The question of whether bank mergers generate cost savings has received a great deal of attention recently, and for good reason.

The Treasury Department in 1991 recommended that banks be allowed to branch across state lines to help improve the industry's financial strength. Furthermore, megamergers are on the rise, with their architects promising dramatic reductions in operating expenses.

Opponents of these mergers, however, point to recent research that suggests the savings are illusory, and many in the industry count our research on New England mergers in this "anti-merger" camp. One financial services executive called us part of an "insidious onslaught" against the industry's return to health.

We want to set the record straight: Our research shows that the typical merging bank controlled noninterest expenses better than other banks in its state.

Success on Cost Control

The banking industry was expanding rapidly during the 1980s, and the challenge was to constrain expense growth. Merging banks did this, and they did it better than their nonmerging competitors.

The savings were greatest when the merged bank was newly acquired. Mergers between bank subsidiaries of the same holding company produced only modest improvement in noninterest expenses relative to other banks in the industry, probably because some economies had already been achieved.

In the typical merger of a newly acquired bank, noninterest expenses grew about 18% from a year before merger to a year after. The comparable figure for banks that were not merging was 23% over the two years. But the best merger performers did much better, some actually reducing expenses by 10% to 15%.

Such performance is consistent with a 1990 study that found bankers reporting 30% to 35% savings just in the back-office and information-technology areas in the first year after a merger.

But there is a "bad news" side to the story.

Merging banks typically lost so much business to their competitors that their expense ratios (noninterest expenses to assets) actually deteriorated in comparison with those of other banks.

From the year before to the year after a merger, the growth in assets of merged banks was typically about 10 percentage points below that of competitors.

This loss of asset share, and the related net interest revenue, prevented banks that merged with newly acquired institutions from outperforming the industry in profitability, in spite of cost savings.

In contrast, it is important to note that mergers between units of the same holding company did generate significant improvements in operating profitability. These banks achieved only modest cost savings, as we noted, but they improved net interest margins significantly.

Even though the typical merger of this sort also lost business to competitors, it was able to improve operating ROA more than competitors through consolidation.

What Happened?

A variety of factors contributed to these results:

* First, some loss in asset share was undoubtedly deliberate.

In the process of integrating a new institution, bankers rethink products and pricing and deliberately encourage runoff in unprofitable lines of business.

This tack reduces assets but improves return on assets. However, the losses in our study -- typically about 10% of the asset share of the combined institution -- may have been more than was intended.

* Second, perhaps our study's time frame is too short.

It certainly takes more than 18 months to fully digest a new institution and achieve all the benefits of a merger. But several recent mergers -- Fleets acquisition of Bank of New England, Chemical Bank and Manufacturers Hanover, and the NCNB and C&S/Sovran combination -- are reporting significant performance improvements in the first year.

* Third, bankers may have set their savings goals too low and not cut back enough on operating costs. By failing to anticipate the merger's impact on asset share, they might have expected more business activity and staffed accordingly.

* Fourth, because of inadequate due diligence processes, some banks may have been unprepared to manage the acquired institution.

More-experienced acquirers prepared a detailed operating assessment of the target institution -- even in the heat of dealmaking -- so they knew exactly what they were getting.

Follow-Through

These four reasons may explain our results. More important, they point to a critical factor in achieving performance improvements: excellent execution.

As bankers who have merged would certainly report, the process is grueling. But some organizations are better at it than others.

Bankers who excel in executing mergers take control of the target institution quickly, consolidate and streamline operations, and take deliberate steps to attract and retain high-quality business.

Let us elaborate.

Banks that merge effectively take control quickly. Within weeks after announcing a merger, executives establish a clear direction and an organizational structure that lets people know who is in charge, who is accountable for what, how success will be measured, and how long they have to achieve results.

Bank executives pay particular attention to gaining control over critical dependencies. They reassure important customers and valuable employees, make certain they can settle the bank and close the books, and manage asset quality relentlessly.

High-performing banks aggressively consolidate redundant information systems, back office operations, administrative support structures, and distribution outlets.

Markets overlap increases the distribution economies that can be gained, but a well-executed consolidation of back offices can reduce costs significantly even in mergers between neighboring banks.

The best solutions work to a "right size" business model that can be implemented only if products and operating processes are simplified as redundancies are eliminated.

Outstanding banks use the merger to market - not just sell, but market. Basing their actions on a clear notion of how the combined bank adds value, they take deliberate steps to offer a set of competitive, high-quality products and services that attract and retain desirable customers and make money for the institution.

The issue is not just how to hold on to the target bank's customers, but how to sustain directed, profitable marketplace momentum.

Clarity Essential

Trying to simultaneously take control and activity market the merged bank creates some powerful management dilemmas.

For example, consolidation interrupts products development, but an active customer focus requires it. Furthermore, a new organizational structure may disenfranchise employees on whom the bank depends to implement the consolidation.

The banks that balance these demands best make the marketing strategy and the process of merging clear to all key players from the start. This is a proven approach to integration. Such clarity squelches the political posturing and compromise-style decision-making that can stall progress for even the best-intentioned managers.

Implications

Some bankers, policymakers, and concerned citizens are currently arguing that banks should be prohibited from merging across state lines.

We disagree. The banking industry's health will not improve until its excess capacity is retired. While merging is not a panacea, it is an important tool to help accomplish this.

However, as our study and others show, achieving benefits from mergers is not simple. If bankers repeat the experiences of the 1980s, mergers of newly acquired institutions are unlikely to improve bank profitability, at least in the short term.

Three Strategies

The institutions that will thrive in the 1990s will acquire and merge only to add value.

Some of these leading firms will manage acquired institutions as semiautonomous subsidiaries, achieving superior performance by exploiting back-office economies in information technology and operations and sharing best practices quickly and efficiently across subsidiaries.

Moreover, they will use market-based outcome measures to discipline their performance to exceed industry norms.

Other leading banks will acquire and merge previously unaffiliated banks but will manage the downsizing process. They will accomplish this by combining careful and persistent back-office consolidation with focused attention on the marketing side of the equation.

Whether through relationship management or excellent products, they will give profitable customers a good reason to bank with the newly merged institution.

A third group of excellent banks may well remain small and focused, serving local markets distinctively through close customer ties, unique expertise, and tailored services. These banks will press inexorably for incremental improvements in customer value rather than opt for large changes in scale.

These three operating strategies use the merger tool deliberately by differently. Although each demands clear goals and disciplined implementation, the management skills required vary markedly.

We have no evidence that one or another will dominate in the market. But we can say that implementing any of them poorly is a formula for disaster. Ms. Linder is an assistant professor of information management and Mr. Crane a professor of finance at Harvard Business School.

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