Banking Industry

The US banking industry has been undergoing a major structural change since the eighties. The consolidation of the banking industry has not only reduced the number of commercial banks, but also created large banks whose market capitalisation exceeds US$100 billion. Not so long ago, Citigroup and HSBC were the only banks in that bracket, but now they have been joined by JP Morgan Chase and Bank of America after mergers with Bank One and FleetBoston respectively.

A study of the Federal Reserve Bank of San Francisco has identified four major forces behind the consolidation in the US banking industry.

Banking industry – economies of scale

The first force is economies of scale. In the past, regulatory restraints in the banking industry stopped commercial banks in the USA from deriving scale benefits from geographic coverage. The commercial banks were not allowed to operate a branch network across multiple states through a single entity. Instead the banks had to open separately capitalised, individually chartered bank subsidiaries in the states where they wished to operate.

The passage of the Riegle-Neal Act, however, allowed interstate branch banking from 1997 onwards. This act allowed banks to consolidate individual state charters into a single charter, resulting in immense scale benefits. It also gave commercial banks the option of creating a nation-wide franchise through mergers. As yet none of the large banks operate in all of the 50 states in the USA. The anti-trust regulations of the banking industry, however, impose a cap on the extent to which large banks can pursue scale.

economies of scope

The second force driving consolidation in the US banking industry is economies of scope. Studies have shown that combined production of two related products is more cost effective than producing them separately. The commercial banks in the USA, however, were not allowed to engage in investment banking (securities business) and retail banking at the same time by the Glass Steagall Act. They were, however, permitted to engage in securities business in a limited way through Section 20 subsidiaries. In addition, banks were allowed to engage in general insurance business only in small towns where the population did not exceed 5,000 people. The Gramm-Leach-Bliley Act in 1999, repealing Glass Steagall Act, broadened the scope of activities that a bank could engage in. It allowed banks to gain scope economies by combining banking with insurance and investment banking.

risk diversification

The third force driving consolidation in the US banking industry is risk diversification. The greater geographic reach resulting from mergers and acquisition not only reduces the risk on the asset side, but also those on the liabilities side. The fund base, for instance, is spread over a broader geographic area. Product diversification into segments such as insurance also reduces risk.

top management

The fourth force driving consolidation in the US banking industry is the top management of banks. Empirical studies have established a clear link between executive compensation and firm size. History has shown that top executives pursue deals in the hope of running bigger banks.

While these four forces continue to motivate consolidation in the US banking industry, antitrust regulations and the Riegle-Neal Act imposes caps on expansion in the banking industry. The Riegle-Neal Act prohibits any merger or acquisition that results in a combined entity which controls more than 10% of the total amount of deposits of insured depository institutions in the USA. The banks could exceed the deposit limit through organic strategies, but will not be allowed to engage in mergers and acquisitions after they cross the specified limit.