High-Risk Strategy in a Time of Crisis – the Cautionary Tale of Bank Acquisitions

If anything positive can be derived from the global financial crisis, it is the increased scrutiny of banks and the pressure for them to act with greater responsibility and accountability. However, this does not take away the fact that many high-risk strategies were adopted (and maybe still are) where, in the event of failure, it was ultimately the taxpayer who footed the bill, due to the government support in place in the event of significant financial losses. Lessons need to be learned. In the specific case of bank acquisitions, the potential benefits and losses involved in such schemes remain the same, whether one is talking in a pre- or post-2008 context. Breaking banks down into sub-categories and analysing and measuring the risks taken per category could be the way forward.

To acquire or not to acquire?

Previous research into bank acquisitions sees the situation in two very different lights. On the plus side, such operations can enable banks to function more efficiently, improve risk diversification by spreading business across multiple product lines and geographical locations, potentially reduce liquidity and solvency risks and, overall, achieve economies of scale. On the downside, banks engaging in such processes may be exposing themselves to higher risks at an individual and systemic level, end up with a more opaque and hybrid structure due to the increase in bank size, and also adopt the often-seen “too big to fail” strategy, whereby unnecessary risks are continued to be taken, safe in the knowledge of the afore-mentioned government support in the case of real failure. However, not all banks should be tarred with the same brush, as a recent study breaking down results into retail and investment banks illustrates.

Measuring risk and solvency

The study in question focusses upon 41 of Europe’s largest banks from 1990 to 2006 and representing 1603 transactions for a total value of 813 billion USD. A series of empirical and mathematical techniques were applied in order to perform three main analyses. Firstly, the level of bank risk via the distance to default, meaning the distance between the market value of a bank’s assets and the book value of its debts. The second step involved measuring the level of solvency, based upon data taken from financial statements and an estimation of asset profitability and the bank equity-asset ratio. Finally, the level of correlation per bank was established between risk in 2008 and the cumulative size and nature of acquisitions over 1990-2006. In all cases, particular attention was paid to the nature of each bank in question – retail or investment.

First the good news or the bad?

The results of the study reveal a fairly clear divide between the potential repercussions of risky acquisition strategies taken by investment banks (for the worse) as opposed to retail banks (for the better). The additional category of mutual banks (meaning banks not listed on the stock exchange, such as building societies) emerged as being less exposed to the risk of failure. It must be underlined that the results apply specifically to Europe and part of the reason for this is as follows. Many, for example, Asian-based banks have maintained a firm anchoring in the local heritage and business practices of the area, as reflected in their internal set-up and governance. However, in the case of Europe, a great many banks brought in new heads pre-crisis from around the world with very different mind-sets and ways of doing business in order to achieve immediate results, resulting in a mish-mash of ways of doing business, the ejection of those adopting a more conservative approach, followed by the adoption of high-risk policies with the consequences we now know. So what can be learnt from this breakdown of retail vs. investment banks and the importance of a coherent corporate culture within banks?

Take risks, but keep them calculated

The encouraging implications of the retail bank results should be weighed against the continued risk that other banks continue to adopt the “too big to fail” approach. The latter could be avoided by not upsetting governance structures within banks via the introduction of more cut-throat, immediate results-oriented heads from conflicting corporate cultures. In addition, large banks considering engaging in an acquisition are strongly encouraged to eye up the institutions that interest them by applying the retail vs. investment bank approach applied in the previously-mentioned study, in order to mitigate the risk factor. Lastly, regardless of bank type, the phenomenon of “executive hubris” needs to peter out, where company heads flushed with previous success feel that they are entitled to continue taking the same high-risk options. The landscape has shifted dramatically since 2008, so let’s keep investing (with all the necessary risks that implies) but on safer, more carefully calculated grounds.

This article draws inspiration from the paper Bank Acquisitiveness and Financial Risk Vulnerability written by Saqib Aziz, Michael Dowling and Jean-Jacques Lilti and published in Bankers, Markets & Investors 143 (2016).

Michael Dowling is an assistant professor of Finance and Accounting at Rennes School of Business, France. His research interests include Asset Pricing, SME Financing, Behavioural Corporate Finance, Investor Psychology, and Energy Finance.

Saqib Aziz is an assistant professor in Finance and Accounting at Rennes School of Business, France.

Jean-Jacques Lilti is a professor of Finance at University of Rennes, France.