Evaluating International Banking and Capital Markets for Acquisition Targets

Introduction and Framework

One of the steps in determining the best countries to target for overseas subsidiaries is by examining different countries for the characteristics of their banking and capital markets. There are four main categories of characteristics that will be the focal point of this report, for each of the banking and capital markets. The four main characteristics are access, depth, efficiency, and stability. For a company seeking a country in which to enter, each of these has particular relevance for both the size of the market and the potential of the market.

Access reflects the market penetration for banking and finance, which can be seen as a proxy of sorts for market potential. Depth is another factor that can highlight the size and potential of a given market. The efficiency reflects whether there are synergistic opportunities. Remember that companies making acquisitions will always pay an acquisition premium above and beyond the current market value of the acquired firm (Haunschild, 1994). While in some cases there will be synergistic benefits accruing from geographic diversification, especially when part of a broader globalization strategy, operational synergies can come when the acquiring bank brings its operational expertise to the acquired bank (Sirower, 1997). The acquiring bank would be able to improve the acquired bank, thereby increasing its value. The acquired bank is unlikely to be able to fully price this in, so there is opportunity to create shareholder value, ironically, when the acquisition target is underperforming (Krishnan, Hitt & Park, 2007).

There are eight metrics that are the subject of this study, one for each characteristic for banking and capital markets. For the banking industry, the access metric is the availability of ATMs per capita. This data is widely available and serves as an effective proxy for banking density at the consumer level. Bank branches are sometimes cited, but since most branches have ATMs, yet there are freestanding ATMs as well, this measure is a more comprehensive study of a country's consumer banking infrastructure. The depth measure is the financial system deposits to GDP. This percentage reflects the degree to which people in the country use their banking system, and a disparity between this and the access measure can highlight a country where wealth is concentrated such that a sizeable infrastructure does not necessarily mean that people can or are willing to use it.

Banking Industry Metrics and Analysis

The efficiency metric is bank noninterest income to total income, which illustrates the sophistication of the banking system. The world's most sophisticated banking systems have relied on ever-increasing use of non-interest fees in their revenue as a complementary revenue source (DeYoung & Rice, 2003). Arguably, a lack of efficiency here creates an opportunity to adapt domestic non-interest revenue streams to the foreign context, to recapture some of the acquisition premium. The stability metric commonly used is bank credit to bank deposits, a figure that highlights the leverage within the industry and therefore its overall risk.

The capital markets measures used are as follows. The access measure is the market capitalization excluding the top 10 companies. In many countries, there may be a handful of dominant companies that skew the size of the local markets. But once the top ten companies are excluded, the size of the remaining market can be an indicator of the breadth of access that firms have for the capital market. The depth measure used here is the stock market's value of total traded to GDP. While this measure does include the top 10 companies, its value lies in how much the local stock market reflects the size of the local economy. While in some cases this could be skewed by companies listing overseas (for example, Israeli companies listing in the US, making the Israeli market look smaller than it actually is), for most countries this measure should deliver an accurate reflection of the market depth. The stock market turnover ratio is the efficiency measure used, as higher turnover indicates higher liquidity, meaning the market is more efficient. Stock price volatility is the stability measure that will be used. This is probably best examined in context with major stock markets, as even they can have some volatility. This will also correlate somewhat with depth, as markets with less depth probably have less stability.

Russia has the highest access in its banking industry, with strong showings coming from Hong Kong. Weak access is reported from Nigeria and Egypt. Germany's banking access is at surprisingly low levels, far below what would be expected from a modern economy.

With respect to market depth, Hong Kong has incredible market depth, while the UK did not register on the chosen metric. Germany and Malaysia also held reasonable levels of market depth, while Mexico and Nigeria had low levels of depth. Despite its broad access, Russia also showed a fairly low level of market depth.

Russia and Hong Kong enjoy the highest scores for banking industry efficiency, well above UK levels. The Germans are at the UK level. The developing world nations all have relatively inefficient banking systems, particularly Sri Lanka. Of the countries studied, Russia has the greatest market stability. The country's oil wealth has allowed its banking sector to enjoy a higher level of stability than the other nations. German banks were less stable, having been weakened somewhat by the recession and the Eurozone crisis. Egypt has the least stable banking system, and this was the case even before that country's recent political troubles. Sri Lanka's banking system has a relatively high level of stability, as does that of Malaysia, both countries roughly at Germany's level.

Capital Markets Metrics and Analysis

Overall, the country that stands out as having the best metrics for the banking industry is Hong Kong. While the bank stability is not great—perhaps a reflection of People's Republic of China control over the territory and consequent departure of major banks like HSBC to safer places—the other metrics are strongly in Hong Kong's favor. There is still a significant opportunity as Hong Kong is seen as the West's window into China, a proxy investment in Chinese growth, but with a more or less British legal system and Western capitalist characteristics.

Sri Lanka is the only other really promising country in this group. While Mexico and Malaysia are decent performers on the metrics, there is no excellence in any one area that would signify a great opportunity. The optimal time to invest in those countries may have passed. Sri Lanka, on the other hand, is benefiting from an upsurge in growth relating to the country's emergence from civil war. The country was a growing economy before the war, a pattern that has picked back up almost immediately after the government victory (Ganegodage & Rambaldi, 2013). Combining the stability of the banks with their operational underperformance and a solid economic growth rate means that Sri Lanka represents a good opportunity to perhaps invest in a country before it becomes overpriced.

Of the countries studied, several markets have equally high access—Malaysia, Hong Kong, and Germany are all comparable to the UK in terms of capital market access. With respect to depth, however, Hong Kong is not comparable to anywhere else. Hong Kong has exceptional market depth, five times the level of the UK. The other countries tend to have relatively poor depth scores, even Germany. Nigeria in particular barely has a stock market; any Nigerian company worth incorporating probably lists in London.

Not surprisingly, Hong Kong has the greatest level of market efficiency. However, Germany and Russia also have efficient financial markets. Nigeria's financial markets are horribly inefficient—again, this is a country that despite its economic promise has almost no stock market to speak of. The other developing market countries on the list do not have particularly efficient stock markets either, though they are at least functional.

Egypt has high market stability, even if this is its only strong attribute. Germany and Hong Kong also perform well on market stability measures, not surprisingly. Frankfurt and Hong Kong are two of the biggest stock markets in the world. Among emerging markets, none stood out as particularly attractive, though Nigeria was particularly unattractive. Egypt was probably the best performer among them, but the measures were simply not strong enough to offer a powerful recommendation for that country. A bad day of business in Hong Kong or Germany would be worth more than the Egyptian market, especially when political risks and liquidity are taken into consideration.