of Pennsylvania’s Wharton School, and Choon-Geol Moon of Hanyang University summarize their findings in “The Dollars and Sense of Bank Consolidation,” published by the Journal of Banking and Finance. The Wharton Financial Institutions Center has also published the study on its web site.

The authors estimated performance measures using 1994 Federal Reserve System data on 441 highest-level bank holding companies, 190 of which were publicly traded. Rather than analyze banks’ actual performance before and after particular mergers, Hughes, Lang, Mester and Moon simulated the banks’ performance by manipulating data on such institutional characteristics as number of interstate acquisitions, asset size, number of states in which each holding company operated, number of branches and deposit dispersion {the degree to which assets and deposits were scattered among the bank’s branches). They also factored in a relatively novel consideration, the economic diversity of the states into which the bank holding companies expanded, by weighing unemployment rates of the different regions in which the banks operated.

The researchers’ intense scrutiny of Federal Reserve data and (for public companies) financial statements unearthed a number of positive effects of bank mergers.

Some of the most important conclusions of their analysis were:

A higher growth rate of assets appears to reduce profit risk, risk of insolvency and profit efficiency. By its novel method of measuring risk, the researchers’ model distinguishes itself from other models of banks’ financial performance. Two banks that show the same profitability might seem identical, but one may not control risk as well as the other. The researchers account for this difference in terms of what they refer to as “profit risk,” “risk of insolvency,” and “profit efficiency.”

Profit risk is the likelihood that a bank will achieve the profit for which its executives plan. Insolvency risk includes profit risk but also considers the amount of capital a bank holding company has at its disposal.. Profit inefficiency is derived from estimates of the profits that the strongest (i.e. “best-practice” bank holding companies) achieve. It can be described as a shortfall in a bank holding company’s expected profit compared to the profit that the best managed banks would make for a given level of risk.

These concepts are valuable because banks, after all, necessarily take risks in lending and investing money. Certainly, greater risks yield higher profits. On the other hand, the risk if loans and investments turn sour includes higher rates on the money the bank itself borrows.

The more states in which a bank holding company operates, the higher the expected profit, but also the higher the risk to both profits and solvency. This finding may mean that bank holding companies with more extensive interstate operations may be taking on more risk in exchange for higher expected profits. Higher economic diversification, however, also reduced the risk to profits and solvency, created greater profit efficiency and, possibly, increased asset value.

The more extensive a bank’s branch networks, the higher the expected profits, the lower the risk of insolvency and the lower the profit inefficiency. Higher economic diversification also helped lower risk to profits and solvency.

An increase in both asset size and number of branches appears to reduce the risk of insolvency and to increase profit efficiency. Larger bank holding companies, because they have more extensive branch networks and better economic diversification, are safer, more profit-efficient, and command a relatively higher stock price in the securities marketplace. The clearest gains come from expansion across state lines, especially into economically diversified markets.

Diversification, then, is an important incentive for banks to consolidate, providing significant gains in financial performance, safety and in the market price of a bank holding company’s stock. Certainly, the advantages to the bank and its stockholders are not the only consideration. From society’s viewpoint, the impact on customers of reduced competition must also be weighed. Not to be overlooked, however, is that diversification and consolidation also benefit the economy as a whole if they strengthen the nation’s banking system.