CHAPTER ONE

INTRODUCTION

• Background of the Study

The consolidation of banks has been the major policy instrument being adopted in correcting deficiencies in the financial sector. The economic rationale for domestic consolidation is indisputable. An early view of consolidation in banking was that it makes banking more cost efficient because larger banks can eliminate excess capacity in areas like data processing, personnel, marketing, or overlapping branch networks, cost efficiency also could increase if more efficient banks acquired less efficient ones. Though studies on efficiency in banking raised doubts about the extent of overcapacity, they did point to considerable potential for improvement in cost efficiency through mergers. Consolidation is viewed as the reduction in the number of banks and other deposit taking institutions with a simultaneous increase in size and concentration of the consolidation entries in the sector (Bis 2001).

The driving forces in bank consolidation include better risk control through the creation of critical mass and economics of scale advancement of marketing and product initiatives, improvements in overall credit risk and technology exploitation. These drivers have led to improved operational efficiencies and larger and better capitalized institutions. The results of this policy are neither here nor there contrary to the expectation. The most difficult aspect of consolidation is the ones induced by government through mergers and acquisition. Farlong (1994) claimed that consolidation in banking is distinct 1990’s market induced consolidation normally holdout promises of scale economics, gains in operational efficiency, profitability improvement and resources maximization, the outcomes have however, not totally confirmed these supposed benefits and they have varied across jurisdictions, especially when compared with the particular pre-consolidation expectations.

Whatever the potential, the research go far on the effects of bank mergers ahs not found strong evidence, that on balance, mergers banks  improve cost efficiency relative to other banks. This does not mean that many mergers, including those of some large banks, have failed to lead to significant gains in cost efficiency. It just means that the outcomes for those banks tend to be offset by problems encountered in other mergers, and that many banks have improved cost efficiency without merging.

A new view is that bank mergers are not just about adjusting inputs to affect costs; rather, they also involve adjusting output (products) mixes to enhance revenues. Two research efforts taking this approach are Akakhavein, et al. (1997), covering mergers in the 1980’s, and Berger (1998), covering mergers in the 1990s. These studies find that bank mergers do tend to be associated with improvements in overall performance, in part, because banks achieve higher valued output mixes. While these studies do not track all of the channels through which bank mergers affects the value of output, they suggest that one channel has been banks’ shift towards higher yielding loans and away from securities.

This channel is particularly interesting given the other, results in these studies. They find that merged banks also tend to experience a lowering of their cost of borrowed funds without needing to capital ratios. The lower cost of funds is consistent with a decline in the overall risk of the combined bank compared to that of the merger partners taken separately. This apparently occurs even though a shift to loans by itself might be expected to increase risk. One interpretation of these results, then, is that a merger can result in a reduction in some dimensions of risk, which then affords the post-merger bank more latitude to shift to a higher return, though perhaps higher risk but output mix. The sources of diversification could be differences in the range of services, the portfolio mixes, or regions several by the merging banks.

It is against this background that the subject matter of this research becomes worthy of investigation.