Monday, May 21, 2012
Mergers: Proceed with caution
The following article on mergers was published in Republica on May 20, 2012 with the title "Tread with caution". The direct link to Republica is here.
The financial market is not going to suffer for eternity. We have seen
weak and stagnant financial activities in the last few years in Nepal due to
the recent liquidity crisis. As I have stressed in my previous articles, the
liquidity crisis in Nepal was primarily the result of our banks and financial
institutions (BFIs) providing majority of their loans to the real estate
sector. The real estate market slowed down beginning late 2008. As a result,
borrowers could not pay interests, let alone the principle amount of the loans.
So, the banks lost money, and this brought a liquidity crisis.
However, the real estate sector will eventually start improving again,
and will experience increase in its activities. Then, the borrowers—who have so
far defaulted in their payments—are going to start making their payments again.
When that happens, our BFIs are going to be flush with cash, again. So, what
will they do with that excess cash?
Since their investment and loan portfolio is not diverse, the BFIs will
have to choose between two options. First, they will have to take risk and
start providing loans to the real estate sector, again. This has a tendency to
bring another liquidity crisis if the real estate market slows down, again.
Second, to move away from the risky real estate portfolio, the BFIs could use
their cash to purchase securities which are much safer than issuing real estate
loans. However, the securities yield much lower returns compared to real estate
loans.
That would be a very confusing scenario for the BFIs. On one hand, the
BFIs would not want to go back and issue excessive loans to the real estate
sector because that was what caused them suffering in the last few years. On
the other hand, the securities option delivers them poor returns. If the BFIs
are flush with cash and do nothing with it, they will have to face intense
pressure from their shareholders. When the pressure becomes unbearable, the
past experience from around the world suggests that a third outcome is more
likely: a merger spree.
The bottom line for the BFIs is to ensure that their shareholders are
happy. The best way to make shareholders happy is to show them that their
institution is growing. The best way to grow a financial institution is to
acquire assets. And, the best asset a strong and cash flush BFI can acquire is
another BFI. So, once the real estate market in Nepal wakes up from its
hibernation, and starts making money again, our BFIs will have no logical option
to follow other than engage in mergers to grow their assets.
While the shareholders will be happy seeing their institution grow
through such mergers, the mergers do not guarantee a healthy BFI or a healthy
financial market. Today, the mergers happening in the market are not the result
of choice but compulsion in saving the institutions. In the future, the mergers
will not be the result of choice but that of compulsion—to “show” the
shareholders that the excess cash is being used in asset-building.
There are reasons why shareholders should not be too happy with mergers
and acquisitions. First, the New York Times reported during the merger surge in
2005 in the US that the shareholders’ stakes in the acquiring firm typically
declines post-merger. The structure of BFIs in the US and Nepal are not very
different. So, this decline could happen in the case of merging Nepali BFIs,
too. Second, evidences from past mergers worldwide show that the CEOs end up
pocketing around 8 percent of the merger cost as their own “compensation”. So, everyone
should ask: Was the merger done for the benefit of the institution or was it
done for the personal benefit of the CEO?
The New York Times report also mentions that there has been a strong
correlation between the size of a financial institution and the salary of its
CEO. It did not matter whether an institution was faring well or poorly in the
market. The CEOs of larger BFIs always get paid more than those in smaller
BFIs. Therefore, the shareholders need to be cautious and skeptical when their
CEO argues in favor of a merger. Who benefits the most from the merger should
be considered. Do we know how much our BFI CEOs are pocketing from their merger
deals? We need to find that out.
Labels: banks, mergers, NRB, Republica
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