sou · GOB311d5 · 2001-01-01 00:00:00 — Sometimes this is a mixed blessing because banks may suffer from a soft-budget constraint (the borrowers may realize that they can renegotiate ex post, which could give them perverse ex ante incentives). In reality, bank loans therefore often have priority. With priority a bank may strengthen its bargaining position and thus become tougher.5 The bank could then credibly intervene in the decision process of the borrower when it believes that its long-term interests are in danger. For example, the bank might believe that the firm's strategy is flawed, or a restructuring is long overdue. Could the bank push for the restructuring? If the bank has no priority, the borrower may choose to ignore the bank's wishes. This is because the borrower realizes that the bank cannot enforce its demands. The bank could threaten to call the loan, but the borrower – anticipating the dreadful consequences not only for himself but also for the bank – realizes that the bank would never carry out such a threat. However, when the bank has priority, the prioritized claim may [1936] and Boot, and Thakor [1993]. 4Mayer [1988] and Hellwig [1991] discuss the commitment nature of bank funding. Boot, Thakor and Udell [1991] address the credibility of commitments. Schmeits [1997] formally considers the impact of discretion (flexibility) in bank loan contracts on investment efficiency. 5See Dewatripont and Maskin [1995] on the issue of soft-budget constraints. [1993], and Von Thadden [1993], and and [1993] address the priority structure. Volym D:228 Supplement 27 insulate the bank from these dreadful consequences. It could now credibly threaten to call the loan, and enforce its wishes upon the borrower. This then identifies an important advantage of bank financing: timely intervention.6 These observations highlight the complementarity of bank lending and capital market funding. Prioritized bank debt facilitates timely intervention. This feature of bank lending is valuable to the firm's bondholders as well. They might find it optimal to grant bank debt priority over their own claims, and in doing so delegate the timely intervention activity to the bank.7 Consequently, the borrower may reduce its total funding cost by accessing both the bank-credit market and the financial market. The overall conclusion is that bank lending potentially facilitates more informative decisions based on a better exchange of information. While not universally valuable, this suggests a benefit of relationship banking.8 2.3Securitization: A threat to bank lending? Securitization is an example of a financial innovation – or an innovation in funding technology – that suggests a potential gain of (transaction- oriented) markets at the expense of bank lending. Is this true? Let's first evaluate the economics of securitization.9 Securitization is a process whereby assets are removed from a bank's balance sheet. Asset-backed securities rather than deposits would then fund dedicated pools of bank-originated assets. 6One could ask whether bond holders could be given priority and allocated the task of timely intervention. Note that bond holders are subject to more severe information asymmetries and are generally more dispersed (i.e. have smaller stakes). Both characteristics make them ill-suited for an early intervention task. 7The bond holders will obviously ask to be compensated for their subordinated status. This – ignoring the timely intervention effect – is a wash. In other words, the priority (seniority) or subordination features can be priced out. That is, as much as senior debt may appear cheaper (it is less risky), junior, or subordinated debt, will appear more expensive. 8See e.g. and [1994] and and [1995] for empirical evidence. 9Gorton and Pennachi [1995] provide an economic rationale for bank loan sales and securitization. See also Boot and [1995]. Consolidation and Strategic Positioning example of unbundling of financial services. specifically, banks would no longer fund those assets, instead the investors buying the asset- backed securities would provide funding. As I will emphasize, securitization does not signal the demise of banks, even if it becomes an economically important innovation (and thus substantially reduces the banks' on-balance sheet assets). To see this point, one needs to analyze the traditional lending function in some detail. The lending function can be decomposed into four more primal activities: origination, funding, servicing and risk processing. Origination subsumes screening prospective borrowers and designing and pricing financial contracts. Funding relates to the provision of financial resources. Servicing involves the collection and remission of payments as well as the monitoring of credits. Risk processing alludes to hedging, diversification and absorption of credit, interest rate, liquidity and exchange-rate risk. Securitization decomposes the funding activity; banks would no longer fund securitized assets. The economics of securitization dictates that the originating bank credit enhances the issue. Credit enhancement is typically achieved through the provision of excess collateral or with a letter of credit. Effectively this means that the originating bank continues to bear part of the consequences (losses) if the securitized assets do not perform. The credit enhancement reduces the riskiness of the asset-backed claims from the investors' perspective, but, more importantly, it addresses conflicts of interest rooted in the originating bank's proprietary information. With private information in possession of the originating bank, the market requires that the bank will truthfully reveal the quality of the assets it seeks to sell. As with a warranty in product markets, credit enhancement discourages misrepresentation by requiring the originator to absorb a portion of the losses owing to default. Similarly, credit enhancement signals the market that the originator will perform a thorough credit evaluation and an undiminished monitoring effort. Credit enhancement therefore reduces the information sensitivity of securitized claims by enhancing their marketability.10 Securitization could lead to a reconfiguration of banking. But even with widespread securitization the incremental value of banks would largely be preserved.11 They would originate and service assets, while 10The reputation of the originating bank will be equally important. Moreover, accreditation by credit rating agencies could also add to the marketability of the securitized claims. 11See also and Gertler [1994]. They argue that banks have not lost importance. They argue that a substitution from on-balance sheet to off- balance sheet banking may have (falsely) suggested a shrinking role for Volym D:230 Supplement 27 also processing the attendant risk in order to sustain these activities. Banks would therefore continue to screen and monitor borrowers, design and price financial claims, and provide risk management services. How important will securitization become? I can only give a very tentative answer. So far, securitization barely exists in Europe. In the US securitization has spread rapidly in the last decade but mainly for car loans, mortgages and credit-card receivables. The standardization and modest size of these credits allows diversification of idiosyncratic risks upon pooling. Private information distortions – as discussed above in the context of credit enhancement – are thought to be less severe for these standardized credits. What does this imply for the larger, more customized and heterogeneous commercial loans? These tend to be more information sensitive. Their quality is therefore more dependent on the rigor of initial screening and subsequent monitoring. , the pooling of commercial loans does less to dissipate their information sensitivity, attenuating the benefits of securitization. These considerations, however, do not preclude the securitization of business credits. They merely elevate the cost. For example, with more information-sensitive assets, the originating bank may need to retain a larger portion of the credit risk; credit enhancement becomes more important. If the information sensitivity is too severe, credit enhancement, short of total recourse may not overcome the private- information problem. Thus, the potential advantages of securitization would largely be lost, and traditional bank lending would continue to dominate. However, for an increasing array of moderately information- sensitive assets, securitization might become the preferred intermediation technology. As my discussion of the economics of securitization suggests, banks even then continue to be indispensable for most of the primal activities that were previously combined together in bank lending. importantly, the comparative advantage of banks rooted in proprietary information about their clientele would be preserved. 2.4Is relationship banking at risk? Relationships may facilitate a continuous flow of information between debtor and creditor which could guarantee a smooth access to funding. Banks comparative advantages are often rooted in these relationships. Many believe that a competitive environment may threaten relationships. Borrowers might be tempted to switch to other banks, or to the financial As in the description of securitization in the text, much of the banks value added in the primal activities would be preserved. Consolidation and Strategic Positioning In particular, increased credit market competition imposes constraints on the ability of borrowers and lenders to inter-temporally share surpluses (and [1995]). When parties anticipate a shorter expected life-span of their relationships they may respond by reducing their relationship-specific investments. specifically, anticipated shorter relationships inhibit the reusability of information, and thus diminish the value of information. Banks may then find it less worthwhile to acquire (costly) proprietary information, and relationships suffer. Paradoxically, shorter or weaker relationships actually become a self-fulfilling prophecy. These arguments highlight the negative spiral that may undermine relationship banking. An important observation is that this negative spiral might be self-inflicted. While competitive banking challenges relationships, the bankers' response - cutting back on information acquisition - may actually damage relationship banking most. Borrowers, however, face an equal challenge: how to benefit from competitive pricing without jeopardizing the benefits of relationships (see [1992])? This is the relationship puzzle. The relationship puzzle has no obvious solution. Relationships may the exchange of information, but may simultaneously give lenders an information monopoly and undermine competitive pricing.12 Transaction-oriented finance, however, may give incentive to acquire information but is potentially subjected to more competition. There might be no winners in this process; e.g. transaction-oriented finance may not be feasible where relationship-oriented finance retreats. specifically, markets for transaction-oriented finance may fail when problems of asymmetric information are insurmountable. This argument is used by some to highlight the virtues of (relationship-oriented) bank-dominated systems (e.g. and ) vis-à-vis market-oriented systems. As discussed in the preceding subsections, bank lending, securitization of loans and underwriting of public capital market issues may all benefit from a relationship orientation. The distinction between relationship-oriented finance and transaction-oriented finance, or between bank-dominated systems and market-oriented systems, may 12The informational monopoly on the inside lenders side may be smaller if a borrower engages in multiple banking relationships. This would mitigate the possibilities of rent extraction by informed lenders and induce more competitive pricing (see Sharpe [1990] and also and [1995]. 13A fascinating academic literature is emerging on the design of financial systems. See [1993], and Gale [1995] and Boot and Thakor [1997]. One objective of this literature is to evaluate the pros and cons of bank-dominated and financial market-dominated systems. Volym D:232 Supplement 27 therefore be less well-defined than it appears. What might be true is that a bank-dominated system invites oligopolistic behavior such that competition is contained (and relationships preserved) while a market- dominated system suppresses competition less. A less competitive financial system may thus preserve relationships more. Competition threatens relationships, but it may simultaneously elevate the importance of relationships as a distinct competitive edge. This is the relationship paradox. A relationship orientation can alleviate competitive pressures. Thus, a more competitive environment should encourage banks to become client-driven, and customize services. Since a relationship orientation may earn banks a substantial added-value, banks could then isolate themselves from pure price competition.14 14 Boot and Thakor [1999] develop this intuition further. They show that competition may indeed induce banks to resources to relationship- specific activities. In their model banks choose between passive transaction lending and more intensive relationship lending. Transaction lending competes head-on with funding in the financial market. Their key result is that as interbank competition increases, banks make more relationship loans, but each has lower value-added for borrowers, relative to transaction loans. Capital market competition reduces relationship lending (and bank lending shrinks), but each relationship loan has greater value-added for borrowers. In both cases, welfare increases for some borrowers but not necessarily for all. Consolidation and Strategic Positioning 3 Scale and Scope Issues in Banking Scale and scope economies are often cited as one of the main reasons behind the current merger and acquisition wave in banking. Are scale and scope economies present? And could they rationalize the current restructuring in the industry? Scale and scope economies in banking have been studied extensively. In general, the empirical evidence cannot readily identify substantial economies of scale or scope. Scale economies could not be found beyond a relatively small size of banks as measured by total assets (i.e., beyond $ 100 million up to $ 10 billion in total assets), see Table 1. Only recently have some studies succeeded in showing some economies of scale at a level of total assets up to $ 25 billion. Similar results were obtained for scope economies. These results seem hard to reconcile with the perceived wisdom of bankers and the observed mega-mergers. Most empirical researchers in the area of industrial organization will acknowledge that scale and scope economies are difficult to measure. So, at best, very modest conclusions could ever be drawn from these empirical studies. With this in mind, we can start analyzing the evidence. A first observation is that the inconclusive results are not really surprising. Inefficiencies in managing larger organizations may mitigate possible scale and scope benefits. This would be in line with the sizable literature on the "diversification discount". A complication is also that increasing scale and scope may facilitate market power and thus elevate profitability in absence of scale and scope economies. This effect might be less important in inter-(geographic) market mergers. Moreover, alternative distribution network (e.g., direct banking) and the proliferation of financial markets may have reduced the effective market power of locally concentrated financial institutions. This points at a more general issue: the level of concentration may no longer be a good proxy for the (non-) competitiveness of a market. What more can be said? Volym D:234 Supplement 27 The empirical evidence on scale and scope economies Market power analysis: effect on prices and profits Higher rates on small business loans, lower deposit rates ° Effect on deposit rates has become less in the 90s ° Deposit rates sticky (show downward rigidity) ° Multi-state BHCs charge higher fees to retail ° Small effect of concentration on bank profits Most profitable banks are not in most concentrated (effect of M&A) Downward effect on deposit rates if related to increase in ° Effect on profitability ratios mixed, but possibly positive ° Event studies show mixed results on combined value of target and acquirer: but focus (both geographic and activity) adds value. International mergers more profitable vis-à-vis domestic US mergers focus on cost-control: scale economies disappear between $ 100 million and $ 10 billion in total assets ° Scope economies studies find similar results ° Recent 1990s studies find greater potential economies (up to $ 25 billion in total assets, but possibly ° Potential for scale, scope and product mix efficiencies in managing risk, particularly diversification benefits of ° Combining bank and non-bank (insurance) activities has mixed effect on total risk ° Cost efficiency (controlled for market power ° Efficiency gains in US mega-mergers, some for large in- ° Some diversification benefits: higher proportion of loans per dollar of capital (at expense of securities holdings) Source: , Demsetz and Strahan [1999]. Consolidation and Strategic Positioning Several other qualifications should be made. First, most studies concern the US Contrary to banking in many other countries, US banking has historically been quite fragmented.15 The mergers and acquisitions that were included in most studies (mostly dating back to the 70s and 80s) took place in an environment where severe constraints existed on the type and geographic dispersion of activities. It is conceivable that these restrictions made it difficult to benefit from scale and scope economies (see also Calomiris and Karceski [1997]). Second, the level of aggregation in most studies may obscure benefits to scale and scope. In particular, we should look at what type of mergers and acquisitions involve scale and/or scope benefits. For example, Flannery [1999] points at recent research that suggests that mergers with both a geographic and activity focus are most value enhancing.16 Similarly, in analyzing scope and scale issues we should focus on the type of activities. What are the scale economies in each activity? And what product-mix offers true scope economies?17 Some of these and other concerns are summarized in Table 2. These observations offer yet proof for true scale and scope economies. I see the following five primary sources of scale and scope economies (see also Canals [1994]):18 15This is not really surprising. banks face(d) substantial regulatory constraints on their activities concerning both the type of their activities (e.g. banks could engage in commercial banking or investment banking, not both) and their location (e.g. limits on interstate banking). recently, however, regulatory constraints have become less binding. This undoubtedly partially explains the surge in mergers and acquisitions. 16An important issue is whether this only points at market-power benefits (see also Table 1) or whether also true efficiency gains could be at work. 17Surprisingly, this type of research is yet hard to find. A lot of research has been done on potential conflicts of interest in banking. To some extent, this is activity specific (investment banking versus commercial banking). However, this research is of very limited interest because it ignores the question of complementarity between activities. This is not really surprising because the literature is solely motivated by the obscure Glass- Steagall regulation in the U.S. (see Kroszner and [1994] and Puri [1996]). 18Observe that some of these sources of scope and scale economies are inter- related. Volym D:236 Supplement 27 i.Information technology related economies; ii.Distribution-network related benefits (strengthened by IT developments); iii.Marketing/brand name and reputation related benefits; iv.Financial-innovation related economies; Some problems with the existing empirical studies on scale and scope Market power analysis: effect on prices and profits contestability of markets? ° Combined effect of market power and efficiency (effect of M&A) changes difficult to disentangle ° Profitability ratios affected by market power ° Cost ratios via costs of deposits linked to market importance of deposits versus purchased funds studies affected by "signaling". That is, the immediate effect of a merger announcement on stock prices incorporates all types of changes in ° How to measure scope economies ° Lack of data points for mega-institutions. and/or type of activities The first source, information technology, is potentially of great importance. Most of the existing studies on scale and scope economies involve data that precede the information technology revolution. It is likely that recent information technology developments facilitate a much more efficient and effective utilization of information over ranges of services and . That is, client-specific information may allow for scope economies and facilitate a competitive advantage to financial institutions that can offer a range of services to their clientele. Similarly, possibilities for reusability of information across may have increased. Also, information technological developments may help Consolidation and Strategic Positioning facilitate differentiation of products and services.19 Together with the sizable investments projected in information technology, scale and scope benefits may have become more important. The implication is also that sizable investments in information technology are needed to truly benefit from scale and scope economies. This relates also to the second source: distribution network related benefits may be rooted in information technology developments. In particular, IT developments may facilitate scale economies offering gains in running a sizable distribution network. The next source of scale and scope economies is linked to marketing and reputation. Marketing expenses involve substantial fixed costs. This suggests some economies of scale. Also, scope benefits may be present in the joint marketing of products to . Brand image is partially marketing related but is also linked to the notions of "trust", "reputation" and "confidence". These notions play an important role in the financial services industry. Increasingly, financial service providers offer services that crucially depend on their reputation. For example, the growing importance of off-balance sheet claims puts great emphasis on the ability of financial institutions to honor these contingent liabilities. Also, under certain conditions, increasing scale and scope allows financial institutions to capitalize more on their reputation. That is, a wider scope (or scale) may help a financial institution "to put its reputational capital at work" (see Boot, and Thakor [1993]). The next source of potential scale and scope economies is financial innovation. Financial innovation as a source of scope and scale economies is a two-edged sword. Some suggest that larger institutions are less likely to innovate due to the inherent bureaucracy. This might be true but this is a governance issue. Ceteris paribus, larger institutions could better recoup the fixed costs of financial innovations. Innovations could be marketed to a larger customer base and/or introduced in a wider set of activities. For financial innovations scale and scope might be particularly important given the rapid imitation by competitors. Only for a short period of time does a true competitive advantage exist. A wider scope and larger scale may help recoup the fixed costs in this short period of time.