Ebook Bank Mergers, Competition and Liquidity
The last decade has witnessed a substantial number of mergers and acquisitions in the financial services sector of many industrial countries. This ‘merger movement’ has been documented in detail and generally discussed in various official reports and research papers. For example, it was observed that the phenomenon was particular concentrated among banking firms, that this type of consolidation accelerated during the last years of the 1990s, that most M&As occurred within national borders and that - as a consequence - many countries (e.g. Australia, Belgium, Canada, France, the Netherlands and Sweden) reached a situation of high banking sector concentration or faced a further deterioration of an already previously concentrated sector, whereas a few others (notably Germany and the United States) remained relatively unconcentrated. The origins of the ‘merger movement’ were found, interalia, in technical progress (particularly in communication technology), deregulation, general globalisation and the resulting competitive challenges for financial firms and, related to the latter, monetary integration in Europe. Of particular interest for policy makers, market participants and researchers are the consequences of such an extensive consolidation process for the efficiency and competitiveness of bank intermediation, for market liquidity and financial stability and for the working of monetary policy.
In the present paper we address some of these issues and draw some tentative policy conclusions. We provide a theoretical basis for the joint analysis of the impact of mergers on competition among banks and of their effects on individual reserve management and banking system liquidity. The Ferguson ‘Report on Consolidation in the Financial Sector’ pointed out that ‘...by internalising what had previously been interbank transactions, consolidation could reduce the liquidity of the market for central bank reserves, making it less efficient in reallocating balances across institutions and increasing market volatility’ (Group of Ten, 2001, p. 20). Although the central banks contributing to this report did not see any evidence so far that financial sector consolidation had led to this result, they agreed that the situation should be monitored carefully.
Our main aim is to address the link between bank consolidation and bank liquidity at two levels, the level of individual banks and the level of the banking system as a whole. At the individual level, we are interested in how banks compete in loan markets, how they manage their reserve assets and what liquidity risks they are taking in doing this. We then ask the question in which way mergers change individual bank behaviour, in particular regarding the level of reserves they hold to insure against liquidity risk. At the aggregate level, we are interested in the overall level of loan rates in the system and in the question how individual reserve choices and liquidity risks add up to system wide liquidity fluctuations. In particular, we analyse how bank consolidation affects money market liquidity. Private money market liquidity is important in two respects. First, greater aggregate liquidity fluctuations may make it more difficult for central banks to keep money market rates stable around policy rates. Second, in the absence of a central bank or in the case where central banks cannot perfectly compensate for all liquidity shocks occasional shortages may endanger the stability of financial institutions. In conducting our analysis, we are not only able to address the question whether bank consolidation may drain liquidity from the money market and if yes in which way, but we can also study whether the competitiveness of bank loan markets is complementary or in conflict with money market liquidity. Moreover, our results are suggestive of how central bank liquidity management, the implementation of monetary policy, may have to change in response to the effects of large mergers. This indicates whether bank consolidation increases or reduces the dependence of the banking sector on public liquidity provision. Finally, we use our framework for an exploratory analysis of the bank lending channel in the transmission of monetary policy and how it is affected by merger activity.
To address those issues we develop a model combining liquidity considerations from the banking literature with competition considerations from the industrial organization literature. Our set-up describes banks as raising deposits to invest in long-term loans to entrepreneurs and in liquid short-term assets (reserves). On the market for loans banks compete in prices and retain some market power through differentiation. They hold reserves as a cushion against stochastic liquidity shocks originating from uncertainty about whether depositors wish to withdraw before loans mature. The share of deposits withdrawn early is distributed independently across banks. If depositors’ liquidity demand exceeds reserves, a bank can fund the difference by borrowing in the interbank market. The interbank or money market redistributes reserves from banks with excess liquidity to banks with individual liquidity shortages. However, as we assume aggregate uncertainty, the economy-wide demand for liquidity can sometimes exceed the total stock of available reserves. In those circumstances the missing liquidity can be provided by a central bank.
Banks choose reserves balancing the marginal benefit of lower refinancing needs with the marginal cost of having to raise more deposits. At the optimum, reserve holdings increase with the interbank market rate and decrease with the deposit rate. Equilibrium loan rates are set at the level that equates the marginal revenue of providing loans with the marginal costs of monitoring loans, refinancing in the interbank market and raising deposits. They decrease in the competition parameters (number of banks, substitutability of loans) and increase in the cost factors (monitoring costs, interbank and deposit rates).
The occurrence of a merger modifies banks’ behaviour concerning both liquidity management and loan market competition. As regards the former, an important feature of our analysis is that mergers can create an internal money market. This form of internal capital market implies cost advantages, as liquidity can be reshuffled without paying the interbank market rate. Interestingly, this internal insurance mechanism rather tends to lead to higher reserve holdings. The reason is that as long as the interbank market rate is not too high relative to deposit rates, the positive externality of an additional unit of reserve held in one part of the bank on the other part of the bank dominates the forces of diversification. A low interbank rate means that reserve ratios are relatively low before merger, so that the internalisation of the positive externality is more important and reserves rise after the merger. Only for a very high interbank rate are pre-merger reserve ratios so large that the diversification effect dominates. In any case, the liquidity situation of the merged banks improves, both in terms of liquidity risk and expected needs.
The effect of the merger on the loan market depends on the relative strength of increases in market power and potential cost efficiency gains. Since the merger allows the two banks to internalise the effect of their pricing also on the demand of their companion bank, they are able to set ceteris paribus higher loan rates. At the same time, potential efficiency gains together with the savings of interbank financing costs through the internal money market make banks more aggressive in setting loan rates. Hence, overall loan rates may either increase or decrease depending on how strong cost reductions are. Since banks compete in strategic complements, the loan rates of the competitors move in the same direction as the loan rates of the merged banks. Regarding lending quantities, the merged banks gain market shares at the expense of competitors when loan rates fall and they lose market shares to competitors when loan rates rise. What is important to keep in mind is that consolidation changes banks’ balance sheets creating (or reducing) heterogeneity, both through the reshuffling of loan market shares and through changes in optimal reserve holdings.
The change in the size distribution of banks’ balance sheets and in their balance sheet composition affects the liquidity situation in the money market. This applies to both aggregate liquidity risk (the probability of facing a liquidity shortage in the interbank market) and to expected aggregate liquidity needs (the expected amount of the liquidity needed). Mergers affect these features of aggregate banking system liquidity through two fundamental channels in the model, one working through the aggregate level of reserves and the other through the degree of asymmetry in banks’ balance sheets. The reserve channel is directly related to individual banks’ changes in liquidity management, as described above. When reserve levels are relatively low in the ‘status quo’ (i.e. the interbank refinancing costs are low compared to deposit financing costs), then individual banks increase reserves, the aggregate supply of liquidity goes up and both aggregate liquidity risk and average liquidity needs become more moderate. For decreasing reserves aggregate money market liquidity deteriorates.
As to the second channel, greater asymmetry or heterogeneity of bank balance sheets leads to a higher variance of aggregate liquidity demand. Whether the greater variability of liquidity demand related to this asymmetry channel leads to higher aggregate liquidity risk, depends again on whether the system is characterised by high or by low reserve levels. When reserves are low, then the total supply of liquidity in the money market is lower than the average liquidity demand and the greater variance of demand caused by the asymmetry effect of the merger implies less frequent liquidity shortages. In the opposite case, high refinancing costs and high reserve supply, aggregate liquidity risk is reinforced. In contrast, greater asymmetry of bank balance sheets always leads to higher expected liquidity needs. As this measure of money market liquidity captures the severity of shortages, the higher frequency of extreme events in particular of very large demand realizations ensures that the amount of liquidity that central bank will have to provide on average increases with a merger.
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