The Market Is Best Judge of Mergers

Bank merger mania is clearly in vogue. First it was Chemical and Manufacturers Hanover, then NCNB and C&S/Sovran followed by BankAmerica and Security Pacific. Is this trend good or bad for the country?

The short answer is that while the merger trend entails risks and potentially negative effects, it is necessary. There is considerable excess capacity in the banking industry - too many banks chasing too little good business.

Doubters need only look at the enormous loan losses many banks have suffered during the past decade and at their anemic returns on equity.

I'm a great believer in the marketplace. It will, if permitted to operate, weed out weak and inefficient firms. At some point, an equilibrium will be achieved in which the remaining firms will earn an appropriate return on equity. If they earn too little, more firms will disappear. If they earn an excessive return, more will enter the business.

Market Forces Stifled

One of the major flaws in the U.S. banking system has been that the marketplace has not been allowed to operate. We have interfered with it by attempting to limit entry into the business. New charters have been made difficult to obtain. Expansion by existing competitors has been tightly controlled. Deposit interest rates have been regulated.

Even more detrimental, we have interfered with the process by which banks exit the business. Deposit insurance has allowed marginal firms to remain in business beyond their time. The Bank Holding Company Act has prevented firms and individuals from outside the "banking establishment" from taking over marginal performers.

Restraints on geographic expansion have prevented stronger banks from entering new markets to eliminate weaker performers. Until recently, anti-trust enforcement has severely limited in-market firms from taking over weak competitors.

While we have eliminated some of the obstacles to the efficient operation of markets (for example, deposit interest rate controls) and have eased others (geographic restraints), many remain. This has left us far too dependent on the regulatory process to shape the structure of the banking industry.

In a democracy the government simply cannot address a problem, particularly when private property rights are at stake, until the problem is very serious. One result has been staggering losses on bank and thrift failures.

Laudable Motives

To their credit, the managements of some of the nation's banks are beginning to take the bull by the horns. The three recently announced megamergers will involve a lot of disruption, and thousands of employees will be out of jobs. There's no joy in any of that. But the mergers represent a recognition of marketplace realities and are motivated by a laudable desire to serve the interests of shareholders.

There are, to be sure, risks and negative consequences. To say the loss of jobs is regrettable is an understatement - particularly if the job is yours. Some worry about the loss of local control over financial assets. Still others are concerned about the pricing of banking services as the number of competitors is diminished.

I understand and have sympathy for these concerns, but I have no doubt the market will take care of most of them in due course if it is allowed to work its will.

With respect to jobs, the sad truth is that the banking industry can no longer support as many people as it has in the past. It will be painful for those having to make the transition, but the economy will absorb them in other areas.

One of my principal concerns about the merger movement is whether the megafirms will be able to control risk-taking. Typically in these deals everyone focuses a great deal of attention on resolving the "social" issues (the name of the resulting entity, who loses jobs, and the composition of the board) and on cutting costs.

Experience has shown that too little attention has been paid to what is by far the most critical and difficult challenge - implementing and maintaining the proper credit culture and controls throughout the organization.

A significant number of acquisitions during the past two decades have not worked out very well, and the primary reason has been that the resulting entity did not institute proper controls over the lending process. This will be the ultimate test of the current round of deals. The stakes are large and growing as the deals get bigger.

Mr. Isaac, a former chairman of the Federal Deposit Insurance Corp., is managing director and chief executive of the Secura Group, a Washington-based financial services consulting firm.

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