that is a takeover offer signals to the market that the bidder saw more
value in the
target than the market currently does - therefore
if the market
agreeswith the
undervaluation, the target stock price will rise.
In another development they (Weston, Chung and Siu) came up with the theory
of
2+2=5 effect from the synergy of improvement mechanism. Here the sum of two parts is greater than the two parts alone. They noted that many
horizontal
mergersoccur because it is believe that the two firms make a good fit and complement each
other. The merger can therefore compensate for the deficiencies in each of the
firms.
3.2 Conceptual Framework
3.2.1 Financial intermediaries
McKinnon and Shaw (1993) have demonstrated the immense influence which bank
have on economic growth in developing countries. Their key argument is the symbiotic relationship between financial markets and economic growth, by noting
that well developed financial markets area sine qua non for economicdevelopment.
Other empirical studies like Isik (2004) have noted that large banks are more involved in loan production than in portfolios that are biased towards investment in securities. Okuda and Hashimoto (2002) however opined that the bank consolidation
24
in Malaysia facilitated the expansion of banks and
widen their business operations,
through reorganization and integration.
The studies by Fixler and Zieschang (1993), Hughes, et al (1999)
have noted that
after consolidation: banks shifted their portfolios from securities to loans; had lower equity ratios and purchased more unused funds which were raised at
reduced
rates.This study confirmed Berger (2003) which is consistent with the hypothesis
that
improvement in portfolios diversification allows institutions to make additionalhigh
risk- high expected return investments without additional equity.
3.2.2 Corporate Governance
The Literature followed from the research conducted by Scholl Hans Jochen (?) into
various issues so discussed. There is no single or simple definition of corporate governance and certainly no definition that all countries agree on (Mayes, et al., 2001). Corporate governance is defined and practiced differently throughout the world, depending on the relative power of owners, managers, and providers of capital (Craig, 2005). Basically, different national systems of corporate governance have reflected major differences in ownership structure and ownership concentration (Shleifer and Vishny, 1997). The concepts of corporate governance relate to the relationships between a company's Management, Board, Shareholders and other
Stakeholders.
The narrow approach to corporate governance views the subject as the mechanism, through which shareholders are assured that managers would act in
their best interests. As far back as Adam Smith, as indicated in Henderson (1986), it
has been recognized that managers do not always act in the best interests of shareholders. Jensen and Meckling (1976) addressed the principal-agent problem,
which was observed to occur when managers with private information have incentives to pursue their own interests at the owners' expense. The broad view of corporate governance, however, refers to the process that seeks to direct and control the affairs of an organization so as to protect the interest of all stakeholders in a balanced manner. The process is underpinned bythe principles ofopenness.
25
3.2.3. Corporate Governance Mechanisms
One of the consequences of the separation of ownership from management is that
the day-to-day decision-making power (that is, the power to make decision over the
use of the capital supplied by the shareholders), rests with persons other than the
shareholders themselves. The separation of ownership and control has given rise to
an agency problem whereby there is the tendency for management to operate the
firm in their own interests, rather than those of shareholders' (Jensen and Meckling, 1976; Fama and Jensen, 1983). This creates opportunities for managers to build illegitimate empires which in extreme cases, are outright expropriation and therefore
affect good governance.
3.2.4 Stakeholders
The classical definition is: 'A stakeholder in an organization is any group or individual
who can affect or is affected by the achievement of the organization's objective' (Freeman, 1984,). Mitchell et al. argue that the use of risk as a second defining property for the stake in an organization helps to "narrow the stakeholder field to
those with legitimate claims, regardless of their power to influence the firm or the legitimacy of their relationship to the firm". (Mitchell et al. 1997, 857). In a similar approach, Alkhafaji proposed focusing the stakeholder definition on only those
groups that have a vested interest in the survival of the firm can be referred to as stakeholders (Alkhafaji, 1989).
3.2.5 Shareholder
Shareholders are a type a stakeholder who plays a key role in the provision of corporate governance. Small or diffuse shareholders exert corporate governance by directly voting on critical issues, such as mergers, liquidation, and fundamental changes in business strategy, and indirectly by electing the boards of directors to represent their interests and oversee the myriad of managerial decisions. Incentive contracts are a common mechanism for aligning the interests of managers with
those of shareholders. The Board of Directors may negotiate managerial compensation with a view to achieving particular results. In general, large shareholders could maximize the private benefits of control at the expense of small investors (DeAngelo and DeAngelo, 1985). Thus, while concentrated ownership is a
26
common mechanism for confronting the corporate governance issue, it has its own drawbacks.
3.2.6. Debt Holders
Debt purchasers provide finance in return for a promised stream of payments and a
variety of othercovenants relating to corporate behaviour, such as the value and risk
of corporate assets. If the corporation violates these covenants or default on the payments, debt holders typically could obtain the rights to repossess collateral,
throw the corporation into bankruptcy proceedings, vote in the decision to reorganize, and remove managers. However, there could be barriers to diffuse debt
holders to effectively exert corporate governance as envisaged. Small debt holders
may be unable to monitor complex organization and could face the free-rider incentives, as small equity holders. Large creditors for example, as noted by Myers (1997), may induce the company to forego good investments and take on too little
risk because the creditor bears some of the cost but will not share the benefits.
3.2.7. Competition in Product Market and Takeovers
Some economists have argued that competition in the product or service
market may act as a substitute for corporate governance mechanisms (Allen and gale, 2000). The basic argument is that firms with inferior and expropriating management could be forced out of the market by firms possessing non-expropriating managers due to sheer competitive pressure. That is, rather than focusing on the legal mechanisms through which equity and debt holders seek to
exert corporate control, market competition can discipline a poorly managed firm.
Also, a fluid takeover market as noted by Jensen (1993) could create incentives for
managers to act in the best interests of the shareholders to avoid being fired in a takeover. Evidence however suggests that, given the power of managers and the scarcity of liquid capital markets, takeovers are essentially non-existent as a corporate governance mechanism outside the USA and UK (Shleifer and Vishny, 1997).
27
3.2.8. Customers:
The bank customers are an important class of stakeholder as their choices
influences the products and services made available. Therefore customers determine part of the success of the merger, because if the new integrated bank provides service demanded by the customers, the new outfit's value will increase.
Turnover which is crucial to banking business is scouted for to maximize share
holders wealth the banks are all out to ensurethat the customers determine product
choice.
3.2.9. Employees
This stakeholder seeks job security and increase in pay. Though the stockholders
own the company, the employees are the ones who carry out the day-to-day operations and make most decisions of the bank. Principal agent issues can arise
when the owning and decision making are separated. After merger it is the employees who undertake the integration process. Because employees are instrumental to the success of the merger, their action and opinions must be
considered by the bank in orderto realize wealth gain.
3.2.10. Government andSociety in general:
They are interested in the increase in the overall wealth of the country and provision
of guidelines and rules to realize same (the government can however prohibit a merger that is detrimental to its citizens). A society may become wealthier if it has
more choices, and the bank promotes wealth creation if it provides more choices.
However the society always wants it standard of living to increase which can come
about through strong financial returns, income, credit and employment.
From the foregoing the stakeholders are tied together in the valuation process. The
customers along with their agents determine turnover and loans. The government regulates the industry and can pressure the bank into conducting business according to the rules. These stakeholders affect the cash flow of the bank, which determines the stock prices and bond value, which is linked to the stockholders and the bondholders. When two or more banks are considering a merger and throughout
an integration process, the opinions of the stakeholders are to be considered, for
28
they all affect the new banks net wealth. However the concern of the stakeholders should be objectively considered as under the assumption of efficiency, the bank
that makes the best decision should see its value increase in comparison to its competitors.
3.3. Scenariofor Corporate GovernanceofIntegrated Banks
Banks are special and different from other non-bank financial institutions due to their public purpose. They are subject to corporate governance rules, regulations, and policies issued by the bank regulatory agencies and subject to regular supervisory
review of their corporate governance practices and procedures. According to Macey
and O'Hara (2003), there are more stakeholders in the governance of banks than
other businesses due to the banks' liquidity function and its role in promoting the
health and stability of the economy. Accordingly, a loss of confidence in banks has
the potential to create severe economic dysfunction, adversely affecting its general
welfare. A systemic banking crisis caused by bank misconduct (or the appearance of it) has the potential of shifting bank losses to the deposit insurance funds (if it exists)
or tothe tax payers.
The banks' corporate governance focus is also different due to the source of their financing. Banks typically receive a greater percentage of their financing through debt, which tends to be in the form of deposits from multiple unsophisticated depositors rather than from the more typically sophisticated debt-holders of non-financial businesses. Banks are also different due to deposit insurance which exists
in some jurisdictions and which largely removes the incentive for depositors (the
debt-holders of the bank) to monitor their activities and which can also lead to risky
behaviour on the part of bank management (Hanc, 1999). Also, banking businesses
are generally more opaque than non-financial firms' businesses. Although
information asymmetries plague all sectors, evidence suggests that these information asymmetries are larger with banks (Furfine, 2001). Banks can alter the risk composition of their assets more quickly than most non-financial firms, and can
readily hide problems by extending it.
29
The greater the information asymmetries between insiders and outsiders in banking
sector the more difficult the monitoring of bank managers become for small equity
and debt holders. This asymmetry could become more dangerous when banking
institutions face insolvency and the situation is not resolved quickly. In such circumstances, controlling shareholders and management, having nothing to loose themselves, as they may be tempted to engage in reckless behaviour to recoup losses.
Osota (1999); Umoh (2002); and Alashi (2002), provided the evidence that insiders
in some Nigerian banks diverted the flow of loans to themselves and also defaulted
in payments. Reports from these research efforts showed that in some of the banks
that were closed between 1994 and 2002, over 60% of their loan portfolios to clients
cannot service its debt obligations. Also, due totheir importance in the economy and opacity of their operations, banks are often heavily regulated and they enjoy the
benefits of the government safety nets. Oluyemi (?) therefore made an inference that
these traits have some implications for the corporate governance of banks: insider's
credits to their directors and related business interests; and the opacity of banking
businesses can weaken competitive forces which in other industries would had helped to discipline managers through the threat of takeover or competitive product
markets.
3.4 Why do banks merge?
It is widely believed that bank on the prowl of mergers are attempting to pick up new customers, expand into new markets, cut overhead, exploit economies of scale,
reduce overcapacity and extend their product offerings into mutual funds, derivatives
and other financial products. By merging with competitors in the same market
(so-called in-market mergers), bankers typically promise to cut overall expenses by consolidating operations, eliminating duplication, and exploiting economies of scale
in activities with high fixed costs. In-market merger also presents an opportunity to
create regional banking giants that can gain greater market control. Alternatively by merging with a bank that operate in predominantly different market (cross-market
30
merger), bankers hope to reduce overall risk through geographic and product diversification as well as cut costs where appropriate through consolidated operations.
Merger may increase diversification through product extension (new product), geographic extension (same product, new location), or pure diversification (no to
firms products). The Amalgamated Bank of South Africa (ABSA) of South Africa and
the Kenyan case of the merger of the African Mercantile Banking Corporation are Africa's example that has improved its diversification through merger.
Macy, (1998) reported that some mergers may cause precautionary economies,
which provides money benefitswithout improving the use of real resources. Merged
firms may be able to get lower input prices through integration with the newly
combined firm gaining promotional advantages from the increased marketing power since sales are transferable. The total effect of a merger takes time before they are realized. Firms may not immediately gain from the external growth, but instead after
a successful integration. The success can then be passed on to employees, customers, and other stake holders in the form of more and better product, lower prices and higherwages.
However a study undertaken by Siem, (1996), examined five hypotheses for why
banks merge and why they are interested in merging with other financial institution,
as follows:
i. Manager-utility-maximization: This suggests that factors other maximizing
shareholder value motivates mergers. These factors include management
level of satisfaction, job security, and span of control. In this view the
managers act to maximize their own utilities rather than those of its owners or shareholders of the firm. If investors perceive that the managers are pursuing
a merger solely in management's own interest,
the price of the
acquiringbank's share should drop to reflect expected losses from an unprofitable
investment. Taken to the extreme, the manager-utility-maximization hypothesis predicts no aggregate
wealth creation
or even adrop in
wealth,31
because of the acquiring bank management's selfish motives. The gains
realized by the target bank shareholders should equal the losses suffered by
the acquiring banks shareholders, plus any expenses incurred to account for
thetransfer.
ii. Hubris: The behavioral explanation for hubris hypothesis suggest that
managers believe they can uncover "bargains." They persist in the believe
that their own valuation of the target bank is correct, even when confronted
with objective information that shows that the target's true economic value is lower, as reflected in its market valuation. Here, the acquiring bank winds up for paying too much for the target institution. Thus, under the hubris hypothesis, the stock price of the acquiring bank could be expected to fall and
that of the target bank to rise at the merger announcement date. Further, a merger under these circumstances should simply transfer wealth from the acquiring bank shareholders and not result in any aggregate wealth creation.
Because of similar stock price prediction of this hypothesis and the manager-utility-maximization hypothesis, it is difficult to distinguish empirically between
the two.
iii. Synergy: The Synergy hypothesis suggest that
the acquiring bank
can effectively generate synergies via economies of scaleand
scopeby reducing
cost and eliminating redundancies and duplications.
All else being equal,
lower cost means increased profit and higher stock prices for both acquiring
bank shareholders and target bank shareholders. Expected synergistic gains
should create positive net aggregatewealth,