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.

Despite these warnings, I clearly see more mergers happening in the future in Nepali financial industry. I am also confident that the BFIs are going to be leading the discussions, setting the agenda, and finalizing the details of the merger propositions. However, the Nepal Rastra Bank (NRB) has to monitor and facilitate the merger processes to ensure that the shareholders are not kept in the dark by their greedy CEOs, that the consumers of the financial services do not suffer as a result of mergers, and that the BFIs that are merging do not get weakened after the merger. The NRB should ensure a robust and stable financial market in Nepal as an expected outcome of the mergers.

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# posted by Mukesh Khanal @ 10:29 AM 0 Comments

Wednesday, July 27, 2011

 

Links for July 27, 2011

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Migrant workers return from Malaysia with no money---Nepalnews

I have written in the past about Nepalese workers being promised a certain wage and not receiving it after landing in the destination country. Our newspapers keep writing about such types of mental and physical abuses that Nepalese workers face in the Middle East and other countries. This case from Malaysia is just one more story. I wonder when our government is going to act and make sure our workers are not exploited.
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Republica's Editorial urges NRB to respond to merger calls---Republica

The editorial argues in favor of mergers to protect the failing BFIs. Although it makes sense to try and save the BFIs from going belly up, personally, I am against mergers. These BFIs sprouted up due to private investors trying to make quick bucks and huge profits. If they fail, they should exit the market just like any other business entity in a capitalist market. Simple. My arguments are here.
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Nepal Tourism Year being promoted in Washington DC---Republica

It is a good idea. DC gets a lot of tourists. If only a fraction of those become attracted with the advertisement and pay a visit to Nepal, it will be good for our tourism industry.

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Real estate market poor---Republica

In 2009/10, the government earned Rs 6 billion in revenue from real estate deals. In 2010/11, it earned only Rs 3.21 billion. This is way off target of Rs 6.3 billion that the government had announced it would earn.

Dealers have been cutting rates by as much as 30 percent in the last year, but sales have still fallen by over 50 percent compared to last year. In Kathmandu, sales dropped by 53 percent. In Bhaktapur and Lalitpur, sales dropped by 52 percent.

Reckless loans by BFIs is a major cause for the asset bubble of Nepal for the last few years. I predict that this bubble will burst by 2015. Remittance money cannot keep this bubble floating forever.
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Far-west students demand a university---Nepalnews

I have not been to the far-west of Nepal. But, it is true that the region does not have a single university. This is a shame.
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19 died in Tanahun district last year due to Tuberculosis---Nepalnews

TB has a cure. TB medicine is available for free in Nepal at any government health posts and hospitals. Yet, 19 people died last year in a single district due to TB. This is a shame. This shows that something is wrong with the Nepalese information system and public service delivery system.
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NRB governor urges NRNs to invest in Nepal---Himalayan Times

Dr Yubraj Khatiwada urged NRNs to invest in Nepal through Hydropower Development and Investment Company.

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# posted by Mukesh Khanal @ 10:47 AM 0 Comments

Thursday, June 30, 2011

 

Bank Mergers: A Bad Idea

Recently, during his presentation of mid-term review on monetary policy, Nepal Rastra Bank governor Yubraj Khatiwada suggested to the bankers that they should engage in mergers and acquisitions. He posited that the increase in credit interest that has been observed was the result of increase in interest rates on deposits. Therefore, funds for further growth have been difficult to obtain due to the resulting higher costs of obtaining such funds. A merger of banks, the governor believes, will help reduce the costs of operating a financial institution. However, it is a dangerous suggestion.

Like many other economists, the governor believes that a merger or acquisition will result in an institution that is bigger than its individual parts. This bigger institution will experience lower costs due to economies of scope and scale, increase in market power, diversification, and reduced operational expenses. Thus, the perception is that this consolidation will accrue higher gains than the simple sum of gains from two separate institutions.

The perceived gains arise out of the belief that the newer and larger organization is considered to be efficient in allocating resources—human and capital—to maximize the output gains. The same personnel and infrastructure can deliver different services and products. Thus, redundant operating costs will be minimized. The belief is also that the larger bank, with more resources now at disposal, can even offer more products and services than before. In essence, the larger entity could take the best tools and methods from the pre-merger entities to maximize efficiency and capabilities.

However, these perceived gains do not occur, at least not to the extent that is perceived. Research on mergers and consolidations has shown that there is no conclusive evidence of such gains existing in real life. Hence, the governor’s suggestion to the bankers was based on little factual evidence. While the suggestion might have been genuine and made in earnest, the repercussions could be devastating. In this case, the idea of bank mergers creates risk of underperformance and loss in overall valuation of the banking industry. Therefore, the governor needs to be careful while dispensing his wisdom.

A prominent effect of bank mergers observed around the world has been the reduced availability of loans to the customer base in the aftermath of the merger. This reduced availability mainly results due to the decline in competitiveness that arises due to the mergers. When a market becomes less competitive, it becomes difficult for people and businesses to obtain loans at reasonable rates. The unreasonable interest rates for loans, in turn, results in lower investment in real estate, and devaluation of real estate property prices. If mergers are going to cause similar cascading aftereffects in real estate, which is our fastest growing economic sector, bank mergers are an ill advice for today’s Nepali banks.

Studies have shown, time and again, that diversification, efficiency, enhanced production and service have largely been found missing as results of a merger. Also, whatever the varied intentions provided for mergers, the underlying incentives have always been cost reduction. And, cost reduction is not an issue that is severe enough to grant merger and acquisition rights from the central bank. Our central bank has to be cautious in this regard.

Cost reduction can be done in a variety of ways. Mergers should be advised as the last option, and should only be allowed if one of the merging banks is facing a dire consequence, such as bankruptcy, if not merged. It helps to be cautious because mergers often result in anti-trust issues. Well-meaning intentions before the merger go haywire after the merger. Companies have been observed engaged in activities ranging from anti-competitiveness to corruption after the merger.

Also, mergers do not work, most of the time, in achieving the stated objectives. They don’t increase efficiency, don’t promote diversification, and don’t reduce costs in the extent that are touted before the merger. In fact, just the opposite has been observed in real world. Although the results from post-mergers vary from one country to the next, empirical studies have shown that only 14 to 17 percent of mergers result in lower costs. However, the question could then be asked: could the costs have been lowered by other means before deciding that the merger was the best option? There are many methods for cost-cutting, and numerous austerity measures can be implemented if the banks are in trouble. Mergers should be the last option, and not the first, that should come into the minds of Nepali bankers and the central bank’s governor, when there’s trouble.

The main argument that economists and policymakers put forward to support mergers has been the supposed creation of scale economies. In simple terms, it means there are advantages in cost reduction when a company becomes larger. However, there is strong evidence of uncertainty over the very existence of economies of scale. And, in cases where economies of scale have been observed, there is significant uncertainty over how wide the range of the scale is. In addition, in cases where scale economies have been observed, the banks that merged have always been two smaller banks.

However, the gains are very small and likely attributable to technological progress rather than economies of scale. The gain is not observed in instances when two large banks have merged to create an even larger bank. Therefore, in Nepal, if the central bank does grant permission for banks to merge, it has to ensure that the banks that are merging are not large. Such precautions have to be taken because those kinds of mergers have been shown to reduce market competition among banks and create unfair market power, anti-trust issues, and corruption.

Another argument policymakers use to support mergers has been the creation of scope economies because of subsequent diversifications of the portfolio. It means a large bank is able to utilize more resources to render diverse and wide range of products and services. However, customers that have accounts in the merged banks experience deteriorating customer service, increasing fees, new and unfair account features and structures applied without prior notification. These are not desirable results from a merger.

In addition, in order to prevent closed accounts, banks have practiced activities such as lowering the fees and rates in the short-term. When the competition fades off and the merged banks gain significant market power due to their large size, they have hiked their fees and charges. Economists at the Federal Bank of New York have observed that, even when there was no competition with rivals, the merged banks always lowered the interest rate paid to customers on savings. That is a practice meant to increase shareholders’ profits by harming the customers. It is not a desirable outcome for the market.

The most important question in our case could be whether the Nepali banking industry needs mergers at all. The banking industry in Nepal is still growing, and doesn’t seem to be in much trouble. If the central bank feels that there are too many banks in Nepal, it should stop issuing new permits. Issuing too many permits, and then asking the banks to merge, is a bad way of doing business. It also makes the central bank look like it is run by a group of amateurs. And, that is the last thing you want people to think about the central bank. This type of amateurish activity deteriorates the confidence that the consumers and businesses have in our central bank, and can have devastating economic consequences.

We all saw, in the last few years that big American and European banks, those created mainly as results of various mergers, all came crashing down while little banks survived. If there’s one lesson we can all take away from recent world-wide financial crisis, it is this: the bigger our banks are, the harder they come crashing down when there’s any trouble. The bottom line is this: no more permits to open new banks and no more mergers. If they can’t stand the competition, let them fail and exit the market. That is what capitalism teaches us. That is what should be practiced.

This opinion piece was published in The Republica on 12 April 2011.

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# posted by Mukesh Khanal @ 6:48 PM 0 Comments

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