Recent megamergers have returned antitrust policy to the fore in banking.

In the 1980s, banks focused on mergers that extended their markets geographically, as interstate barriers fell. The focus in the 1990s is on in-market combinations to reduce costs and solidify franchises.

Such combinations raise the red flag of market concentration.

In deciding whether an in-market combination should be permitted, the Federal Reserve Board and the Justice Department are required to consider the impact on competition.

In some recent cases, including BankAmerica-Security Pacific and Society-Ameritrust-the Justice Department required significant divestitures.

On competitive grounds, the Fed even denied Norwest's application to acquire First Federal Savings Bank of South Dakota.-

Many merger applications will raise no problems. For those that do, however, the best defense is a good offense.

To avoid delays, denials, or unattractive divestitures, the merging banks must be able to show that they will face enough competition in the near term to limit their market power.

Effective preparation of an application must include thoughtful economic analysis of the likely competitive effects of the transaction, including studies of:

* The product market

* The geographic market.

* Existing and potential competition.

Traditionally, banks have provided transaction capabilities, savings vehicles, financing, and fiduciary and safekeeping activities.

In earlier years, banks were viewed as offering a "cluster of services." Competition was limited, in analysis and in reality, to other providers of the same cluster.

But a number of trends have eroded bank franchises and subjected them to a broader range of competitors.

On one product or another, U.S. banks may be competing with any of a long list of financial-services providers.

Product-Specific Competition

In this environment, "cluster of services" has become a less persuasive concept in competitive analysis. Product-specific competition has become key.

Therefore, the first step in competitive analysis of a proposed merger is to describe the products offered and see where the banks overlap.

The focus should be on the products on which there is relatively little competition.

In most cases this means small-business loans, since this is the area in which banks traditionally have faced the least competition.

But competition for these loans is growing all the time. The key to showing its strength is to demonstrate the range of sources traditionally supplying small-business credit in the market as well as the innovative ways that businesses are funding themselves.

Drawing boundaries

The geographic market in which a bank competes for customers varies by product. For example, large corporations can access financial services providers worldwide; small businesses are typically limited to more local sources.

In concept, the geographic market is the area within which all providers of the same type of product are subject to the same customer demands.

In economic theory, markets are defined as areas that react in the same way to the same influences. For a market to be competitive, there must be a free flow of information, products, and services, and entry and exit should be easy. Also, there must be enough players to preclude any firm or group of firms from maintaining prices above competitive levels.

Blurred Lines

In practice, delineating a geographic market is not straightforward. Even for a given product, the boundaries between adjacent markets are blurred.

Defining the geographic market involves looking not only at where customers currently obtain services, but also at where they might if prices rose.

For example, assume that a small ($10 million in sales) company in western New York state needs to borrow money.

Clearly the banks in its immediate town are potential lenders.

But what if they won't make the loan, or if the rate is too high? In such cases, the borrower would probably go to banks in surrounding towns and cities. However, the search probably would not go as far as New York City. So the market boundary lies somewhere between the local town and New York City.

The question for competitive analysis is "where?"

Realistic Approximations

The answer is derived from experience. Some information about actual choices is readily available. Population densities, commuting patterns, newspaper distribution routes, public transportation routes, and toll-free telephone areas give a good indications of local market boundaries.

Other information must be developed, especially information useful for predicting responses to price increases. Ways to develop it might include monitoring advertisements and surveying actual and potential customers and competitors.

Thus, though there is no clear-cut method for defining geographic markets, realistic approximations can be made on the basis of information garnered about the market.

A realistic market definition is a critical component of a credible competitive analysis. Using county or metropolitan statistical areas as proxies is convenient but often is not realistic. Such an approach does not present the competitive environment in the best light for the merging banks.

Once the product and geographic markets are defined, the next step is to determine whether the merger will adversely impact competition for any of the products in any of the markets.

A simple first test is to calculate the pre-merger and post-merger Herfindahl-Hirschman index for each market.

The index is simply the sum of the squares of each competitor's share of the market. For example, a market served by only one company has a Herfindahl-Hirschman Hirschman index of 10,000 (100% times 100%). A market with 10 equal-size competitors has an index of 1,000.

Ideally, the market share calculations should be related to the product in question, but data limitations usually preclude any share measurement other than one based on deposits.

The Federal Reserve Board and the Department of Justice use similar guidelines, based on the Herfindahl-Hirschman index, to trigger further review. Currently, if a market's index is 1,800 and the merger will increase the figure by 200 points or more, further analysis will be required.

Wider Perspective

The 1992 merger guidelines particularly emphasize that the Department of Justice will look at all factors affecting the likelihood that the merged firms could raise and maintain prices, either unilaterally or through coordinated action.

Other factors that will be considered include:

* The extent of nonbank competition such as thrifts, credit unions, and finance companies in the specific markets.

* The capacity of existing competitors to expand their output in response to a price increase, and the likelihood that they would do so.

* The likelihood of entry from outside the market.

Motives for Entry

In evaluating the attractiveness of a market, banks generally look at factors including market potential, market performance, competitive environment, bank-specific factors, and perceived entry barriers.

But interpretation of market characteristics will depend on the motive for entry. The application should include a realistic evaluation of which institutions are potential entrants, taking into account the motives that induce a bank to enter a new market.

Sometimes the reasons are strategic: growth, economies of scale, diversification, market opportunity, ability to leverage capital better, and a means to fill gaps in the distribution system.

And sometimes the reasons are emotional: prestige, herd mentality, or management confidence or overconfidence of doing a better job than banks already in the market.

It is important also to provide a realistic appraisal of incumbent banks' financial and business ability to expand.

An effective application will go beyond the Herfindahl-Hirschman index to argue that the merger will not adversely affect competition in any markets. One basis for such an argument might be that existing competition is strong; another, that if the merger reduced competition, new competitors would probably enter the market.

There are cases in which these arguments cannot be made credibly. In such a case, if the bank to be acquired has serious problems, the regulators may determine that the merger should be permitted anyway, so the convenience and needs of the customers can continue to be served.

Nevertheless, the agencies are more likely to approve merger options that do the least damage to competitiveness.

Absent mitigating factors (such as the merger's involving a failing bank), banks must be prepared to offer up divestitures that will help maintain the competitive balance in the affected markets.

In so doing, the banks should develop a divestiture strategy that, while addressing the competitive problem, retains the benefits of the merger as much as possible.

Ms. Glassman is a partner and director of research at Furash & Co., a consulting firm based in Washington.

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