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IMPACT OF MERGERS ON BANKS PROFITABILTY

The activity of Mergers and Acquisitions (M&A) is good for stability of the financial system. Mergers and Acquisitions (M&A) is the main strategy followed by organizations to increase their value. Merger and acquisition also help to reduce costs, increase in revenue, creating economies of scale, gaining market power, more effective management, and increased innovation. It can be said that merger is the financial tool to enhance profit.

M&A is not a unique phenomenon for Pakistan. The aim of this study is to evaluate the financial performance of acquiring banks in Pakistan after and before the mergers and acquisitions. This study also involves whether these mergers and acquisitions provide benefit to the acquiring firm or not. The main focus of this study will be the merger of PICIC Commercial Bank and NIB, Union Bank and Standard Chartered. This study will examine the impact of merger on the profitability of these banks.

Table- 1 : About NIB Bank Ltd and Standard Chartered Bank Ltd

Name of Company

Merged with

Date of Merger

Paid-up Capital

Ratio

PICIC Commercial Bank Limited

NIB Bank Limited

01/01/2008

2,734.875

[ 1 : 2.27 ]

Union Bank Limited

Standard Chartered Bank Ltd.

29/12/2006

3,387.505

[ 1 : 2.50 ]

(http://www.kse.com.pk/)

PICIC Commercial Bank was merged with NIB Bank on January 1, 2008. In the result of this merger NIB Bank becoming the seventh largest bank in the country in terms of distribution network with 240 branches and total assets are exceed Rs. 185 billion.

Standard Chartered Bank Limited and Union Bank Limited were merged on December 29, 2006. In the result of this merger Standard Chartered became the sixth largest bank in Pakistan. Standard Chartered currently has a network of 46 branches in 10 cities.

Definition of Mergers and Acquisitions:

In literature, the two terms merger and acquisition are often used interchangeably, but there is a subtle difference between the two concepts (Grinblatt, 2004). Mergers and acquisitions are widely used phrases that do not have exact definitions. For instance, Weston & Copeland (1992) describe: “A merger as a transaction between more or less equal partners, while acquisitions are used to denote a transaction where a substantially bigger firm takes over a smaller firm” Clearly, Weston & Copeland distinguish mergers and acquisitions on basis of firm size involving with the transaction. Datta & Pinches (1992) use another basis to describe the difference between a merger and an acquisition. They define: “A merger as a direct negotiation with the target firms’ management and/or the board of directors and approved by them before going to a shareholder vote. On the other hand, acquisitions can take place in an unfriendly way, where the offer is made directly to the target firm shareholders. This unfriendly way is considered hostile if the target firm’s board of directors rejects a particular offer, but the bidding firm continues to pursue it, or the bidding firm makes the offer without informing the target firm’s board beforehand. It is then the choice of the shareholders and not that of the board of directors to decide whether or not to tender shares to the bidding firm” Hence, Datta & Pinches distinguish mergers and acquisitions on basis of management versus shareholders approach involving with the transaction. Dick, Ullrich & Wieseke (2005) found significant evidence of discrepancy in the sphere of identity changes that occur during a merger or acquisition transition. “After the merger, the separately owned firms become jointly owned and obtain a new single identity. This new identity is almost always a mix of the two firms which together form a new bigger firm. Conversely, with acquisition, one firm takes over another and appoints its power as the single owner. In most cases, the acquiring firm is the bigger and stronger one than the target firm. The relatively less powerful, smaller firm loses its existence, and the acquiring firm, runs the whole business with its own identity”. Asquith & Mullins (1986) define mergers and acquisitions on basis of share distribution. “When two firms merge, shares of both are surrendered and new shares in name of the new firm will be issued. Unlike a merger, shares of the acquiring firm are not surrendered but traded in the market prior to the acquisition and continue to be traded by the public after the acquisition. The shares of the target firm cease to exist publicly”

Types of Mergers and Acquisitions:

Reasons behind mergers and acquisition activity are achieving synergy in operation, economies of scale and finding new market.

There are some types of acquisition like acquisition can be done by using cash, some by using stocks, some by using assets of the company, and some with the combination of all of above. Conglomerate merger, Horizontal merger, Vertical merger, Congeneric merger are few types of mergers.

Horizontal mergers take place where the two merging companies produce similar product in the same industry.

Vertical mergers occur when two companies, each working at different stages in the production of the same good, combine.

Congeneric mergers occur where two merging companies are in the same general industry, but they have no mutual buyer/customer or supplier relationship, such as a merger between a bank and a leasing company.

Conglomerate mergers take place when the two companies operate in different industries.

Reasons behind Mergers and Acquisitions:

These can be reasons for mergers and acquisition.

Enhancing company productivity.

Political factors.

Cutting down expenses and increasing revenues.

When a company is not self sufficient to operate on its own like if the company have insufficient investment capacity, excessive competition.

Benefits of Mergers and Acquisitions:

There are various benefits of mergers and acquisitions. Mergers and Acquisitions can generate cost efficiency through economies of scale, can enhance the revenue through gain in market share and can even generate tax gains.

The shareholder value of a firm after mergers or acquisitions would be greater than the sum of the shareholder values of the parent companies, it is expected. Through the implementation of economies of scale mergers and acquisitions generally succeed in generating cost efficiency.

Merger & Acquisition also leads to tax gains and can even lead to a revenue enhancement through market share gain. Sometimes companies prefer to do Mergers and Acquisition because the joint company will be able to generate more value than the separate firms and it is expected that the newly generated shareholder value will be higher than the value of the sum of the shares of the two separate companies.

If the company is suffering from various problems in the market and is not able to overcome the difficulties, it can go for an acquisition deal. If a company, which has a strong market presence, buys out the weak firm, then a more competitive and cost efficient company can be generated. Here, the target company benefits as it gets out of the difficult situation and after being acquired by the large firm, the joint company accumulates larger market share. This is because of these benefits that the small and less powerful firms agree to be acquired by the large firms.

Cost efficiency benefits can be achieved when two companies come together by merger or acquisition, the joint company. A merger or acquisition is able to create economies of scale which in turn generates cost efficiency. As the two firms form a new and bigger company, the production is done on a much larger scale and when the output production increases, there are strong chances that the cost of production per unit of output gets reduced.

An increase in market share is one of the most important benefits of mergers and acquisitions. In case a financially strong company acquires a relatively distressed one, the resultant organization can experience a substantial increase in market share. The new firm is usually more cost-efficient and competitive as compared to its financially weak parent organization.

Failure of Mergers and Acquisitions:

Mergers and acquisitions may seem to be beneficial, resulting in the merger of two companies. They have been found to lead to cost cuts and increased revenues. On the other hand, the failures of mergers and acquisition may harm the companies, spoil their credibility in the market, and ruin the confidence of their shareholders. There are several reasons for the failure of merger or acquisition.

If a merger or acquisition is planned depending on the bullish conditions prevailing in the stock market, it may be risky.

Failure may occur if a merger takes place as a defensive measure to neutralize the adverse effects of globalization and a dynamic corporate environment.

Failures may result if the two companies which are going to merge hold different "corporate cultures."

It does not mean that all mergers and acquisitions fail. There are many examples of mergers that have improved the performance of a company.

Mergers and Acquisitions in Banking Sector of Pakistan:

In response to financial liberalization reforms initiated in the early 1990s to develop a sound and competitive banking system, a number of private banks appeared in the banking arena. As a consequence, the number of scheduled banks increased from 31 in CY90 to 41 in CY92, and then to 45 by end CY95. However, these newly established small sized banks were unable to provide any meaningful competition to the big five banks. The financial health of these small banks also deteriorated with the passage of time. These developments undermined the basic objectives of banking sector reforms to develop an efficient, sound and competitive banking sector. Consequently, SBP imposed an unannounced moratorium on commercial banking licenses in 1995 to limit the fragmentation of the banking sector. This step was followed by the introduction of risk-based regulatory capital requirements in 1997.

To further strengthen the capital base of the banking sector, SBP increased the minimum paid-up capital (net of losses) requirement (MCR) in a phased manner during 2000. Subsequent increases in the minimum paid up capital requirements for banks/NBFIs, restructuring of public sector financial institutions, and corresponding changes in the business strategies of the various categories of financial institutions are the main drivers of on-going M&As in the financial sector.

The role of the SBP in promoting mergers and acquisitions discussed in Box 1.

Box: 1- Measures to Facilitate Mergers and Acquisitions by the SBP

Regulatory capital requirements: SBP raised the minimum paid-up capital requirements gradually from Rs 500 million to Rs. 750 million from 1st January 2002, to Rs. 1,000 million from 1st January 2003, to Rs. 1.5 billion from 31st December, 2004 and to Rs. 2 billion from 31st December, 2005. Under the existing road map for increase in capital requirements, banks/DFIs are required to raise their paid up capital to Rs 6 billion by 31st December, 2009.

Changes in Legal Framework: SBP has facilitated M&A transactions by incorporating the necessary amendments in the legal framework; Section 48 of Banking Companies Ordinance 1962 was amended to allow the merger of NBFCs with banks and simplify the process for merger of foreign banking companies.

Fiscal Measures: SBP proposed changes in the Income Tax Ordinance, 2001 including reduction in the tax rate for banking companies from 58 percent to 35 percent and tax incentives to facilitate mergers between financial institutions through addition of a new section 57-A which allows carry forward of tax losses of both amalgamated (target) and amalgamating(surviving) institutions.

Innovation: SBP introduced the concept of Newco which facilitated the merger of foreign banking companies not incorporated in Pakistan through issuance of a new license to a new banking company.

Moral suasion: Promoted various acquisition deals through moral suasion.

Fast track processing: SBP has processed most of the merger and acquisition transactions on fast track basis to facilitate the market players, while ensuring compliance with the relevant legal and regulatory requirements.

Source: Banking Surveillance Department, SBP

(http://www.sbp.org.pk/fsr/2006/English/Financial%20sector%20Consolidation.pdf)

The most notable factor is the MCR, which is a reflection of the regulatory push for consolidation in the banking sector. It may be noted that such a regulatory strategy is not unique to Pakistan. International experience suggests that regulatory pressure is more prominent in emerging economies, while market pressure encourages this process in developed economies.

M&A transactions in the banking sector are likely to remain in the limelight for the next couple of years as: (1) scheduled banks are required to increase their MCR to Rs 6.0 billion by end December 2009, compared to an MCR of Rs 3.0 billion as on end December 2006; and (2) unprecedented profitability of the banking sector is likely to attract more foreign banks to increase their stake in the country. Specifically, the after tax profits of commercial banks reached Rs 84.1 billion (US$ 1.4 billion), with return on assets (ROA) at 2.1 percent, well above the international norm (data for CY06). Stable macroeconomic environment along with a relatively low penetration level of the banking sector are also factors which have contributed to attracting foreign banks to the country.

Institutional level data on MCR indicates that 12 of the 35 commercial banks were unable to meet the minimum capital requirements as on 31st December 2006. While some of these banks are well positioned to meet the desired MCR due to strong general reserves and accumulated un-appropriated profits, few weak banks would have to join hands with others if they want to remain in the banking sector. To date, one of these banks has already been acquired by ABN Amro Bank. Moreover, although 7 out of 35 commercial banks have already achieved the MCR of Rs 6.0 billion, some more M&As will still be inevitable during the next few years. As a result, it is generally expected that the banking sector in Pakistan will comprise of well-capitalized commercial banks by the end of this decade, each offering a broad range of financial services.

Motives of Consolidation:

There is more than one factor responsible for M&As in the financial sector.

Box: 2 - Motives of Consolidation

In practice, there may be a wide variety of factors behind mergers/acquisitions (M&As) in the financial sector which depend on the characteristics of financial institutions. All these factors can be bifurcated into two broad categories, namely: (1) value maximizing factors; and (2) non-value maximizing factors.

In case of value maximizing factors, M&As are likely to increase the expected future profits by reducing expected costs and increasing expected revenues. Specifically, costs are expected to decline due to benefits from economies of scale and scope, change management, favorable change in the risk profile due to product and geographic diversification, increased bargaining power etc. On the other hand, revenues are likely to increase as the relatively bigger size of the surviving institutions allows them to offer a number of different services (‘one-stop shopping’), attract and better serve big customers, invest in more risky assets, and increase service charges to some extent.

Given market imperfections in the real world, M&A decisions may not always be driven by value-maximizing factors. There may be non-value maximizing factors emerging from the management’s inclination to control big organizations to match the size of competitors, and to reduce risks (even when value remains unchanged), or there may be defensive acquisitions.

Empirical evidence based on interview surveys on the motives of M&As in advanced economies shows that motives vary across product lines and across various segments of financial institutions (for example, M&As across the commercial banking, investment banking, insurance sector etc.). Motives also differ for different sizes of financial institutions. Findings indicate that 36 out of 45 respondents ranked economies of scale as a ‘very important’ motivating factor for M&As within a country-within a segment. Desire to increase revenue, size and market power were the other important factors. However, reducing risk through product diversification and cost through change management were largely considered unimportant. In comparison, the desire to offer one-stop shopping facilities and increasing revenue through product diversification were considered ‘very important’ for mergers within a country, across segments.

Source: Group of Ten: Report on Consolidation in the Financial Sector, BIS, January 2001.

(http://www.sbp.org.pk/fsr/2006/English/Financial%20sector%20Consolidation.pdf)

Impact of Mergers and Acquisition on the Structure of the Banking System:

The on-going consolidation of the banking sector has significantly affected its ownership structure. Not only is the number of banks declining despite the issuance of new licenses to Islamic and Microfinance Banks, the underlying ownership structure is also changing. The overall number of banks has declined from 43 to 39 since CY00. Over the same period, the number of domestic banks has increased to 32 from 24 as of end CY00. As a result, local private banks have emerged as the leading player in the banking sector, with an asset share of 72.4 percent as at end CY06. The asset share of both foreign banks and public sector commercial banks has declined over the same period.

It may be noted, however, that the declining asset share of foreign banks should not be interpreted as indicative of the declining interest of foreign banks in Pakistan. The opposite is certainly true though, as foreign direct investment in the banking sector is on the rise. Acquisition of a strong mid-sized local commercial bank by Standard Charted plc to establish Standard Charted Bank (Pakistan) Ltd, acquisition of another mid-sized local commercial bank by ABN Amro Bank N.V., and acquisition of majority shares of Crescent Commercial Bank by the SAMBA financial group, are some of the noteworthy transactions, as a consequence of which the foreign stake in the Pakistani banking sector has jumped to 43.4 percent. Incidentally, these M&As have also led to the transformation of foreign banks operating in branch mode to locally incorporated subsidiaries of their respective parent organizations.

Impact of Mergers and Acquisitions in Stakeholders and Shareholders:

Mergers and acquisitions help to improve the quality of service, products and assets quality. Mergers and acquisitions also affect the senior executives, labor force and the shareholders.

Impact of Mergers and Acquisitions on workers or employees:

Mergers and acquisitions impact the employees or the workers the most. It would require less number of people to perform the same task if a new resulting company is efficient business wise. The company would attempt to downsize the labor force under such circumstances. Skillful employees can continue on new resulting companies but those who are inefficient and don’t have capability to perform significant role in new resulting firm, their incompetence will be the cause of their removal from the new organization set up or they work with a much lesser pay package than the previous one.

Impact of mergers and acquisitions on top level management:

Two organizations might have different cultures. In the new set up the manager may be asked to implement such policies or strategies which may not be quite approved by him. In this kind of situation, executives want to settling matters among themselves or moving on. If however, the manager is well equipped with a degree or has sufficient qualification, the migration to another company may not be troublesome at all.

Impact of mergers and acquisitions on shareholders:

We can further categorize the shareholders into two parts:

The Shareholders of the acquiring firm

The shareholders of the target firm.

Shareholders of the acquired firm:

The shareholders of the acquired company benefit the most. The reason being, it is seen in majority of the cases that the acquiring company usually pays a little excess than it what should. The shareholders give up their shares; the company has to offer an amount more then the actual price, which is prevailing in the market. Buying a company at a higher price can actually prove to be beneficial for the local economy.

Shareholders of the acquiring firm:

They are most affected. If we measure the benefits enjoyed by the shareholders of the acquired company in degrees, the degree to which they were benefited, by the same degree, these shareholders are harmed. This can be attributed to debt load, which accompanies an acquisition.

Mergers and Acquisitions Effects on Efficiency:

The M&A process should theoretically increase the profit efficiency of the institutions as the value maximizing factors generally play an important role in the consolidation process. Costs are likely to decline and revenues are expected to rise as a result of consolidation of operations. As a result, the profitability of the financial sector is expected to increase. Despite strong theoretical backing, international experience based on advanced countries’ data yields mixed results. The BIS report notes that “studies that examine ex post changes in cost efficiency resulting from mergers and acquisitions generally fail to find any evidence that efficiency gains are realized.” However, it is acknowledged that the inability to detect efficiency gains by the author may be attributed to ‘accounting complexities’.

In case of Pakistan, the administrative expense to total expense ratio and the after tax return on assets (ROA) is used to analyze the impact of M&As on the cost and profit efficiency of individual institutions. The difference in difference approach is used to gauge the impact of consolidation on selected institutions. Table 2 indicates that the administrative expense to total expense ratio for 4 out of 5 banks increased after undergoing acquisition (as in case of HBL, UBL and ABL), while it declined for one bank. These findings can be termed inconclusive at best, as there is no strong support for cost efficiency for the selected banks.

Table-2: Effect of M&A on Cost and Profit Efficiency

Difference in Difference Estimates

Average Before M&A

Average After M&A

Impact

Ad. expense to total expense ratio

HBL

6.28%

8.37%

2.09%

UBL

5.11%

12.17%

7.06%

ABL

9.74%

9.66%

-0.08%

NIB

1.01%

5.75%

4.74%

KASB

-6.85%

2.93%

9.78%

After tax Return on Assets

HBL

0.40%

0.20%

-0.21%

UBL

-0.95%

0.32%

1.27%

ABL

-1.57%

-0.12%

1.45%

NIB

1.39%

0.19%

-1.20%

KASB

0.22%

-1.73%

-1.94%

(http://www.sbp.org.pk/fsr/2006/English/Financial%20sector%20Consolidation.pdf)

The rise in administrative expense to total expense ratio at a rate faster than the industry may be attributable to a number of factors including the expense for right-sizing, changes in defined benefits, repair & maintenance etc.

About NIB Bank Limited:

NIB Bank Limited started operations in October 2003 when all assets, liabilities, rights and obligations of the former National Development Leasing Corporation (NDLC) and Pakistan operations of IFIC Bank were amalgamated with and into the Bank with a paid up capital of Rs. 1.2 bn. In April 2004 the Pakistan operations of Credit Agricole Indosuez were also amalgamated with and into NIB. In March 2005 Temasek Holdings of Singapore acquired 25% shareholding in NIB Bank, through Bugis Investments. This shareholding was further enhanced to over 70% in June’05 following an increase in NIB’s paid up capital to Rs 3.4 bn. NIB Bank has since grown rapidly from a base of 2 branches in 2003 to 45 in the 4th quarter of 2007, with a corresponding increase in its assets and deposits base.

NIB Bank’s vision is to rank amongst the top 5 banks in the country. Therefore towards the end of June 2007 it acquired majority share of PICIC with the aim of merging PICIC and its commercial banking subsidiary PICIC Commercial Bank Limited (PCBL) into NIB. The acquisition was financed through the country’s largest private sector rights issue, with resultant increase in NIB’s paid up capital to Rs. 22.0 bn. The PICIC acquisition bought with it another subsidiary “PICIC AMC” and an affiliate “PICIC Insurance”.

 NIB already has a shareholding in NAFA, an Asset Management Company (AMC) whose shareholders also include National Bank of Pakistan and Fullerton Fund Management Company; thus NIB Group’s asset management business has also increased, while it has diversified into the insurance business as well.

 The legal merger of PICIC & PCBL into NIB took place on December 31, 2007, once all regulatory approvals were in place. NIB Bank continues to be led by Khawaja Iqbal Hassan, supported by four business heads and ten business enabling function heads. The merger resulted in a vastly expanded branch network and total assets of Rs 176.6 bn on merger date. NIB has the highest paid up capital of Rs. 40.4 bn amongst all banks in Pakistan. Merger synergies include lower cost deposits, enhanced customer service delivery channels and overall improved efficiencies. These help provide a competitive edge in the face of increasing competition in the banking sector. Temasek Holdings continues to be the largest single investor in NIB Bank with approximately 74% shareholding.

The powerful franchise of the three merged entities has been brought together to form a much larger and stronger bank to complete in the market place. (http://www.nibpk.com/AboutNIB/HistoryOfBank.aspx)

About Standard Chartered Bank Limited:

Standard Chartered is the largest and fastest growing International Bank in Pakistan. The Bank has been operating in Pakistan since 1863 when it first established its operations in Karachi.

Standard Chartered now employees over 4,000 people and has a branch network of 162 branches across 41 cities in the country. Standard Chartered’s core businesses in Pakistan are in Consumer Banking and Wholesale Banking.

Standard Chartered Pakistan is the first international bank to get an Islamic Banking license and to open the first Islamic Banking branch in Pakistan and has been given credit ratings of AAA/ A1+, the highest long-term rating assigned by PACRA to any private sector commercial bank. The Bank’s efforts have been recognized by independent and credible authorities; we won "Best Foreign Commercial Bank in Pakistan" award by Finance Asia; "Best International Trade Bank in Pakistan 2009" by Trade Finance Magazine, a publication of Euro money; "Best Foreign Exchange Provider" Award from the Global Finance Magazine for 2010; Triple A awards for the 'Best Debt House in Pakistan' award by The Asset; "Pakistan Deal of the Year – 2009" award by the Islamic Finance News; 'Awards for Excellence', London 2009, by the Global Custodian; Consumer’s Choice Award for being the "Best Credit Card Provider in Pakistan" by the Consumer Association of Pakistan. (http://www.standardchartered.com/pk/personal/about-us/en/about-us.html)

Objective of the Study:

The objective of the study was established on the NIB bank and Standard Chartered Bank to analyze their profitability by comparing pre-merger financial performance with post-merger financial performance.

Chapter no: 2 - Rationale, Theoretical or Conceptual Background/Foundation

Neo Classical Profit Maximizations Theory states that the firms will engage in takeovers if it results in increased wealth for acquiring company’s shareholders (Manne 1965). Increased shareholder wealth is likely to result if acquiring company’s profitability increases after take over. The shareholder wealth maximization theory thus requires that a takeover should lead to increased profitability for the acquiring firm for it to be justified. Profitability can increase though the creation of monopoly power, synergies or injecting superior management into the acquired firm.

In opposition to the neo classical economists, Robin Marris (1964) W.J.Baumol (1959) and other have put forward the Theory of Maximizing Management Objective of Growth. The theory, therefore, holds that beyond achieving a certain satisfactory level of profits, managers will attempt to maximize their own self-interests and these do not necessarily correspond with maximizing shareholders’ wealth. Management’s self interests include such factors like reducing the risk of losing their jobs, increasing their salary levels and increasing their power and job satisfaction. The maximization of management growth theory does not necessarily require increased profitability; an increase in size and an increase in manager’s benefits are the criteria.

Marris in his Economic Theory of Managerial Capitalism propounded for the first time a theory of takeover bids. Single variable “Valuation ration” suggested by Marris.

V= Stock market value of a firm’s equity capital

Book value of its net equity assets

Denominator of the above expression reflects the value of economic resources employed by the firm. The numerator on the other hand, reflects stock market’s valuation of earning power of these resources under the present management.

Williamson’s (1968) Native Trade off Model states that only a small gain in efficiency is necessary to offset a relatively large gain in market power and as such mergers are generally beneficial. Thus the theory of hypothesis those horizontal mergers are generally beneficial because the loss suffered by consumers resulting from an increase in prices is more than outweighed by fain to producers.

Gort’s (1969) economic Disturbance theory is based on the premise that differences exist between the shareholders concerning the present value of shares because of information imperfections, as individuals possess different information and assess it differently. These differences occur because of economic disturbances such as rapid change in technology and share prices. Whenever share prices change rapidly merger activity will increase. Gort examined whether explanations of mergers, such as pursuit of monopoly power or economies of scale, actually explained fluctuations in the level of merger activity. The rate of merger was defined as the number of acquisitions to total business firms in a given sector.

He tested the hypothesis that frequency of merger was a function of either economic disturbance that lead to valuation discrepancies or economic of scale by taking few explanatory variables. His results supported the valuation discrepancy hypothesis and argued against an important role for economies of scale.

Chapter no: 3 – Literature Review

The bank merger phenomenon has been widely accepted as the way to achieve performance improvement, especially when merger activities focus on geography, economic of scale, and activity lines (DeLong, 2001; Houston et al., 2001). In addition, many urge that bank mergers could improve economies of scale and cost reduction when they share information, transaction system and monitoring costs (van Rooij, 1997). The economies of scale of merged banks could be achieved since they can reduce the average cost by expanding the volume of similar banking products. Therefore, when the economies of scale argument hold, then the greater the benefits received by the merged banks (Jensen and Ruback, 1983).

It is widely known that the Asian financial crisis of 1997 has affected mostly the countries in the Asian region. The 1997-1998 Asian financial crises gave the much needed push for the industry to consolidate. In general, the crisis was associated with a sharp reduction of economic growth, especially in Indonesia, Thailand, Malaysia, South Korea, and the Philippines. For example, in 1998, the real per capita GDP of these most affected countries have been dramatically reduced by 16 percent in Indonesia, 12 percent in Thailand, 10 percent in Malaysia, 8 percent and 3 percent in South Korea and the Philippines respectively. On the other hand, countries such as Taiwan and China, despite of GDP growth declines, their real per capita GDP grew at 4 percent and 6 percent respectively, while Hong Kong, Singapore and Japan experienced only 5 percent, 3 percent and 1 percent GDP growth declines respectively (Barro, 2001).

In Indonesia, the crisis hits the banking sector very much. To overcome the problems resulted from the economic crisis, the Indonesian government through the central bank, proposed financial liberalization programs as one of strategies to increase the bank performance and competitiveness. This strategy had been implemented across affected countries, especially in the Southeast Asian countries. It is assumed that more competitive environment will encourage bank to be more efficient by lowering costs and increase revenue trough efficiently allocation of resources. As the most affected sector, it is important to distinguish the effect of the merger on bank performance. In general, there are three main reasons for performance measurements: a concern for value of money in all evaluation process; a concentration upon economy, efficiency and effectiveness; and a focus on management rather than administration staff (Sharma, 2001).The most widely applied measure to banks’ performance is financial measures, which is not the same as production efficiency, which motivates this study.

In Malaysia, the plan to consolidate and rationalize the banking sector was initiated as early as mid 80’s when the industry was badly hit by the 1985-1986 economic recession. One of the banks, United Asian Bank Berhad, was subsequently merged with Bank of Commerce (M) Berhad. Since then, the only market-oriented mergers in banking sector were between Kwong Yik Bank and DCB Bank which became RHB Bank Berhad, and Chung Khiaw Bank and United Overseas Bank (M) Berhad. The merger programs undertaken by the Malaysian banking system as proposed by the central bank are indeed in tandem with the direction of the global industry. Efficiency, economies of scale coupled with the impending liberalization of the Malaysian banking system make consolidation inevitable. The total number of banking institutions as of 20th October 1999 was 55, which consisted of 20 commercial banks, 23 finance companies and 12 merchant banks.

These banks were given a dateline by end of January 2000 to forward their comprehensive proposal to Bank Negara Malaysia (BNM) on this merger. Initially, BNM has approved 6 anchor banks i.e. Maybank, Multi-Purpose, Public, Southern, Perwira Affin and Bumiputra Commerce. Consequently, the number has been examining to 10 with the additional EON, Hong Leong, RHB and Arab Malaysian joining the elite group. To date, all fifty five banks have consolidated into ten anchor banks. Following this consolidation, some investigations had been performed to investigate the impact of this consolidation on the Malaysian banking system. Using data for the period of January 1999 to February 2000, Isa and Yap (2003), for example, found that there is a positive market reaction on the announcement of bank mergers with substantial returns recorded mostly on the day before the announcement. This finding is supported by the results produced by Mahmood and Mohamad (2004) who conclude that bank mergers after the 1997 crisis have led to an improvement in performance of these banks.

Here, we briefly review the operating performance studies, which examine the reported performance before and after the merger. The issue of real economic gains from mergers and acquisitions is better examined in the light of theses studies. Study on the effect of bank mergers on performance has been conducted in many countries with various findings. Meek (1977) compared the change in Return on Assets (ROA) of the acquirer following five years of acquisition. Revenscarft and Scherer (1987) examined how mergers of 1950-70 affected the operating efficiency and profitability of the merging firms. Mueller (1980) edited a collection of studies of M&A profitability across seven nations. Regarding profitability, he reports that acquirers show no significant differences. Healy et al. (1992) analyzed both accounting returns and stock returns to examine post-acquisition performance of the 50 largest US mergers. They found a strong positive relation between post-merger increases in operating cash flows and abnormal stock returns at merger announcements. Berger and Ofek (1995) found an average loss in value from diversification ranging from 13% to 15%. The degree of relatedness between the business of buyer and seller is positively associated with returns. Unrelated mergers tend to be associated with worse performance than related mergers. Rahman and Limmack (2004) reported that in Malaysia, target companies had higher operating performance than their peer group prior to acquisition, but acquiring companies had lower operating performance than either their targets or control companies. The performance of combined firms improved significantly following acquisitions. Martynova et al. (2006) investigated the long-run profitability of both acquiring and target firms from UK. Employing alternative measures of operating performance, they found that both acquiring and target companies outperformed their peers significantly prior to takeovers but the probability of the combined firm decreased significantly after the merger.

The results of various operating performance studies do not give a consensual view of the effects of acquisitions. While some studies report gains, e.g., Healy et al. (1997), Parrino and Harris (1999), and Powell and Strak (2005), some showed losses to the acquiring firms, e.g., Hogarty (1978), Clark and Ofek (1994), Pawaskar (2001), and Sharma and Ho (2002) and others report mixed results e.g., Neely and Rochester (1987), and Ghosh (2001). Kaveri (1986) compares post-merger performance of merging companies with pre-merger performance on a case by case basis. Kumar and Parchure (1990) offer a general introduction to mergers and discuss their accounting framework. Pawaskar (2001) took a sample of 36 merged companies from 1992 to 1995 and calculated operating gains for three pre-merger and three post-merger years. Kumar and Rajib (2007) analyzed the financial and product market characteristics for 227 acquirer and 125 target firms over a period 1993-2004.

Allen and Boobal-Batchelor (2005) studied the post-crisis bank mergers in Malaysia. The study found that the target banks tend to be less efficient than those acquiring banks. Samosir (2003) found that there were no performance differences between before and after the merger. In contrast, Soemonagoro (2006) found that a merged bank experienced a continuing performance improvement from 1999 to 2005. Other study by Hadad et al. (2003) found that only privately-owned banks found as the most efficient banks.

Studies that show bank mergers result in efficiency gains, however, have produced mixed results. Houston et al. (2001) found that the bulk of the efficiency gain being attributable to estimated cost savings rather than projected revenue enhancements. On the other hand, all 39 studies of bank mergers and performance published between 1980 and 1993 summarized by Rhoades (1994) show no evidence of efficiency gains from bank mergers. Rhoades (1998) further investigates the efficiency effect of bank mergers by using case studies of nine mergers in America. The same basic analytical framework was employed in all of the case studies, such as financial ratios, econometric cost measures and the effect of the merger announcement on the stock of the acquiring and acquired firms. All nine mergers resulted in significant cost cutting in line with pre-mergers projections. Four of the nine mergers were clearly successful in improving cost efficiency but five were not. The most frequent and serious synergies experienced in bank mergers that increase bidder returns relative to nonfinancial mergers were unexpected difficulty in integrating data processing systems and operations.

Other researchers have identified possible causes of poor multidivisional performance. Lamont (1997) and Shin and Stulz (1997) provide evidence that inefficient or poorly performing divisions of conglomerates are subsidized by other divisions, without proper regard to divisional investment opportunities. Scharfstein (1998) finds that the investments of small divisions are not sensitive to their own-division cash flow, while the investments of stand-alone firms are. Moreover, stock returns Comment and Jarrell (1995) and operating performance John and Ofek (1995) react favorably when firms reverse the effects of diversification by divesting assets or otherwise refocusing their activities. Maksimovic and Phillips (1998) find that the growth of most conglomerates is consistent with optimal behavior; they do not find evidence that peripheral divisions are protected inefficiently by headquarters. Similarly, Billet and Mauer (1998) show that internal capital markets transfer funds to financially constrained divisions with good investment opportunities, which is consistent with a well functioning internal capital market. Chevalier (1999) finds that investment patterns commonly attributed to cross-subsidization between divisions are apparent in pairs of merging firms prior to their mergers. Chevalier also finds that the market reacts positively to announcements of diversifying mergers in her sample, implying that the market does not expect the acquisition to destroy value.

Merger is the joining of two or more companies to form a single company. Many explanations have been advanced for the reasons behind mergers. According to the neoclassical economic theory, mergers occur as the result of a profit maximizing behavior. Companies may wish to merge because they want to improve their productive, distributive or financing capacity by achieving economies of scale or scope or they may aim at increasing market power. Another reason is the attainment of cost efficiencies and synergies from acquisition of technology or intangible assets. Besides, mergers could eliminate inefficient target management. There are some non-profit maximizing reasons such as maximization of sales or growth, reduction of risk and bigger size. In such circumstances, managers initiate a merger not to maximize the value of the company but their own utility. The various motives of mergers are discussed as follows:

Profitability: Profit maximization is a vital objective of mergers. Efficiency theory predicts improved performance from M&As as managers are motivated to create value by exploiting efficiencies and synergies. Profitability is defined alternatively in terms of return on capital employed, return on net worth and profit margin.

Size: The analysis of the size variable is also used to infer if the takeovers are for managerial self-interest, that is, if managers undertook the takeovers to increase the size to enhance their potential compensation. If size is the only motive for managers, it leads to decline in post-merger profitability. It is a gain for managers at the expense of shareholder wealth. Size is measured in terms of the net capital employed.

Liquidity: Another motive advanced for mergers is the expected improvement in the liquidity of the acquiring firms. A firm hard pressed for liquidity might merge with one which abounds in liquid assets with the objective that the combined short-term financial position will improve (Pawaskar, 2001). Liquidity measures the firm’s ability to satisfy its current obligation and is denoted by current assets to current liabilities.

Leverage: Mergers provide an opportunity to enhance the debt capacity. Firm with unused debt capacity may be acquired to enhance the debt limits of the combined firm. This additional debt capacity helps in creating additional value. Leverage is defined as debt equity ratio ad interest coverage ratio.

Relatedness: Relatedness means two merging firms belonging to the same industry, i.e., sharing the same four digits Standard Industrial Classification (SIC) code. One can reasonably expect a greater likelihood to gains from higher managerial expertise. As Jensen (1986) suggests, conglomerate mergers are less likely to succeed since mergers of acquiring firms are often not familiar with the industry of the target company.

Age: With respect to age, one stream of research suggests that older firms enjoy better performance because of their experience and the lack of liabilities and newness. The other stream of research supports the idea that older firms are prone to inertia, bureaucracy and the lack of flexibility to adjust to change, thus exhibiting lower performance as opposed to younger and more flexible firms (Agiomirgiankis et al., 2006)

Group Mergers: The case of mergers between group and subsidiary firms has been very specific to the Indian firms. The formation of many group or subsidiary firms is attributed to the government policies, which played an active role in the growth of the firm until 1991. The merger of the subsidiaries or group companies into the same firm has been a major part of the restructuring process to improve performance. Thus, mergers of group firms are expected to improve the performance by attainment of economies of scale (Pawaskar, 2001)

Chapter no: 4- Hypothesis

Research Questions:

Q1: Is there any difference in pre-merger and post-merger financial performance of acquiring bank?

Q2: What are the factors give impact on the profitability of acquiring bank?

Q3: What are the methods uses to evaluate the financial performance of acquiring bank?

Q4: Does merger and acquisition activity always give benefit to the acquiring bank?

Statement of Hypothesis:

Ho: There is no significant difference between the financial performance of the acquiring bank before and after the merger.

H1: There is significant difference between the financial performance of the acquiring bank before and after the merger.

Significance of this Research Project:

The financial performance of NIB and Standard Chartered Bank after merger will be evaluating in this study and make sure the position of banks either they gain profit or not.

Assumption:

There is no assumption in this study.

Limitation:

The focus of the study is mainly based on merger and acquisition in Pakistan but there are few examples of mergers and many acquisitions have taken place in the banking sector.

Delimitation:

The study will focus on the mergers during the period of 2006-2007 so the data will be available for 4 to 5 year to evaluate.


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