A surprising number of bankers seem to believe there is some asset size their organization must attain to maximize earnings, remain independent, or both.

The interesting thing to me is that their views of the optimal size vary widely, depending on the current size of the organization.

If a bank currently has $10 billion of assets, for example, it probably believes or has been told by a consultant or investment banker that it needs to grow to $15 billion or $20 billion. If the bank is currently $15 billion in size, it has probably been told it needs to be $25 billion or $30 billion.

It's probably true that the bigger a bank, the fewer potential acquirers exist. For example, a $50 billion bank has considerably fewer potential acquirers than a $5 billion bank.

Pros and Cons

But is that good or bad? If you believe creating wealth for your shareholders is your most important responsibility, having fewer sale options could well be a negative.

Focusing excessively on asset size could be detrimental in other ways. It could cause you to pay too much for acquisitions or to pursue high-risk business at profit margins that are inadequate to compensate for the risks being taken.

The larger an organization and the more rapid its growth, the higher are the odds that management will lose control over both asset quality and the quality of customer service.

Deciding the optimal size and strategy for a banking organization requires a clear understanding of the objectives of the enterprise. Many believe there is only one proper objective: to maximize return to shareholders. But how does one accomplish that objective, and over what time frame is it to be measured?

For example, if your bank has average or above-average earnings and a larger bank offers a stock swap at a 40% premium to market, should you accept?

Important Questions

Many would conclude the answer is clearly yes. I believe the answer is neither as clear nor as simple as that, even if your only objective is to maximize shareholder value.

I would need to know the answers to questions such as: What is your bank's earnings outlook? How much confidence do you have in your management team and its business plans? How do they stack up against those of the potential acquirer?

How much risk is there in the potential acquirer's stock? What is its earnings outlook, and what is its track record on acquisitions? Will your shareholders likely cash in the acquirer's stock, or will they likely hold it for the longer term? Could you do better for the shareholders selling at a later date?

I don't believe there are always simple or clear answers, even if maximizing shareholder value is the only objective.

Wider Responsibilities

Moreover, I believe shareholders are but one of several constituencies of a bank. Granted they are the most important constituency, but they are not the only one.

What duty of loyalty do you owe your employees? If a transaction might increase the return to your shareholders by two percentage points per year but would cost one-third of your employees their jobs, should you forge ahead with the deal?

Where do your customers fit in the equation? What if the proposed deal would diminish competition and result in lower quality services, less attractive pricing, or both?

What duty do you owe to your community? What if the deal would leave the community without a locally controlled bank of size, would result in the loss of many high-paying jobs at the headquarters, and would diminish the bank's role in civic and charitable activities?

Many Businesses

One reason I have difficulty equating size with success in banking is that banking today is a multiplicity of very different businesses under one roof

One business, for example, is the credit-card business. It involves high fixed costs and low variable costs and is clearly volume driven. The same can be said for mortgage servicing.

Middle-market lending tends to be low on fixed costs and high on variable costs. Volume, or economy of scale, is not nearly as important to profitability in middle-market lending as it is to the credit-card or mortgage-servicing businesses.

Careful Analysis Needed

So there is no single formula to determine an optimal size for a given bank. The determination requires an analysis of the individual businesses in which the bank is engaged.

The analysis might indicate that extra volume would benefit some of them but make it harder for others to provide high-quality, personalized service on which customer loyalty can be built and for which premium prices can be charged.

Is bigger better in banking? It depends.

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