- Consulting with Canadians -

SECOR Consulting Submission in Response to Finance Canada's Large Bank Mergers in Canada:

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Shareholder Value Created And Destroyed In Financial Services Mergers – Implications For Public Policy

Respectfully submitted to the Federal Department of Finance by SECOR Consulting, December 22, 2003

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During the consolidation of the financial services industry in North America and Europe, bankers have been looking to mergers and acquisitions as a way to gain economies of scale, build market share and enter new markets. Yet our research shows that most in-market "bank-bank" combinations have failed to create value for the shareholders of the acquiring company. There has typically been less value derived from these deals than was anticipated, and much of the value of the cost synergies has been transferred to the sellers through acquisition premiums.

In contrast, "cross-pillar" combinations between banks and investment banks or insurers have created value for both the buyer and the seller. The shareholders of acquiring companies have generally enjoyed substantial and lasting benefits of revenue synergies. These are derived from more and better products being offered to customers through more effective and efficient channels. The well executed deals have benefited shareholders of both firms because they have created real and lasting value for customers.

The purpose of this submission is to introduce SECOR's research findings into the public policy debate on bank and cross-pillar mergers. The research was conducted independently by SECOR without client funding and, as a firm, SECOR has no particular view on what type of transactions should be allowed. However, the findings offer compelling evidence of the potential benefits of cross-pillar combinations to customers and shareholders that need to be considered, in contrast to a poor M&A success record for bank-bank deals to date.

This submission includes:

1. The research approach – description of the data and analysis, and the importance of the shareholder value metric;

2. Bank-bank versus cross-pillar success rates -- the results of applying the metric to in-market bank-bank deals versus cross-pillar deals;

3. How value is created -- the reasons for the superior performance of the cross-pillar deals; and

4. Implications for public policy – the issues that need to be considered in developing the regulatory roadmap.

1. The research approach

SECOR's database includes all acquisitions since 1990 with a market value greater than US$1 billion by public companies in the US and the EC, or greater than US$100 million by Canadian companies. The measure of success is whether the merged entity's total return to shareholders outperformed its industry average during the implementation of the deal. We start the clock from the date three months before the deal is announced, to precede insider-trading effects, and study the return relative to industry over a three-year period, to allow any market "sizzle" surrounding the deal to dissipate and the actual effects of the merger's implementation to be felt. The author developed this metric in 1995. Analyses of various industries and M&A issues have since been published in a variety of articles and are extensively referenced in the business press.

Our research on financial services M&A transactions focussed on the US and EC, considering these three questions:

• Which deals created wealth for shareholders, considering deal premiums paid to the seller and appreciation of shareholder value for the buyer, relative to the industry?
• Are there significant differences in success rates between consolidation transactions and cross-pillar transactions?
• What characteristics of major deals in financial services correlate most strongly with success?

The metric deployed and the results are material to the debate on how the restructuring of the Canadian financial services industry should proceed. Overall shareholder value appreciation is highly correlated with the health of an industry, and in the case of financial services, the health of the economy. The shareholders of the seller win by definition – no deal premium, no sale. However, if the shareholders of both the seller and the buyer win, then the deal has not only transferred value, it has clearly created value. If only the seller wins, then wealth created (if any) has been transferred to the seller, raising serious questions about the benefits of the deal to the economy and, in particular, to the large institutions most likely to be on the buy side of such transactions.

The reasons behind the successes and failures are equally important to the public policy debate. Are the successful deals creating a net benefit to the customer – i.e. the consumers and businesses that rely on the financial services industry? Which deals represent the greatest opportunity to enhance the offering to customers of financial services and which risk stifling competition and raising the cost of service? The latter question is important for Canada's global competitiveness.

2. Bank-bank versus cross-pillar success rates

Studies of acquisitions across all industries have found that acquirer shareholders are generally better served by related diversification than by consolidation. This seems counter-intuitive, but the analysis of over 2000 deals is quite compelling. In the US, only 36% of consolidation deals have succeeded for the buyer compared to 48% of related diversification deals, (still not high). In Europe, 49% of consolidation deals have been successful while 70% of related diversification deals have succeeded. (Note that unrelated diversification deals perform badly in both markets.)

The IBM – Lotus combination best illustrates the potential of a sound related diversification deal to grow revenue. Leveraging its vast global channels to sell Lotus product, IBM greatly expanded market penetration of Lotus' software products. But it doesn't stop there. Sales of initial products were then followed by sales of product extensions. Furthermore, this deal took IBM into the software business and paved the way for other new or acquired software products to use the IBM channels.

In contrast to the lasting revenue benefits of a well fitting related diversification, consolidation deals are justified mostly on the basis of one-time cost savings. The time and effort to achieve these savings are frequently underestimated, resulting in a loss of value relative to the expectations built into the deal premium.

What is true in general, also turns out to be true in the financial services industry. Only 34% of the bank-bank deals in the US and EC from 1990 have been successful in adding shareholder value. Insurance-insurance deals faired better at 58%. The combined success rate of like-buys-like is 44%.

However, cross-pillar deals (related diversification) performed better. Overall 65% of cross-pillar deals were successful. The bank-investment bank combinations of the 1990's were successful for the acquirer 55% of the time. The more recent bank-insurance combinations have performed best, with 73% of bank-insurer deals creating value for shareholders.

On average, bank-bank deals lost 10% of shareholders' value, while bank-insurer deals earned 8%, relative to the industry.

In fact the only type of bank-bank deal with a passing grade are cross-border deals. While only 31% of domestic bank-bank deals succeeded, nearly twice that – 60% – of cross-border bank-bank deals were successful, and most of those were in Europe.

Cross-border bank-bank deals have something in common with the cross-pillar deals: they are less about cost cutting and more about revenue. Continuing the pattern, deals that were both cross-border and cross-pillar topped them all with 75% adding shareholder value.

To put these results in perspective, the 34% success rate of bank-bank deals is the worst success rate of any industry in our database of over 2000 large deals over the last 12 years. The bank-insurer deals, while a relatively new phenomenon, are enjoying one of the highest success rates at 73%. There have been 18 bank-insurer deals with a market value of one billion dollars or more for which there is three years of performance data. This is enough to suggest a winning pattern and belie the conventional wisdom in Canada that cross-pillar deals are not good for shareholders. Some early opinions may have been based on a couple of "famous failures" and not on a comprehensive study of cross-pillar deal performance.

3. How value is created

The above findings are, at first, counter-intuitive. Studying the deals behind the data reveals why cross-pillar deals have generally performed better than bank-bank deals.

Cost synergies often fall short of shareholder expectations.

The main difference between consolidation plays and related-diversification is the logic behind the deals. In a consolidation play, the principle economic justifications are usually scale and related cost reductions – through distribution rationalization and squeezing out duplicate management and systems.

Many executives and boards refer to cost synergies as "hard" synergies, meaning that they are directly measurable and can be tracked, compared to the so called "soft" benefits of a deal for which the return is more difficult to measure. However, cost synergies are often disappointing for three reasons:

First, cost savings are frequently overestimated. This is because of unforeseen barriers to achieving planned savings. In banking, however, there is much industry experience now and most of the planned savings are real.

However, even in banking, cost savings almost invariably take longer to implement than anticipated. In major bank mergers, for example, large systems changes are required before consolidation can occur and these systems projects are routinely underestimated by the deal-makers. Integration costs more as a result and, because of the time value of money, the delay also reduces the economic return. Therefore, even if all of the cost synergies are eventually achieved, a significant portion of the value has been lost along the way.

Finally, anticipated cost savings are transparent to the seller and to competing buyers, so they are usually factored into the acquisition price paid. This is particularly true in banking, where it is easy to count the branches that could be closed, for example, in an in-market merger. As a result, the negotiation process builds much of the anticipated cost savings into the deal premium, and that value is transferred to the shareholders of the seller.

True benefits to customers can create lasting revenue synergies.

The value in cross-pillar deals is based on the customer. Both consumers and commercial banking customers can realise real benefits from cross-pillar mergers, where regulation permits.

The financial needs of customers across pillars are closely linked. This is already in evidence in Canada. For example, for an individual investor the movement of funds between savings and investment products has been made simpler, faster and with a lower cost by having banking and equity trading with the same company, especially for on-line traders. Insurers have moved into investment products because of the close linkages between insurance and investment products in personal financial planning. Similarly, banks have been meeting some of the personal security needs of homeowners by providing credit insurance.

In more liberal regulatory environments, more related banking and insurance products can be offered together, and synergies between the products can be realised as well. For example, the level of compulsory insurance on a leveraged asset (e.g. home or auto) could decline as the principle on the loan declines. There are also actuarial synergies between products because the insurance and credit risks of an individual or a business are not independent. That is why full-line property and casualty insurers can offer savings to customers who consolidate home and auto insurance. Similar benefits could be passed on to the customer if insurance and credit for auto, home or business could be purchased together.

(Note that this is not dependent on the practice of "tied selling". Tied selling is the coercion of the customer to buy multiple products from the same company. In the case of some of these product combinations, there is value created by combination, but products could and should be offered separately or together.)

Combining channels offers improved effectiveness and efficiency.

Customers would benefit from distribution convenience, effectiveness and possibly lower distribution costs. Over the counter, ATM and on-line customers would value the convenience of a "one stop shop" for car loans and car insurance, or home loans and home insurance.

Use of one advisory channel for life insurance and financial planning would also be a benefit. Note that while the banks have more extensive retail, ATM and on-line channels, the insurers are generally regarded as having superior advisory channels.

Like the IBM-Lotus combination, these product-channel synergies can be "the gift that keeps on giving", first facilitating synergies between current products and current channels, and also paving the way for future products and stimulating innovation.

In customer surveys in the US and Canada, consumers have responded favourably to the idea of buying bank and insurance products together. For example, in a 2003 IPSOS-Reid survey of 1000 Canadians, favourable responses to purchasing credit and insurance products at the same place ranged from 70% to 77%. In addition, 250 of the respondents were small business owners or managers, and 74% of them were in favour of buying business credit and insurance at the same place as well.

Cross-pillar versus bank-bank deals offer additional benefits to the public.

There is concern that further consolidation of banks in Canada would lead to further reduction in credit availability to small business and further increases in transaction fees. Cross-pillar mergers would not contribute to credit restriction or fee escalation because they would not reduce competition in banking services. Unlike bank mergers, cross-pillar mergers would increase, not decrease, customer choice. More products and product combinations would be possible and customers could buy from traditional or combined companies.

Most Canadian customers are also bank shareholders, directly or indirectly. The large financial institutions are prominent in most mutual funds and pension plans, including the CPP. Therefore the poor track record of performance of bank-bank deals for the dominant banks' shareholders is a financial risk for the majority of Canadians. In contrast, the potential of cross-pillar deals to create shareholder value for both the buyer and the seller, particularly in a liberalised regulatory environment, is a financial opportunity for anyone holding bank or insurance stocks in their investment or retirement fund.

There are also potential benefits of further bank consolidation, such as achieving the scale to be globally competitive, as has been put forward by the banks. In addition some of these combinations offer benefits to the customer and the shareholder through the complementary strengths of the merger partners in products, channels, geographies or skills. However, the benefits of bank-bank deals are less obvious to the average Canadian, who would fear further branch closures, higher transaction fees, and job losses. In the previously mentioned IPSOS-Reid survey, the prospect of bank-insurance mergers was preferred to further consolidation of either banks or insurers.

Cross-pillar mergers require less integration to succeed.

Integration failures are often blamed on differences in corporate culture and the failure to integrate the organisations, business processes, norms and the values that make up the cultures of merging companies. For in-market bank-bank deals, where the synergies are related to economies of scale, the organisations have to be fully integrated to achieve the cost savings. Any remnants of "we –they" culture in consolidation deals are often a sign of flawed implementation.

On the face of it, this would seem to be a greater challenge in cross-pillar deals than bank-bank deals. Bank and insurance company cultures are different in many ways.

However, it is important to note that a "product-channel" synergy does not have to involve total integration of the two merging organizations. Witness IBM's acquisition of Lotus – Big Blue's pinstriped culture was deliberately restrained from overwhelming the much more entrepreneurial culture of Lotus, and yet IBM had great success expanding the Lotus footprint throughout the IBM customer base.

Similarly, implementing the deal logic of cross-pillar deals does not require complete integration. This was demonstrated in the mergers of banks and investment banks in the 1990's, which were largely positive for shareholders. In most of the successful bank-investment bank deals, integration was limited to specific overlapping customer segments and related products. The distinct investment bank culture has been largely retained within these banks many years after these deals were closed.

The bank-insurance deals to date have employed a variety of integration models, seldom requiring complete integration. Some of the successful deals have limited integration to the minimum required to cross-sell each other's products. Other mergers have integrated product lines but kept separate "manufacturing". Those operating as one integrated company are in the minority.

4. Implications for public policy

There are two overarching public policy questions with regard to consolidation within the financial services industry in Canada.

• In the long run, what are the structural characteristics of a competitive financial services industry that will serve the public interest?
• What is the regulatory roadmap that will lead to the outcomes beneficial to Canadians without undue risks to stakeholders along the way?

Note that the merger benefits to customers and the institutions are dependent on the permission to share distribution channels, cross sell and bundle products, so Canada must adopt a point of view on the convergence of financial services, i.e. if and how insurance and banking products will be sold together, as a context to setting policy for cross-pillar mergers.

With regard to the long run outcome, it would seem that the convergence of financial services offers quantitative and qualitative benefits to consumers and commercial customers. There is also a growing body of experience in more liberalised markets that can be studied to understand the benefits and risks of convergence to stakeholders. These markets should be studied to test assumptions about the benefits of convergence to customers, and to identify evidence of any negative or positive effects on competition, credit availability, soundness of financial institutions and other aspects of the public interest.

Global trends toward convergence may also be relevant to the desired outcome for Canada. That is, if convergence of banking and insurance is to be the norm internationally, then (all other things being equal), convergence in Canada would benefit global competitiveness for Canadian financial institutions and also to some degree for the industries they serve. Currently, Canada has among the least liberal regulatory environments with respect to convergence.

(There are, of course, many other aspects of the future regulatory environment to be considered by policy makers, such as foreign ownership, shareholder concentration, industry concentration, etc. This submission is focussed on the matters of convergence and cross-pillar mergers, but acknowledges that these issues must be considered within a broader context.)

An ideal regulatory roadmap would be comprised of a series of regulatory changes over time that will likely lead to a desirable industry structure and serve the public interests during transition as well. The sequencing and timing of regulatory changes is critical. For example, the prohibition of cross-pillar mergers to date has given time for the life insurance industry to de-mutualise, acquire, and increase scale and effectiveness in the capital markets. Restrictions on foreign ownership to date have provided time for Canadian banks to become more efficient and to expand internationally.

Similarly, the sequence and timing of changes to bank-bank mergers, cross-pillar mergers and convergence rules could affect the outcome and will be material to stakeholders. For example, if further concentration of banking occurs first, then the future liberalisation of cross-pillar merger restrictions and/or liberalisation of cross selling and distribution restrictions may be seen to be giving too much market power to too few institutions. If cross-pillar mergers are allowed without changes or at least the promise of changes to cross-selling and distribution restrictions, then companies may choose not to merge or, worse, deals may occur that fail.

Moreover, public policy regarding mergers to be allowed now, needs to be informed by the desired or likely outcomes for public policy regarding bank-insurance convergence in the future. Furthermore, whichever mergers are to be allowed now need to be considered as a next step in the ongoing restructuring of Canada's financial services industry, rather than the last step in bank consolidation.