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«Allen N. Berger Board of Governors of the Federal Reserve System Washington, DC 20551 U.S.A. and Wharton Financial Institutions Center Philadelphia, ...»

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The Integration of the Financial Services Industry:

Where are the Efficiencies?

Allen N. Berger

Board of Governors of the Federal Reserve System

Washington, DC 20551 U.S.A.

and

Wharton Financial Institutions Center

Philadelphia, PA 19104 U.S.A.

Abstract

We examine the efficiency effects of the integration of the financial services industry and suggest directions for

future research. We also propose a relatively broad working definition of integration and employ U.S. and European data on financial service industry M&As to illustrate several types of integration. The analysis suggests that there is a large potential for efficiency gains from integration, but only a relatively small part of this potential may be realized. Integration appears to bring about larger revenue efficiency gains than cost efficiency gains, and most of the gains appear to be linked to benefits from risk diversification.

Forthcoming, North American Actuarial Journal 4 (2000) JEL classification codes: G21, G22, G24, G28, G34, F23, F36 Key words: Banks, Insurance, Securities Firms, Mergers, Efficiency, International Finance.

The opinions expressed do not necessarily reflect those of the Federal Reserve Board or its staff. The author thanks Harold Skipper (the Bowles chairholder) for suggesting the topic of this paper and organizing the symposium; Dave Cummins and Marty Grace for giving excellent discussant comments; Bob Avery, Bob DeYoung, Hesna Genay, Mary Weiss, Greg Udell, and the anonymous referees for very valuable suggestions; and Kelly Bryant and Linda Pitts for outstanding research assistance.

Please address correspondence to Allen N. Berger, Mail Stop 153, Federal Reserve Board, 20th and C Sts. NW, Washington, DC 20551, call 202-452-2903, fax 202-452-5295, or email aberger@frb.gov.

1. Introduction The financial services industry is becoming more integrated in a number of ways. In nations around the world, mergers and acquisitions (M&As) are occurring among some of the largest financial service providers. In Japan, the Fuji Bank-Dai-Ichi Kangyo Bank-Industrial Bank of Japan M&A and the Sanwa Bank-Tokai Bank- Asahi Bank M&As are expected to create the world’s largest two banks, respectively, with about $1.4 trillion and $1.0 trillion in assets. In Europe, the UBS-Swiss Bank Corp. M&A and other consolidation activities also created a number of very large institutions. In the U.S., the recent BankAmerica-NationsBank M&A created the largest domestic deposit base in the nation.

There is also considerable integration creating universal-type institutions that provide many categories of financial services. For example, the Citicorp-Travelers M&A created a financial institution that provides commercial banking, securities underwriting, insurance services. Moreover, considerable cross-border integration is taking place in which financial institutions are establishing physical presences in other nations. In Europe, cross-border M&A activity exceeds domestic M&As for both the securities and insurance sectors. Recent policy changes around the world -- particularly legislation allowing interstate banking and universal banking in the U.S.

and changes that allow easier cross-border entry and common currency in the European Union (EU) -- make it likely that these waves of integration will continue.

The main purposes of this paper are to examine the efficiency effects of the integration of the financial services industry and to suggest directions for future research. In addition, we propose a relatively broad working definition of financial services industry integration, since there is no unanimously accepted definition. We also break down integration into simple and complex types, provide examples of each type, and discuss the different ways that integration may take place. Additionally, we use some U.S. and European data on financial service industry M&As to illustrate the importance of several types of integration.

Our review of the research on the efficiency effects of integration covers three complex types of financial integration. These are 1) the national consolidation of financial institutions within a single product category, such as commercial banking, securities, or insurance; 2) the integration of multiple categories of financial services into universal-type organizations, such as combining commercial banks with insurance companies; and 3) the consolidation of the financial services industry across international borders.

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value other than changes in market power. This broad treatment covers the scale efficiency, scope efficiency, and X-efficiency consequences of integration, and includes both cost and revenue effects. An important caveat to our analysis is that the availability of relevant research on the efficiency of the financial services industry is uneven, requiring a considerable amount of extrapolation to draw meaningful conclusions. Most of the research is on U.S.

commercial banks, with some findings for the insurance industry, and very little for the securities industry.

Fortunately, the available research generally supports the notion that the efficiency consequences of integration are similar across financial industries and across nations. There is also little direct evidence on the efficiency effects of the integration of the providers of different categories of financial services into universal-type organizations. We must largely extrapolate from scope efficiency studies within one category of financial services and from simulation studies of risk diversification benefits. Similarly, there is relatively little research on the efficiency effects of the cross-border integration of financial institutions, a topic which grows in importance as financial markets become more globalized.





Section 2 provides background material on financial services industry integration, including our proposed working definition, the breakdown of types of integration, the ways that integration may take place, and some international data on integration. Section 3 briefly reviews the economic efficiency concepts employed in the analysis. The next sections review the research on the efficiency effects of the national integration of institutions within a single product category (Section 4); the integration of financial service providers into universal-type organizations (Section 5); and the international integration of financial institutions (Section 6). Section 7 assesses the findings and suggests directions for future research.

By way of preview, our analysis suggests that there is a large potential for efficiency improvements from integration, but that only a small part of this potential appears to be realized. Perhaps surprisingly, our findings suggest that integration appears to bring about larger revenue efficiency gains than cost efficiency gains, and that most of these gains appear to be from the benefits of risk diversification. Our analysis also suggests that much research remains undone and suggests ways to address the unanswered questions.

2. Background material on financial services industry integration We begin our background material with a proposed working definition of financial services industry

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more dimensions of the production or distribution of financial services. By production of financial services, we mean underwriting of financial contracts, intermediation, risk management, payments processing, and other backoffice operations. By distribution, we mean the direct contact with customers, including sales, marketing, provision of services, and other front-office operations.

Several simple types of integration are illustrated in Table 1, along with an example of each. Scale integration occurs when the production or distribution of financial services is consolidated into fewer, larger organizations, such as occurs when there is an M&A of similar financial institutions. Scope integration occurs when the range of services produced or distributed by financial institutions is expanded. This may take place when institutions move from offering a single category of financial services to become universal-type organizations that provide commercial banking, investment banking, insurance, etc. in a single organization through M&As or other types of expansion. Geographic integration occurs when financial institutions expand to produce or distribute financial services in an expanded set of locations, such as takes place in cross-regional M&As or when institutions set up subsidiaries or offices in other locations. International integration occurs when institutions expand across borders through M&As, establishment of new subsidiaries or offices, or other means.

International integration often requires organizations to adapt to differences in language, culture, currency, regulatory/supervisory structures, etc., as well as geographic distance. Financial service providers may also horizontally integrate their production or distribution systems or vertically integrate by combining production with distribution in the same organization (examples given in Table 1). This list of simple types of integration is obviously not complete and there is unavoidable overlap among even these simple types.

As illustrated in these examples, integration can take place in a number of ways, including through M&As among organizations, or through individual organizations expanding on their own or integrating their own production or distribution systems. Integration may alternatively be accomplished with the same industry structure through the formation of correspondent networks, syndicates, shared-access networks, or alliances in which the production or distribution of services is collectively shared or parceled out.

Importantly, any one integration event is usually complex, involving several of the simple types of integration simultaneously. Consider, for example, an M&A between two organizations that each previously

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integration by creating a larger total organization, scope integration by providing a broader array of services, geographic integration by creating a more geographically dispersed organization, and international integration by creating a multinational organization. Such an M&A may also involve the different types of simple horizontal and vertical integration of production and distribution systems.

It is not possible to cover thoroughly the efficiency effects of all types of financial integration in one paper of manageable size. Instead, we review what is known and unknown and suggest directions for future research on the efficiency effects of three complex types of financial integration. Each of the three types chosen has significant current and likely future integration activity, a high degree of policy significance, and a reasonable body of extant efficiency research available to be reviewed. The three complex types of integration chosen, their correspondence to the simple types, and the research subjects reviewed are summarized in Table 2.

The first complex type of integration covered is the national integration of financial institutions within a single product category. This always involves scale integration and may also involve scope and geographic integration as well. The most substantial within-nation integration usually takes place through M&A activity.

The second complex type of integration covered is the integration of the providers of different categories of financial services into universal-type organizations. This typically involves scale and scope integration and may also involve geographic and international integration as well. Universal-type integration often takes place through M&As among commercial banks, securities firms, and/or insurance companies.

The third complex type of integration considered here is the international consolidation of financial institutions. This typically involves scale, geographic, and international integration, and may also involve scope integration as well. This type of integration often takes place through M&As among financial service organizations in different nations.

Table 3 summarizes data on M&A activity that represent these three types of complex integration. The data reported are for M&As of large, publicly traded corporations, and so exclude M&As of small targets and other types of integration activity. Panel A reports the flow of domestic M&A activity within the U.S. (columns 1-3) and within individual European nations (columns 4-6). Panel B reports the corresponding information for cross-border or international M&As. The values shown are the sums of the market values of all target institutions

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In both the U.S. and Europe, most of the domestic M&A activity is national integration of financial institutions within a single product category, represented by the diagonal elements of the two 3x3 matrices in Panel A. In both the U.S. and Europe, banks-consolidating-with-other-banks was the most voluminous form of domestic M&A in terms of market values. Not surprisingly, the domestic M&A activity within category is much greater in the U.S., particularly in the banking sector. In part, this reflects the gradual deregulation over time of interstate banking restrictions, culminating in the Riegle-Neal Act that removed most of the remaining interstate barriers as of June 1, 1997. The European nations generally allowed nationwide banking prior to the start of the sample period in 1985.

The off-diagonal elements of the 3x3 matrices in both Panels A and B of Table 3 correspond to consolidation of the providers of different categories of financial services into universal-type organizations. The off-diagonal elements in Panel A give the domestic consolidation of different categories of financial institution.

Not surprisingly, a higher proportion of domestic European M&A activity is of the universal type, given the fewer regulatory restrictions in Europe. Consolidation across sectors comprised 37.5% of domestic M&A activity in Europe versus only 13.4% of domestic activity in the U.S. The off-diagonal elements in Panel B indicate the international consolidation of different financial institutions across categories. Again, the consolidation into universal-type organizations shown in the off-diagonal elements of the matrix are smaller than the on-diagonal integration within a single product category. Again, more of the European activity is of the universal type than in the U.S.



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