MERGERS AND ACQUISITIONS ı N EUROPEAN UNION BANKING SECTOR: ROLE OF STRATEGIC SIMILARITIES ı N POST- MERGER BANK PERFORMANCE

Transcription

1 MERGERS AND ACQUISITIONS ı N EUROPEAN UNION BANKING SECTOR: ROLE OF STRATEGIC SIMILARITIES ı N POST- MERGER BANK PERFORMANCE by Sule Aysegul Ozturk ANR: MSc. Finance Thesis Supervisor : Prof. Dr. H.A. Benink Second reader : Dr. P.C. de Goeij Tilburg School of Economics and Management Tilburg University October 2016

2 Mergers And Acquisitions In European Union Banking Industry: Role Of Strategic Similarities In Post-Merger Bank Performance by Sule Aysegul Ozturk ABSTRACT: This research examines how strategic similarities between target and bidder commercial banks operating in the European Union countries affect post-merger performance over the period The results indicate mergers between banks with similar strategic characteristics in terms of credit risk, capital structure, capital adequacy and liquidity strategies result in better performance compared to banks with different strategic characteristics. Keywords: Banks, European Union, Hierarchical Regression, Strategic Similarity 2

3 TABLE OF CONTENTS 1. INTRODUCTION LITERATURE REVIEW OVERVIEW OF MERGER AND ACQUISITION ACTIVITIES TYPES OF MERGERS AND ACQUISITIONS HORIZONTAL MERGERS VERTICAL MERGERS CONGLOMERATE MERGERS MOTIVES AND VALUE CREATION FOR MERGERS AND ACQUISITIONS EMPIRICAL STUDIES ON IMPACT OF MERGER AND ACQUISITION ACTIVITIES ON BANKING SECTOR METHODOLOGIES USED TO ANALYZE THE BANK MERGERS IN THE LITERATURE EVENT STUDY METHODOLOGY ACCOUNTING RATIO METHODOLOGY IMPACT OF BANK MERGER AND ACQUISITION ON STOCK PERFORMANCE IMPACT OF BANK MERGER AND ACQUISITION ON ACCOUNTING PERFORMANCE STRATEGIC FIT AND PERFORMANCE METHODOLOGY STRATEGIC CHARACTERISTICS VARIABLES DEPENDENT VARIABLE: PROFITABILITY MEASURES INDEPENDENT VARIABLES: CONTROL VARIABLES INDEPENDENT VARIABLES: STRATEGIC INDICATORS STRATEGIC FIT MODEL DATA SOURCES RESULTS CONCLUSION REFERENCES APPENDIX

4 1. INTRODUCTION Over the past twenty years, there has been a growing intensity in the activities of merger and acquisition. The number of mergers and acquisitions has escalated into high levels, and they keep on increasing annually. To be more specific, a significant increment in the number of mergers and acquisitions around the world is observed after Rapidly developing information and communication technologies, changing legal borders and world s globalization are some of the reasons for this behavior. Merger and acquisition activities have been switched from across borders to cross-borders with the expectation of more efficiency and effectiveness. The number and value of mergers and acquisitions globally between 1995 and 2015 are provided in Figure 1. A gradual increase after 1995 in the number and value of merger and acquisition can be verified by the figure below. Figure 1- The number and value of merger and acquisition transactions One of the most dynamic industry regarding mergers and acquisitions is the banking sector. According to Focarelli, Panetta, and Salleo (2003), many changes have taken place in the banking sector for last twenty-five years. They state that bank mergers have started in the United States around the 1980s and reached to Europe around 1990s. 4

5 Banks prefer to involve in merger and acquisition activities since these activities help banks to diversify their risks, reduce their costs and increase their efficiency. Besides, there are other reasons why banks prefer to merge. These reasons are mainly about the intense competition in the banking sector, innovation in the technology and new financial products. When competition is not heavy, inefficient banks are able to survive. However, when the competition reaches high levels, the decrease in profit margins makes impossible to survive for inefficient banks (Berger, Demsetz, and Strahan, 1999). Consequently, banks tend to involve in more mergers and acquisitions with similar financial institutions in order to strengthen their position. As a result of mergers and acquisitions, banks from different geographical or cultural environment come together by using some essential elements. Some of these elements can be their strategic decisions and their values. Also, mergers help banks to scale up quickly and gain a significant number of new customers. According to Hernando and Nieto (2008), financial integration helps economic growth and contributes to collect the benefits of monetary integration. In other words, mergers and acquisitions promote intense competition and better financial development, and these bring about better and more complete financial intermediation at the lower cost. In turn, better financial intermediation results in higher economic growth, and as a result, productivity increases. There are many types of research work on the mergers and acquisitions. Each of them focuses on different aspects of mergers and acquisitions. Up until now, many studies have been devoted to the topic of stock market valuations and profitability of institutions. Compared to performance and value effects, relatively few studies work on understanding performance differences. There can be many reasons for these performance differences. According to some studies, relatedness between merging entities is one of the most important factors influencing profitability. For example, Kusewitt (1985) and Lubatkin (1987) show product-market relatedness between merging firms may positively affect post-merger performance. 5

6 Although some studies indicate that related mergers outperform unrelated mergers, why some related mergers succeed while others fail is still questionable (Ramaswamy, 1997). Ramaswamy (1997) works on this question and try to answer it. We also focus on this question and by using different sample and variables, try to give a proper answer for this shortcoming of the literature. There are more studies focusing on the U.S data to examine the merger and acquisition effects on banking sector since it is the first country to be observed bank mergers and acquisitions in the 19th century (Hubbard, 2001). However, relatively few studies use European Union data to investigate the effects of merger and acquisition activities on bank performance, especially in recent years. Although there is an increasing amount of research, which are working with EU data, nonetheless, there is still more to explore. Since there are regulatory and economic differences between EU and US, merger and acquisition activities are valued differently for them. Also, the evidence from other sectors cannot be directly applied to banking industry since banking sector operates under different regulatory environment compared to other sectors. Thus, all these factors create a necessity to observe European market reaction to the merger and acquisition announcements separately from the US. Because of the reasons above, this research concentrates on merger and acquisitions in European Union banking industry, which makes contributions to the literature by means of strategy and performance. In this study, we focus on banks involving in a merger in the European Union area and try to investigate whether these mergers of banks leads to higher profitability for them when they are strategically similar. In other words, we will combine Ramaswamy (1997) and Altunbas and Marques (2008) studies and try to explain the differences in performances of bidder banks in EU for the post-merger period by using strategic similarity concept. As a starting point for this research of the financial performance changes, the research question remains same as Ramaswamy (1997): 6

7 Why do some horizontal mergers succeed while others fail? The remainder of the research consists six parts. Section 2 presents the previous literature in detail. It gives an overview of merger and acquisition studies, types and motives of them. Also, the methods used to measure the profitability of mergers and effects of strategic similarity discuss in detail. Section 3 presents the methodology used. Section 4 describes the sample used. Section 5 provides our empirical results and Section 6 consists of conclusions. This research ends up with the references used. 2. LITERATURE REVIEW 2.1. OVERVIEW OF MERGER AND ACQUISITION ACTIVITIES TYPES OF MERGERS AND ACQUISITIONS There are three types of mergers and acquisitions, namely horizontal, vertical and conglomerate mergers and acquisitions HORIZONTAL MERGERS The horizontal mergers take place between two companies offering similar or compatible product lines or services to the same market. These mergers occur when merging entities are in competition. In other words, companies are direct competitors of each other in this kind of mergers. According to Hillier et al. (2010), when bidder and target companies are from the same industry line, these types of mergers are called horizontal mergers. Most of the bank mergers and acquisitions belong to this kind of merger. According to Sudarsanam (2004), horizontal mergers help to eliminate the competition so that the company increases its market share, power and revenues. Also, these kinds of mergers offer economies of scale due to the increase in size. In other words, higher production volume results in a decline in average cost. Moreover, he highlights that horizontal mergers help removing redundant and wasteful activities from the operations, and by this way, encourage cost efficiency. He exemplifies this 7

8 with cost efficiency concept. While it can be costly for one firm to carry out an activity, the cost will be reduced when two companies running similar activities combine and this integration will lead to an increase in profit for combined firm and thus, value creation for it. In addition, Sudarsanam (2004) also indicate that operational efficiency as a result of changes in the scope of economies and the scale of economies, and increased market share, market power and network externalities will lead to new growth opportunities for the firms VERTICAL MERGERS Vertical integration is the degree of how much a firm involves operations with its suppliers and buyers. Contrary to horizontal integration, which is a merger between competitors; vertical integration occurs between players that are complementary. In other words, vertical mergers take place between a customer and a company or a supplier and a company. The purpose of vertical mergers is to get control over the value chain. According to Sudarsanam (2004), a company may enter into arm s-length transactions with its suppliers to obtain their inputs or with its distributors to sell their outputs. Vertical mergers also offer to the company the ability to control its costs. In addition to the benefits regarding cost reduction, vertical mergers also provide an increased competitive advantage to the company over its competitors (Sudarsanam, 2004). Lastly, Sudarsanam (2004) also indicates that vertical mergers are far less frequent than horizontal mergers CONGLOMERATE MERGERS When two companies operate in completely different industries than each other, regardless of the stage of production, a merger between these companies is known as conglomerate mergers (Hillier et al., 2010). In other words, conglomerate mergers occur between companies that are neither competitors nor potential or actual buyers or suppliers of each other. 8

9 There are two types of conglomerate mergers, namely pure conglomerate mergers and mixed conglomerate mergers. If there is no economic relationship between the bidder and target firms, then this merger is called pure conglomerate mergers. On the other hand, mixed conglomerate mergers take place between the firms that are looking for product or market extensions. According to Sudarsanam (2004), the primary purpose of the conglomerate mergers is diversification, which helps to create value by increasing market power of the company and efficient internal capital market. As a result of conglomerate mergers, merging companies decrease their levels of risk exposure. Also, these kinds of mergers help a company to diversify. Moreover, conglomerate mergers also beneficial when the company has excess cash but does not have enough opportunities for growth in the same industry. That company can invest outside of its industry with the help of conglomerate mergers. Lastly, it helps to increase the customer base of the company. As a result, with the help of cross-selling products to the new clients, company has a chance to increase the sales of its core products, and in turn, this leads to higher profits for the company. On the other hand, conglomerate mergers have some disadvantages. The biggest disadvantage of this type of merger is one of its benefits; diversification. As much as diversification is helpful, it also has some adverse effects on companies. The main reason why diversification is not good for a company is that companies can spread themselves across too many areas as a result of diversification. That is, if a company shifts its focus from its core business to other businesses, this may cause poor performance in both areas for the company. For example, according to Rajan, Servaes, and Zingales (2000), the diversified divisions within the firm compete for power control, which makes the capital allocation of resources problematic and as a result poor performance. Another disadvantage of conglomerate mergers is that it is hard to control and govern such a big company. When companies from different sectors merge, they combine all of their customers with different accounts. Moreover, merging cultural 9

10 values, employees are also problematic compared to the merger between companies, which are working in the same industry. As Prahalad and Bettis (1986) state the more complex financial institution, the more difficult and problematic for managers to control this a large firm. As a result, less efficient internal control procedures and duplicated or overlapping expenses will arise. They indicate that it is more difficult to create a common culture for banks which are active in both commercial and investment banking activities. Thus, when managers use their current management styles to manage the acquired banks that are not similar, inefficiencies may be created. Lastly, with conglomerate mergers, companies go into another sector in which they have not any experience in the industry, which, in turn, increases the risks of mismanagement and poor performance. Additionally, merger and acquisition transaction can also be categorized geographically, namely domestic mergers and acquisitions and cross-border mergers and acquisitions. If bidder and target firms are operating in the same country, this type is called domestic mergers and acquisitions. On the other hand, cross-border mergers and acquisitions take place between bidder and target firms from different countries (Sudarsanam, 2004) MOTIVES FOR MERGERS AND ACQUISITIONS Motis (2007) groups merger and acquisition motives into two: motives to increase the value of the firm and motives to increase the wealth of the manager. Motives increasing firm value are economies of scale, economies of scope, economies of vertical integration that helps synergy gains, increased market share, diversification and as a result decreased cost. The second group, motives to increase the wealth of the manager, includes empire building, hubris and risk spreading (Motis, 2007). According to Hawkins and Mihaljek (2001), merger and acquisition activities allow financial institutions to diversify their risk and sources of revenues, thus, a 10

11 bank prefer to involve in a merger to reduce its cost and increase its efficiency. In addition, as it is mentioned above, although diversification has some disadvantages, it offers some benefits as well. For example, as a result of diversification, banks are able to obtain additional benefits. These benefits can be a brand name, customer loyalty or some firm-specific assets. Lastly, diversification reduces the cost of financing for banks (Houston et al., 1997). Intensive market competition, innovation of technology and new financial products, and consolidation of financial systems between national and regional systems are the other reasons for the banks around the world going for mergers. When competition is not heavy, inefficient banks are still able to survive. However, when the competition gets intense, a decrease in profit margins makes it impossible to survive for inefficient banks from this competition (Berger, Demsetz, and Strahan, 1999). Consequently, banks tend to make more mergers and acquisitions with similar financial institutions in order to strengthen their position. According to Hernando and Nieto (2008), merger and acquisition activities help economic growth. In other words, the main reason behind the strong financial development is mergers and acquisitions. They continue by indicating that as a result of mergers and acquisitions, better financial intermediation with lower cost can be obtained and, in turn, better financial intermediation results in higher economic growth, and as a result, higher productivity levels. Berger et al. (1999) also assert that merger and acquisition activities help to increase efficiency, market power, economies of scale and economies of scope for banks EMPIRICAL STUDIES ON IMPACT OF MERGER AND ACQUISITION ACTIVITIES ON BANKING SECTOR METHODOLOGIES USED TO ANALYZE THE BANK MERGERS IN THE LITERATURE The existing empirical literature examining the performance effects of mergers and acquisitions in the banking sector use two major categories. The first group of 11

12 studies is using event study methodology. These types of studies concentrate on stock returns, which is an indicator of performance. The second category of studies focuses on accounting ratios or productive efficiency indicators to measure the company performance (Altunbas and Marques, 2008). These studies commonly use accounting ratios to measure the profitability of a company. Most of the studies compare the premerger and post-merger performance of institutions using these measures to determine whether mergers and acquisitions lead to changes in costs or profits of the company EVENT STUDY METHODOLOGY Studies using event study methodology try to assess the impact of a merger announcement on the value of a bank. These studies focus on stock price changes, specifically cumulated abnormal stock returns, and try to determine whether merger announcement creates or destroys value for shareholders of the bidder, target, and combined company. According to these studies, stock prices reflect all available information and expectations about the prospects of firms; thus, excess returns around the announcement day could be used to reveal whether merger results in value creation or destruction. Researchers who prefer to use this approach argue that accounting ratios are unreliable, and they are difficult to obtain. They also assert that the reaction of the market to the announcements of mergers and acquisitions is the much better indicator in terms of economic effects. Schwert (1981) believes that using market s reaction to the announcement of a merger is more efficient method. According to him, the reason why the market reaction is a better indicator is market prices immediately reflect the market s expectation of new information on the target and bidder firms. Piloff and Santomero (1998) discuss both event study and accounting ratio methodologies. According to them, although event study methodology depends on market data rather than actual ratios of a company, it is a better indicator of real 12

13 economic effects and it allows us to reveal the real impact of mergers and acquisitions on the value creation or destruction. Caruso and Palmucci (2008) also prefer to use event study methodology in measuring value creation of mergers and acquisitions in the banking sector. As stated by them since accounting ratios are less objective, and obtaining accounting ratios are not easy, using this methodology is problematic. Also, they state that since they want to investigate the value creation and the short-term effects, their choice becomes the event study methodology. Fridolfsson and Stennek (2005) conclude that in the literature while some studies working on performance effects of mergers and acquisitions use event study methodology, others prefer to use accounting ratios. They state that these two methodologies are not substitutes but complements of each other. According to them, using stock prices for analysis may fail to detect unprofitable mergers, while accounting ratios analysis may not be able to identify the reason behind the unprofitable mergers. Like any other approaches, using market prices is not perfect. The event study methodology has some drawbacks. First, the period from the announcement date differs significantly from study to study, and the results are often sensitive to the period chosen. Rhoades (1994) argues that significant positive abnormal returns are commonly found on the announcement date or two days around it. On the other hand, when abnormal returns are cumulated for ten to twenty days after the announcement, the absence of significant abnormal returns is also common. Secondly, many merging banks, either bidders or targets, are not publicly traded, but the event study methodology uses only large, publicly traded banks as bidders or targets since it requires complete stock data. Thus, results based on only publicly traded stocks cannot be used as representative of all bank mergers. Thirdly, many economists are skeptical about the assumptions of efficient market hypothesis and the market s ability to accurately anticipate the competitive effects of mergers (Duso, Gugler, and Yurtoglu, 2010). 13

14 ACCOUNTING RATIO METHODOLOGY Accounting ratio methodology is a comparison of financial ratios before and after the merger and acquisition (Chronopoulos et al., 2013). Accounting ratio methodology helps to determine the amount of impact of merger and acquisition on bank performance by using accounting ratios of performance. These accounting ratios can be return on assets, return on equities, or productive efficiency indicators, specifically indicators of scale economies (Altunbas and Marques, 2008). After obtaining data from both pre-merger and post-merger periods, changes in accounting ratios are analyzed and evaluated to determine the impact of a merger on the performance of a bank. Use of the accounting ratio methodology was focused on the last years of the period, and after this period, this methodology has being used in studies analyzing bank performance for the post-merger period. Rhoades (1994) states that the number of studies using accounting ratio methodology to measure merger performance during this period increased substantially. There are some drawbacks of this methodology just like event studies. Firstly, accounting ratios are based on historical data. Thus, this methodology often ignores current market values, and this makes accounting ratio methodology inaccurate. Moreover, as Rhoades (1994) states that accounting ratios measure efficiency most frequently with the ratio of non-interest expenses to assets. This is problematic because this ratio does not take into account the changes related to mergers and acquisitions, and as a result, this would shift expenses from non-interest expenses to interest expenses. According to Berger et al. (1999), using profitability ratios to obtain figures about firm performance is problematic because they incorporate changes in both market power and efficiency and unless controlling for efficiency, these two concepts cannot be separated. 14

15 Numerous studies investigate the adverse impact of mergers and acquisitions on bank performance using accounting data, but despite these drawbacks, there are powerful strengths of this approach. According to Sufian, Majid, and Haron (2007), interest in cost cutting and efficiency increased in the banking sector, and this made this approach very attractive since this methodology allows the researcher to focus specifically on cost controlling and efficiency. Fisher and McGowan (1983) states that the use of accounting rates of return is a reliable measure of the economic rate of return and, thus, of a firm s performance. Altunbas and Marques (2008) also prefer to use accounting ratio methodology to observe the impact of mergers and acquisitions in European Union banking sector on bank performance in the case of strategic similarities. Their results indicate that, on average, mergers and acquisitions that took place in EU countries lead to an improvement in return on capital of these banks. Kemal (2011) analyze the financial performance of Royal Bank of Scotland (RBS) after the merger, and he uses accounting ratios methodology instead of event studies since accounting ratios were easy to obtain. Choi and Harmatuck (2006) investigate the performance of mergers in the US using operating performance measures. Also, Hviid and Prendergast (1993) discuss the merger failure and profitability focusing on the accounting ratios of bidder and target firms. There are many other studies in the literature, which preferred accounting ratios methodology instead of event studies IMPACT OF BANK MERGER AND ACQUISITION ON STOCK PERFORMANCE Up until now, many cross-country studies have worked on Europe bank mergers. According to them, bank mergers and acquisitions lead to stock market valuation and improvement in performance (Cybo-Ottone and Murgia, 2000; Diaz, 15

16 Olalla, and Azofra, 2004; Beitel and Schiereck, 2006), specifically in the case of product-focused transactions (Beitel, Schiereck, and Wahrenburg, 2004). Goddard et al. (2012) conduct an event study for the sample of banks involving merger and acquisition activities in Asia and Latin America between the years 1998 and Their results suggest that shareholders of acquiring firms do not lose value as a result of merger and acquisition announcements, while the shareholders of some target banks earned positive and significant returns. They also find out that geographical diversification for their sample creates shareholder value for acquirers. Sirower and O Byrne (1998); Schwert (1996); Healy, Palepu, and Ruback (1992); Kaplan and Weisbach (1992) and Ravenscraft and Pascoe (1989) worked on different samples, but they came up with a common conclusion. They showed that exante market returns are positively correlated with ex-post performance. Amihud, De Long, and Saunders (2002) try to find the effects of merger and acquisition announcements on bidder firm s abnormal returns. Their conclusion is the cumulative abnormal returns for bidder firm is significantly negative. Houston and Ryngaert (1994) focus on large bank mergers and gains from these large mergers. They state that unlike positive returns of target banks, bidders get negative returns after the merger. As a result, the total return of merger is slightly greater than zero but not significantly different from zero at the announcement date of the merger IMPACT OF BANK MERGER AND ACQUISITION ON ACCOUNTING PERFORMANCE Studies in the literature determine the profitability of financial institutions by comparing their pre-merger profitability ratios, such as Return on Equity (ROE), Return on Average Equity (ROAE), Return on Average Asset (ROAA) and Return on Asset (ROA), with their post-merger ratios (Rhoades, 1998; Pilloff, 1996; Spindt and Tarhan, 1992; Akhavein et al., 1997; Cornett and Tehranian, 1992; Altunbas and Marques, 2008; Keasey and Hagendorff, 2009). 16

17 There are different conclusions in the literature for accounting ratio methodology. Some of the studies find out that profitability ratios of banks are improved after mergers and acquisitions (Rhoades, 1998; Spindt and Tarhan, 1992; Cornett and Tehranian, 1992; Altunbas and Marques, 2008; Hagendorff and Keasey, 2009; Akhavein et al., 1997). On the other hand, others studies find either no improvement or decline in profitability. While Berger and Humphrey, 1992; Chamberlain, 1998; Linder and Crane, 1992; Pilloff, 1996; and Correa, 2008 find no improvement in these ratios, Kwan and Eisenbeis, 1999; and Knapp, Gart, and Becher, 2005 conclude that, on average, mergers result in a decline in overall performance. Rhoades (1998) works on nine case studies and investigates the efficiency effects of bank mergers by using financial ratios. He states that an improvement in efficiency results in decrease in costs. He concludes that, in general, more efficient firms acquire less efficient ones. Also, he finds that all nine of the mergers resulted in significant cost cutting. Moreover, he shows that four of the nine mergers were successful in improving cost efficiency. Spindt and Tarhan (1992) examine 154 mergers and acquisitions. They demonstrate that these mergers and acquisitions lead bidder companies to gain significant returns and, in turn, bidder companies improve their return on equity and profitability margins. Altunbas and Marques (2008) state EU bank mergers between 1992 and 2001 result in an improvement in their accounting profitability. Also, Hagendorff and Keasey demonstrate that mergers and acquisitions result in improved performance for European banks for the period after the merger. Akhavein et al. (1997) find out large bank mergers of the 1980s experienced significant improvements in profit efficiency. According to their study, the average profit efficiency is increased by 16 percentage points for the merged banks relative to other large banks. Berger and Humphrey (1992) analyze 57 large bank mergers of the 1980s. They use multiple regressions and observe statistically insignificant and small cost 17

18 and profit efficiency gains following a merger. They also investigate return on asset ratios and total costs to asset ratios. Their results indicate that there are no gains to the merged company. Chamberlain (1998) examine effects of mergers on bank profitability by using 180 bank mergers and acquisitions between the years 1981 and According to this study, the profitability of banks does not change after the merger. While net interest margins widen and expenses are decreased in the post-merger period, these gains are balanced by increases in other non-interest expenses. Linder and Crane (1992) work on bank mergers in the New England between the years 1982 and They test whether bank holding companies experience an increase in their performance when they merged with their subsidiary banks. To be able to test this, they check the pre-merger and post-merger performance of all bank mergers in their sample. Their results suggest that there are not significant improvements in operating profits of merged banks relative to others. Pilloff (1996) work with 47 mergers between the years 1982 and The results show that both performance measures and abnormal returns show little to no change on average related with mergers. Correa (2008) demonstrates that there is no improvement or change in performance following a merger and the reason for this is a reduction in net interest margins and increase in overhead costs of targets. Kwan and Eisenbeis (1999) use a sample of 94 large US bank mergers in the 1990s. They examine the performance and value effects of banks. According to their results, mergers do not significantly improve performance or efficiency. Moreover, they state that there is only weak evidence that the market viewed these bank acquisitions with favor. Knapp, Gart, and Becher (2005) investigate reasons and results of mergers for bank holding companies (BHCs). Their study shows merging BHCs experience decline in the profitability for the period after the merger and they are 18

19 underperforming the industry average. They state that the reasons for this underperformance are mostly related to credit quality and below-average generation of fee income STRATEGIC FIT AND PERFORMANCE Many studies in the literature revealed that product and geographical similarity is important for post-merger performance. Recently, studies working on US data have contributed substantially by creating the sub-samples of the population of merging banks with respect to their product relatedness or market relatedness. The purpose of these studies is to determine whether some common characteristics between targets and bidders could create value or destroys it (Altunbas and Marques, 2008). In general, these studies suggested that companies could improve their profitability and market value by focusing on their core businesses. After classifying mergers and acquisitions in the banking sector according to their activities and geographic similarities or dissimilarities, DeLong (2001) examine the abnormal returns to each group. According to him, market reacts positively to mergers concentrating on both activities and geography. That is, market is aware that focusing is beneficial and bank mergers that cause diversification either in geographically or activity do not create any value. Cornett et al. (2003) examine bank acquisitions and extend DeLong s research. Similar to DeLong (2001), they found that diversification in geography or activity of bank acquisitions produce significantly negative abnormal returns for bidder banks. The strategic fit concept from strategic management literature is also important for the post-merger performance. Strategic fit, in other words strategic similarity, between merging institutions can be used as a factor in determining the success or failure of a deal. Strategic similarities between merging institutions have an impact of value creation or destruction of a deal (Ramaswamy, 1997; Altunbas and Marques, 2008; Thanou and Daskalakis, 2013). 19

20 According to Lubatkin (1983), the better the strategic fit between the acquiring and acquired firm, that is, the more the respective environments of the two firms have unifying features, the greater the performance gain for the acquired firm. Singh and Montgomery (1987) work on value effects of similarities and dissimilarities between merging entities. They examined similarities between bidders and targets in terms of their product-market relatedness and technology. According to their results, related mergers lead to greater gains compared to mergers that are unrelated. Their study reveals that if two companies with similar product-market relatedness and technology strategies involve in a merger, then their benefit from this merger will be higher than the unrelated mergers. According to Markides (1992), many firms preferred diversification earlier start to reduce their diversification levels and, again, decided to concentrate on their core businesses during the 1980s. In his study, he tries to find out whether refocusing in their core businesses creates value for the companies involved in mergers. The results of this study demonstrate that refocusing announcements result in significant and positive abnormal returns. In other words, firms choices of strategical refocusing on their core businesses lead to substantial improvement in their market value and reduction in diversification is associated with value creation for those firms. He highlights that there is a limit to how much a firm can diversify. Firms should be careful about this limit because if the firm goes beyond this limit, their market value will decrease. Thus, he sees strategic refocusing as an adjustment process. Lastly, he demonstrates that the relationship between diversification and profitability is nonlinear, which means low levels of diversification creates positive profitability; however, if the firm goes beyond the limit, diversification affects profitability negatively. Indeed, high levels of diversification diminish firm profitability. Also, there are other studies supports the idea that by refocusing their core businesses, companies achieve more profitability (Lichtenberg and Siegel, 1990; Williams, Paez, and Sanders, 1988). 20

21 Ramaswamy (1997) examines the strategic similarities between target and bidder firms in U.S. banking industry and the tries to decide whether these similarities affect post-merger bank performance positively or negatively. His results show that mergers between banks with similar strategic characteristics lead to better performance compared to those strategically unrelated. Chatterjee et al. (1992) examined the cultural differences and shareholder value in related mergers. They found that related mergers in terms of risk-taking attitude, reward, innovation, and autonomy orientation increase value for stockholders. On the other hand, another part of mergers, which do not involve cultural match, did not perform efficiently. Prahalad and Bettis (1986) state that when two firms that are strategically same or similar involve in merger and acquisition, this activity will lead to improvement in the performance. They explain it by giving an example; if two firms with similar strategic characteristics in terms of cost and efficiency decide to merge, the combined entity will experience improvement in its performance and will take advantage of synergy gains. Ramaswamy (1997) also indicate that dissimilarities between target and bidder firms might be preferable for conglomerate and vertical mergers. According to his study, dissimilarities between strategies of firms are an advantageous source of value creation for conglomerate mergers and acquisitions. Although the result of the merger is not as strong as conglomerate mergers, it can still be beneficial in the case of vertical mergers as well. On the other hand, this positive outcome is not the case for horizontal mergers. In the case of horizontal mergers, the strategic similarity between firms is more favorable in terms of value creation. Altunbas and Marques (2008) investigate the impact of European Union banks strategic similarities on post-merger performance between 1992 and They use Ramaswamy s methodology as a starting point. The results of their study demonstrate that there is an improvement in the performance of banks, which are strategically similar compared to the banks following different strategies. They also examine 21

22 mergers separately as cross-border mergers and domestic mergers. Their study shows that similarities between merging banks in terms of capital and cost structure brings higher performance for cross-border mergers. Because of the reasons above, this research is concentrated on strategic similarities on bank mergers and the hypothesis is same with Ramaswamy (1997): Mergers between target and bidder firms with similar strategic characteristics will result in a better performance than the mergers between targets and bidders with different strategic characteristics. 3. METHODOLOGY Every company has its visions, missions, strategies and values and by means of characteristics, each company is different from each other. Companies strategies are one of the main variables that directly affect their success or failure. Therefore, it is important to know which strategies companies follow and what is the post-merger performance effect of a merger between these companies following similar strategies. To be able to answer this question, in this study, we combine the methodologies from Ramaswamy (1997), and Altunbas and Marques (2008), who analyzed the effects of strategic similarities on the bank performance after a merger in US and EU, respectively. In addition to Dess and Davis (1984) and Zajac and Shortell (1989), Altunbas and Marques (2008) also state resource allocation patterns can be used for indicators of the strategies companies followed. They explained this by giving an example that when a company follows cost-efficiency strategy, it can be observed that the ratio of operations expense to total assets for these companies will decrease. That is, this ratio will be lower for the companies following cost-efficiency strategy compared to their peer groups. Overall, strategies companies follow can be observed from their resource allocation decisions. 22

23 3.1. STRATEGIC CHARACTERISTICS The pattern of resource allocation decisions of companies can be understood from their strategic orientations (Ramaswamy, 1997). In the banking industry, resource allocation strategies can be obtained from financial statements, particularly balance sheet, of each bank. According to Rose (1989), Roussakis (1989), and Ramaswamy (1997), market coverage, marketing posture risk propensity, efficiency and client mix are some important areas related to strategic resource allocation decision. Altunbas and Marques (2008) extend these areas by using the earnings diversification, efficiency, capital structure, liquidity, risk exposure, financial innovation and cost controlling strategy. In this study, we combine the studies of Altunbas and Marques (2008) and Ramaswamy (1997). We also add other strategic indicators to our analysis. The strategic variables used in this study is shown in Table-1 and explained in detail below. Cost controlling strategy shows that how banks control their costs relative to their revenues. In other words, it shows bank s ability to minimize its cost by relating expenditure to returns (Thanou and Daskalakis, 2013). It is calculated by dividing the cost by the total revenues of a bank. Altunbas and Marques (2008) indicate that if a firm follows low cost and operating efficiency strategies, then it is expected that merging two similar banks will results in higher profitability. On the other hand, if two firms with different strategies in terms of cost and efficiency merge, then a decrease in performance is expected (Altunbas, Molyneux, and Thornton, 1997). Thus, it is expected that there is a negative correlation between similarity index of cost controlling ratio and bank profitability. Equity to total assets ratio is used as a capital adequacy measure. According to Pasiouras and Kosmidou (2007), high ratios of equity to total assets are assumed to be indicators of low leverage and as a result lower risk. Also, they state that wellcapitalized banks have lower needs for external funding, and this increases their profitability. In this study, we also expect capital strength strategies led to synergies 23

24 associated with enhanced performance. In other words, a merger between banks with similar capital adequacy strategy is expected to result in higher profitability. Table 1- Strategic Variables Strategic Variable Symbol Formula Cost to Income Ratio (Cost Controlling) Equity to Total Assets (Capital Adequacy) Total Capital Ratio (Capital Structure) Net Loans to Total Assets (Loan Ratio) Loan Loss Prov. to Net Int. Revenues (Credit Risk) Other operational Income to Avg. Assets (Diversity of Earnings) Liquid Assets to Dep.&Shor-Term Fund. (Liquidity) Net Loans to Total Dep.& Borrowing (Liquidity) Capital Funds to Liabilities (Capital Structure) CTIR EQTA TCR NLTA LLPNIR OORTA LADSTF LADSTF CFL Total Costs Total Revenues Equity Total Assets Total Capital Risk Weighted Assets Net Loans Total Assets Loan loss provisions Net interest revenues Other operational revenues Total Assets Liquid Assets Dep. &Short Term Funding Net Loans Total Dep. & Borrowing Capital Funds Liabilities For capital structure measure we used total capital ratio and capital funds to liabilities ratio. Total capital ratio of banks is measured by dividing total capital to risk-weighted total assets, and it shows bank s capital structure. According to Altunbas and Marques (2008), the impact of the capital structure of banks on their profitability depends on the theory banks follow. They explain this theory by using signaling hypothesis of the asymmetric information theory from Berger, Herring, and Szego (1995). According to them, it is difficult to integrate banks with different 24

25 capital structures. Therefore, it is expected that there is a positive relationship between capital structure similarities and performance (Altunbas and Marques, 2008; Thanou and Daskalakis, 2013). On the other hand, for the capital funds to liabilities ratio, we expect a positive sign. Loan ratio is the ratio of net loans to total assets. It measures the percentage of a corporation's assets financed with loans. Loan ratio provides a general overview of the long-term financial position of a company and it is used as one of the measures of asset quality. According to Demsetz and Strahan (1997), one of the reasons why banks merge is enhancing revenues derived from the new portfolio strategies, positive sign is expected between loan ratio as an asset quality indicator and bank profitability measure. Differences between loan ratio strategies tend to improve profitability. The credit risk ratio is calculated by dividing loan loss provisions with net interest revenues. As it can be costly to integrate different banks regarding their credit risk ratios (Altunbas and Marques, 2008), we expect similarities in credit risk measures help to improve profitability. The earnings diversification strategy shows the revenues of a bank, which is coming from other sources instead of net interest revenues. It is calculated as the ratio of other operational revenues to total assets of the bank. According to Gande et al. (1997), since new sources of revenues enhance post-merger profitability, firms with different non-interest income sources will have higher profitability levels. Thus, banks try to improve earnings diversification and as a result, it is expected that earning diversification strategy helps banks to increase their profitability. Therefore, positive relationship between earnings diversification and post-merger profitability is expected (Altunbas and Marques, 2008; Thanou and Daskalakis, 2013). We use two different ratios for liquidity measures: the ratio of liquid assets to deposits and short-term funding and net loans to total deposit and borrowing. In general, it is expected that liquidity is positively related with bank s profitability. Also, Bordeleau and Graham (2010) indicate that holding liquid assets up to some point helps to improve the profitability of banks. Altunbas and Marques (2008) state 25

26 that since maintaining high levels of liquidity is costly, different liquid management strategies suggest that merging banks can increase its liquidity level for the postmerger period. As a result of improved liquidity, this bank can increase its profitability. Therefore, a negative sign is expected for liquidity indicators VARIABLES DEPENDENT VARIABLE: PROFITABILITY MEASURES According to the Banking Profitability and Performance Management report of PWC (2011), net income can be used as a profitability measure; however, it has an important drawback: it does not take into account the size of the bank. Thus, it is difficult to compare banks with their net income. There is another common measure: Net Interest Margin. It captures the spread between the interest costs and earnings on bank s liabilities and assets. Thus, it determines how well the bank uses its assets and liabilities. However, this measure also has a drawback; it fails to measure the operational efficiency of a bank (PWC, 2011). According to Huian (2012), profitability based measures are more robust. As her words: Between all the accounting measures of profitability, return on assets (ROA) is the least sensitive to the upward or downward estimation bias that can be induced by changes in leverage or bargaining power resulting from a merger. ROA is calculated simply by dividing the net income of the bank by a number of its assets. That is, compared to the net income and net interest margin, ROA takes into account the size of the bank. Thus, ROA is a suitable measure of how well a bank s assets are being used to generate profits (Mishkin, 2013). Just like ROA, return on equity (ROE) can also be used as a performance measure because equity holders are mostly interested in returns of their shares. ROE is measured as the ratio of net income of the bank to its shareholder s equity. According to Petersen and Schoeman (2008), the main interest of equity holders is how much the bank is earning 26

27 on their equity investment. Overall, while ROA measures the operational efficiency of the bank, ROE is a measure of equity holder returns and the potential growth of their investment (Petersen and Schoeman, 2008). In this study, we separate our way from the studies of Altunbas and Marques (2008) and Ramaswamy (1997), and instead of using Return on Assets (ROA), we use Return on Average Assets (ROAA) as the main measure of financial performance. ROAA is calculated by dividing net income by average assets. According to Popovici (2013), ROAA represents how efficiently a bank is utilizing its assets, and it is an adjusted version of ROA. Therefore, ROAA gives more accurate information about company s profitability. We also use Return on Average Equity (ROAE) as an alternative measure of profitability and for robustness check. To calculate the dependent variable, ROAA, the 3-year period is used as Ramaswamy (1997) did. We do not use more than three years because many banks in the sample involved in mergers and acquisitions within that period. Moreover, using longer period makes it difficult to distinguish effects of mergers than other economic factors. Also, we do not use one or two year period because they are not long enough to observe synergistic gains of merger and acquisitions (Ramaswamy, 1997). Therefore, since while adding additional years violate the "clean data" principle (Choi and Philipatos, 1983), using the short period does not allow to observe synergistically, we prefer to use 3-year time window to observe performance effects of strategic similarity indicators INDEPENDENT VARIABLES: CONTROL VARIABLES As both Altunbas and Marques (2008) and Ramaswamy (1997) use pre-merger period of profitability and relative size of the bidder firm as control variables in their studies, we also include them in our analysis. Irrespective of strategic similarities or dissimilarities, the size of the banks might explain some variance in post-merger performance (Ramaswamy, 1997). Also, most of the studies on merger and acquisition show that larger companies prefer to 27