Brookings-Wharton Papers on Financial Services

Brookings-Wharton Papers on Financial Services 2000 (2000) 23-120

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Globalization of Financial Institutions: Evidence from Cross-Border Banking Performance

Allen N. Berger, Robert Deyoung, Hesna Genay, and Gregory F. Udell

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Mergers and acquisitions among very large financial institutions are becoming more frequent in markets around the world, attracting the attention of policymakers, researchers, and the financial press and continually reshuffling the rankings of the world's largest financial services firms. Most of these mega-mergers have combined commercial banking organizations within a single nation. In the United States, recent mergers and acquisitions (M&As) between large banking organizations--such as Bank of America-NationsBank, Banc One-First Chicago, and Norwest- Wells Fargo--rank among the largest M&As in terms of market values in any industry in U.S. history. In Europe, mega-mergers like UBS-Swiss Bank are similarly creating giant banking organizations that are much larger than the world's largest banks of just a few years past. In Japan, the three-way combination of Fuji Bank, Dai-Ichi Kangyo Bank, and Industrial Bank of Japan is creating the world's first trillion-dollar bank. [End Page 23]

More to the point of this paper, there also is a trend toward cross-border M&As between large financial service firms in different nations. These cross-border M&As often involve large universal-type institutions that provide multiple types of financial services in multiple nations. One prominent example is the Deutsche Bank-Bankers Trust mega-merger, which provided a leading European universal bank with greater access to wholesale commercial and investment banking resources in the United States. In Europe, there has been considerable cross-border consolidation of all types of financial institutions following substantial deregulation of cross-border economic activity in both financial and nonfinancial markets. For the securities and insurance industries, the market values of cross-border M&As involving European financial institutions have actually exceeded the values of within-nation M&As in recent years. ¹

The increased M&A activity raises important research and policy questions about the causes and consequences of consolidation and the future structure of the financial services industry. There is an extensive research literature on the motives for and consequences of consolidation, covering efficiency, market power, and managerial topics. Presumably, much of the increase in consolidation represents market responses to deregulation that made it more possible and less costly to consolidate, such as the Riegle-Neal Act in the United States and the Single Market Programme in the European Union (EU). Future consolidation may be motivated by recent policy changes, such as passage of the Gramm-Leach-Bliley Act in the United States and creation of the monetary union in the European Union. These policy changes may precipitate further consolidation of large institutions, with important social consequences for systemic risk, the safety net, and monetary policy as well as for efficiency and market power in the financial services industry.

In this paper, we address these issues in three ways. First, we extensively review several hundred research studies on the causes and consequences of consolidation, covering the topics of efficiency, market power, managerial and government motives, and consequences. Second, we provide a number of relevant descriptive statistics, including data comparing financial systems in different nations, information on cross-border provision of financial services through both cross-border lending and the establishment of a physical presence in foreign nations, and the market values [End Page 24] of within-nation and cross-border M&As. The literature review and descriptive statistics are intended in part to provide reference material to promote future research. Third, we analyze cross-border banking efficiency in five home countries. This analysis is designed to address our main hypotheses about cross-border banking efficiency and may help to foretell the extent to which global financial institutions may penetrate financial markets around the world.

We broadly define the efficiency effects of consolidation to include any cost, revenue, or risk factors that affect shareholder value other than changes in the exercise of market power in setting prices. Although we acknowledge the importance of factors other than efficiency in consolidation decisions, our approach reflects a presumption that cross-border consolidation is sustainable in the long run only if it increases efficiency or does not reduce efficiency substantially. In this framework, we expect that foreign-owned institutions would be at least as efficient on average as domestic institutions. Efficiently managed organizations would gain shares in foreign markets and export their superior skills or policies and procedures to other nations. However, the empirical evidence in the literature (and in our own analysis) typically finds the opposite result--foreign institutions are generally less efficient than domestic institutions. We analyze this mysterious finding by developing and testing two main hypotheses, the home field advantage hypothesis and the global advantage hypothesis.

Under the home field advantage hypothesis, domestic institutions are generally more efficient than institutions from foreign nations. This advantage could occur in part because of organizational diseconomies to operating or monitoring an institution from a distance. Operating problems could include turf battles between staff in different nations or high costs and turnover in persuading managers to work abroad. Monitoring problems may make it difficult to evaluate the behavior and effort of managers in a distant market or make it difficult to determine how well they are performing relative to other institutions in that market. Organizational diseconomies may also make it difficult to establish and maintain some retail deposit relationships with households or lending relationships with small and mid-size enterprises, because such accounts may require local information and a local focus. The home field advantage could also occur in part because of barriers other than distance, including differences in language, culture, currency, regulatory and supervisory structures, other [End Page 25] country-specific market features, bias against foreign institutions, or other explicit or implicit barriers. The home field advantage may be manifested as disadvantages for foreign banks, such as higher costs of providing the same financial services or lower revenues from problems in providing the same quality and variety of services as domestic institutions.

Under the global advantage hypothesis, some efficiently managed foreign institutions are able to overcome these cross-border disadvantages and operate more efficiently than the domestic institutions in other nations. These organizations may have higher efficiency when operating in other nations by spreading their superior managerial skills or best-practice policies and procedures over more resources, lowering costs. They may also raise revenues through superior investment or risk management skills by providing superior quality or variety of services that some customers prefer or by obtaining diversification of risks that allows them to undertake investments with higher risk and higher expected returns.

We consider two forms of the global advantage hypothesis. Under the general form, efficiently managed foreign banks, regardless of the nation in which they are headquartered, are able to overcome any cross-border disadvantages and operate more efficiently than domestic banks in other nations. Under the limited form of the hypothesis, only the efficient institutions headquartered in one or a limited number of nations with specific favorable market, regulatory, or supervisory conditions can operate more efficiently than domestic institutions in other nations. Home-country favorable market conditions may include stiff product market competition that provides a proving ground for efficient organizations, an active market for corporate control that prevents cross-border consolidation that reduces shareholder value, access to a well-developed securities market that allows for exploitation of scope efficiencies, or access to an educated labor force with the ability to adapt to new technologies, new financial instruments, and new techniques for risk management. Favorable regulatory or supervisory conditions may include access to universal banking powers to offer multiple types of financial services or relatively relaxed prudential regulation, relaxed supervision, or strong safety net guarantees that allow the organizations to undertake financial strategies with high risk and high expected returns. Alternatively, relatively tough supervision or regulation at home may give some institutions global advantages by certifying their quality or reducing the risks of their contractual counterparties. As will be seen, distinguishing empirically between these two forms [End Page 26] of the global advantage hypothesis is an important key to unlocking the mystery of why foreign institutions are on average less efficient than domestic institutions and to determining why prior studies may have drawn a starkly different conclusion from our conclusion, given below.

We test the hypotheses using data from five home countries--France, Germany, Spain, the United Kingdom, and the United States--countries for which data on a significant number of foreign-owned commercial banks are available. We also extend our analysis by including foreign banks from other nations such as Canada, Italy, Japan, the Netherlands, South Korea, and Switzerland. For each home country, we estimate separate cost and profit frontiers from which we estimate domestic and foreign bank efficiency. The hypothesis tests compare the mean domestic bank efficiency against the mean efficiency of banks from each foreign nation.

Overview of the Paper

First we present some background information, including trends in cross-border provision of financial services, regulatory changes that have fostered cross-border consolidation, and trends in cross-border M&As. We then review the extant research on the efficiency motives and consequences of cross-border consolidation of financial institutions. This is followed by a review of the research on nonefficiency motives for and consequences of cross-border consolidation.

Then we report our tests of the home field advantage and global advantage hypotheses for cross-border bank ownership in the five select home countries. We find that domestic banks generally have higher cost and profit efficiency than foreign banks on average, although these differences are not always statistically significant. This is consistent with most of the findings in the literature, where it has been interpreted as supporting the home field advantage hypothesis. However, we do not draw this same conclusion. Rather, by digging deeper and disaggregating the results by foreign nation of origin, we find that the data appear to reject the home field advantage hypothesis in favor of the limited form of the global advantage hypothesis. These results, should they continue to hold in the future, may have important implications for the future structure of financial markets. The finding that foreign banks are less efficient on average than [End Page 27] domestic banks suggests that efficiency considerations may limit the global consolidation of the financial services industry and leave substantial market shares for domestic institutions. However, our finding in favor of the limited form of the global advantage hypothesis also suggests that additional cross-border consolidation may be in the offing and that financial institutions from some countries may capture disproportionate shares of the global market.

Finally, we summarize our main results, draw conclusions based on the results, qualify the conclusions with a number of caveats, and suggest directions for future research. An appendix contains a comparative overview of the structure of credit markets in major industrial nations.

Some Background on Cross-Border Financial Services and Institutions

This section provides a backdrop for our investigation of the cross-border consolidation of the financial services industry. We begin with a brief discussion of recent trends in the cross-border provision of financial services. Next we examine deregulation that has reduced the impediments to cross-border ownership of financial institutions. Finally, we investigate whether M&As of financial institutions have increased in the wake of this deregulation.

Trends in the Cross-Border Provision of Financial Services

One of the factors motivating cross-border consolidation of financial institutions may be the increase in the general level of economic integration across national borders. Reductions in trade barriers, declines in transportation costs, and advancements in communications technology have led to an acceleration of international economic integration in recent years. International transactions in goods and services account for an ever-increasing fraction of the world economy. For example, trade in goods increased from 21 percent of world gross domestic product (GDP) in 1987 to 30 percent in 1997. ² [End Page 28]

The recent increase in international commerce has created a demand for international financial services. A financial institution can use a variety of channels to deliver financial services to a business customer in a foreign country. The institution can provide the services directly to the foreign business from its home-country headquarters. The institution can participate in a syndicate that finances a large loan or securities issue that is originated by another financial institution that is located in the foreign country. Finally, the institution can obtain a physical presence in the foreign country (by acquiring a financial institution there or by opening a branch or subsidiary) and provide the service in the foreign country.

Establishing a physical presence in a foreign country entails a number of costs, such as the organizational diseconomies to operating or monitoring an institution from a distance. However, establishing a physical presence in the foreign country offers some potentially offsetting advantages, including (a) more effective servicing and monitoring of retail customers and (b) an opportunity to compete for retail and wholesale customers in the foreign country. Recent deregulation has reduced the costs of this delivery channel.

Securities markets also reflect the trend toward globalization. International issues of debt securities, equity securities, and cross-border flows of bank funds have all increased in recent years. From 1993 through 1998, international bonds (bonds issued by foreign residents plus eurobond issues) increased from a little over $1.3 trillion to more than $2.6 trillion, which doubled from 8 to 16 percent the share of international bonds to total bonds outstanding in world markets. ³ International equity issues have also increased substantially, from less than $50 billion in 1996 to more than $70 billion in 1998 in real terms. Despite these increases, the international flow of bank funds remains at least as large as international bond issues and is substantially larger than international equity issues. For example, in 1998 international syndicated loan facilities totaled $574 billion, compared with about $413 billion for net debt security issues and a little over $70 billion for international equity issues. Similarly, the international assets of banks reporting to the Bank for International Settlements (BIS) totaled nearly $7 trillion in 1998, compared with $2.6 trillion of international debt securities. In other words, banks are the largest conduit of international flows of capital. [End Page 29]

Regulatory Changes That Have Fostered Consolidation

The deregulation of geographic restrictions and the harmonization of regulatory and supervisory environments have boosted the consolidation of financial institutions. A sequence of laws over the past two decades, often referred to as the Single Market Programme, has made it more possible and less costly for financial institutions to operate across national borders within the European Union. The First Banking Co-ordination Directive of 1977 created a framework for establishing a single banking market across the member states of the European Union. It established minimum requirements for authorizing credit institutions; it introduced (but did not implement) the concept of "national treatment" by which a foreign branch is subject to the banking restrictions of its home country rather than the host country; it forbade host countries from denying entry of a foreign bank on the basis of "economic need"; and it began the process of unifying prudential regulations across the member states. The Single Europe Act of 1986 in effect created a single uninterrupted economic marketplace stretching across the European Union. It went into effect in February 1992 and eliminated all physical, legal, and technical barriers to the cross-border movement of labor, goods, services, and capital (which is especially important for financial institutions). The Second Banking Co-ordination Directive of 1989 liberalized the trade of financial services across EU borders. It introduced a single banking license valid throughout the European Union, limited branching and product mix restrictions to those imposed by a bank's home-country regulators, ended the practice of requiring cross-border branches to hold extra-normal levels of capital, and harmonized minimum capital requirements across countries (although for purposes of monetary policy and prudential regulation it allowed host countries to set liquidity ratios). Also important, the second directive made universal banking the norm in the European Union by default: any nation not allowing these powers risked putting its own banks at a competitive disadvantage. The second directive was implemented in 1993 and 1994. At the same time, a series of directives was introduced to achieve a European single securities market and to establish a "single passport" for investment firms. ⁴ [End Page 30]

In the United States, a series of less well-coordinated deregulatory actions has enabled increased consolidation of financial institutions. In the 1980s, most of the individual states began to pass laws permitting out-of-state bank holding companies to enter into the state via acquisition of an existing bank. These changes in state laws, which were often extended only on a reciprocal basis to banking companies in states with similar laws, gradually eroded the existing federal restrictions on interstate banking. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 eliminated most of the remaining restrictions on interstate banking and branching and thus legitimized and extended the changes in state laws. Riegle-Neal was fully implemented in June 1997, although some states opted-in early and other states enacted legislation to delay implementation. Riegle-Neal did for geographic expansion in the United States what the second directive did for geographic expansion in the European Union, but until recently U.S. banking laws still forbade most types of universal banking. Over time, however, the restrictions on separation of commercial banking from securities and insurance activities were gradually eroding. For example, in 1987 the Federal Reserve began allowing commercial bank holding companies to underwrite corporate debt and equity on a restricted basis through Section 20 affiliates. The initial revenue limit from this underwriting was raised from 5 percent of the subsidiary's total revenue to 10 percent in 1989 and to 25 percent in 1996. The recently passed Gramm-Leach-Bliley Act of 1999 effectively removed many of the remaining restrictions on combining commercial banking, securities underwriting, and insurance in consolidated organizations.

Trends in Cross-Border M&As of Financial Institutions

Figures 1 and 2 display the aggregate value (purchase price in 1998 dollars) of financial institution M&As in the United States and the European Union from 1986 to 1998 (two-year moving averages). The figures include M&As both between and among commercial banks, insurance companies, and securities firms. ⁵ The figures show the annual trends for three types of [End Page 31] M&As. In figure 1, domestic M&As are combinations of two institutions within the United States, entry M&As are acquisitions of U.S. firms by non-U.S. firms, and expansion M&As are acquisitions of non-U.S. firms by U.S. firms. In figure 2, the corresponding items are intra-EU M&As, entry M&As, and expansion M&As. The figures reveal three similarities between the M&A trends in the United States and the European Union. First, the value of domestic or intra-EU M&As has generally exceeded the value of cross-border (entry or expansion) M&As. Second, the values of all three types of M&As have generally increased over time. Third, the value of cross-border M&As has increased more rapidly in recent years than in the past. However, there are some differences in exact timing and detail across the two figures, and these differences are broadly consistent with the differences in regulatory history and more recent changes in regulation.

The U.S. trends are dominated by domestic M&As throughout, reflecting the changes in state and federal interstate banking rules during the 1980s and 1990s. The large jump at the end of the U.S. domestic M&A time series is attributable primarily to a small number of very large M&As (for example, Citicorp-Travelers, Bank of America-NationsBank, Banc One-First Chicago, and Norwest-Wells Fargo). Cross-border M&As involving U.S. financial institutions increased substantially after the mid-1990s, although they are still small relative to domestic M&As.

M&A activity in the European Union was virtually nil at the start of our sample period, but intra-EU M&As began to increase rapidly around 1987. The value of intra-EU M&As began to decline around 1992 and then increased again in the late 1990s. The two inflection points (1987 and 1992) correspond roughly with the passage and implementation of the Single Europe Act and the second banking directive. Entry and expansion M&As involving EU institutions were very small for most of the sample but took off in the mid-1990s. By the end of the sample period, the value of international M&As into and out of the European Union was on a par with the value of intra-EU M&As. ⁶ [End Page 32]

Cross-Border Consolidation: Efficiency Factors

Different economic agents have different motives for making consolidation decisions. Shareholders may engage in cross-border consolidation activity in order to maximize value by improving the financial institution's efficiency or increasing their market power in setting prices. Professional [End Page 33] managers may have personal motives for engaging in cross-border consolidation when corporate governance structures do not sufficiently align the incentives of managers with those of shareholders. In addition, governments often play important roles in constraining or encouraging cross-border consolidation activity by changing the explicit or implicit regulatory or supervisory limits on consolidation, by directly approving or disapproving individual M&As, or by providing M&A assistance during periods of financial crisis. Consistent with the roles played by shareholders, managers, and governments, we divide our review of the motives for and consequences of cross-border consolidation of financial institutions into four categories: efficiency, market power, managerial, and government. In this section, we review the extant evidence on efficiency as it relates to cross-border consolidation. We review the evidence on the other three categories in the next section.

We define efficiency improvements from consolidation in the broadest possible terms to include any effects that increase the consolidating firms' existing shareholder value other than increasing the exercise of market power in setting prices. This definition includes the possibility that cross-border consolidation may allow the institutions to achieve superior scale, scope, or mix of output. Cross-border consolidation may also be associated with changes in managerial behavior or organizational focus that increase shareholder value by improving X-efficiency. To the extent that cross-border consolidation improves scale, scope, product mix, or X-efficiency, the global advantage hypothesis may be supported. To the extent that cross-border consolidation decreases these types of efficiency, the home field advantage hypothesis may be supported. One type of efficiency analysis--the X-efficiency of foreign versus domestic institutions within the same country--is particularly relevant for testing our two main hypotheses.

Scale, Scope, and Product Mix Efficiency

Efficiency gains from exploiting scale economies are often cited as a motivation for financial institution consolidation. Potential improvements in scope and product mix efficiencies may also be a motivating factor, particularly for universal-type consolidation. We consider cost (scale, scope, and product mix) efficiencies, revenue efficiencies, and, finally, efficiencies related to the risk-expected return trade-off. [End Page 34]

costs. Practitioners often refer to the need for large scale to reduce average costs to competitive levels. However, most of the research on bank scale economies finds that the average cost curve has a relatively flat U-shape, with medium-size banks being slightly more cost scale efficient than either large or small banks. Average costs are usually found to be minimized somewhere in the wide range between about $100 million and $10 billion in assets. ⁷ Similar U-shaped average cost curves or conflicting cost scale results are found for securities firms and insurance companies. ⁸ These findings generally suggest no gains and perhaps even losses in cost scale efficiency from further consolidation of the type of large institutions typically involved in international activity. Consistent with this, a recent study that simulated pro forma M&As between large banks in different nations in the European Union finds that these M&As are more likely to increase costs than to decrease them. ⁹

Most of this research uses data on financial institutions from the 1980s, and it is possible that recent technological progress may have increased scale economies in producing financial services and thus created opportunities to improve cost scale efficiency through consolidation, even for large institutions. The tools of financial engineering, such as derivatives contracts, off-balance-sheet guarantees, and risk management may be exploited more efficiently by large institutions. In addition, financial and regulatory innovations in securities activities (such as 144A private placements and the shift toward bought deals in underwriting) may be relevant only for large commercial and investment banks. ¹⁰ Moreover, some new [End Page 35] methods for delivering customer services, such as Internet banking, phone centers, and automated teller machines, may also exhibit greater economies of scale than traditional branching networks. ¹¹ As well, advances in payments technology may also create scale economies in back-office operations and network economies that may be exploited more easily by large institutions. ¹² Consistent with these arguments, some recent research on bank cost scale efficiency using data from the 1990s suggests that there may be substantial scale economies even at the largest banks, possibly due in part to technological progress. ¹³ An important caveat is that technologies embodying scale economies may currently or in the future be accessed at low cost by small institutions through franchising or outsourcing to firms specializing in the technologies or through shared access to networks.

A number of studies have examined the cost scope and product mix efficiencies of providing multiple products within a single type of financial institution, for example, providing deposits and loans within a commercial bank. Scope efficiencies are often difficult to estimate because there are usually no specializing firms in the data sample, creating extrapolation problems for evaluating the costs of hypothetical specializing firms with zero outputs for some products. As a result, many studies use measures of product mix efficiencies that evaluate at points near zero outputs or use concepts such as expansion-path subadditivity that combine scale and product mix efficiencies. Although there are exceptions, these studies usually find very little evidence of substantial cost scope or product mix economies or diseconomies within the banking, securities, or insurance industries. ¹⁴

For cross-border consolidation, it is particularly important to evaluate the scope and product mix efficiencies of universal-type institutions--that is, the effects of combinations among commercial banks, securities [End Page 36] firms, and insurance companies--because the institutions engaging in cross-border consolidation are often of this type. Cost economies from universal-type combinations may be realized by sharing physical inputs like offices or computer hardware; employing common information systems, investment departments, account service centers, or other operations; obtaining capital by issuing public or private debt or equity in larger issue sizes that reduce the impact of fixed costs; or reusing managerial expertise or information. For example, a consolidated commercial bank and insurer may lower total costs by cross-selling, using each other's customer database at a lower cost than building and maintaining two databases. Similarly, information reusability may reduce costs when a universal bank acting as an underwriter conducts due diligence on a customer with whom it has had a lending or other relationship. ¹⁵ The evidence on the underwriting activities of Section 20 subsidiaries of U.S. bank holding companies is consistent with this hypothesis--these companies certify their private information about companies with whom they have had a lending relationship when they are underwriting their securities. ¹⁶

However, cost scope and product mix diseconomies may also arise because of coordination and administrative costs from offering a broad range of products, often outside the senior management's area of core competence. ¹⁷ Universal banking may also be associated with less financial innovation because commercial banks and investment banks may have fewer incentives to produce innovative financial solutions to attract corporate customers from one another. ¹⁸

It is not known how well the research just reviewed on cost scope and product mix efficiencies within a certain type of financial institution represents the efficiencies across types of institutions. The relatively few studies of the scope and product mix efficiencies associated with universal banking in continental Europe are mixed. One study of European universal banking finds very small scope economies, one study finds some limited evidence of scope economies but no consistent evidence of expansion-path subadditivity, and one study finds mostly diseconomies of producing loans and investment services within German universal [End Page 37] banks. ¹⁹ However, these studies may not be good predictors of universal banking as it evolves in the future. Specifically, commercial banking and underwriting in the banking-oriented continental Europe of the past may bear little resemblance to commercial banking and underwriting activities in market-oriented financial systems such as the United States, the United Kingdom, and possibly continental Europe and elsewhere in the future.

revenues. It is important to consider revenue efficiencies as well as cost efficiencies when evaluating cross-border or global consolidation. The increase in scale associated with consolidation may create revenue scale economies because some customers may need or prefer the services of larger institutions. For example, large wholesale customers may need loan facilities or issue public debt or equity in quantities that small institutions cannot handle. However, some small customers may prefer the more personalized or relationship-based services often associated with small financial institutions, creating revenue scale diseconomies.

A related revenue efficiency effect that is particularly relevant for cross-border consolidation concerns the benefits from serving customers that operate in multiple nations, which often require or benefit from the services of financial institutions that operate in the same set of nations. That is, multinational nonfinancial firms may want to do business with multinational financial institutions. Presumably, the cross-border consolidation of financial institutions in recent years derives at least in part from the cross-border consolidation of nonfinancial industries (and vice versa as well). Part of this revenue efficiency comes from financial institutions following their existing customers across international borders, maintaining the benefits of existing relationships. For example, some analyses find that many foreign banks initially entered the United States to help service home-country clients that were starting U.S. operations. ²⁰ One analysis finds that foreign direct investment in a U.S. state is a positive determinant of foreign banking assets in the state, also consistent with follow-your-customer behavior. ²¹

Financial institutions may also be able to exploit revenue scope and product mix economies by cross-selling different types of financial services. [End Page 38] These revenue scope economies may occur because of consumption complementarities arising from reductions in consumer search and transaction costs. For example, some customers may be willing to pay more for the convenience of one-stop shopping for their commercial banking and insurance needs. Similarly, a corporate customer may prefer to reveal its private information to a single consolidated entity that provides its commercial and investment banking needs. Revenue economies can also arise from sharing the reputation that is associated with a brand name that customers recognize and prefer. These reputation economies might arise, for instance, if a universal bank levers off its reputation built in commercial banking when forging a stronger reputation in investment banking, or vice versa. ²²

Consolidation of different types of financial institutions alternatively may create revenue scope diseconomies. Such diseconomies may arise if specialists from different types of financial services have better knowledge and expertise in their areas, can better tailor products for individual customers, and thereby can charge higher prices than joint producers. Revenue scope diseconomies might also arise to the extent that combining commercial banking and investment banking creates the appearance of conflicts of interest. The market may underprice securities underwritten by a universal bank for its existing loan customers because of concerns that the proceeds from the issue will be used to pay off (or otherwise enhance the value of) distressed loans extended to that customer by the bank. As a result, commercial loan customers might shy away from using the underwriting services of their own universal bank. The empirical research suggests that universal banks have successfully addressed this problem. ²³

A few recent studies have examined the effects of financial institution scale, scope, and product mix on revenue efficiency and profit efficiency (which incorporates both cost and revenue efficiency). The scale results are ambiguous, with some evidence of mild ray scale efficiencies in terms of joint consumption benefits for customers and profit efficiency sometimes highest for large institutions, sometimes highest for small institutions, and [End Page 39] sometimes about equal for large and small institutions. ²⁴ One study finds little or no revenue scope efficiency between deposits and loans from charging customers for joint consumption benefits, while another study finds revenue scope diseconomies from providing life insurance and property-liability insurance together, consistent with a greater ability of specialists to tailor products to their customers' needs. ²⁵ Studies of profit scope efficiencies both within banking and within insurance find that joint production is more efficient for some firms and specialization is more efficient for others. ²⁶ One study finds that universal banks in Europe typically have both higher revenues and higher profitability than specializing institutions. ²⁷

risk-expected return trade-offs. The prospect of efficiency gains from improvements in the risk-expected return trade-off may also motivate cross-border consolidation. The greater scale, more diverse scope or mix of financial services, or increased geographic spread of risks associated with cross-border consolidation may improve the institutions' risk-expected return trade-off. This improved trade-off fits into our broad definition of efficiency gains to the extent that the increased diversification reduces the impact on shareholder wealth of the expected costs associated with financial distress, bankruptcy, and loss of franchise value.

Taking the risk-expected return trade-off into account also allows for possible scale, scope, and product mix efficiencies in managing risk. For example, larger institutions may be able to deploy sophisticated models of credit and market risks more efficiently. In addition, for commercial banks and other regulated or supervised financial institutions, regulatory rules like prompt corrective action and supervisors with discretion may restrict the activities or impose other costs on institutions in poor financial condition, giving additional value to keeping risks low. An improvement in the risk-expected return trade-off does not necessarily mean that the institutions would have lower risk--they may still choose a higher-risk, higher-expected-return point on the improved frontier. ²⁸ [End Page 40]

These risk considerations would not affect shareholder value and therefore would not be included in our definition of efficiency under an assumption of perfect capital markets with no informational opacity, no distress, bankruptcy, or franchise costs, and no regulatory or supervisory intervention. Investors in perfect capital markets would diversify their own risks by owning shares of different institutions and thereby would negate any diversification value that arises when the institutions they own purchase other institutions.

However, capital market imperfections may be quite important for financial institutions. Under the modern theory of financial intermediation, financial institutions are delegated monitors with economies of scale or comparative advantages in the production of information about informationally opaque assets. ²⁹ These institutions exist to solve these information problems, and part of the solution is to diversify large pools of the opaque assets. In addition, many small financial institutions are owner-managed, and the owner-managers have invested a substantial portion of their personal or family wealth in their institution. Diversifying this risk away by selling a substantial portion of their investment is problematic because it results in loss of control and because investments in these institutions are typically illiquid. Thus these institutions are likely managed in a way that reflects the risk aversion of their owners. ³⁰

Financial institutions are also concerned with risk because of government regulation and supervision. Governments typically provide a safety net for at least some of their nation's financial institutions, and this safety net absorbs some of the losses or provides liquidity in the event of the failure or distress of the institutions. The safety net may include deposit insurance, unconditional payment guarantees, access to the discount window, help in arranging private sector funding or M&A partners, forbearance, or other explicit or implicit government guarantees. It is often argued that the safety net provides moral hazard incentives to take on more risk [End Page 41] than would otherwise be the case and that this incentive to risk taking becomes stronger as an institution's equity capital or charter value gets very low. ³¹ However, prudential regulation and supervision works in the opposite direction, imposing costs on risk taking and giving incentives for value-maximizing institutions to reduce risk to avoid penalties. Prudential regulations designed to deter risk taking include risk-based capital requirements, risk-based deposit insurance premiums, prompt correct action rules, and legal lending limits. Prudential supervision includes regularly scheduled examinations backed by threats of cease-and-desist orders, withdrawal of deposit insurance, closure, limits on growth, and prohibition of dividend payments.

Some empirical evidence suggests that large U.S. banking organizations act in a risk-averse fashion, trading off between risk and expected return. ³² However, it is difficult to determine whether this trade-off is for the benefit of shareholders or managers of professionally managed institutions who are protecting their own job security at the expense of shareholder value. Managerial incentives with regard to risk are discussed below.

The available empirical research also suggests that at least some types of cross-border consolidations are likely to improve the risk-expected return trade-off. The literature on commercial banks in the United States generally finds that larger, more geographically diversified institutions tend to have better risk-expected return trade-offs. ³³ Similarly, international diversification has been found to improve the risk-expected return trade-off and profit efficiency in the reinsurance industry. ³⁴ More relevant to the issue of universal-type financial institutions, some simulation-type studies have combined the rates of return earned by U.S. banking organizations and other financial institutions from the 1970s and 1980s with mixed results. ³⁵ Another study of U.S. firms also finds that risk can be reduced by combining banks with securities firms and insurance companies. ³⁶ Other studies of combining commercial banking organizations with [End Page 42] insurance companies in the United Kingdom and of combining commercial banking organizations with securities firms in the United States show favorable results for the risk-expected return frontier. ³⁷

To get further insight into the potential for improvements in the risk-expected return frontier from geographic diversification, table 1 gives information about the distribution of bank earnings across nations. The table shows the correlations of average bank earnings across international borders, giving information for the United States, Japan, and all but one of the EU nations (insufficient data were available for Ireland). The data are for 1979-96, except as noted. The correlations across nations are quite low. These nations often had changes in regulatory or supervisory structure that were not coordinated, they had different currencies, and their economies were usually not well integrated. However, it is surprising just how much lower the correlations among bank earnings across these nations are and how many of the correlations are negative. Even within the European Union, which has moved closer to the model of the U.S. national market by harmonizing regulatory and supervisory structures, beginning the process of monetary union, and removing tariffs and entry barriers, the correlations are surprisingly low. For each of the fourteen EU nations shown, there are at least three negative correlations of bank earnings with those of the thirteen other EU nations. These data suggest very strong possibilities to diversify and opportunities to improve the institutions' risk-expected return trade-offs through cross-border consolidation, even within the European Union.

X-efficiency

Improvements in X-efficiency may also be an important motive for and consequence of cross-border consolidation. Improvements in X-efficiency--movements toward the optimal point on the best-practice efficient frontier--may be accomplished through consolidation if the M&A improves the managerial quality of the organization or changes its focus. X-efficiency may be improved, for example, if the acquiring institution is more efficient [End Page 43] [Begin Page 45] ex ante and brings the efficiency of the target up to its own level by spreading its superior managerial expertise or policies and procedures over more resources. Alternatively, the M&A event itself may awaken management to the need for improvement or may provide an excuse to implement substantial unpleasant restructuring. ³⁸

We consider both cost and profit X-efficiency. ³⁹ Cost X-efficiency improvements occur when an institution moves closer to what a best-practice institution's cost would be for producing the same output bundle using the same input prices and other environmental conditions. Profit X-efficiency improvements occur when an institution moves closer to the profit of a best-practice institution under the same conditions. Profit X-efficiency is a more inclusive concept than cost X-efficiency. Profit X-efficiency incorporates cost X-efficiency, the effects of scale, scope, and product mix on both costs and revenues, and to some degree the effects of changes in the risk-expected return trade-off. Profit X-efficiency also corresponds better to the concept of value maximization than cost X-efficiency, since value is determined from both costs and revenues.

We review the results of four types of X-efficiency studies. First we examine research on the effects of M&As on financial institution X-efficiency. These are important to the prospects for X-efficiency gains from cross-border consolidation, given that cross-border market penetrations usually are performed via M&As rather than via the opening of new branch offices. Second, we examine the research on international comparisons of financial institution X-efficiency. This bears on our hypotheses, in that the institutions from one or a few nations are more likely to expand across borders under the limited form of the global advantage hypothesis if the institutions from these nations are much more X-efficient than those from other nations. Third, we review the research on the X-efficiencies of foreign versus domestic institutions within a single nation. This is the most important type of evidence in our opinion for evaluating the global advantage versus home field advantage hypotheses because it is the only direct evidence on the extent to [End Page 45] which financial institutions are able to monitor and control their subsidiaries operating in other nations. Finally, we examine evidence on the effects of deregulation, especially the reduction of entry barriers. This may contribute to the debate on the hypotheses, given that this type of deregulation precedes most cross-border consolidation.

THE EFFECTS OF FINANCIAL INSTITUTION M&AS. The extant research suggests a substantial potential for improved X-efficiency from consolidation. Average X-inefficiencies on the order of about 25 percent of costs and about 50 percent of potential profits are typical findings. ⁴⁰ Simulation evidence also suggests that large X-efficiency gains are possible if the best-practice acquirers reform the practices of inefficient targets. ⁴¹

The research also suggests that many institutions engage in M&As for the purpose of improving X-efficiency. Many studies have found that acquiring institutions are more efficient ex ante than targets. ⁴² Also, acquiring banks bid more for targets when the M&A would lead to significant diversification gains, consistent with a motive to improve the risk-expected return trade-off and increase profit X-efficiency. ⁴³

A number of studies measure the change in cost X-efficiency after M&As. Studies of U.S. commercial banking generally show very little or no improvement in cost X-efficiency, on average, from the M&As of the 1980s, on the order of 5 percent of costs or less. ⁴⁴ Studies of U.S. banks and other types of financial institutions using 1990s data are mixed, but some show more gains in cost efficiency. ⁴⁵ Studies of M&As of credit institutions in Europe find that some groups of M&As, particularly cross-border consolidations, tend to improve cost efficiency, whereas other types tend to decrease cost efficiency. ⁴⁶ Studies of Italian banks and U.K. building societies find significant cost efficiency gains following M&As. ⁴⁷ [End Page 46]

Studies of profit X-efficiency usually paint a more favorable picture of M&As. Studies of the profit efficiency effects of U.S. bank M&As in the 1980s and early 1990s find that M&As improved profit efficiency and that this improvement could be linked to an increased diversification of risks and an improved risk-expected return trade-off. ⁴⁸ After consolidation, the institutions tended to shift their asset portfolios from securities to loans, to have more assets and loans per dollar of equity and to raise additional uninsured purchased funds at reduced rates, consistent with a more diversified portfolio. Other studies using similar measures of profit X-efficiency find consistent results. ⁴⁹

There are also a number of event studies of the effects of M&As on stock market values. The change in the total market value for the acquiring and target institutions together (adjusted for changes in overall stock market values) provides an estimate of the effect of the M&A on shareholder value, which embodies the present value of expected future changes in all types of efficiency plus changes in the expected exercise of market power over prices. Although these effects cannot be disentangled, in some circumstances, inferences can be made about whether the market expects improvements in efficiency. Specifically, since it is unlikely that M&As would reduce market power, a decrease in market value would suggest an expected deterioration in efficiency, and no change in market value would signal either no change or a decrease in expected efficiency.

The empirical results for U.S. data are mixed. Some studies find increases in the combined value around the times of M&A announcements, others find no improvement in combined value, while still others find that the measured effects depend on the characteristics of the M&A. ⁵⁰ A study of domestic and cross-border M&As involving U.S. banks finds that cross-border M&As create more value than domestic M&As, although it also finds that more concentrated geographic and activity focus has positive effects on value. ⁵¹ One study finds that foreign banks that enter the United States via acquisition tend to acquire domestic banks that already have performance problems and, despite achieving some performance [End Page 47] improvements at the target bank, generally are not successful in raising the acquired banks' performance up to the levels of their domestic peers. ⁵²

There is some evidence that M&As in Europe increase combined value. One study that examines M&As among banks and between banks and insurers in Europe finds positive combined returns mostly driven by domestic bank-to-bank deals and diversification of banks into insurance. ⁵³ This study attributes the differences in findings from many of the U.S. studies to differences in structure and regulation in Europe. However, another study of European bank M&As finds that abnormal combined returns are not significantly different from zero. ⁵⁴

INTERNATIONAL COMPARISONS. A number of studies compare the average X-efficiency of institutions in different nations, focusing on the operations of institutions operating within each nation, rather than cross-border. For example, one study evaluates the efficiency of banks operating within Norway, within Sweden, and within Finland relative to a common frontier made up of the best-practice institutions from the three nations. ⁵⁵ Similar studies compare the average X-efficiencies of institutions across different sets of nations. ⁵⁶ The results often show that some institutions of some nations are substantially more efficient than the institutions of other nations, although the ordering among nations sometimes differs across the studies. Swedish banks tend to be measured as superior performers, despite the fact that these banks suffered a crisis in the early 1990s requiring substantial government intervention and that U.S. banks sometimes are measured as inferior performers, despite the common cross-border result that U.S. banks tend to be more efficient than foreign competitors in the United States.

Although these studies may be informative, they are not helpful for evaluating the global advantage versus the home field advantage hypotheses for two main reasons. First, the economic environments faced by financial institutions differ across nations in important ways. It is likely that [End Page 48] measured X-efficiency would vary considerably with the amount of supervisory and regulatory intervention in the financial system. As well, nations differ significantly in the intensity of competition among their financial institutions, in the level and quality of service associated with their financial products, in their capital market development, and in their markets for labor and other factors of production, all of which may affect measured efficiency. As a result, a finding of greater X-efficiency for institutions in one nation does not necessarily imply that they would be more efficient in the environments of other nations.

Second, and more important, even if all of the environmental differences do not exist or are well controlled for with econometric procedures, the performance of institutions within their own borders may not be representative of how well they may perform as foreign-owned entities in other nations, which is the information most pertinent to testing our hypotheses. Even if institutions are very efficient in their home country, they may have difficulty in other nations in part because of organizational diseconomies to operating or monitoring an institution from a distance or because of difficulties in overcoming differences in language, culture, currency, regulation, and other barriers.

Some recent studies have made progress in dealing with the first problem by controlling for some of the environmental differences across nations. These studies include variables measuring banking market conditions (for example, income per capita, population, deposit, and branching densities) and market structure and regulation (for example, concentration ratio, average equity capital ratio, risk, and firm specialization). ⁵⁷ Of course, control variables for a firm's environment, risk, and specialization are often specified in efficiency measurement, but these recent studies have taken this further by investigating the effects of these variables on measured efficiency. In one case, these environmental variables, along with the efficiency scores, are used to predict what the efficiency of institutions from one country would be if they operated in another country. ⁵⁸ These authors study commercial banks in ten European nations (Belgium, Denmark, France, Germany, Italy, Luxembourg, the Netherlands, [End Page 49] Portugal, Spain, and the United Kingdom) and predict, for example, that banks from Spain, Denmark, Portugal, and Belgium would have high efficiency scores if they crossed into other European nations.

Although this research is interesting, we caution against drawing such strong conclusions about cross-border performance from it. It is difficult to control for environmental differences across nations. More important, not even perfect environmental controls address the second problem of potential organizational diseconomies and other difficulties in operating or monitoring financial institutions across borders.

FOREIGN VERSUS DOMESTIC institutions within a single nation. Some recent studies have compared the X-efficiencies of foreign versus domestic institutions operating within the borders of a single nation. This avoids the econometric problem of controlling for all the environmental differences across nations, since all of the institutions studied face essentially the same environmental conditions. More important for our purposes, this is direct evidence only on the extent to which financial institutions are able to monitor and control operations on a cross-border basis, which is critical to distinguishing between the home field advantage and global advantage hypotheses.

Studies of U.S. data generally find that foreign-owned banks are significantly less cost efficient on average than domestic banks and less profit X-efficient on average than domestic institutions. ⁵⁹ Unfortunately, this type of evidence alone cannot distinguish between our hypotheses. The data are consistent with both the home field advantage hypothesis and with a case of the limited form of the global advantage hypothesis in which U.S. banks tend to be the most efficient. The data are also consistent with another case of the limited form of the global advantage hypothesis in which foreign banks from a limited group of other nations tend to be more efficient than domestic U.S. banks, but this cannot be determined because the authors do not break out their data by foreign nation of origin. More evidence is needed to differentiate among these hypotheses--data from more home countries and disaggregation of the results by nation of foreign ownership.

Some of the research on other nations finds that foreign institutions have about the same average efficiency as domestic institutions. One study [End Page 50] finds that foreign banks in EU countries that were acquired in the past three years have about the same cost efficiency as domestic banks, one study finds that foreign banks in Spain are about equally as profit efficient as domestic banks, and one study finds that foreign banks in India are somewhat more efficient than domestic banks held by private sector investors but that both are less efficient than domestic banks held by the government. ⁶⁰ Again, the results are not reported by nation of origin, making it difficult to determine which hypotheses are consistent with the data. If the banks from some of the foreign nations tend to have higher efficiency than those from the home country and other foreign nations, this would support the limited form of the global advantage hypothesis.

Some other research using data from non-U.S. countries finds very different results. These studies measure profit efficiency for fourteen home countries (Australia, Belgium, Canada, Chile, Denmark, France, Germany, Italy, Mexico, the Netherlands, Portugal, Spain, Switzerland, and the United Kingdom), classified into four groups based on banking system development and regulatory and supervisory environment. ⁶¹ They find that domestic banks are more efficient on average than foreign institutions (including U.S.-owned banks), although foreign banks from the same type of environment as the host nation generally fare better than other foreign institutions. Although they appropriately measure separate frontiers for the institutions located in each country, they pool the efficiency estimates from the foreign and domestic banks in the several nations in each group (after normalizing the estimates to have a common mean and standard deviation). This may create problems of comparison because of differences in the environments of these nations. Their logit analysis of whether foreign bank efficiency is above or below the mean takes into account the signs, but not the magnitudes, of the efficiency differences.

THE EFFECTS OF DEREGULATION. One of the most important issues in the current policy debate is the effect of deregulation on efficiency, given that much of the observed cross-border consolidation has followed significant deregulation. For example, much of the consolidation within the European Union has followed reductions in its cross-border entry barriers and harmonization of its regulatory structures. [End Page 51]

Most of the studies measuring changes in performance over time use the concept of productivity change, rather than X-efficiency change. Productivity change is a measure of the change over time in the performance of an industry as a whole (rather than an individual institution); it incorporates both changes in managerial best practice in the industry and changes in cross-sectional X-efficiency or dispersion from best practice.

A number of studies examine productivity change during the banking deregulation in the United States. ⁶² It is often found that measured cost productivity declined in the 1980s primarily because depositors got the benefit of higher interest rates after the deposit rate ceilings were lifted. The increase in competition appears to be primarily a social good, although it is measured as poorer performance for the banking industry. ⁶³ Recent research suggests that the decline in measured cost productivity may have continued well into the 1990s, but that improvements in revenues more than offset the higher costs, yielding improved profit productivity. ⁶⁴ The data are consistent with the hypothesis that banks offer wider varieties or higher quality of financial services that raise costs but also raise revenues by more than the cost increases and that banks involved in M&As are responsible for much of these findings.

The results of deregulation in other individual nations are sometimes found to be favorable to financial institution performance, as in Norway and Turkey, and are sometimes found to be mixed or unfavorable, as in Spain. ⁶⁵ Finally, one study of the changes in productivity, cost X-efficiency, and profit X-efficiency in a number of EU nations from 1992 to 1996 finds small improvements in efficiency and attributes most of the changes in productivity to technological progress, rather than the effects of EU deregulation. ⁶⁶ [End Page 52]

IMPLICATIONS OF THE EFFICIENCY RESEARCH. The efficiency research reviewed here, while extensive, suggests very few strong conclusions regarding the efficiency effects of cross-border consolidation. The literature on scale efficiency is somewhat uncertain, but it suggests that there may be gains from large-scale consolidation based on technological, financial, and regulatory changes in the 1990s. The literature on scope and product mix efficiencies also provides mixed results and very little information on cross-industry efficiencies. The literature on scale, scope, and product mix also provides little information on cross-border performance, which may differ from the scale, scope, and mix effects within a single nation without significant internal entry barriers or differences in language, culture, and regulation that may raise the costs of becoming large.

The X-efficiency research reviewed here is more promising, but it does not provide solid evidence regarding cross-border efficiency nor does it distinguish well between our home field advantage and global advantage hypotheses. The literature on the effects of M&As on financial institution X-efficiency often suggests efficiency gains, but most of the evidence is based on within-nation consolidation, which does not take into account organizational diseconomies or other difficulties in operating or monitoring across borders. The literature on international comparisons of X-efficiency has significant problems in estimating efficiency against a common frontier because market, regulatory, or supervisory differences are so great. More important, this literature does not address the issue of potential organizational diseconomies and other difficulties of cross-border operations. The literature on the X-efficiency effects of deregulation finds somewhat mixed results but focuses mostly on deregulation within a nation, rather than on the types of deregulation that facilitate cross-border consolidation.

The evidence on the X-efficiencies of foreign versus domestic institutions within a single nation is the most important type of evidence for evaluating our hypotheses, because it is the only direct evidence on the extent to which financial institutions are able to monitor and control their subsidiaries operating in other nations. However, the extant literature does not provide much guidance for distinguishing between the hypotheses because these studies (a) examine foreign and domestic efficiency in only one country, which cannot alone distinguish between the hypotheses because the institutions from that home country might have a global advantage, (b) do not distinguish among nations of foreign ownership, which cannot [End Page 53] test the limited form of the global advantage hypothesis that institutions from only one or a limited number of foreign nations have an advantage, or (c) combine efficiency information from different home countries, which creates problems of comparison because of significant differences in the market, regulatory, or supervisory environments of these nations. None of the studies has all three of these drawbacks, but all have at least one, to our knowledge. We address these drawbacks in the next section.

Cross-Border Consolidation: Topics Other Than Efficiency

We complete our review of the extant research on cross-border consolidation by covering topics other than efficiency. Specifically, we cover market power motives and consequences, managerial motives and consequences, and government motives and social consequences.

Market Power Motives and Consequences

Most of the research on the market power effects of consolidation focuses on M&As within a single nation and their effects on small retail customers. More specifically, the focus is typically on the effects on small depositors and small businesses of M&As between institutions in the same local market. These in-market M&As may increase local market concentration and allow the consolidated institution to increase shareholder value by setting prices less favorable to small retail customers (lower deposit rates, higher small business loan rates). Consistent with this focus, it has been found that U.S. households and small businesses almost always choose a local financial institution. ⁶⁷

market power over retail customers. Cross-border consolidation does not directly increase local market concentration for the products typically purchased by small retail customers. Nonetheless, it may affect the exercise of market power over these customers by (a) affecting consolidation within nations, (b) changing the competitive dynamic among cross-border institutions, or (c) enhancing competitive rivalry by increasing the contestability of domestic banking markets. We discuss each of these possibilities in order. [End Page 54]

Cross-border consolidation or the threat of it may lead to consolidation of financial institutions within nations, raising local market concentration. To protect previously existing market power or entrenched management, institutions within nations may engage in M&As to help fend off potential foreign competitors. In addition, efficiency motives may help to motivate local M&As. When reductions in cross-border entry barriers create opportunities to improve scale, scope, product mix, or X-efficiencies by invading the markets in other nations, institutions may first engage in within-nation M&As to grow large enough to compete in international markets.

The research evidence generally suggests that higher local market concentration created by consolidation within a nation is likely to raise market power in setting prices on retail financial services. Studies on the effects of bank M&As on pricing find that M&As that involve very substantial increases in local market concentration tend to raise market power in setting prices but that the effects of other M&As are ambiguous. ⁶⁸ Other studies usually find that banks in more concentrated markets charge higher rates on small business loans and pay lower rates on retail deposits and that their deposit rates are "sticky" or slow to respond to changes in open-market interest rates, consistent with the exercise of market power. ⁶⁹ It has been suggested that market power over small customers may have declined in recent years because of an increase in the degree of contestability of financial services markets and new technologies for delivering financial services, but the empirical evidence on this issue is mixed. ⁷⁰

Cross-border consolidation may also affect the exercise of market power within individual markets even if there is no change in local market concentration. First, at least to some extent, institutions tend to charge uniform prices throughout the organization, even when the local market structures differ substantially across the markets in which they compete. For example, one study finds that large U.S. banks often set uniform rates for deposits and loans across geographic markets within a state or region, although the reasons for this are not clear. ⁷¹ Uniform pricing may occur [End Page 55] because it is easier to administer, because of public relations concerns about fairness, or because of other factors.

Evidence on bank fees for retail deposit and payments services shows very little relationship with measures of local market concentration in the 1990s and a tendency of multistate bank holding companies to charge higher fees to retail customers than other banks. ⁷² These results similarly suggest that factors other than local market concentration are important in the exercise of market power. For example, this pricing strategy may be designed to engineer a shift from serving small customers toward serving large customers.

In addition, cross-border consolidation may result in the same institutions competing against each other in multiple countries. The theory of multimarket contact suggests that if firms face each other in multiple markets, there could be either more or less exercise of market power. There could be more exercise of market power because the firms may mutually forbear. That is, they may set high prices rather than compete to avoid retaliation in other markets. There could also be less exercise of market power, at least in the short run, if firms price strategically to signal their costs or to drive competitors out of business. The data are mixed as to the effects of multimarket contact on prices for retail banking products. ⁷³

Finally, cross-border consolidation or the threat of cross-border entry may reduce the exercise of market power because of increased market contestability. One way this may occur is if the existing financial institutions in a market alter their limit pricing behavior, setting prices more favorable to customers in an effort to deter foreign entry. This may also occur if efficient foreign producers enter and provide services at more favorable prices and take market share away from inefficient local producers that were formerly protected by cross-border entry barriers. In the European Union, a key prediction of the 1988 Cecchini study on the impact of the Single Market Programme was that cross-border competition would create considerable potential for prices to converge and fall to the level of the lowest-cost producers. ⁷⁴

Indeed, the creation of a single market for financial services in the European Union is an important test of this phenomenon. Since the adoption [End Page 56] of the Treaty of Rome in 1957, the European Union has adopted legislation designed to promote competition in financial services through the creation of a single banking license and harmonization of regulation. ⁷⁵ The adoption of a single currency is likely to increase financial institution competition further by reducing entry barriers and by lowering currency risk, which may increase the willingness of some customers to shop for financial services in other nations. The deepening of capital markets in the European Union is likely to provide additional competition to banks in the most banking-oriented nations of continental Europe. This encroachment of securities markets may increase the competitive pressure on banks by giving business customers additional opportunities to raise capital by issuing commercial paper, public debt, or public equity in place of bank loans and by giving savers additional opportunities to invest in money market funds, mutual funds, or other traded assets in place of bank deposits. ⁷⁶

There has been some recent empirical investigation into the issue of whether the single market for financial services in the European Union has achieved this policy objective. The evidence generally suggests that the regulatory changes have had only a modest impact on loan, fee, and deposit prices. ⁷⁷ The impact does not appear to be uniform across countries. Specifically, the decline in prices tends to be greater in countries where regulation was tightest prior to implementation of the second banking directive in 1993, such as Greece, Portugal, and Spain. Also, the modest decline in prices was somewhat greater for corporate services than for retail services.

Several studies analyze changes in market power using econometric models. One study uses the Rosse-Panzar statistic to evaluate changes in competitive conditions in banking in major EU nations between 1986 and 1989 and finds that the monopolistic competition prevailing at the beginning of the period did not change substantially over time. ⁷⁸ Another study of the EU uses similar methodology and finds no major change in competitive banking conditions between 1989 and 1996. ⁷⁹ However, one study finds more price competition that is linked to interest rate deregulation in individual countries. ⁸⁰ [End Page 57]

A caveat to this analysis is that there may not be a single uniform market for financial services even in one nation. For example, one study finds that foreign banks in Switzerland exercise more market power than domestic banks, suggesting that foreign and domestic financial services might be at least somewhat differentiated products. ⁸¹ Such differentiation tends to limit the potential for reductions in market power and price convergence as a result of lower barriers to entry.

MARKET POWER OVER WHOLESALE CUSTOMERS. The impact of cross-border consolidation on the wholesale market for financial services might be quite different from its impact on retail markets. One the one hand, it may be difficult to exercise market power against large wholesale customers. These customers often have sufficient resources to choose among many suppliers on a global basis, and product differentiation may be less important in wholesale commercial banking, securities, and insurance service markets than in retail markets. On the other hand, the number of suppliers in wholesale markets is considerably smaller than in retail markets, and cross-border consolidation may reduce the number of wholesale financial institutions. For example, the ten-firm concentration ratios in U.S. domestic corporate stock and bond underwriting and in Euromarket underwriting exceed 80 and 50 percent, respectively. ⁸² Evidence from the 1980s also suggests the presence of some market power in the securities industry. ⁸³

More recent work sheds further light on this market. A study of the mid-size initial public offering (IPO) market in the United States finds that more than 90 percent of the issues paid precisely the same 7 percent underwriting fee. ⁸⁴ The authors argue that, in the absence of market power, the percentage fee would be declining with issue size due to economies of scale in spreading fixed costs. In addition, IPO fees in other areas (such as Australia, Europe, Hong Kong, and Japan) are approximately half as high. ⁸⁵ These data suggest that market power is exercised in pricing for this mid-issue-size range in the U.S. market. However, for large deals, spreads [End Page 58] are found to be lower, and clustering is absent. ⁸⁶ Arguably, the mid-issue-size range may be more of a national market, while the large-size range may be more of a global market.

Deregulation may have affected the competitiveness of the wholesale securities industry. As noted, the Federal Reserve began allowing bank holding companies to underwrite corporate debt and equity through Section 20 affiliates in 1987, and the restrictions were later further relaxed. While bank holding companies have not had as much impact on the equity side of the market, they have made a significant impact on the debt side. For example, in 1998 six bank holding companies were listed among the top fifteen underwriters of investment-grade debt. ⁸⁷ Recent studies have found evidence that a decline in underwriting fees is associated with the entry of bank holding companies into this market. ⁸⁸ This evidence, combined with the data on high prices in the United States, suggests that cross-border consolidation may have the potential to reduce the exercise of market power in the mid-issue-size IPO market and other national wholesale financial markets. However, it is also possible that cross-border consolidation might increase the exercise of market power in the large-size IPO market and other global wholesale financial markets.

An additional concern is how cross-border M&As between commercial banking organizations and investment banks (for example, Deutsche Bank-Morgan Grenfell and Bankers Trust-Alex. Brown) will affect pricing given that universal-type organizations simultaneously operate in two key markets in which wholesale customers raise funds. These combinations create universal banks that may potentially acquire power over customer access to both the private and public markets, although the effect may be limited if at least one of the markets is competitive. ⁸⁹

Managerial Motives and Consequences

Cross-border consolidation may be driven in some cases by managerial motives rather than the goal of maximizing shareholder value. In professionally managed organizations, entrenched managers may make [End Page 59] decisions regarding cross-border consolidation based on their own preferences for compensation, perquisites, power, and job security. Cross-border consolidation may either strengthen or weaken the hands of entrenched managers directly, by affecting the market for corporate control or governance or, indirectly, by changing the market power of their firms.

MANAGERIAL MOTIVES. Consistent with the presence of these agency problems, there is evidence that banking organizations may overpay for acquisitions when corporate governance structures do not sufficiently align the incentives of managers with those of owners. For example, acquiring banks that have addressed control problems through high levels of managerial shareholdings or concentrated ownership experience higher (or less negative) abnormal returns around the time of the acquisition than other acquirers. In addition, abnormal returns at bidder banks increase when the pay of the chief executive officer (CEO) is based on the performance of the firm and when the share of outsiders on the board of directors is large. ⁹⁰ Moreover, bank managers with more stock-based wealth or compensation tend to make fewer acquisitions. ⁹¹ This evidence suggests that entrenched managers with little pay sensitivity to performance or few constraints imposed by outside directors may engage in M&As that do not maximize shareholder wealth.

The literature on corporate finance has identified size-related compensation and perquisites as key motives behind the decisions of professional managers, and these may play important roles in the cross-border consolidation decisions of some financial institution managers. ⁹² However, to the extent that the compensation boost from consolidation is linked to firm performance, consolidation in general is value maximizing and does not reflect exploitative behavior on the part of management. Compensation studies in both corporate finance and in banking generally show positive links between managerial compensation and both firm performance and firm size, consistent with both the efficiency and managerial motives for consolidation. ⁹³ Also consistent with managerial motives, a recent study finds that CEO compensation rose after bank M&As, even if the stock [End Page 60] price fell. ⁹⁴ However, the personal compensation motive may not be as great in cross-border consolidation decisions in banking as it formerly was, or as it is elsewhere. Research has found that the sensitivity of pay to performance in banking has increased since deregulation, that compensation in banking may be more sensitive to performance than it is in other industries, and that pay-performance sensitivity may be greater at large banks, which tend to engage in cross-border consolidation. ⁹⁵

Perquisite consumption by managers may likewise be a motive behind some cross-border consolidation of financial institutions. Evidence of expense preference behavior has been found in banking in a number of studies. ⁹⁶ This literature often finds that the data are consistent with managers exercising preferences for additional employees, and of course consolidation is the most straightforward way to increase the number of employees. There is also some evidence that consumption of perquisites and reduced work effort by managers may be related to market power, so there may be additional incentives to engage in types of consolidation that increase market power. Similarly, managers may engage in cross-border consolidation because of the prestige or hubris associated with managing a larger or more expansive empire. ⁹⁷

The corporate finance literature has also identified diversification of personal risk as a motive behind the decisions of professional managers. ⁹⁸ Financial institution managers may engage in cross-border consolidation that diversifies the risks of the institution beyond the point that would be in the interest of shareholders for the purpose of enhancing their own job security and protecting the value of their firm-specific human capital. There is evidence that large commercial banking organizations act in a risk-averse fashion, although this evidence does not by itself necessarily imply nonvalue-maximizing behavior. However, other work has linked managerial control specifically to bank behavior and found that managerially controlled banks exhibit less risk. ⁹⁹ [End Page 61]

In some circumstances, however, maximizing job security could encourage management to increase institution risk. If the financial institution is in a declining industry, managers may have incentives to increase risk in order to increase the probability that their institution is one of the survivors. ¹⁰⁰

Managers may also try to enhance their job security by preventing some cross-border consolidation that would otherwise be in the interest of shareholders. Managers may try to protect their jobs by engaging in domestic M&As. This may help to fend off hostile takeovers or prevent foreign entry by creating institutions that are too large to be taken over easily or by taking over the market niche of potential foreign entrants. Other evidence also suggests that managers may try to prevent their institution from becoming takeover targets. One study finds that banks in which managers hold a greater share of the stock are less likely to be acquired, consistent with the possibility that managers with large ownership stakes block outside acquisitions to protect their job. ¹⁰¹

CONSEQUENCES FOR THE PURSUIT OF MANAGERIAL GOALS. Cross-border consolidation or its threat could also affect the magnitude of the corporate governance problems in the financial services industry, although the net impact could go either way. As the evidence suggests, managers may be able to exercise their own preferences rather than maximize shareholder wealth because of weaknesses in corporate control systems. These weaknesses may occur for regulated financial institutions more often than for nonfinancial corporations, since regulatory requirements may inhibit an active takeover market for institutions that are not maximizing value. In the United States and other nations that have prohibited or significantly constrained universal banking, there may be substantial barriers to the acquisition of commercial banks by other types of institutions. The regulatory approval and disapproval process and other prudential requirements may also deter some acquirers. The evidence is consistent with these arguments. Hostile takeovers that replace management are rare in U.S. banking, although they do occur (for example, Wells Fargo-First Interstate). ¹⁰² An alternative explanation for the paucity of hostile takeovers of large, publicly traded U.S. banks is that strong internal corporate controls at [End Page 62] these firms prevent entrenchment by adequately disciplining managers, making private market discipline less necessary. ¹⁰³

Cross-border consolidation may address these control problems by improving managerial incentives and monitoring, particularly if more efficiently controlled organizations tend to acquire less efficiently controlled institutions. However, it is also possible that the monitoring of managers may worsen after cross-border consolidation. One explanation for the home field advantage hypothesis is that it may be difficult for organizations to monitor the managers of their foreign subsidiaries.

Cross-border consolidation may also strengthen or weaken the hands of entrenched managers by affecting the market power of financial institutions. Market power might complicate corporate governance by giving managers more leeway to pursue their own goals. The exercise of market power in setting prices may increase profits, raise shareholder value, and allow managers to proceed according to their own objectives without being easily detected. Consistent with this, one study finds that U.S. banks in more concentrated local markets have substantially lower cost efficiency. ¹⁰⁴ Also consistent with this argument, a number of studies find little effect of concentration on bank profits, even though concentration tends to increase market power in pricing. ¹⁰⁵ Presumably, some of the profits from the exercise of market power are diverted to higher perquisite consumption, other expense preference behavior, or a reduced effort to maximize efficiency or a "quiet life" for the managers. Cross-border consolidation or its threat may increase or decrease the exercise of market power.

The net effect of cross-border consolidation on the behavior of managers in pursuing their own objectives directly through corporate control or indirectly through market power is unknown. However, if the effect of removing cross-border entry barriers is similar to the effect of removing state barriers in the United States, the data suggest that these actions are likely to refocus managers toward improving efficiency in place of satisfying their personal goals. Corporate control appears to have improved as intrastate and interstate banking deregulation increased the number of [End Page 63] potential acquirers, reduced the market share of poorly run banks, and generally improved performance. ¹⁰⁶

Government Motives and Social Consequences

Governments also play important roles in constraining or encouraging consolidation activity. Governments often restrict the types of M&As permitted by putting explicit limits on cross-border M&As or M&As between different types of financial institutions (such as commercial banks with investment banks). Similarly, governments may require that foreign entry occur by M&A with existing domestic institutions, rather than by opening new offices, to help protect the franchise value of domestic institutions. Governments also affect consolidation directly through the decision to approve or disapprove individual M&As. During periods of financial crisis, governments sometimes provide financial assistance or otherwise aid in the consolidation of troubled financial institutions or acquire these institutions in part or in whole themselves.

Governments may also affect decisions regarding cross-border consolidation in less explicit ways. Any decisions that affect the cross-border consolidation of nonfinancial firms or international trade--such as implementation of the European Monetary Union or imposition of tariffs and quotas on other nations--affect the efficiency motives behind cross-border consolidation. Revenue efficiency may increase from cross-border consolidation as the consolidated institutions can better serve customers that operate in multiple nations. Government actions that harmonize or fail to harmonize financial systems or payments systems may affect decisions regarding cross-border consolidation as well. It has been argued that despite the removal of many of the explicit cross-border entry barriers within the European Union, cross-border consolidation of commercial banks in Europe may have been relatively sparse because of differences in the use of paper versus book entry, settlement cycles and methods, and payments systems. ¹⁰⁷ As well, European and other cross-border consolidation may be tempered by structural differences among the capital markets, tax, and regulatory regimes of the nations. ¹⁰⁸ [End Page 64]

There are a number of potential motives underlying some of these government actions or inactions. In some cases, governments may block foreign takeovers or permit M&As within the nation for reasons of national pride--governments may wish to ensure that the largest institutions in their nations are domestically owned. ¹⁰⁹ In contrast, harmonization and other government actions to permit more cross-border entry may reflect an increased strength of interest groups that benefit from technological innovations and globalization of financial services. ¹¹⁰ Alternatively, these actions may simply reflect regulators' official acquiescence to de facto entry that was already occurring. ¹¹¹

Consolidation of banks across state and industry borders within the United States and across international borders in Europe and elsewhere have been driven in significant part by government deregulation. The time series presented in figures 1 and 2 show an association between geographic market deregulation and the volume of financial institution M&A activity, especially in the European Union. In the United States, the removal of restrictions on interstate banking that started in the 1980s and concluded in 1994 with the Riegle-Neal Act (which permits interstate branching in almost all states) permitted the managers of commercial banks to pursue efficiency, market power, and other goals through consolidation. Much of the consolidation was related to this deregulation. ¹¹² In addition, the liberalization of Glass-Steagall restrictions on banking powers--in which the Federal Reserve allowed bank holding companies to underwrite corporate debt and equity through Section 20 affiliates within limits--permitted a number of M&As between bank holding companies and securities firms. ¹¹³ Although real limits remain on nationwide interstate consolidation in the United States, the recently passed Gramm-Leach-Bliley Act removed many of the remaining restrictions on combining commercial banking, investment banking, and insurance activities. ¹¹⁴ If this U.S. experience is representative, similar consolidation across borders in the European Union may be forthcoming as a result of the banking directives and [End Page 65] other harmonizations of regulatory and supervisory structures. The implementation of monetary unions may also increase cross-border consolidation by increasing trade, by reducing the currency conversion costs of institutions operating in multiple nations, and by reducing costs to consumers of purchasing services from foreign institutions. ¹¹⁵

In the remainder of this section, we discuss the research findings for some of the major social consequences of cross-border consolidation: systemic risk and the government safety net, availability and prices of financial services for small retail customers, availability and prices of financial services for large wholesale customers, banking-oriented finance versus market-oriented finance, and other macroeconomic effects. Other government goals and policies (such as enforcement of the Community Reinvestment Act) are excluded.

SYSTEMIC RISK AND THE GOVERNMENT SAFETY NET. Systemic risk may be broadly defined as the risk that credit or liquidity problems of one or more financial market participants will create substantial credit or liquidity problems for participants elsewhere in the financial system. The contagion effects can be transferred through the financial system through failures to settle in the payments system, through panic runs that follow the revelation of problems affecting one or more institutions, or through falling prices, liquidity problems, or markets that fail to clear when large volumes of securities are offered for sale simultaneously.

Changes in systemic risk from cross-border consolidation have important potential social consequences, including possible financial market gridlock, problems in the payments system, and difficulties in implementing monetary policy, as well as the costs of financial distress, bankruptcy, and loss of franchise value to other institutions caught up in the contagion. Much of the overall justification for the government safety net and other government involvement in supervision and regulation rests on concerns about systemic risk.

Cross-border consolidation may affect systemic risk and the government's cost of maintaining the safety net if the consolidation changes the risks of individual institutions involved in the M&As. It may also affect [End Page 66] systemic risk by increasing the size of the institutions. This may increase systemic risk because the systemic consequences of the failure of larger and larger institutions may be increasingly more severe. However, systemic risks may also decrease if the smaller number of larger institutions increases the efficiency of monitoring by government supervisors or other market participants.

Systemic risk may also either increase or decrease with cross-border consolidation. On the one hand, the effects of a systemic crisis within one nation may be mitigated because some of the institutions are diversified across national borders and can use their foreign operations as a source of strength. On the other hand, these transfers of funds may help to spread a crisis by weakening the institutions in the other nations.

Cross-border consolidation may also expand the safety net and raise the government's cost of maintaining the safety net in at least four other ways. First, if the government provides more safety net protection to larger institutions because they may be considered "too big to fail" or for other reasons, then safety net costs are increased by consolidation, which creates larger institutions that receive stronger explicit or implicit government guarantees. Thus, in addition to the moral hazard incentive to take on more risk, the presence of the safety net also may encourage consolidation by institutions trying to become too big to fail. ¹¹⁶ To offset these costs, governments use prudential regulation and supervision to try to control risk taking and may block or discourage M&As that appear likely to increase substantially the costs of safety net or systemic risk.

Second, cross-border consolidation may expand the safety net by extending government guarantees to types of financial institutions that normally receive much less safety net protection. Consolidation that creates universal-type institutions by combining commercial banks with securities firms or insurance companies may extend the safety net because commercial banks typically receive much more protection than these other types of institutions. Much of the current debate over operating structure centers on the issue of how best to control this potential extension of the safety net. ¹¹⁷ The potential costs of extending the safety net may be the greatest for combinations of commercial banks with nonfinancial firms, which typically receive much less government protection. ¹¹⁸ [End Page 67]

Third, cross-border consolidation may expose one government's safety net to losses incurred by the offices or subsidiaries of its institutions operating in other nations. That is, when a domestic institution acquires offices or subsidiaries in other nations, the home-country safety net may be exposed to the risk that those foreign entities will bear losses and drain some or all of the equity of the home-country parent institution. This may be particularly costly in some small nations in which the size of potential losses from abroad and at home are very large relative to the nation's GDP. ¹¹⁹ However, to some extent, these additional safety net exposures are offset by reduced exposures in the host foreign nations.

Fourth, cross-border consolidation may increase the cost of coordinating the regulatory responses among various national authorities to the failure of large banking organizations. For instance, national central banks in the European Union, rather than the European Central Bank, have the lender-of-last-resort responsibilities under the Maastricht Treaty. The cost of resolving future failures among pan-European banking organizations might be higher due to differences in the incentives of national governments to bail out various institutions and the impact of these policies on European monetary policy. ¹²⁰

AVAILABILITY AND PRICES FOR SMALL RETAIL CUSTOMERS. Cross-border consolidation may also raise social concerns about the availability and prices of financial services for retail customers who often depend on locally based financial institutions. Cross-border consolidation may be associated with increases or decreases in efficiency or with increases or decreases in the market power of financial institutions over small retail depositors and borrowers. These changes in efficiency or market power may in turn result in services that are either more or less available at prices that are more or less favorable for these customers. Rather than go into detail on all of the possible causes and consequences, we concentrate here on three specific ways in which cross-border consolidation may affect financial institutions' supply of retail services: (a) increases in financial institution scale, (b) increases in organizational complexity, and (c) dynamic changes in focus or organizational behavior associated with the process of cross-border consolidation itself. We discuss each of these in order. [End Page 68]

The increases in financial institution scale associated with cross-border consolidation may induce the institutions to shift away from providing certain services to small retail customers. This may occur because large institutions may encounter Williamson-type organizational diseconomies from providing these retail services alongside the capital market services provided to wholesale customers that typically purchase services from multinational financial institutions. ¹²¹ This may be particularly the case for relationship-based services to small retail customers, such as some types of small business loans that demand intimate knowledge of the customer, business owner, and local market. ¹²² It may be costly to provide these services in institutions that primarily provide wholesale services to customers operating in global markets. In addition, if the financial institutions face upward-sloping supply curves of funds, the improved opportunities to provide funds to large wholesale customers may crowd out funding to small retail customers.

It is also possible that the large, diversified financial institutions that result from cross-border consolidation may provide an efficient, stable flow of retail services to small customers, particularly during times of financial stress. The institutions that consolidate across borders may be better able to withstand financial crises in any one nation and to continue providing services to its households and small businesses. In contrast, small, undiversified institutions may more often have to withdraw credit and other services from small customers in times of financial stress. Moreover, even in periods without financial stress, the large institutions created by cross-border consolidation may act as efficient internal capital [End Page 69] markets that allocate financial resources across borders where and when they are most productive.

The research is consistent with the prediction that increases in financial institution scale are associated with reduced supplies of small business credit from these institutions. Several studies have found that large U.S. banks devote lesser proportions of their assets to small business lending than do small institutions. ¹²³ As banks get larger, the proportion of assets devoted to small business lending (measured by domestic commercial and industrial loans to borrowers with bank credit less than $1 million) declines from about 9 percent of assets for small banks (assets below $100 million) to about 2 percent for very large banks (assets above $10 billion).

Some evidence also suggests that it is specifically relationship-dependent small business borrowers that tend to receive less credit from large banks. One study finds that large banks tend to charge about 1 percentage point less on small business loans and require collateral about 25 percent less often than small banks, other things being equal. ¹²⁴ These data suggest that large banks tend to issue small business loans to higher-quality transaction-based credits, rather than relationship-based loans that tend to have higher interest rates and collateral requirements. Similarly, one study finds that large U.S. banks tend to base their small business loan approval decisions more on financial ratios, whereas the existence of a prior relationship with the borrowing firm matters more to decisions by small banks. ¹²⁵ Consistent with this, another study finds that large U.S. banks more often lend to larger, older, more financially secure businesses, consistent with the predicted focus on transaction-driven lending; the reverse is true for small banks focusing on relationship-driven lending. ¹²⁶

The data are also consistent with the argument that large financial institutions may provide efficient, stable flows of retail credit services. One study finds that during the U.S. credit crunch of the early 1990s, a $1 decline in equity capital at a small bank reduced business lending more than $1 at a large bank, and the financial distress of large financial institutions [End Page 70] had fewer adverse effects on the health of small businesses in their states. ¹²⁷ Other studies find that loan growth by banks in multibank bank holding companies is constrained less by the banks' own financial conditions than by the financial condition of the holding company, consistent with the argument that bank holding companies serve as internal capital markets to provide efficient, stable loan funding. ¹²⁸

The arguments about the effects of increased organizational complexity from cross-border consolidation are similar to those for increased financial institution scale. Many of the institutions engaging in cross-border consolidation are likely to (1) add layers of management, (2) expand the number of nations in which they operate, or (3) increase the number of different types of wholesale financial services they provide. Similar to the effects of increases in financial institution scale, it may be difficult to maintain strong local relationships and process relationship-based information when (1) there are more layers of management through which to pass the local information, (2) there are more local conditions to monitor, or (3) there are more wholesale businesses drawing the attention of the institution. Also similar to the arguments for scale, the increased organizational complexity may improve stability in the delivery of retail credit and other services, as risks may be better diversified or more sources of financial strength are available.

Two dimensions of complexity that have been studied are out-of-state ownership and multibank affiliation of bank holding companies in the United States. Out-of-state ownership is analogous to foreign ownership, and multibank affiliation is analogous to being a separately chartered entity in a multinational financial institution. Out-of-state ownership is usually found to have a negative effect on small business credit, although one study finds no effect and one study finds that recent interstate acquisitions may provide at least a temporary offsetting boost to small business lending. ¹²⁹ Multibank affiliation is also generally found to have a negative effect on small business lending. ¹³⁰ However, empirical analysis [End Page 71] that specifies simultaneously multiple dimensions of organizational complexity generally finds mixed results, with some dimensions of complexity positively associated with small business lending and other dimensions negatively associated. ¹³¹

The process of cross-border consolidation itself may be associated with dynamic changes in the treatment of retail customers. M&As are dynamic events that often involve significant changes in organizational focus that might shift the organizations away from or toward serving retail customers. Also, disruptions may affect the ability to serve retail customers during the transition period and may drive away some retail customers. Other changes in organizational focus and managerial behavior may also alter the availability and pricing of services to small customers. For example, the consolidated institution may change the policies and procedures of the foreign subsidiary to bring them into accord with the acquirer's preconsolidation focus on either retail or wholesale services.

Also important are the external effects of cross-border consolidation or the dynamic reactions of other institutions in the same markets as the consolidating institutions. The changes in competitive conditions may affect the behavior of rival institutions, which may either augment or offset the actions of the consolidating firms. For example, if consolidating institutions reduce the availability of credit to some small businesses, other institutions may pick up some of the dropped credits if it is value-maximizing for them to do so. Only by including these external effects can the total effects of cross-border consolidation be determined.

A number of studies analyze the effects of U.S. bank M&As on small business lending of the consolidating institutions. ¹³² The measured outcomes include any effects of the changes in the institutions' scale and organizational complexity as well as any changes in focus or managerial behavior associated with the consolidation process. The most relevant results for predicting the effects of cross-border consolidation are those for M&As in which one or more of the banking organizations are large, given that the institutions involved in cross-border consolidation are typically quite large. The literature generally finds a reduction in small business [End Page 72] lending from this type of M&A (although M&As between small organizations are often found to increase small business lending).

Some research also measures the external effect or dynamic responses to consolidation of other financial institutions in the same local markets. One study finds that increases in small business lending of other banks in the same local market tend to offset much, if not all, of the negative effects on small business lending of M&As, although this external effect is not precisely measured. ¹³³ In contrast, another study finds a very small external effect of M&As on the lending of small banks in the same market, and the measured effect depends on the age of the bank, with the positive effect primarily occurring for more mature small banks. ¹³⁴

Another way the external effect may be manifested is through increased market entry. That is, there may be an external effect in terms of additional provision of services by institutions that were not in the market prior to consolidation. One way that this might occur is that loan officers who leave the consolidated institution may take some of their relationship-based loan portfolios with them and start a de novo bank. This effect may be substantial, given that studies have found that recent entrants tend to lend much more to small businesses than do other banks of comparable size. ¹³⁵ However, the research on the effects of M&As on entry are mixed--one study finds that M&As increase the probability of entry, and another finds that M&As decrease the probability. ¹³⁶

Finally, some studies have examined the treatment of small business borrowers and depositors based on the consolidation of their banks, that of other banks in the market, or the size distribution of banks in their market. Their results indicate the net effect of consolidation on the supply of retail services, inclusive of the effects of the consolidating institutions and the external reactions of other preexisting and entering firms. One study examines the probability that small business loan applications will be denied by consolidating banks and other banks in their local market and finds no clear positive or negative effects. ¹³⁷ Another study examines a [End Page 73] number of dimensions of how well the borrower is treated after its lender is acquired and finds mixed results for the effects of consolidation on satisfaction of borrowing needs, loan approval or rejection, shopping for lenders, and loan rates. ¹³⁸ A third study finds that the probability that a small firm will obtain a line of credit or pay late on its trade credit does not depend in an important way on the presence of small banks in the market. ¹³⁹ A fourth study examines the effects of M&As on the number of bank branches in local markets in the United States and finds that only in-market M&As reduce the number of branches per capita, but that other M&As that would be analogous to cross-border consolidation have little effect on the availability of branch offices. ¹⁴⁰ The results of these studies and the other evidence summarized here suggest that the total effects of consolidation on retail customers may be relatively small.

AVAILABILITY AND PRICES FOR LARGE WHOLESALE CUSTOMERS. Cross-border consolidation of the financial services industry may also raise issues about the availability and prices of financial services for wholesale customers. Two separate trends may affect wholesale customers and must be distinguished. The first is the consolidation of the institutions associated with wholesale capital markets. These institutions include securities firms, universal banks, commercial banks, and other institutions that underwrite securities, act as brokers, traders, and market makers in the secondary markets, or offer other wholesale corporate financing products such as derivatives or M&A advisory services. There is also consolidation of the stock, bond, and derivatives exchanges, the institutions that comprise the secondary market on which the securities are traded.

The second trend is the globalization of wholesale capital markets, which may occur without the consolidation of financial institutions. This trend arguably began with the first eurobond underwriting in 1964. The market for eurobonds began in London and has now spread to other locations such as the Bahamas, Bahrain, Hong Kong, Japan, Singapore, and the United States. There has also been a trend toward globalization in the corporate securities and derivatives markets. For example, the New York Stock Exchange and the London Stock Exchange now both list substantial numbers of foreign companies. [End Page 74]

The trends toward consolidation of institutions and globalization of markets are intertwined. For example, some of the consolidation of wholesale institutions may be associated with economies of scale in the global markets into which the customers issue new securities. With the advent of the "bought deal" in the eurobond market and its spread to the United States (facilitated by the Rule 415, shelf registration), investment banks are required to commit large sums of capital nearly instantaneously. Cross-border consolidation provides an important avenue for financial institutions to amass the scale and scope needed to raise capital to underwrite in this global market. Wholesale customers, in turn, may benefit from a lower issuance cost in the primary market.

Institution consolidation and market globalization are also intertwined in the secondary markets, where larger markets beget larger institutions and vice versa. Examples of this are the signing of the strategic alliance between the London Stock Exchange and the Deutsche Börse in July 1998 and the signing of a memorandum of understanding among eight European exchanges (Amsterdam, Brussels, Frankfurt, London, Madrid, Milan, Paris, and Zurich) in May 1999 to work to harmonize their markets and establish a pan-European equity market. In these two cases, the introduction of the euro may have been a key facilitating event, reducing the segmentation of wholesale capital markets along national lines. There have also been other efforts to consolidate exchanges across national and currency boundaries (for example, Eurex and the Chicago Board of Trade), and more may be forthcoming.

There may be considerable benefits to issuers and investors when exchanges consolidate. Viewed as networks, exchanges can increase the utility of their customers as they increase their size. ¹⁴¹ Greater size may create economies of scale in clearing and settlement and improve liquidity, which may, in turn, lower the cost of capital to the customers that list their securities on these exchanges. Modeled as networks, integration among stock exchanges, particularly in the form of "implicit" mergers, may promote social welfare. ¹⁴² Implicit mergers involve agreements among exchanges to cross-list but do not involve total and legal integration. Benefits arise out of network externalities (customer utility rises with exchange membership), and some competition is preserved because the [End Page 75] mergers are not explicit. Cross-border mergers and alliances can also allow participants to defray transaction and operating costs and enable them to introduce new technologies. ¹⁴³ Technological advances that provide alternative delivery channels (for example, electronic links and screen trading) may also create new sources of competition and lead to specialization in the provision of exchange services. ¹⁴⁴ In either case, increased competition and consolidation among exchanges can lead to more efficient provision of listing and trading services, increase the attractiveness of capital markets to investors, and lower the cost of capital to listing firms. The evidence on scale economies associated with the size of exchanges themselves (as opposed to ancillary activities such as clearing and settlement) suggests that they may be limited, although significant X-efficiency gains may be available from consolidation. ¹⁴⁵ However, estimation of economies of scale in securities exchanges is problematic because it is difficult to determine the inputs and the outputs and because many of the M&As have not yet reached fruition.

Another segment of the customer market that may benefit from consolidation of the securities markets is high-growth, often technology-based, start-up firms, although such firms do not fit our classification of wholesale customers. High-growth start-ups often require substantial private external equity financing in the early stages of their growth cycle from individual investors ("angels") or from formal venture capitalists. ¹⁴⁶ As a condition for investment, both types of private equity investors require a viable exit strategy, a market where they can sell their equity stake via an IPO if the firm is successful. An IPO, in turn, requires a vibrant small-cap stock market--something that is currently absent in continental Europe. The development of such a market (possibly out of Easdaq or EuroNM) could lead to a significant increase in high-tech entrepreneurial activity similar to that in the United States.

BANKING-ORIENTED FINANCE VERSUS MARKETS-ORIENTED FINANCE. An analysis of the effects of consolidation on wholesale customers must also be viewed in the context of a separate but closely related phenomenon--changes in the mix of funding between intermediated markets (intermediated finance) and securities markets (direct finance). The principal [End Page 76] contrast is between a markets-oriented financial system like the United States and a banking-oriented system like Germany.

Tables 2 and 3 indicate the differences among countries in the mix between intermediated and direct finance. Specifically, they demonstrate that the U.S. financial system lies substantially closer to the markets-oriented end of this spectrum than the financial systems of other industrial nations. Table 2 shows that in 1997 total banking assets in the United States were only 52 percent as large as the market capitalization of the U.S. stock and bond markets, while the ratio for all of the other countries (excepting Luxembourg) was considerably greater, indicating that the financial systems in other industrial nations are much more bank-oriented. Table 3 provides corroborating evidence from corporate balance sheets. In 1994 debt securities provided more than four times as much financing for U.S. corporations as did bank loans (82 and 18 percent, respectively). In contrast, bank loans were more important sources of financing than debt securities in Canada, Japan, and most European countries. U.S. securities markets are more developed than those of other nations and thus are relatively more important than banks as a source of external finance for U.S. corporations.

These differences also reflect a trade-off between liquidity and corporate governance mechanisms. ¹⁴⁷ In the United States, highly developed securities markets reduce the cost of capital by increasing liquidity to investors. However, managerial control problems are exacerbated by the atomistic ownership of large corporations. This problem is addressed in the U.S. system primarily through the market for corporate control (that is, the takeover market), through performance-based managerial compensation, and through monitoring by market outsiders and institutions (that is, large bondholders and bond rating agencies). In Japan and Germany, however, the corporate governance problem is addressed by the consolidation [End Page 77] of corporate ownership in large financial institutions rather than the stock market. This reduces the incentive (free-rider) problem that arises in monitoring management when ownership is diffuse. The parallel growth of these two types of systems among developed economies, it has been argued, may have been principally due to the evolution of different legal environments. ¹⁴⁸ For example, regulatory constraints in Germany and Japan against issuing corporate bonds and commercial paper were major factors in promoting bank dependence among large firms. It can also be argued that banking-oriented systems may be better suited to solve moral hazard and adverse selection problems in lending. This suggests that a banking-oriented system may be the preferred architecture for countries with poor information infrastructures such as the formerly centrally planned economies of Eastern Europe. ¹⁴⁹ Banking-oriented systems may also offer better intertemporal risk sharing at the cost of less cross-sectional risk taking than markets-oriented systems. ¹⁵⁰ [End Page 78] [Begin Page 80]

The legal and economic institutions that determine whether a country's financial system is markets-oriented or banking-oriented can change over time. For example, legislative changes in France between 1978 and 1984 were designed to increase the role of capital markets and reduce the dependence of French companies on bank financing. The reduction in bank finance in France between 1983 and 1994 suggests that those changes were effective. Equity and bond markets in most European countries have grown significantly in recent years, due in part to regulatory changes like the "Big Bang" in the United Kingdom and the deregulation of guilder-denominated bond issues in the Netherlands. ¹⁵¹

While financial institution consolidation and changes in financing mix are often discussed together, they need not occur together. It is conceivable, for example, that continental Europe could experience considerable consolidation of both its securities markets and its banking markets while remaining predominantly a banking-oriented system. Alternatively, consolidation could be accompanied by a shift in mix toward the securities markets and away from the intermediated markets. Similarly, the proportions of funding through universal-type institutions versus separate commercial banks, securities firms, and insurance companies could conceivably either increase or decrease, depending in part on the type of consolidation.

A shift from a banking-oriented system to a markets-oriented system in continental Europe or Japan could have a significant impact on large companies. Such a shift could arise, for example, if the network and scale efficiency benefits from consolidation of the securities markets are sufficiently large relative to the benefits from consolidation of banks and other financial intermediaries that they drive a shift in the mix toward direct finance at the expense of intermediated finance. The net benefit to large companies would depend in part on whether the reduction in the cost of capital from the issuance of liquid securities is greater than any increase in the cost of capital from a shift in governance mechanisms.

Of course a shift toward a markets-oriented financial system would likely be facilitated by growth--possibly through consolidation--of the investment banking industry that provides wholesale services in the primary and secondary markets. This growth may be skewed toward universal banking if universal banking is characterized by economies of scope. A [End Page 80] wave of nonfinancial M&A activity in Europe has already precipitated fierce competition for advisory business. Intra-European merger and acquisition activity between 1985 and 1988 averaged $43 billion a year versus $280 billion a year between 1995 and 1998. ¹⁵² In order for European universal banks to compete for this business--particularly against U.S. investment banks that have acquired substantial expertise in the M&A advisory business--they either have to develop this expertise internally or have to acquire it externally. It appears, for example, that in part Deutsche Bank has acquired this expertise by purchasing British and U.S. investment banks (Morgan Grenfell and Alex. Brown). Similarly, domestic institutions in Asia may seek to acquire foreign investment banks to compete in the burgeoning Asian IPO business. To the extent that these types of acquisitions in the securities industry improve scale and scope efficiency or increase overall competitiveness, the cost of capital to larger companies should decline as a result of lower underwriting spreads and advisory fees.

A change in financial mix might also have an impact that operates through a link between mix and firm capital structure. However, the evidence on the impact of different financial systems on capital structure of firms is ambiguous. One study suggests that the differences between banking- and markets-oriented systems are reflected more in the sources of financing and less in the capital structure of firms. ¹⁵³ In contrast, two other studies find significant differences in the capital structures of companies across European countries. ¹⁵⁴

However, there is also evidence that this type of disintermediation away from banking-based finance to markets-based finance has not occurred in Europe. One study of flow of funds data in France, Germany, and the United Kingdom finds no general trend (except in France) toward disintermediation or a markets-oriented system. ¹⁵⁵ In contrast, there may be a lengthening of the intermediation chain. It may be argued that the development of new financial products has primarily created markets for intermediaries rather than end users of these products. ¹⁵⁶ Consistent with this [End Page 81] argument, most of the European funds (nearly 80 percent in some countries) are controlled by banking organizations, and banks distribute more than half of these funds. ¹⁵⁷

OTHER MACROECONOMIC CONSEQUENCES. The consolidation of the financial services industry may have a number of macroeconomic effects. The most obvious of these would be the effects of any improvements in the efficiency of financial institutions, which may affect the economy through a reduction in the cost of capital. Depending on the degree of competition in financial markets, some of any gains may accrue to the issuers of financial claims in the form of a reduced cost of capital or to savers in the form of higher returns on their investments. In the intermediated markets, interest rates on loans might decrease, and interest rates on deposits might increase. In the securities markets, trade execution, liquidity, access, and price may improve.

Other potential impacts of consolidation on the macroeconomy may operate through monetary policy. Traditional monetary theory argues that the transmission mechanism of monetary policy operates through either an interest rate or a money channel. For the most part, this traditional theory was built on models of the economy in which there were only two assets, (noninterest-bearing) money and (interest-bearing) securities. Banks play a very passive role as benign caretakers of the money supply constrained by reserve requirements. Under the traditional theory, consolidation would have very little effect on the operation of monetary policy.

Relatively recently, however, a competing theory has emerged in which banks play a critical role. Under this "bank lending view," monetary policy operates in part through bank lending behavior. ¹⁵⁸ The reduction in bank reserves that accompanies a tightening of monetary policy results in some banks reducing their supplies of loans. This reduction in loan supply forces some borrowers to reduce real spending and slows the macroeconomy because alternative means of funding are unavailable or unaffordable, at least in the short term. ¹⁵⁹ The effect is disproportionately greater on small bank-dependent companies that do not have access to the securities markets. ¹⁶⁰ [End Page 82]

Under the bank lending view, the impact of the monetary policy may depend on the structure of the banking industry. Small banks may be much more sensitive to shifts in monetary policy because their access to nondeposit money market funding is significantly less than that of large banks. The evidence suggests that small bank lending is more sensitive to changes in monetary policy than large bank lending and that this sensitivity is greatest for those small banks that are the least liquid. ¹⁶¹ It has been argued that countries with a higher fraction of bank-dependent borrowers, weaker banking systems, and fewer market alternatives to intermediated finance may be much more sensitive to monetary policy shocks. ¹⁶² The nations of the European Union are ranked according to these criteria. Belgium, the Netherlands, and the United Kingdom appear to be the least sensitive to the lending channel, whereas Italy and Portugal appear to be the most sensitive. ¹⁶³ These asymmetric responses across member countries will likely continue under the common monetary policy of the European Central Bank.

Bank consolidation may reduce the effect of the lending channel in part by creating larger institutions with greater access to capital markets. In addition, cross-border consolidation may also reduce the effect of monetary policy through the lending channel by diversifying the effects of any one nation's monetary policy. To the extent that monetary policies are independent, the multinational banks can use more of the reserves from their operations in the nation with the looser monetary policy to lend in the nation with the tighter monetary policy. Of course, this effect is nullified to the extent that monetary policies tend to be coordinated or, in the case of the European Union, there is a common monetary policy for multiple nations.

Consolidation of the financial services industry might also affect nonfinancial firms' access to funding and the macroeconomy by affecting the number of potential sources of funding. While consolidation does [End Page 83] reduce the number of financial institutions, it may also increase the number of options available. If consolidation is associated with a shift from a banking-oriented system to a markets-oriented system, this could increase the menu of alternative markets in which firms may obtain financing. For example, the highly developed private placement market and the junk bond market in the United States represent alternatives to bank loan financing for lower-quality firms. For investment-grade firms, the commercial paper market and the medium-term note market represent alternatives to the bank loan market. There is some evidence to suggest that firms shift their funding sources as macroeconomic conditions change, such as shifting from bank loans to commercial paper in the United States. ¹⁶⁴ Small firms may also benefit to the extent that larger firms increase their issuance of commercial paper to finance more trade credit to small firms. ¹⁶⁵ More generally, the impact of macroeconomic crises on economic activity may be mitigated by diversification across funding sources, as firms shift sources when one source of funding fails. ¹⁶⁶ However, credit crunches may be correlated across markets. For example, evidence suggests that a contraction of supply occurred simultaneously in the early 1990s in the United States across three different markets--the bank loan market, the junk bond market, and the below-investment-grade segment of the private placement market. ¹⁶⁷

Tests of Home Field Advantage versus Global Advantage Using International Data

In this section, we present our efficiency analysis of cross-border banking. We evaluate the relative efficiency of foreign versus domestic commercial banks in five home countries--France, Germany, Spain, the United Kingdom, and the United States. For each home country, we estimate separate cost and alternative profit frontiers and compare the efficiency of foreign and domestic banks. We also extend our tests by [End Page 84] including foreign banks from other nations, presenting efficiency statistics in all cases for which we have data for at least three banks from a given foreign nation. We use these relative efficiency comparisons to test the home field advantage hypothesis versus the two forms of the global advantage hypothesis. We test these hypotheses in light of the extant research on cross-border X-efficiency, which often finds that foreign banks are less efficient than domestic banks and concludes that the evidence supports the home field advantage hypothesis. However, the methodologies used in previous studies may not be able to distinguish properly among the hypotheses. We address the drawbacks in the prior methodologies by (a) examining the performance of foreign and domestic banks in five different home countries, (b) distinguishing among nations of origin of foreign institutions to test the limited form of the global advantage hypothesis, and (c) conducting separate analyses of data from banks located in different countries to avoid problems of comparison because of differences in the economic environments across nations.

A Brief Summary of the Estimation Methods

Performing separate efficiency estimations in each of the five home countries allows us to specify the cost and alternative profit functions differently in each of these countries, depending on the activities in which banks are permitted to engage. This is especially relevant for universal banking powers, which were present more often in European nations than in the United States. Separate treatment also allows us to adjust the specification and the estimation procedures when certain variables are available for one country, but not for others.

Although our approach offers a number of methodological improvements, it does tax the availability of the data. Since we do not pool data across countries, each of our home-country efficiency frontiers is estimated with fewer degrees of freedom. We limit our analysis to home countries for which our data sets contain (a) data on enough banks to estimate the cost and profit frontiers with reasonable accuracy and (b) data for at least three foreign banks from at least two foreign nations during the sample period. Fortunately, these data limitations do not pose major problems. We are still able to test domestic versus foreign efficiency for a large number of nation-pairs, many of which yield statistically and economically significant results. [End Page 85]

ESTIMATING X-EFFICIENCY FOR BANKS IN THE UNITED STATES. In this subsection, we present a nontechnical overview of the procedures used to estimate cost and alternative profit X-efficiency for banks in the United States. In the following subsection, we describe how we altered these estimation procedures for the other four home countries. A more detailed technical appendix is available from the authors.

Both cost efficiency and alternative profit efficiency measure how well a bank performs relative to a best-practice institution that produces the same output bundle under the same environmental conditions. Cost efficiency is measured from a standard cost function that specifies the quantities of four variable outputs (consumer loans, business loans, real estate loans, and securities), the quantity of one fixed output (off-balance-sheet activity), the quantities of two fixed inputs (physical capital and financial equity capital), the prices of three variable inputs (purchased funds, core deposits, and labor), and the ratio of market-average nonperforming loans to total loans (to control for business environment of the bank). The cost function is estimated using the Fourier-flexible functional form, which has been shown to fit banking data better than more conventional functional forms. ¹⁶⁸ Because this functional form fits the data globally, rather than just around the mean of the data, it allows us to measure more accurately the relative performance of banks with starkly different output bundles or other characteristics.

Alternative profit efficiency is derived from a profit function with the same right-hand-side variables as the cost function and is estimated using the same functional form. As described elsewhere, alternative profit efficiency is a particularly useful concept when some of the standard assumptions of perfect markets do not hold. ¹⁶⁹ Alternative profit efficiency may capture some of the revenue effects of differences in investment or risk management skills that are not captured in cost efficiency, which neglects differences in revenue across banks. Alternative profit efficiency may also [End Page 86] capture some of the revenue benefits of cross-border risk diversification if banks use these diversification gains as an opportunity to invest in higher-risk, higher-expected-return projects. Finally, alternative profit efficiency may reflect revenue differences associated with service quality or product variety. For example, banks may "skimp" on loan underwriting, loan monitoring, cross-selling, customer convenience, or other activities important for producing high-quality financial services and high levels of interest and noninterest revenue. ¹⁷⁰ Since it is difficult to control for service quality, this skimping may mistakenly be measured as high cost efficiency (that is, lower costs for a given quantity of output) but may be captured at least in part as low alternative profit efficiency, which includes both costs and revenues.

These efficiency measures have a fundamental advantage over simple accounting-based cost and profit performance ratios. The efficiency measures statistically remove the effects of differences in output bundles, input prices, and so forth that affect accounting-based performance ratios but are not necessarily related to the efficiency or managerial quality of the organization. This may be particularly important when comparing foreign and domestic banks, which often have different output mixes. Thus we reduce the potential problem of "comparing apples to oranges" by controlling for output mix and other nonefficiency factors when comparing the performance of foreign and domestic banks within a home country.

We use alternative profit efficiency as our main measure of performance to test the home field and global advantage hypotheses, because it is a more comprehensive measure that includes both costs and revenues. We use cost efficiency as an ancillary measure to diagnose whether differences in profit efficiency are rooted in cost control, revenue generation, or both and to compare our results to those of the previous cross-border cost efficiency literature.

We estimate the U.S. cost and alternative profit functions using data on 2,123 banks with greater than $100 million in gross total assets (1998 U.S. dollars) and continuous, complete annual data for the six-year period from 1993 through 1998. Using the results of these estimations, we calculate cost efficiency and alternative profit efficiency for every bank in the data set (1,940 domestic banks and 43 foreign banks) using the distribution-free method, which distinguishes efficiency differences from random error by [End Page 87] averaging the cost or profit function residuals over time. ¹⁷¹ We exclude small banks from the analysis because the vast majority of banks owned by international banking organizations are large and because the efficiency data for the other four home countries generally include only large banks. The data are taken from the U.S. Call Report. Table 4 displays summary statistics for the data used in the U.S. efficiency estimations. [End Page 88]

ESTIMATING X-EFFICIENCY FOR BANKS IN FRANCE, GERMANY, SPAIN, AND THE UNITED KINGDOM. We alter the U.S. specification in a number of ways to estimate efficiency for banks in France, Germany, Spain, and the United Kingdom. First, we take our data from the Fitch-IBCA database, which presents data on financial statements from financial institutions in different nations using internally consistent accounting definitions. This database reports a more limited amount of financial information than does the U.S. Call Report and does so for a sample of (mostly large) financial institutions in each country. Second, we specify the European cost and profit functions using the quantities of four variable outputs (total loans, total nonequity securities, total equity securities, and commission revenues), the quantity of one fixed input (equity capital), and the prices of two variable inputs (labor and borrowed funds). This different specification partly reflects the broader insurance and securities powers of European banks (which we capture in the equity securities and commission revenues variables) and partly reflects the reduced level of detail in the IBCA database. Third, we use definitions supplied by IBCA to identify and retain commercial banking firms and to identify and discard other types of financial institutions. This further ensures that we are estimating performance and testing our hypotheses based on a relatively homogeneous group of firms across nations. Fourth, we observe commercial banks in these countries annually over the six-year time period from 1992 through 1997 (rather than 1993 through 1998 in the United States) and include in the estimations any commercial bank that appears in the database in at least four of those six years. Our final samples include 215 commercial banks in France (158 domestic and 57 foreign); 206 commercial banks in Germany (121 domestic and 85 foreign); 76 commercial banks in Spain (60 domestic and 16 foreign); 124 commercial banks for the profit function in the United Kingdom (63 domestic and 61 foreign); and 57 banks for the cost function in the United Kingdom (26 domestic and 31 foreign). Table 5 displays summary statistics for the data used in these estimations.

OVERALL X-EFFICIENCY ESTIMATES. Our overall cost efficiency estimates (that is, not differentiating between domestic and foreign ownership) are consistent with those found in the previous literature. The average estimated cost efficiency is 70.9 percent for banks in France, 79.3 percent for banks in Germany, 91.5 percent for banks in Spain, 79.1 percent for banks in the United Kingdom, and 77.4 percent for banks [End Page 89] [Begin Page 91] in the United States. An average cost efficiency of 70.9 percent as in France indicates that a best-practice bank producing the same output bundle under the same environmental conditions as the average bank could do so for an estimated 70.9 percent of the costs. The average estimated alternative profit efficiency is 44.2 percent for banks in France, 52.2 percent for banks in Germany, 67.1 percent for banks in Spain, 66.1 percent for banks in the United Kingdom, and 66.7 percent for banks in the United States. An average alternative profit efficiency of 44.2 percent as in France indicates that the average bank earns only an estimated 44.2 percent of the profits of a best-practice bank producing the same output bundle under the same environmental conditions.

We again emphasize that the efficiency estimates for one home country are not comparable to the efficiency estimates for the other four home countries. For example, the 91.5 percent mean cost efficiency for banks operating in Spain does not indicate that the average bank operating in Spain is more cost efficient than the average bank operating in the other home countries. The efficiency differences across home countries reflect market factors (for example, the degree of competition, the development of securities markets, and the quality of the labor force), regulatory and supervisory factors (for example, the enforcement of prudential limits on risk taking), and differences in specification of the frontier. In our tests, we evaluate the home field advantage and global advantage hypotheses only by comparing domestic bank efficiency versus foreign bank efficiency within each of our home countries. Although this approach allows us to distinguish better among the main hypotheses, it unavoidably reduces sample sizes and statistical significance.

The Relationship between the Cross-Border Efficiency Results and the Hypotheses

Although we estimate ten separate efficiency frontiers (cost and profit for five home countries) and use the results to test the comparative efficiencies of a large number of nation-pairs, we can classify our results into four simple possible outcomes. In this section, we identify each of these four possible outcomes, map each outcome into support for or rejection of the home field versus global advantage hypotheses, and identify the implications of each outcome for the future of global integration of the financial services industry. [End Page 91]

The first possible outcome is that foreign institutions are generally found to be less efficient than domestic institutions. This would support the home field advantage hypothesis that organizational diseconomies of operating or monitoring an institution from a distance or other advantages for domestic banks (for example, language, culture, regulation, and other barriers) are too difficult to overcome in most cases, even for efficiently operated cross-border organizations. This outcome, if it extrapolates to the future, may suggest that efficiency problems could limit the degree of globalization of financial institutions.

The second possible outcome is that foreign institutions are generally found to be more efficient than domestic institutions. This would support the general form of the global advantage hypothesis that efficiently managed foreign banks headquartered in many nations are able to overcome any cross-border disadvantages and operate more efficiently than the domestic banks. The higher efficiency occurs as a result of spreading superior managerial skills or best-practice policies and procedures, of obtaining diversification of risks that allows for higher-risk, higher-expected-return investments, or of providing services of superior quality or variety that raises revenues. This second outcome, if it extrapolates to the future, may suggest that efficient institutions from many nations could successfully expand on a global basis, limited only by nonefficiency constraints, such as regulatory or supervisory intervention or other barriers to entry.

The third possible outcome is that foreign institutions headquartered in one or a limited number of nations are found to be more efficient than domestic institutions. This would support the limited form of the global advantage hypothesis in which only efficiently managed foreign banks headquartered in nations with specific favorable conditions in their home countries are able to overcome any cross-border disadvantages and to operate more efficiently than the domestic banks. This third outcome, if it extrapolates to the future, may suggest that efficient institutions from this limited group of nations could successfully expand on a global basis if the conditions fostering their higher efficiency remain intact and if nonefficiency barriers do not prevent their expansion.

Finally, if neither domestic nor foreign institutions are found to be systematically more efficient--which essentially corresponds to all outcomes other than the first three listed here--then neither the home field advantage hypothesis nor the global advantage hypothesis is supported by the data. [End Page 92] This final potential outcome, if it extrapolates to the future, may suggest that global consolidation will be more likely to turn on issues other than efficiency maximization, such as managerial motives and government actions.

Empirical Results

Table 6 shows the results of our cross-border alternative profit efficiency tests. Each of the five columns of the table corresponds to an alternative profit frontier estimated only for banks operating in that home country. The first row displays efficiency results for the domestic banks in each home country. The second row displays efficiency results for all the foreign banks in each home country. The other rows correspond to subsets of foreign banks, grouped according to their nation of ownership. Table 7 displays estimates of cost efficiency. The results can be summarized as follows. In most countries, domestic banks are found to have both higher mean profit efficiency and higher mean cost efficiency than the mean of all foreign banks operating in that country, although these differences are not always statistically significant. This result, consistent with most of the findings in the literature, has been interpreted as supporting the home field advantage hypothesis, but we do not draw this same conclusion. Rather, by disaggregating the results by foreign nation of origin, we find that the data appear to reject the home field advantage hypothesis in favor of the limited form of the global advantage hypothesis. As shown below, the disaggregated results suggest that domestic banks may be more efficient than banks from most foreign countries, may be about as efficient as banks from some foreign countries, but may be less efficient than banks from one of the foreign countries.

domestic versus foreign bank efficiency. In France, Germany, and the United Kingdom, cost efficiency and alternative profit efficiency are both higher on average for domestic banks than for foreign banks. Some of these differences are small, although in Germany and the United Kingdom the difference in profit efficiency is economically large, over 4 percent of potential profits.

In Spain and the United States, domestic banks exhibit either higher cost efficiency than foreign banks or higher profit efficiency than foreign banks, but not both. In Spain, mean domestic cost efficiency is about 2.1 percent of costs higher than mean foreign bank cost efficiency, but on [End Page 93] [Begin Page 98] average domestic banks are less profit efficient than foreign banks by about 5.4 percent of potential profits. This implies that while domestic Spanish banks may have a slight cost advantage over their foreign rivals, their lower revenues overwhelm their lower costs. This may be due to poor investment choices, to poor risk diversification that requires a relatively low risk, low-expected-return choice of investments, or to poor service quality such as skimping on expenditures necessary to monitor and service customers.

In the United States, domestic banks are more profit efficient on average than foreign banks by a wide margin, 25.5 percent of potential profits, but domestic banks are on average slightly less cost efficient than foreign banks by 2.8 percent of costs. Both differences are statistically significant. The much higher profit efficiency suggests that the extra spending by U.S. domestic banks likely is not due to waste or inefficiency--rather, these higher expenses more likely reflect efforts to produce a quality or variety of financial services that generates substantially greater revenues. ¹⁷²

disaggregating foreign bank efficiency by nation of ownership. Thus far, our results are consistent with the main finding of the prior research in this field, that is, the average domestic bank is generally more efficient than the average foreign bank. In four of our five home countries, mean domestic bank profit efficiency is higher than mean foreign bank profit efficiency. In some cases, particularly the United States, this efficiency edge is also economically large, accounting for a substantial percentage of potential profits. However, we cannot draw conclusions about our hypotheses without also disaggregating these results by nation of origin for the foreign banks. We show this disaggregation in tables 6 and 7.

In France, domestic banks have slightly higher mean cost and profit efficiency than foreign banks on average, but this masks considerable heterogeneity [End Page 98] across the foreign banks by nation of origin. For example, U.S.-owned banks in France have the highest mean profit efficiency of 64.85 percent, which is more than 20 percent of potential profits higher than domestic French banks, and the difference is statistically significant. The Netherlandic-owned banks in France have much higher measured cost efficiency but lower measured profit efficiency than domestic French banks, suggesting poor revenue performance. In contrast, Italian-owned banks in France have much higher measured profit efficiency, but lower cost efficiency, than domestic French banks.

In Germany, as in France, heterogeneity among foreign institutions is again apparent once the results are disaggregated by nation of origin. Again, the U.S.-owned banks have the highest mean profit efficiency of all foreign institutions, and again the U.S.-owned institutions post a higher mean profit efficiency than domestic banks (although the difference is not statistically significant). Domestic German banks have statistically higher mean profit efficiency than foreign banks from the Netherlands, Switzerland, and the United Kingdom, although the foreign U.K. banks have statistically higher cost efficiency than the domestic German banks. Again, these mixed cases suggest that studies using only the less-comprehensive cost efficiency measure can be misleading, because this measure does not account for differences in the ability to generate revenues. There is weak evidence that the strong profit efficiency of German domestic banks carries over to their foreign operations in France, although this result is not statistically significant and we do not have any data from German banks in foreign nations other than France to determine whether German banks have a global advantage.

In Spain, our database contains only two foreign nations (France and the United States) operating three or more banks. On average, both of these sets of foreign banks are more profit efficient than the domestic banks, providing further evidence against the home field advantage hypothesis in Spain. The cost efficiency results continue to differ from the profit results in Spain, suggesting that most of the profit efficiency advantage of the foreign banks is on the revenue side.

In the United Kingdom, domestic banks have higher mean cost efficiency and higher mean profit efficiency than all of the foreign nations operating in the United Kingdom. However, none of these differences is statistically significant, and they do not suggest that U.K. banks have a global advantage. U.K. banking organizations have only three or more [End Page 99] banks in one other home country in our data set, Germany, where the cost efficiency and profit efficiency of U.K. banks are both statistically and economically significantly lower than those of domestic German banks. Thus, although it may be hard for foreign banks to do business in the United Kingdom, U.K.-owned banks do not appear to be particularly efficient players outside their home country.

In the United States, domestic banks have higher mean profit efficiency than the foreign banks from all other nations, and the difference is usually statistically significant and economically large. The much higher profit efficiency and somewhat lower cost efficiency of domestic U.S. banks relative to foreign banks in the United States suggest a strong advantage for U.S. domestic banks on the revenue side of the ledger. Furthermore, unlike the results for the other home countries, the domestic profit efficiency advantage of U.S. banks does not disappear when these banks go abroad--U.S.-owned banks earn higher-than-domestic levels of profit efficiency in France, Germany, and Spain.

Overall, these disaggregated data tend to support rejection of the home field advantage hypothesis in favor of the limited form of the global advantage hypothesis. In three of the five home countries, foreign banks from at least one other nation are more efficient on average than domestic banks, contrary to the predictions of the home field advantage hypothesis. Banks from one nation, the United States, exhibit mean efficiency levels that are higher than those of domestic banks in all but one of the other home countries, supporting the limited form of the global advantage hypothesis. Banks from Germany also exhibit high mean efficiency levels both at home and abroad, although the foreign performance of German banks is based on a single, statistically insignificant result in only one foreign country. These data suggest that some efficient institutions from the United States (and perhaps Germany) may have overcome the difficulties imposed by distance, language, and culture to operate in foreign countries above the mean domestic efficiency levels, possibly because of specific favorable market or regulatory and supervisory conditions at home. However, determining which home-market conditions might give these banks an advantage is beyond the scope of this study.

A potential problem with our finding of support for the limited form of the global advantage hypothesis is that a banking organization may use transfer pricing or other accounting methods to shift profits from an affiliate in one country to an affiliate in another country for tax, regulatory, or [End Page 100] other reasons. Thus the generally high efficiency performance of U.S. banks in other nations could reflect a shifting of net cash flow out of the domestic banks in the United States toward their foreign affiliates, and the poor performance of domestic Spanish banks could reflect a shifting of net cash flow to the Spanish-owned institutions in other nations. However, three pieces of evidence suggest that this is not the case and that banks performing well abroad also tend to perform well at home. First, we find that U.S. banks are more profit efficient at home as well as abroad. This suggests a true efficiency advantage for U.S. banks, rather than simply a shift of net cash flow overseas. Second, we find some evidence that the poor performance of Spanish banks at home is mirrored by similarly poor performance abroad. Our French data set contains two Spanish-owned banks (not displayed in tables 6 or 7 because we constrained our tests to include only foreign-owned banks in groups of three or more), and these two banks had relatively low average profit efficiency (0.320) and relatively high average cost efficiency (0.850), figures that are consistent with the domestic performance of Spanish banks. Third, another study of cross-regional bank efficiency in the United States has found that banking organizations that do well in other regions also tend to do well in their home region. ¹⁷³ This supports a national advantage hypothesis similar to the global advantage hypothesis tested here.

Robustness Tests Using U.S. Regional Data

Although our main finding supports a global advantage for U.S. banks, we also find that domestic banks tend to have higher efficiency on average than foreign banks, consistent with previous studies of cross-border efficiency. In this section, we use the larger and more detailed U.S. bank data set to investigate the reasons for this result. First, we examine whether the higher average efficiency of domestic banks is caused by the diseconomies of operating or monitoring subsidiaries located far from headquarters or by the difficulties of overcoming cross-border differences such as language, culture, and regulations. Second, we examine whether the higher average efficiency of domestic banks arises simply because foreign banks tend to locate in regions where it is difficult for both foreign and domestic banks to earn high profits. [End Page 101]

We address the first question by dividing the United States into eight distinct geographic regions and evaluating the "cross-regional efficiency" of U.S. domestic banks. That is, we compare the estimated efficiency of 1,883 within-region banks (domestic U.S. banks operating in the region in which their organization is headquartered) to the estimated efficiency of 57 out-of-region banks (domestic U.S. banks operating in a region different from the one in which their organization is headquartered). The results of these tests, which are shown in table 8, suggest a modest efficiency advantage to cross-regional ownership. Large banks owned by out-of-region organizations have a statistically significant cost efficiency edge of 3.1 percent of costs and a statistically insignificant profit efficiency edge of 2.3 percent of potential profits over banks owned within the region. ¹⁷⁴ Given that the United States is a relatively homogeneous nation with potentially large distances between banks and their headquarters, these results suggest that efficient organizations can overcome any organizational diseconomies of operating or monitoring subsidiaries from a distance. If these results extrapolate to the cross-border context, they suggest that other barriers--such as differences in language, culture, regulatory or supervisory structures, currency, or monetary policy--more likely explain why domestic banks tend to be more efficient than foreign banks on average.

We address the second of these questions by comparing the efficiencies of foreign and domestic banks in the United States within each of these geographic regions. The results of these tests, which are shown in table 9, are consistent with the results in tables 6 and 7 that suggested an advantage for U.S. banks. The forty-three foreign banks operate in just four of the eight U.S. regions (Mideast, Great Lakes, Southeast, and Far West) and are located predominantly in the regions that include the international banking centers of New York (Mideast), Chicago (Great Lakes), and San Francisco (Far West). In three of these four regions, the average foreign bank has significantly lower profit efficiency than the average domestic bank, the only exception being the Southeast region, with only two foreign banks. Furthermore, in three of the four regions there is no significant difference between foreign bank and domestic bank cost efficiency. Foreign banks' locational choices do not appear to be driving our results. [End Page 102]

Implications of the Tests

If the results of this research extrapolate to the future, they may have important implications for the structure of globalized financial markets. The finding here and in the literature that foreign banks are less efficient on average than domestic banks in most countries, if it continues into the future, suggests that efficiency considerations may limit the global consolidation of the financial services industry. Domestically based institutions would continue to play a large role in the provision of financial services. Nonetheless, our results also suggest that some banking organizations can operate in foreign countries at or above the efficiency levels of domestic banks, paving the way for additional global consolidation. Furthermore, the ability to operate efficiently across borders appears to be linked to nation of ownership--only the U.S. banks were able to operate efficiently across borders on a reasonably consistent basis. If this U.S. advantage continues, U.S.-based organizations may capture a significant share of any future globalization of financial institutions.

A potential goal of future research might be to determine which conditions in the United States might foster the apparent efficiency advantage of U.S. banks. If it is based on market conditions like securities market development, then policymakers can do little to affect financial institution efficiency. If, instead, it is based on regulatory or supervisory factors like the deregulation of geographic restrictions, deposit interest rates, and relatively easy bank chartering, then policymakers may have an important influence. If deregulation is important, then this might predict strong cross-border [End Page 103] [Begin Page 105] efficiency gains from the Single Market Programme in the European Union and other liberalizations in other parts of the globe.

Our results may also have important implications for research methodology. While the aggregated results in the top two rows of tables 6 and 7 alone appear to support the home field advantage hypothesis, the more detailed results in these two tables appear to support the limited form of the global advantage hypothesis. These results suggest disaggregation by foreign nation of ownership in future research.

Our results also suggest that it is important to include a substantial number of different nations in the analyses. If we had only used European data in this study, our results may have supported the home field advantage hypothesis, since the nation with the global advantage would have been excluded. If we had only used data from a single home country, our results would have supported either the home field advantage, the global advantage, or the limited global advantage hypothesis, depending on which country we investigated. And if we had been able to expand our database to include additional home countries, we may have found global advantages for banks from additional countries as well.

Finally, our results support the future use of complete separate analyses of data from each home country. Estimating efficiency jointly or pooling the efficiency estimates from institutions in different countries may create problems of comparison because of significant differences in the environments of these countries.

Summary and Conclusions

In this paper, we address the causes and consequences of the cross-border consolidation of financial institutions and the implications of this consolidation for the integration of global financial markets. First, we extensively review several hundred research studies on the causes and consequences of consolidation. Second, we provide comparative data on financial systems in different nations, trends in cross-border financing by banks and other financial institutions, and trends in cross-border M&As of financial institutions. Third, we perform an original analysis of cross-border banking efficiency in France, Germany, Spain, the United Kingdom, and the United States during the 1990s. On average, we find that domestic banks in these countries have both higher cost efficiency and [End Page 105] higher profit efficiency than foreign banks operating in the country. This result is consistent with most of the findings in the extant literature, where it has been interpreted as supporting the home field advantage hypothesis. However, after disaggregating our results by foreign nation of origin, we find that the data appear to reject the home field advantage hypothesis in favor of the limited form of the global advantage hypothesis. The disaggregated results suggest that domestic banks may be more efficient than foreign banks from most foreign countries, may be about equally efficient with foreign banks from some foreign countries, but may be less efficient than foreign banks from one (the United States) of the foreign countries.

These results, should they continue to hold in the future, may have important implications for the structure of globalized financial markets, for financial institution policy, and for future research. First, the finding here and in the extant literature that foreign banks are less efficient on average than domestic banks suggests that efficiency considerations may limit the global consolidation of the financial services industry. Thus domestically based institutions would continue to play a large role in the provision of financial services. Second, our finding that some banking organizations can operate in foreign countries at or above the efficiency levels of domestic banks suggests that additional global consolidation of financial markets may be in the offing. Third, our finding that banking organizations from some countries, particularly the United States, are better able to operate efficiently across borders suggests that financial institutions from these countries may capture disproportionate shares of international financial services business in the future. Fourth, if future research finds that U.S. banks derive their apparent efficiency advantage from U.S. regulatory or supervisory conditions (for example, easy geographic mobility) rather than from U.S. market conditions (for example, a well-developed securities market), then one might predict cross-border efficiency gains from similar liberalizations in other nations, such as the Single Market Programme in the European Union. Finally, our results suggest that future empirical investigations in this area should include a substantial number of home countries and institutions from a substantial number of foreign nations. The results also suggest that researchers should disaggregate their analysis by foreign nation of ownership. These changes appear to be important for discerning between the home field advantage and the global advantage hypotheses. [End Page 106]

Because we base our conclusions on empirical results generated over a relatively short period of time, for a relatively short list of countries, and for a relatively small number of foreign banks, we make them cautiously and propose a number of important caveats. First, all five of the home countries we analyze are advanced economies; banks in many less-advanced economies may be less likely to have home field advantages. ¹⁷⁵ Similarly, the patterns of relative domestic versus foreign bank efficiency may be substantially different in important countries that we were not able to include in our analysis due to data limitations (for example, China, Japan, and Russia). Second, the pattern of home field and global advantages that we reveal in our tests is likely to change over time. For example, the introduction of a common European currency, the full implementation of laws allowing expanded powers for banks, and the continued trend of M&As away from domestic deals and toward cross-border deals could alter the balance of home field and global advantages. Third, while we focus on the performance of financial institutions that have acquired or established a physical presence in foreign countries, financial institutions can also provide cross-border financial services at a distance from their home-country headquarters. Financial institutions that excel in one of these cross-border delivery channels might not excel in the other, and in the future we may see institutions from different countries choosing different combinations of these channels, perhaps depending on whether they seek to provide retail services abroad. Fourth, because our tests employ accounting data for banks that are in most cases subsidiaries of larger banking organizations, our results may be capturing the effects of transfer pricing that shifts profits from an affiliate in one country to an affiliate in another country for tax, regulatory, or other reasons. However, our results contain several pieces of evidence that run counter to this argument. For example, we find that banks with the best domestic performance also perform well abroad and that banks with the weakest performance abroad also perform poorly at home, suggesting that the underlying efficiency advantages and disadvantages of these banks may overwhelm the effects of any tax or regulatory profit shifting. [End Page 107]

Appendix

The Structure of Credit Markets in Different Countries

This appendix provides a brief overview of regulatory changes, describes the structure of credit markets, and presents descriptive statistics for domestic and foreign banks in different nations. ¹⁷⁶

Regulatory Changes

Traditionally, financial service firms have been heavily regulated and protected from competition. As a result, credit markets in most countries have been highly fragmented and specialized on the basis of region, product line, or clientele. In the United States, the operations of credit unions, thrifts, commercial banks, securities firms, and insurance companies were kept separate, and banks were restricted to a single state. In Japan, separate entities provided commercial banking, securities, and insurance services. Banking services were highly segmented by both region and product line and were provided by major Japanese banks (city, long-term credit, and trust banks), regional banks, financial institutions for small business, government financial institutions, financial institutions for agriculture, forestry, and fisheries, and the post office. In France, universal banks belonging to the French Bankers Association were distinct from mutual banks, cooperative banks, and savings and provident banks with narrow business or regional focus and also were distinct from finance companies, securities houses, brokerage firms, and other specialized institutions. The German system contained large universal banks, regional banks (and their central giro organizations), private banks, savings banks (and their central [End Page 108] organizations), credit cooperatives, and specialized credit institutions like the postal system and building loan associations. In Italy, the operations of public law banks, private banks, cooperative banks, savings and pledge banks, rural banks, and special credit institutions (for example, industrial credit, real estate, agriculture, and fishery institutions) were separate. In Spain, regulation limited the competition among commercial and savings banks, as well as credit cooperatives. In Switzerland, a universal banking country, financial services were provided by large banks, cantonal and savings banks, rural banks, specialized credit institutions, and finance companies. In the United Kingdom, clearing banks, investment banks, and building societies served distinct markets.

In addition to functional and geographic separation of credit institutions, credit markets were often characterized by interest rate regulations, restrictions on the form and composition of the assets and liabilities of institutions, and barriers to entry and exit. In a number of countries, such as France, Germany, Italy, and Switzerland, the central and local governments were involved directly in the provision of financial services by fiat or through direct ownership of banks.

Over the past two decades, there has been considerable deregulation of the activities of credit institutions. In the United States, deposit interest rates were deregulated, the restrictions on interstate banking were mostly removed, thrift powers were expanded, and most of the Glass-Steagall restrictions on banking powers were recently removed. Since the 1980s, the lines separating various types of commercial banks in Japan have blurred, and competition has intensified, as interest rates were deregulated, rules governing security issues were liberalized, and the permissible range of products was expanded. The Japanese "Big Bang" reforms that began to be implemented in 1997, and still continue, will tear down the barriers separating commercial banks, securities firms, and insurance companies.

In Europe, the Single Market Programme effectively removed many of the cross-border restrictions on financial institutions. Individual nations also engaged in their own deregulation. During the late 1970s and early 1980s, legal changes in France encouraged the development of capital markets and the introduction of new financial products. The major changes introduced by the Banking Act of 1984 overhauled the banking markets and greatly diminished the distinctions among the different types of institutions. In Italy, a legal framework for investment funds was introduced in 1983, branching restrictions were relaxed in 1989, the Banking Law of [End Page 109] 1993 eliminated operational distinctions among credit institutions, and the Consolidated Law on Financial Intermediation of 1998 provided flexibility in the portfolio management activities of credit institutions. In Spain, a series of deregulations starting in the 1970s liberalized interest rates and branching, expanded the permissible activities of savings banks, removed operational differences between commercial and savings banks, removed restrictions on the activities of foreign banks, and (through changes in the tax laws) provided the framework for the development of investment funds. In the United Kingdom, credit and exchange controls were removed during the 1970s and 1980s, permissible activities of building societies were expanded during the 1980s and 1990s, and securities markets were deregulated with the "Big Bang" in 1986.

The Structure of Credit Markets

Tables A-1 and A-2 show market structure in the Group of Ten countries. Owing to historical restrictions on branching and unit banking laws, the U.S. banking market appears to be more fragmented than markets in other nations. In 1997 the United States had the largest number of credit institutions (22,331) and the smallest number of inhabitants per institution (11,997).

Among commercial banks, the number of institutions and branches varies across countries (tables A-3 through A-9). In France, Spain, and the United States, the number of banks and their branches exceeds the number of other institutions. In France, financial companies and commercial banks accounted for 53.4 and 29.7 percent, respectively, of all credit institutions in 1998. In Spain, commercial banks account for the majority of institutions and branches. Similarly, in the United States, insured commercial banks outnumber insured savings institutions, credit unions, and other banks. In contrast, in Germany, Italy, and Japan, commercial banks and their offices represent a small fraction of the total banking markets. In Germany, commercial banks account for 9.5 percent of the total number of institutions and 11.4 percent of the total number of branch offices; credit cooperatives and their central institutions, savings banks, regional giro institutions, and special credit institutions account for the remainder. Similarly, in Italy, limited company banks and foreign banks account for 29.6 percent of the total number of institutions, while cooperatives and mutual banks constitute the bulk of the remainder of institutions. In Japan, [End Page 110] [Begin Page 113] special-purpose financial institutions (for financing small businesses, agriculture, and fisheries) account for the majority of institutions and branches; Japanese commercial banks account for only 6.7 percent of the total number of institutions and 19.2 percent of the branches. However, in all markets, commercial banks have the largest market shares in terms of assets.

Banks in Belgium, France, the Netherlands, and the United Kingdom appear to have the most branches per institution. The smaller number of branches per institution in Italy and the United States is a remnant of historical restrictions on branching. In fact, since the 1989 deregulation of limits on branching, Italy has seen a 24 percent increase in the number of branches. Similarly, while the number of branches of U.S. institutions declined significantly over the 1990-93 period, there has been a slight increase in more recent years.

The number of institutions and their branches declined overall in the 1990s, with a corresponding increase in the number of inhabitants per institution and per branch (tables A-1 and A-2). ¹⁷⁷ France, Germany, Japan, and the United States experienced the largest declines in the number of institutions in percentage terms, on the order of 25 to 35 percent. In most countries, the majority of restructuring occurred among small institutions. The number of German and Japanese institutions declined primarily among cooperative and rural banks. In the United Kingdom, most of the restructuring occurred as a result of M&A activity among domestic banks, primarily smaller institutions. ¹⁷⁸ Similarly, of the forty-four exits from the Italian banking market that occurred in 1997, thirty-two involved mutual and cooperative banks. ¹⁷⁹

The share of total banking assets held by the five largest institutions has increased in all major countries except Norway. Canada, Finland, Portugal, [End Page 113] and Sweden have experienced the largest increases in market concentration, while concentration ratios have been more stable in France, Japan, and Switzerland. Overall, concentration ratios in Germany, Italy, the United Kingdom, and the United States are lower than in other countries. Although national markets within continental Europe are fairly concentrated, the shares held by the top five institutions in continental Europe as a whole are relatively small (about 12 percent, not shown in tables). ¹⁸⁰ It [End Page 114] [Begin Page 118] has been argued that the potential impact of market integration and deregulation on the EU-wide concentration ratio is likely to be influenced by the extent to which competition is based on fixed or variable costs. ¹⁸¹

Activities of Domestic and Foreign Banks

In recent years, the share of banking assets held by foreign banks has increased in most countries. In addition to providing more competition, the presence of foreign banks can alter the types of services provided by banking organizations in individual markets. For instance, entry by foreign banks that focus more on investment banking services might provide additional services to corporate customers. The data from France, Germany, Spain, the United Kingdom, and the United States reveal three interesting patterns in the operations of foreign banks (tables A-10 through A-14):

--In each banking market, there are significant differences in the operations and profitability of foreign versus domestic banks.

--In each country, there are significant differences in the business focus and profitability of banks from different foreign nations.

--Banks headquartered in a single nation vary their business focus across foreign markets. ¹⁸² [End Page 118]

Except for the United States, foreign banks are smaller than domestic banks in every nation. ¹⁸³ With the exception of banks in Spain, foreign banks invest a greater fraction of their assets in securities and have lower ratios of loans to total assets than domestic banks. In France and Germany, foreign banks finance a similar fraction of their assets with deposits as do domestic banks. Foreign banks in Spain are more reliant on deposits than domestic banks, while foreign banks in the United Kingdom and the United States have a lower ratio of total deposits to total assets. In most countries, domestic banks have more retail deposits (demand, time, and savings) than foreign banks, where retail deposits rely more heavily on "other deposits" that are composed mostly of interbank deposits. Furthermore, in most countries, foreign banks have lower net interest income than domestic banks. The lower concentration of assets in loans, greater use of interbank deposits, and lower levels of interest income for foreign banks suggest that foreign banks focus less on traditional banking intermediation and more on other banking services than domestic banks. The data also suggest that domestic banks are generally more profitable than foreign banks. This simple comparison of accounting profitability is consistent with our evidence on profit X-efficiency.

Among foreign banks of different origin, there are significant differences in the operations of U.S., European, and Japanese banks in each market. For instance, in France and Germany, foreign banks from other European countries appear to focus more on traditional intermediation than U.S. banks. European banks have higher ratios of loans to total assets and deposits to total assets (particularly, demand deposits) than U.S. banks. In addition, U.S. banks earn more commission income per unit of assets than European banks in France, Spain, and the United Kingdom. Japanese banks are less profitable, with the exception of Germany, and focus more on security investments than their U.S. and European counterparts. These patterns suggest that foreign banks in any given country are [End Page 119] not homogeneous and that treating them as a group, as is often done in the research literature, can obscure important differences.

The data also suggest that banks headquartered in a single nation vary their business focus across foreign markets. For instance, U.S. banks operating in France, Germany, and the United Kingdom invest a greater fraction of their assets in securities and finance a lower fraction of their assets through deposits than U.S. banks operating in Spain. The extent to which U.S. banks invest in equity securities also varies from market to market, ranging from 0.38 percent of total assets in Germany to nearly 4 percent in the United Kingdom. Similarly, European foreign banks operating in France and Germany appear to focus more on traditional banking (loans, retail deposits) than European banks in Spain, the United Kingdom, and the United States. These results suggest that banks from the same country alter their business focus across the foreign markets in which they operate.

Notes

The authors thank Bob McCormack and Raghu Rajan for their insightful comments; Charles Calomiris, Ed Ettin, Bob Litan, Tony Santomero, and other participants at the Brookings-Wharton conference for their clarifying remarks; Emilia Bonaccorsi, Nicola Cetorelli, Gayle DeLong, Michel Dietsch, Carmine Di Noia, Larry Goldberg, Iftekhar Hasan, Ana Lozano-Vivas, Loretta Mester, Laurence Meyer, Stewart Miller, Phil Molyneux, Darren Pain, Darrel W. Parke, José Pastor, Linda Powell, Rudi Vander Vennet, Ingo Walter, and Juergen Weigand for invaluable help with the preparation of this article; and Kelly Bryant, Portia Jackson, Rita Molloy, and Ozlen Savkar for outstanding research assistance.

1. Berger, Demsetz, and Strahan (1999).

2. World Bank (1999).

3. All data in this paragraph are from Bank for International Settlements (1999) and are stated in terms of 1982 dollars for purposes of comparisons.

4. Benink (1993); Molyneux, Altunbas, and Gardener (1996).

5. These figures were constructed from Securities Data Company's database Worldwide Mergers and Acquisitions, which records all public and private corporate transactions valued at $1 million or more that involved at least 5 percent of the ownership of a company. These s will not exactly match those reported in other sources. For example, small banks are seldom publicly traded, most securities firms are partnerships, and many insurance firms are mutually owned by policyholders. Although this is an incomplete reckoning of all M&As, it does capture the majority of total M&A value.

6. About three-quarters of the value of the intra-EU acquisitions shown in figure 2was generated by "truly" domestic M&As (that is, both target firm and acquiring firm were from the same EU member nation), indicative of domestic market consolidation similar to, but occurring later than, the domestic consolidation in the United States. However, the truly domestic M&As have declined as a fraction of total EU merger activity since the mid-1990s.

7. Hunter and Timme (1986); Berger, Hanweck, and Humphrey (1987); Ferrier and Lovell (1990); Hunter, Timme, and Yang (1990); Noulas, Miller, and Ray (1990); Berger and Humphrey (1991); Mester (1992b); Bauer, Berger, and Humphrey (1993); Clark (1996).

8. For securities firms, see Goldberg, Hanweek, Keenan, and Young (1991). For insurance companies, see Grace and Timme (1992); Yuengert (1993); Gardner and Grace (1993); Hanweck and Hogan (1996); Rai (1996); Toivanen (1997); McIntosh (1998); Cummins and Zi (1998). It is also sometimes argued that scale efficiency gains from consolidation will be most prevalent when the combining institutions have substantial local market overlap, allowing for the closing of retail branch offices and consolidation of back-office operations. However, studies of the scale efficiency effects of bank in-market M&As and research on scale efficiency of branch offices suggest little or no gain from this source. See Berger and Humphrey (1992b); Rhoades (1993); Akhavein, Berger, and Humphrey (1997); Berger, Leusner, and Mingo (1997); Berger (1998).

9. Altunbas, Molyneux, and Thornton (1997).

10. Unlike conventional private placements, 144A private placements can be traded and underwritten on a firm commitment basis. A "bought deal" occurs when an investment bank makes a firm commitment, underwriting before syndicating the risk.

11. Radecki, Wenninger, and Orlow (1997).

12. Bauer and Hancock (1993, 1995); Bauer and Ferrier (1996); Hancock, Humphrey, and Wilcox (1999).

13. Berger and Mester (1997).

14. Kellner and Mathewson (1983); Berger, Hanweck, and Humphrey (1987); Mester (1987, 1993); Hunter, Timme, and Yang (1990); Berger and Humphrey (1991); Goldberg, Hanweck, Keenan, and Young (1991); Grace and Timme (1992); Ferrier, Grosskopf, Hayes, and Yaisawarng (1993); Hanweck and Hogan (1996); Noulas, Miller, and Ray (1993); Pulley and Humphrey (1993); Rai (1996); Toivanen (1997); Meador, Ryan, and Schellhorn (1998); Berger, Cummins, Weiss, and Zi (1999).

15. Greenbaum, Kanatas, and Venezia (1989); Rajan (1996).

16. Gande, Puri, Saunders, and Walter (1997).

17. Winton (1999).

18. Boot and Thakor (1996).

19. Allen and Rai (1996); Vander Vennet (1999); Lang and Welzel (1998), respectively.

20. Goldberg and Saunders (1981); Budzeika (1991); Grosse and Goldberg (1991); Seth and Quijano (1993); Terrell (1993).

21. Goldberg and Grosse (1994).

22. Rajan (1996).

23. See, for example, Ang and Richardson (1994); Kroszner and Rajan (1994, 1997); Puri (1994, 1996); Gande, Puri, Saunders, and Walter (1997); Gande, Puri, and Saunders (1999).

24. Berger, Hancock, and Humphrey (1993); Berger, Humphrey, and Pulley (1996); DeYoung and Nolle (1996); Berger and Mester (1997); Clark and Siems (1997); Berger, Cummins, Weiss, and Zi (1999); the paper by Cummins and Weiss in this volume;

25. Berger, Humphrey, and Pulley (1996); Berger, Cummins, Weiss, and Zi (1999).

26. Berger, Hancock, and Humphrey (1993); Berger, Cummins, Weiss, and Zi (1999).

27. Vander Vennet (1999).

28. Of course, some combinations of financial institutions can worsen risk-expected return trade-offs. For example, a commercial bank may be more likely to fail or have higher

bankruptcy costs in the event of failure if it is combined with another type of financial institution with lower expected return or higher variance of returns that are highly correlated with those of the bank.

29. For example, Diamond (1984, 1991); Boyd and Prescott (1986); Boot and Thakor (1997).

30. Consistent with this, Sullivan and Spong (1998) find evidence that owner-managers of small banks who have a substantial portion of their wealth invested in their banks tend to pursue safer strategies.

31. For example, Merton (1977); Marcus (1984); Keeley (1990).

32. For example, Hughes, Lang, Mester, and Moon (1996, 1997); Hughes and Mester (1998).

33. For example, McAllister and McManus (1993); Hughes, Lang, Mester, and Moon (1996, 1997, 1999); Hughes and Mester (1998); Demsetz and Strahan (1997).

34. For example, the paper by Cummins and Weiss in this volume.

35. Kwast (1989); Rosen, Lloyd-Davies, Kwast, and Humphrey (1989); Boyd, Graham, and Hewitt (1993).

36. Saunders and Walter (1994).

37. For the United Kingdom, see Llewellyn (1996). For the United States, see Kwan (1998). Institutions may also achieve risk diversification through cross-border lending or investments, or through a secondary market in financial instruments. They may buy loans, nonasset-backed or original or primary securities, or asset-backed securities issued in other countries, or they may engage in derivatives contracts with foreign institutions.

38. M&As that diversify the institution may also improve X-efficiency in the long term through expanding the skill set of managers (Milbourn, Boot, and Thakor 1999).

39. Some efficiency analyses using linear programming techniques such as data envelopment analysis do not use prices and so do not calculate costs or profits. Instead of using cost or profit X-efficiency, they focus on minimizing inputs for given outputs or maximizing outputs for given inputs, but the concepts are similar.

40. Berger and Humphrey (1997), pp. 185, 201.

41. Savage (1991); Shaffer (1993).

42. Berger and Humphrey (1992b); Altunbas, Maude, and Molyneux (1995); Focarelli, Panetta, and Salleo (1998); Pilloff and Santomero (1998); Rhoades (1998); Vander Vennet (1998); Cummins, Tennyson, and Weiss (1999); Fried, Lovell, and Yaisawarng (1999); the paper by Cummins and Weiss in this volume.

43. Benston, Hunter, and Wall (1995).

44. Berger and Humphrey (1992b); Rhoades (1993); DeYoung (1997); Peristiani (1997).

45. Berger (1998); Rhoades (1998); Cummins, Tennyson, and Weiss (1999); Fried, Lovell, and Yaisawarng (1999).

46. Vander Vennet (1996, 1998).

47. For Italy, see Resti (1998). For the United Kingdom, see Haynes and Thompson (1999).

48. Akhavein, Berger, and Humphrey (1997); Berger (1998).

49. Fixler and Zieschang (1993); Berger and Mester (1999); Hughes, Lang, Mester, and Moon (1999).

50. Hannan and Wolken (1989); Cornett and Tehranian (1992); Houston and Ryngaert (1994, 1996, 1997); Zhang (1995); Pilloff (1996); Siems (1996).

51. DeLong (1999).

52. Peek, Rosengren, and Kasirye (1999).

53. Cybo-Ottone and Murgia (1998).

54. van Beek and Rad (1997).

55. Berg, Forsund, Hjalmarsson, and Suominen (1993).

56. For example, Fecher and Pestieau (1993); Bergendahl (1995); Bukh, Berg, and Forsund (1995); Allen and Rai (1996); Ruthenberg and Elias (1996); Economic Research Europe (1997); Pastor, Pérez, and Quesada (1997); Bikker (1999); Maudos, Pastor, Pérez, and Quesada (1999a); Wagenvoort and Schure (1999).

57. Pastor, Lozano-Vivas, and Pastor (1997); Maudos, Pastor, Pérez, and Quesada (1999b); Pastor (1999); Pastor, Lozano-Vivas, and Hasan (1999); Dietsch and Lozano-Vivas (2000).

58. Pastor, Lozano-Vivas, and Hasan (1999), p. 7.

59. For cost efficiency, see Hasan and Hunter (1996); Mahajan, Rangan, and Zardkoohi (1996); Chang, Hasan, and Hunter (1998). For profit efficiency, see DeYoung and Nolle (1996).

60. Vander Vennet (1996); Hasan and Lozano-Vivas (1998); Bhattacharyya, Lovell, and Sahay (1997).

61. Miller and Parkhe (1999), p. 22; Parkhe and Miller (1999), p. 25.

62. For example, Hunter and Timme (1991); Berger and Humphrey (1992a); Bauer, Berger, and Humphrey (1993); Humphrey (1993); Elyasiani and Mehdian (1995); Devaney and Weber (1996); Wheelock and Wilson (1996); Humphrey and Pulley (1997); Alam (1998); Berger and Mester (1999).

63. Consistent with this conclusion, one study finds a positive external effect of consolidation following interstate banking deregulation. Out-of-state entry is associated with increased cost X-efficiency in the long term (DeYoung, Hasan, and Kirchhoff 1998).

64. Berger and Mester (1999).

65. For Norway, see Berg, Forsund, and Jansen (1992). For Turkey, see Zaim (1995). For Spain, see Lozano-Vivas (1998); Grifell-Tatje and Lovell (1996); Hasan, Hunter, and Lozano-Vivas (2000).

66. Dietsch, Ferrier, and Weill (1998).

67. Kwast, Starr-McCluer, and Wolken (1997).

68. Akhavein, Berger, and Humphrey (1997); Sapienza (1998); Simons and Stavins (1998); Prager and Hannan (1999).

69. For example, Berger and Hannan (1989, 1997); Hannan (1991, 1994); Hannan and Berger (1991), Neumark and Sharpe (1992); Jackson (1997).

70. Hannan (1997); Cyrnak and Hannan (1998); Radecki (1998).

71. Radecki (1998).

72. Hannan (1998).

73. Mester (1987, 1992a); Pilloff (1999).

74. Commission of the European Communities (1988a, 1988b).

75. Molyneux, Altunbas, and Gardner (1996).

76. De Bandt and Davis (1998).

77. Economic Research Europe (1997).

78. Molyneux, Lloyd-Williams, and Thornton (1994).

79. Bikker and Groeneveld (1998).

80. Cerasi, Chizzolini, and Ivaldi (1998).

81. Shaffer (1999).

82. "1998 Underwriting League Tables," Investment Dealers Digest, October 11, 1999, pp. 18, 30.

83. Hayes, Spence, and Van Praag Marks (1983); Pugel and White (1985).

84. Chen and Ritter (2000), p. 24.

85. Lee, Lochhead, Ritter, and Zhao (1996).

86. Chen and Ritter (2000).

87. "1998 Underwriting League Tables," Investment Dealers Digest, October 11, 1999, pp. 18, 30.

88. For example, Beatty, Thompson, and Vetsuypens (1998); Gande, Puri, and Saunders (1999).

89. Rajan (1994, 1996).

90. Allen and Cebenoyan (1991); Subrahmanyam, Rangan, and Rosenstein (1997); Cornett, Hovakimian, Palia, and Tehranian (1998).

91. Bliss and Rosen (1999).

92. For example, Murphy (1985); Jensen and Murphy (1990).

93. For corporate finance, see Jensen and Murphy (1990); Hall and Liebman (1998). For banking, see Barro and Barro (1990); Hubbard and Palia (1995).

94. Bliss and Rosen (1999).

95. Crawford, Ezzell, and Miles (1995); Hubbard and Palia (1995); Houston and James (1995); Demsetz and Saidenberg (1999).

96. For example, Hannan and Mavinga (1980); Smirlock and Marshall (1983); James (1984); Brickley and James (1987); Mester (1989, 1991).

97. Roll (1986).

98. For example, Amihud and Lev (1981); Morck, Shleifer, and Vishny (1990); May (1995).

99. Saunders, Strock, and Travlos (1990).

100. Gorton and Rosen (1995).

101. Hadlock, Houston, and Ryngaert (1999).

102. Prowse (1997).

103. Demsetz, Saidenberg, and Strahan (1997).

104. Berger and Hannan (1998).

105. For example, Berger (1995); Maudos (1996); Berger and Hannan (1997); Berger, Bonime, Covitz, and Hancock (2000).

106. Schranz (1993); Hubbard and Palia (1995); Jayaratne and Strahan (1996, 1998).

107. Giddy, Saunders, and Walter (1996); White (1998).

108. Lannoo and Gros (1998).

109. Boot (1999).

110. Kroszner (1999).

111. Kane (1999a).

112. Berger, Kashyap, and Scalise (1995); Jayaratne and Strahan (1998).

113. Gande, Puri, and Saunders (1999); Saunders (1999).

114. Regarding restrictions on nationwide interstate banking, the Riegle-Neal Act caps the total bank and thrift deposits that any organization may reach by M&A to 30 percent in a single state and 10 percent nationally.

115. The effects of monetary union on financial institutions and capital markets have been examined extensively elsewhere. See, for example, Dermine (1999a, 1999b, 1999c, 2000); De Bandt (1999); De Bandt and Davis (1998); Morgan Stanley Dean Witter (1998); McCauley and White (1997); White (1998); Dermine and Hillion (1999); European Central Bank (1999); Hurst and Wagenvoort (1999); Merrill Lynch (1999).

116. Kane (1999b); Saunders and Wilson (1999).

117. For example, Kwast and Passmore (2000); Whalen (2000).

118. Boyd, Chang, and Smith (1998).

119. Dermine (1999b).

120. Dermine (1999b); Wihlborg (1999).

121. Williamson (1967, 1988).

122. Research evidence supports the notion that banks use relationships to garner information about small businesses and that small businesses benefit from these relationships. U.S. small businesses with stronger banking relationships generally have been found to receive loans with lower rates and fewer collateral requirements, to be less dependent on trade credit, to enjoy greater credit availability, and to have more protection against the interest rate cycle than other small businesses. See, for example, Lang and Nakamura (1989); Hoshi, Kashyap, and Scharfstein (1990); Petersen and Rajan (1994, 1995); Berger and Udell (1995); Blackwell and Winters (1997); Angelini, Di Salvo, and Ferri (1998); Berlin and Mester (1998); Cole (1998); Elsas and Krahnen (1998); Harhoff and Körting (1998); Hubbard, Kuttner, and Palia (1999); Ongena and Smith (1999). The data also suggest that banks gather valuable private information from depositors and in some cases use this information in credit decisions. See Allen, Saunders, and Udell (1991); Nakamura (1993); Frieder and Sherrill (1997); Mester, Nakamura, and Renault (1998). For a detailed review of the relationship literature, see Berger and Udell (1998).

123. For example, Berger, Kashyap, and Scalise (1995); Keeton (1995); Levonian and Soller (1996); Berger and Udell (1996); Peek and Rosengren (1996); Strahan and Weston (1996); Berger, Saunders, and Udell (1998).

124. Berger and Udell (1996), p. 622.

125. Cole, Goldberg, and White (1999).

126. Haynes, Ou, and Berney (1999).

127. Hancock and Wilcox (1998), pp. 996, 997, 1006.

128. Houston, James, and Marcus (1997); Houston and James (1998).

129. Keeton (1995), Berger and Udell (1996), Berger, Saunders, and Udell (1998), and Berger, Bonime, Goldberg, and White (1999) find a negative effect from out-of-state ownership. Whalen (1995) finds no effect. Berger, Saunders, and Udell (1998) find a temporary offsetting boost from recent acquisitions.

130. Berger and Udell (1996); Berger, Bonime, Goldberg, and White (1999); DeYoung, Goldberg, and White (1999).

131. For example, Berger and Udell (1996); Berger, Saunders, and Udell (1998); Berger, Bonime, Goldberg, and White (1999).

132. For example, Keeton (1996, 1997); Peek and Rosengren (1996, 1998); Strahan and Weston (1996, 1998); Craig and Santos (1997); Kolari and Zardkoohi (1997a, 1997b); Zardkoohi and Kolari (1997); Walraven (1997); Berger, Saunders, and Udell (1998).

133. Berger, Saunders, and Udell (1998).

134. Berger, Bonime, Goldberg, and White (1999).

135. Goldberg and White (1998); DeYoung (1998); Berger, Bonime, Goldberg, and White (1999); DeYoung, Goldberg, and White (1999).

136. Berger, Bonime, Goldberg, and White (1999) find an increased probability, while Seelig and Critchfield (1999) find a decreased probability.

137. Cole and Walraven (1998).

138. Scott and Dunkelberg (1999).

139. Jayaratne and Wolken (1999).

140. Avery, Bostic, Calem, and Canner (1999).

141. Economides (1993, 1996).

142. Di Noia (1999, 2000).

143. European Central Bank (1999); Steinherr (1999).

144. Dermine (1999c); Di Noia (1999, 2000); Steinherr (1999).

145. See the paper by Cybo-Ottone, Di Noia, and Murgia in this volume.

146. Berger and Udell (1998).

147. Tables 2 and 3 give only a rough indication of this trade-off. Specifically, in table 2 the size of the stock market itself is not as important as the ownership of stock. In addition, it does not account for double counting such as in Germany and Japan where banks own a significant fraction of stocks. The ideal would be a breakdown of external finance (both private and public debt and equity) in terms of whether they are passively or actively owned. This would take into account the strong individual ownership of equity in the United States and the proxy ownership of equity in Germany by banks. Data limitations, however, prevent such an analysis. The closest to this type of breakdown is a study that estimates this just for the equity side (Prowse 1995). According to that study, the United Kingdom is similar to the United States in being skewed toward individually owned and passively owned equity.

148. Prowse (1995).

149. Udell and Wachtel (1995).

150. Allen and Gale (1997).

151. Bisignano (1991); Bowen, Hoggarth, and Pain (1999).

152. According to the Securities Data Company.

153. Rajan and Zingales (1995).

154. Rivaud-Danset, Dubocage, and Salais (1998); Delbreil, Cano, Friderichs, Gress, Paranque, Partsch, and Varetto (1998).

155. Schmidt, Hackethal, and Tyrell (1999).

156. Allen and Santomero (1998).

157. Otten and Schweitzer (1999); European Central Bank (1999).

158. See Kashyap and Stein (1997a) for a more detailed summary of the bank lending view and a survey of the empirical literature.

159. Bernanke and Blinder (1988).

160. Under an alternative credit channel mechanism--the "balance sheet channel" or "financial accelerator"--the tightening of monetary policy works in part because the associated higher interest rates impair collateral values or otherwise reduce the net worth of certain borrowers, diminishing their ability to obtain funds. This channel differs from the bank lending channel in that it implies a reduction in the demand for credit, rather than a reduction in the supply of credit in response to monetary policy tightening (Bernanke and Gertler 1995; Bernanke, Gertler, and Gilchrist 1996).

161. Kashyap and Stein (1995, 1997a, 1997b); Gibson (1996)

162. Kashyap and Stein (1997a).

163. Kashyap and Stein (1997a).

164. Kashyap, Stein, and Wilcox (1993, 1996).

165. Calomiris, Himmelberg, and Wachtel (1995).

166. Alan Greenspan, "Lessons from the Global Crises," speech to the World Bank Group and the International Monetary Fund, September 27, 1999.

167. Carey, Prowse, Rea, and Udell (1993).

168. McAllister and McManus (1993); Mitchell and Onvural (1996); Berger, Cummins, and Weiss (1997); Berger and DeYoung (1997); Berger, Leusner, and Mingo (1997).

169. Berger and Mester (1997). Alternative profit efficiency generally yields similar findings to standard profit efficiency, which specifies output prices rather than quantities in the profit function (Berger and Mester 1997). Standard profit efficiency is more problematic to estimate because output prices have to be approximated by balance sheet and income statement ratios. In addition, by controlling for output prices, standard profit efficiency may not account as well for advantages that cross-regional organizations may have in terms of risk diversification and enhanced quality or variety of services.

170. Berger and DeYoung (1997).

171. Berger (1993).

172. Our findings for the United States differ notably from prior efficiency studies of foreign banks in the United States. A number of studies using 1980s data find relatively low cost efficiency or relatively low profit efficiency for foreign banks operating in the United States. Our results suggest that foreign-owned banks in the United States have improved their cost efficiency over the past decade, but that their profit efficiency has continued to lag, possibly due in part to turnover of these institutions. Since the 1980s, foreign banks from some countries (for example, Japan) have reduced their U.S. presence, while foreign banks from other countries (for example, the Netherlands) have increased their U.S. presence. Thus, while domestic U.S. banks appear to continue to be more efficient than foreign-owned banks, the underlying characteristics of this difference may have changed.

173. Berger and DeYoung (2000).

174. This result may be stronger than it at first appears, because the extra operational cost of a multibank holding company (a required organizational structure for interstate banks during most of our sample period) biases against finding cross-regional efficiency.

175. Claessens, Demirgüc-Kunt, and Huizinga (2000) find that foreign banks outperform domestic banks in less-developed economies.

176. Other studies provide more detailed descriptions of credit markets in these and other countries. Berger, Kashyap, and Scalise (1995) discuss the U.S. market. Beduc, Ducruezet, and Stephanopoli (1992), de Boissieu (1993), Matherat and Cayssials (1999), and Pfister and Grunspan (1999) discuss the French market. Bauer and Domanski (1999) and Pozdena and Alexander (1992) cover the German system. Bruni (1993), Fazio (1999a, 1999b), and Szego and Szego (1992) discuss the Italian system. Cargill and Royama (1992), Genay (1998), Hoshi and Kashyap (2000), and Toyama (1999) cover the Japanese market. Caminal, Gual, and Vives (1993), Pastor (1993), and Fuentes and Sastre (1999) discuss the Spanish market. Birchler and Rich (1992) and Braun, Egli, Fischer, Rime, and Walter (1999) discuss the Swiss market. Bowen, Hoggarth, and Pain (1999) and Llewellyn (1992) discuss the U.K. market.

177. In some countries, such as France and Italy, the restructuring also involved significant decreases in the role of the state in the banking industry. For instance, in France, the number of public institutions declined from ninety-two in 1984 to twenty-three in 1997 (Matherat and Cayssials 1999, p. 171). In Italy, the share of total banking assets held by banks in which the state has a majority control declined from 68 percent in 1992 to 20 percent in 1998 (Fazio 1999a, p. 9).

178. Another notable development in the U.K. markets has been the demutualization of building societies and the conversion of these societies into banks. Also, while the number of domestic institutions declined over 1990-97, the number of foreign banks operating in the United Kingdom increased significantly (Bowen, Hoggarth, and Pain 1999).

179. Bank of Italy (1998), p. 318.

180. De Bandt (1999).

181. Gual (1999).

182. The samples used to construct tables A-10 through A-14 differ from the samples used in our analysis in the paper. Although the data were obtained from the same raw databases, the samples used in the tables were filtered in the following fashion. To remove the impact of mergers, we excluded bank-year observations for which the annual growth in inflation-adjusted assets was more than 50 percent in absolute value. We also excluded banks that reported negative values of book-value capital and banks in the lower and higher 1 percent of the distributions of return on assets and return on equity to remove the influence of these outliers on the mean values.

183. The large size of foreign banks relative to domestic banks in the United States may be due to our sampling methodology. Our definition of large banks in the United States (assets greater than $100 million) is small by international standards.

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