Acquisitions and Mergers in Financial Services Management.

M&A across financial institutions is driven by intense competition, lifting of restrictive government rules (deregulation), search for an optimal size, lower costs, geographic and product-line diversification and the following risk reduction.

Motives behind growth in financial-service mergers are:

-expectation of increasing profit potential after the merger and of more effective control over operating expenses;

-reduction of cash flow risk and earnings risk (mergers increase the size and prestige of an organization, open up new services and new markets with different economic conditions; mergers can diversify cash flows and earnings enable a combined firm to withstand fluctuations in the economy and tough competition);

-rescue of failing institutions;

-tax benefits especially when the acquired firm has earnings losses that can offset taxable profits of the acquirer; an acquiring firm can reduce the cost of positioning in a new market;

-large-scale staff reductions and savings from eliminating duplicate facilities;

-lower degree of competition in the market (but this can diminish service quality, while prices and profits may rise);

-possibility to increase salaries for management, lower risk of being fired, enhanced reputation in the labor market for working for a bigger firm (this can lower profits, raise operating costs and decrease return to shareholders);

-ability to expand the loan limit for large and growing corporate customers.

When deciding whether to merge or not, management and BOD of the acquirer consider the following factors: the firm’s history, ownership and management, its balance sheet, income statement and cash flow statements, conditions and prospects of the local economy, the competitive structure of the market, principal customers, track of growth, current personnel, condition of physical assets.

The acquirer may buy assets or share of stock. When assets are purchased the cash is distributed to the shareholders of the acquired firm in the form of liquidating dividend. If stock is purchased the acquired firm ceases to exist, as the acquiring firm assumes all of its assets and liabilities. A stock transaction is not subject to taxation until the stock is sold, while cash payments are usually taxed.

During an M&A the acquired firm gives up its charter and adopts a new name, its assets and liabilities added to those of the acquirer. The proposed transaction should be ratified by the board of directors of each firm and a vote of each firm’s common stockholders.

The acquirer records the acquisition at the price paid to the stockholders of the acquired company plus goodwill. The result of an M&A is consolidated financial statements.

The most frequent kind of merger among financial institutions involves wholesale banks merging smaller retail banks. Most takeovers are friendly, although a few are hostile, resisted by management and stockholders.

55.Measuring and evaluating the performance of banks: financial ratio analysis, profitability analysis.

The behaviour of a stock price is the best indicator of financial performance because it reflects the market’s evaluation of a firm. But this indicator is not always available for smaller banks.

Key profitability ratios:

-ROE (=net income/total equity); it is the net benefit that stockholders received from investing their capital in the financial firm. Its components are net profit margin (NPM=net income/total operating revenues), asset utilization (AU=total operating revenues/total assets), equity multiplier (EM=total assets/total equity). NPM shows the effectiveness of expense management and service pricing policies; AU reflects portfolio management policies, EM reflects leverage, the sources chosen to fund equity.

-ROA (=net income/total assets), it indicates managerial efficiency;

-net interest margin (= (Interest Received - Interest Paid) / total assets), it’s an efficiency measure and measures the spread between interest revenue and costs and how management controls earning assets;

-net noninterest margin ((=noninterest revenues-provision for loan losses-noninterest expenses)/total assets), an efficiency measure;

-net operating margin (=pretax net operating income/total assets); an efficiency measure;

-EPS (=net income/common equity).

Breaking down profitability measures into components tells us much about the causes of earnings difficulties and suggests possible cures for earnings problems. Achieving superior profitability depends on careful use of financial leverage, of operating leverage from fixed assets, control of operating expenses, management of the asset portfolio to meet liquidity needs, control of exposure to risk.

When the performance of one bank is compared to that of another, size becomes a critical factor. Most performance ratios are sensitive to the size. The largest banks usually report the highest noninterest margins because they charge fees for so many of their services. In contrast, smaller and medium-size banks display larger net interest margins and greater spreads between interest revenue and interest costs because more of their deposits are small-denomination accounts with lower interest costs. Efficiency ratios are higher among the largest banks in the system. The smallest banks usually report higher ratios of equity capital to assets. Smaller banks are more liquid (they have lower ratios of net loans to deposits, and loans are often among the least liquid assets).

56.Banking Regulation and Globalization: functions of central banks, the main tools and instruments of monetary policy, banking supervision under the Basel Agreement on International Capital Standards Accord, unresolved regulatory issues.

A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, provides and regulates the money supply, controls the interest rates in a country and acts as a lender of last resort during financial crises. Central banks often also oversee the commercial banking system within its country's borders. A CB has a monopoly on creating the currency of that nation, which is usually that nation's legal tender.

In order to conduct money and credit policy CBs use tools that affect the legal reserves of the banking system, the interest rates charged on loans and currency values in the global forex market. Legal reserves are a percentage required from each dollar of deposits and may consist of cash in the vaults and deposits in legal reserve accounts at the CB. CBs also affect the interest rates by driving them higher to reduce lending and borrowing in the country and slowing down economic activity; and by lowering them to stimulate business and customer borrowing. CBs can also influence the demand for their home currency by varying interest rates. Sales of securities by CBs decrease the growth of deposits and loans, while purchases of securities increase the growth of deposits and loans.

The Basel rules were designed to encourage banks to keep their capital positions strong, reduce inequalities in capital requirements among different countries to promote fair competition and catch up with recent changes in financial services.

Basel I (adopted in 1988), primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with

international presence are required to hold capital equal to 8 % of the risk-weighted assets.

Basel II (2004) stipulated that minimum capital requirements for each bank are based on its own estimated risk exposure from credit, market and operational risks; that each bank’s risk-assessment procedures are subject to supervisory review; and greater public disclosure should lower risk exposure of banks.

Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

57. Bank Financial Management: