This paper analyzes the successive waves of consolidation among financial institutions in the United States, exploring both the drivers and consequences of merger and acquisition activity in the banking sector. It traces how deregulation — particularly the repeal of the Glass-Steagall Act in 1999 — enabled commercial and investment banks to merge, generating economies of scale and improved consumer access while simultaneously creating dangerous concentrations of systemic risk. Drawing on evidence from the 2008 financial crisis and a comparison with Canada's more regulated banking system, the paper argues that while intra-sector consolidation can benefit consumers, cross-sector mergers between retail and investment banks tend to produce misallocations of risk that ultimately burden taxpayers.
Successive rounds of consolidation among financial institutions have been attributed to a number of factors. Most of these factors are fairly common in merger and acquisition activity, so in that sense the financial services industry is not unlike other industries. Efficiency improvements are one key driver; increases in market power, diversification of revenue streams, and lowering risk are all factors commonly cited in such mergers (Berger, Demsetz & Strahan, 1999).
Successive waves of deregulation allowed for a much greater degree of consolidation. First, banks were permitted to operate across state lines, which enabled the growth of national-level retail banks in the United States. By 1999, the Glass-Steagall Act was repealed. This Act had created a separation between commercial banks and investment banks. With that restriction eliminated in 1999, further consolidation followed as these two types of financial institutions began to explore mergers and acquisitions as a means of further diversification (Investopedia, 2014).
For banks, the ability to merge has allowed them to grow substantially larger. Several retail banks have been able to expand into very large — in some cases nearly national — institutions. The increase in scope has given them greater access to capital, greater economies of scale, and, for the consumer, better access to nationwide service. By the 1990s, it had become evident that the fragmented nature of the US banking industry was doing consumers a disservice: other nations were innovating because their banks had scale. US consumers have benefited from being able to keep their bank accounts when they move across the country, and from having much greater access to services.
There have also been significant disadvantages, however. Financial consolidation has resulted in a change in the way that financial institutions allocate risk. While not all outcomes are negative, US investment banks loaded up on retail bank mortgages and securitized them. The creativity of US investment bankers, when applied without adequate regulation to retail bank products, resulted in a high level of exposure among banks to bad debt. This debt was securitized and structured in a way that made it difficult for many banks to recognize its true risk characteristics.
This did not cause the recession outright, but it was a precondition for its intensity. The financial markets were so closely linked that when investment banks began to struggle, retail banks were immediately affected as well. The result was a lending crisis and a liquidity trap in which, even under loose monetary policy, banks were unwilling to lend. The government was forced to bail out many of these institutions, in part because of the effects of linking investment banks and retail banks. In Canada, where the separation between these two types of financial institutions remained in place, no such crisis occurred, no bailouts were necessary, and the banking sector was never at risk of default. Even today, US banks carry higher z-scores than those in most OECD countries — a testament to the greater risk embedded in a US banking system that allows financial institutions to merge across these two sectors (World Bank, 2012).
"Risk misallocation, securitization, and crisis consequences"
Investopedia. (2014). Glass-Steagall Act. Retrieved December 7, 2014, from http://www.investopedia.com/terms/g/glasssteagallact.asp
World Bank. (2012). Rethinking the role of the state in finance. Retrieved December 7, 2014, from http://siteresources.worldbank.org/EXTGLOBALFINREPORT/Resources/8816096-1346865433023/8827078-1346865457422/GDF2013Report.pdf
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