Financial Consolidation: Merits and Problems

Takatoshi ITO (Professor, Hitotsubashi University)

Benefits for Small Financial Institutions

In the last few years, there has been an increasing number of financial mergers and acquisitions in advanced countries. As a result, the size of each financial institution has become bigger and the number of institutions has been decreasing in major financial markets. According to a report submitted to the G10 meeting in early 2001, the characteristics of such financial consolidation can be summarized as follows:

First, most of the financial consolidation cases that increased rapidly in the late 1990s were mergers and acquisitions within the same industry, especially the banking industry in each country. As a result, the degree of concentration increased significantly in such countries as Australia, Canada, France, Sweden, and the Netherlands.

Second, the main reasons for such consolidation are to reduce current costs and to improve profitability by scale expansion and/or product diversification. In particular, scale expansion has been made possible and indeed necessary due to the IT revolution and deregulation on a global scale. However, analyses of the consolidated financial institutions have generally failed to identify the effects of cost reduction or higher profitability due to the economies of scale or scope, except in some cases of relatively small financial institutions.

In Japan financial integration became active a little later than in other advanced nations, and it has been mostly the cases of liquidation or mergers of failed banks or salvaging mergers of weakened banks with relatively few cases of strategic mergers and acquisitions among healthy banks.

Unique Characteristics of Japanese Banks

It seems especially difficult to realize gains from bank mergers in Japan due to its unique conditions. First, the speed of mergers is very slow. Personnel factors are a real obstacle. And there is some concern that keeping banks from being failed by regulator by mergers might delay necessary reforms.

According to a recent report by Ms. Kawamoto of McKinsey and Co., Japan, financial consolidation could have some impact on management efficiency for mergers of small banks, but virtually no impact in the case of large banks, just as the G10 report indicated. This is because the ratio of costs to (gross) profits is decreasing with the increased size of banks, but it stops decreasing beyond a certain size corresponding to typical city banks.

Actually, what is expected of financial consolidation in Japan seems to be accounting benefits directly resulting from business mergers or divisions, and such benefits are estimated to be at least three times as large as the combined amount of cost reduction and revenue increases. Furthermore, it is said that estimates for revenue increases might well be overrated because of possible competition among group banks for greater influence after their consolidation.

There are other disappointing signs such as the maintenance of the seniority promotion system, which tends to discourage the younger generation to stay and work harder, and in fact encourages them to leave for foreign-affiliated institutions. Since Japanese banks are yet to abandon their old-fashioned, ineffective approach to personnel management, loan competition and product development, financial consolidation might well increase the risk of complex organization due to larger scale, rather than diversify the risk of various shocks in individual sectors or regions.

Problems for the Financial Services Agency

The risk of large, complex organization is posing an important problem to Japan's financial supervisory authority. Consolidation among relatively weak banks without management restructuring could hinder the reform of the financial system, since it would be quite difficult to wind down large, complex institutions. The Financial Services Agency must realize that admitting or encouraging bank mergers might well make their financial supervision more difficult in the future. This is an important point since the Financial Services Agency should shift its focus from the backward-looking task of inspecting banks' bad loans to the forward-looking task of managing risks for large-scale financial institutions.

While Japan cannot be exempted from the current trend of financial consolidation that is being strengthened by market globalization, deregulation, and technological innovation, it should be noted that consolidation itself would not automatically improve the profitability of each institution or the stability of the financial system as a whole. The future of larger financial institutions will be very bleak in the midst of financial globalization, if they simply try to pursue accounting profits while maintaining their traditional personnel system.

Japan's financial institutions must establish their own identity for survival in the globalized market by reforming their organizations, promoting young managers, and developing new products to attract and manage personal financial assets. The financial supervisory authority must avoid the situation where mergers would simply produce large financial institutions and give them excuses of being "too big to fail." What is needed now is a new business model in which larger scale will lead to higher profitability.