WASHINGTON - Banks have paid more for acquisition targets over the past decade primarily because deregulation has increased the number of acquirers, according to a study by the Federal Reserve Bank of Chicago.

Surveying all bank mergers from 1990 to mid-1998, the authors find that bid premiums - the ratio of the market price offered to the book value of equity of the target bank - rose to 2.4 in the years after interstate banking was permitted, from 1.7 in 1990-1994. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 opened the door to nationwide banking.

"Our results show how federal and state regulatory policies that restrict interstate branching and banking may produce very different (and distorted) merger prices relative to policies that are less restrictive and market driven," the study said.

The study finds that bid premiums are higher when the target bank's market share is higher. It also suggests more profitable banks, with higher returns on assets and/or equity, tend to get higher bids. Banks are willing to pay more for an institution that efficiently manages its money, perhaps because well-capitalized acquirers seek target banks with a relatively cheap source of funds, according to the authors.

By examining stock return data on the day of and the day following a merger announcement, the authors find the market reacts more enthusiastically when the target is a large bank. Standardized stock returns for target banks with assets greater than $10 billion averaged 8.17%, compared with 4.06% for smaller banks. The authors conclude the market perceives larger banks are merging in order to catapult themselves into the privileged class of too-big-to-fail institutions.

The market's favorable reaction to large bank mergers may prove troubling for policymakers concerned with controlling bank risk-taking and avoiding losses to the deposit insurance funds, according to the study. The authors suggest that regulators should closely monitor the applications of megamergers as well as mergers between large banks and other financial institutions, because their low bid premiums imply a less efficient and poorer-performing organization.

The rapid pace of consolidation in the banking industry, which has seen the number of banks decline about 30% since 1990, is expected to continue. In addition to high bid premiums, which will make bank managers more willing to sell, passage of the Gramm-Leach-Bliley Act, which tore down the barriers between banks, brokerages, and insurance companies, should prolong the merger frenzy, the study concludes.

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