Geographic Diversification Domestic

1
Chapter 22

• Geographic Diversification Domestic

2
Overview

• This chapter discusses the benefits to geographic
  diversification available in the domestic market
  and the reasons underlying the current wave of
  merger activity in the U.S. Evidence on the cost
  and revenue synergies and other factors affecting
  geographic expansion are also explored.

3
Attractiveness of Geographic Expansion

• Some factors are unique to financial services,
  but some also apply to industrial sector
• Regulation and regulatory framework
• Cost and revenue synergies
• Firm- or market-specific factors

4
Domestic Expansions

• Historically FIs' ability to expand was
  constrained by regulation.
• Banks in particular
• Regulations also create potential opportunities
  for new entrants to exploit existing monopoly
  rents.

5
Regulatory Factors/Geographic Expansion

• Insurance companies
• State regulated.
• Usually easy to establish subsidiaries
• Physical presence in nearly every state
• Subsidiary structure can also isolate parent firm
  from higher risk states such as Florida

6
Regulatory Factors

• Thrifts
• Branching controlled by Office of Thrift
  Supervision (prior to 1989, under FHLBB)
• Restrictions loosened by Garn-St. Germain Act of
  1982, FIRREA 1989
• In 1992, OTS permitted interstate branching for
  federally chartered savings institutions
• Since 1980s, restrictions on expanding across
  state lines have been loosened considerably.
• Eased acquisitions of failing thrifts across
  state lines

7
Constraints on Domestic Expansion

• Commercial Banks
• Restrictions on intrastate banking have been
  liberalized in a piecemeal fashion.
• Interstate restrictions
• McFadden Act, 1927
• From 1927 to 1997 relied on establishing
  subsidiaries rather than branching.
• Multibank holding companies (MBHC)

8
Stages in Regulation of BHCs

• One-bank holding company loophole in Douglas
  Amendment 1956.
• Growth in one-bank holding companies from 1956
  to 1970.
• Classic examples of Edward Kanes Regulatory
  dialectic
• 1970 Bank Holding Company Act Amendments.
• Permissible activities closely related to
  banking

9
Erosion of Interstate Banking Restrictions

• Regional and national banking pacts
• Nationwide
• Nationwide reciprocal
• Regional reciprocal
• Purchase of troubled banks across state lines
• Nonbank banks
• Ended by Competitive Equality Banking Act, 1987
• Tightened further in 2004
• Prevents firms such as Walmart from operating its
  own bank

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Erosion (continued)

• Expansion in OBHC activities.
• Riegle-Neal Interstate Banking and Branching
  Efficiency Act of 1994
• U.S. and nondomestic banks allowed to branch
  interstate.
• Full interstate banking with exception of de novo
  branching in 1997
• Wave of consolidation megamergers

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Consolidation

• Megamergers
• Mostly in the same or closely related markets
• Pure bank merger examples BancOne/ First
  Chicago, and NationsBank/Bank of America

12
Synergies Geographic Expansion

• Cost synergies
• X-efficiency
• Berger and Humphrey Less evidence of cost
  savings from economies of scale and scope
• Houston, James and Ryngaert / Rhoades found
  significant cost savings in megamergers
• Berger and DeYoung positive and negative links
  between geographic scope and bank efficiency

13
Synergies Geographic Expansion

• Revenue synergies
• Enhance revenues by expanding into growing market
  
• Enhance revenues by expanding into less than
  fully competitive market
• More stable revenue stream
• Activity or geographically focusing mergers
  generate higher abnormal returns

14
Monopoly Power Concerns

• Regulators concerned with merger activity that
  could result in monopoly power.
• Concentration ratios such as Herfindahl-Herschman
  Index (HHI) employed to measure the effects of
  merger.
• HHI sum of squared percentage market shares.
• Focus on postmerger concentration ratio as
  indicator

15
Web Resources

• Visit
• U.S. Department of Justice www.usdoj.gov

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Other Factors

• Solvency and asset quality
• leverage, loan loss reserves, NPLs
• Attractiveness of bank merger measured in terms
  of merger premium.
• Analysis indicates that highest merger premiums
  paid for well-managed banks in relatively
  uncompetitive environments.

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Success of Geographic Expansion

• Investor reaction
• Abnormal returns for both acquiring bank and
  target bank.
• Although some contrary results for bidders

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Success of Geographic Expansion

• Postmerger performance
• merged banks tended to outperform industry
• improved ability to attract loans and deposits,
  increase employee productivity and enhance asset
  growth.

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Pertinent websites

• Department of Justice www.usdoj.gov
• FDIC www.fdic.gov
• OCC www.ustreas.gov

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Chapter 23

• Geographic Diversification International

21
Overview

• Although many FIs can diversify domestically, the
  benefits to global diversification are available
  only to large firms. This chapter explores the
  potential risk-return advantages and
  disadvantages of international expansion and the
  trends toward globalization of FI franchises. As
  countries such as the U.S. expand, some
  countries, Japan in particular, are contracting
  their overseas operations.

22
Global International Expansions

• Three ways to establish global presence
• Sell financial services from domestic offices to
  foreign customers
• Sell financial services through a branch, agency,
  or representative office in foreign customers
  country
• Sell financial services through subsidiary
  company in foreign customers country.

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Global Expansion of FIs

• U.S. insurance companies and securities firms
  recent expansion
• 12 banks in the world with over 50 percent of
  assets in foreign countries
• No single country dominates the top 30
• Canada had 5 in the top 30, Ireland, Netherlands,
  U.S. all had 3.
• Japanese banks absent in spite of their size

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Top Global Banks (2003)
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U.S. Banks Abroad

• J.P. Morgan/Chase have had offices abroad since
  beginning of century.
• Major growth began in 1960s
• Overseas Direct Investment Control Act, 1964.
• Offshore funding and lending in dollars forged
  beginnings of the Eurodollar market.
• Assets of U.S. bank activities abroad increased
  from 353.8 billion in 1980, to 854.4 billion in
  2003. Declined in percentage terms.

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Factors Encouraging U.S. Bank Expansions Abroad

• Dollar as international medium of exchange
• Effects of Euro
• Political risk
• Encouraged flows to U.S. branches and
  subsidiaries in Cayman Islands and Bahamas.
• USA Patriot Act of 2001 prohibited services to
  shell banks and increased efforts to control
  money laundering
• Know your customer rules

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Factors Encouraging U.S. Bank Expansions Abroad

• Domestic activity restrictions
• Fed regulations permitting banks to engage in
  activities permitted by foreign host.
• Diversification benefits.
• Technology and communications improvements
• CHIPS
• Decreasing operating costs

28
Factors Deterring Expansion

• Capital constraints
• Proposed BIS 2006 reforms
• raise capital requirements for loans to non-OECD
  sovereigns rated below B-
• raise capital requirements for loans to OECD
  countries rated below AA-
• zero risk weights for OECD countries rated above
  AA-

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Factors Deterring Expansion

• Emerging markets problems
• Increased caution due to Korea, Thailand,
  Indonesia and Argentina
• despite improved regulatory environment (NAFTA,
  for example allowing greater expansion into
  Mexico).
• WTO reduction of barriers to global expansion
• China as a recent noteworthy example

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Factors Deterring Expansion

• Competition
• During 1990s, extensive competition from Japanese
  banks
• Japan had 9 of the 10 largest banks
• Effects of recession and bad debts
• European Community Second Banking Directive
  resulted in significant consolidation of European
  banks.

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Foreign Banks in the U.S.

• Choice of organizational form affected by
  regulations in home country as well as risk
  management strategies
• Subsidiary
• Branch
• Agency
• Edge Act Corporation
• Representative Office

32
Trends and Growth

• Rapid expansion of foreign banks in U.S.
• In 1980, foreign banks had assets of 166.7
  billion (10.8 percent of total U.S. bank assets)
• 1992, 514.3 billion (16.4 percent)
• 1994, 471.1 billion (13.8 percent)
• Retrenchments due to several factors including
  competitive and regulatory effects.
• 16.1 percent, 2000
• Global recession effects
• 14.5 percent in 2003

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Regulation of Foreign Banks in U.S.

• Prior to 1978, foreign branches and agencies were
  licensed mostly at state level.
• No access to discount window
• No direct access to Fedwire/fed funds markets
• No FDIC coverage

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Regulation of Foreign Banks in U.S. (post 1978)

• Passage of International Banking Act, 1978
• National treatment to level the playing field
• Accelerated expansion of foreign banks in U.S.
• Japanese bank entry into California, and
  subsequent sales notable

35
Regulation of Foreign Banks

• Foreign Bank Supervision Enhancement Act 1991,
  increased federal control.
• Triggered by three events
• collapse of BCCI
• issuance of 1 billion in unauthorized letters of
  credit to Iraq by Atlanta agency of Banca
  Nazionale del Lavoro
• unauthorized taking of deposit funds by U.S.
  representative of Greek National Mortgage Bank of
  New York.

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Features of FBSEA

• Feds approval required for entry
• Closure under control of Federal Reserve
• Daiwa Bank ordered to cease operations.
• Examination by Fed
• Deposits Only foreign subsidiaries with FDIC
  coverage can take deposits under 100,000.
• Activity powers restricted to activities
  permitted to federal branch.

37
Web Resources

• Visit
• Federal Reserve www.federalreserve.gov
• FDIC www.fdic.gov

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Advantages to International Expansion

• Revenue and Risk diversification
• Economies of scale
• Innovations
• generate extra returns from selling new products
  abroad.
• Funds source
• Customer relationships
• Regulatory avoidance

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Disadvantages

• Information/monitoring costs
• Example differences in accounting standards
• Nationalization/expropriation.
• Fixed costs may be high
• Tokyo real estate prices for example.
• Uncertainty about volume of business from foreign
  entry versus entry costs

40
Pertinent websites

• Federal Reserve www.federalreserve.gov
• The Banker www.thebanker.com
• FDIC www.fdic.gov