Courtesy of Eduard Dzhagityan
Guided by the objectives of international banking regulation reform in the post-crisis period (Basel III), I explore the idea of risk-centered regulation of mergers and acquisitions (M&A) deals. This idea introduces a new set of microprudential standards aimed at improving both the integrity of M&A and the stress resilience of the banking sector. I also propose a single conceptual platform for an M&A-related rulebook, as well as an M&A risk matrix that would further shape the mechanism of systemic risk alarmism during the processes of mergers and acquisitions.
The Current Context of M&A Deal Making
M&A value in all industries has been erratic in recent years, falling from $4.8 trillion in 2015 to $3.7 trillion in 2017, and then rising to $3.9 trillion in 2018. It is expected that in 2019, M&A value will reach $4.4 trillion. In contrast to the downward trend in 2015–2017, the amount of withdrawn M&A increased from $520 billion in 2015 to $658 billion in 2017. Many of the remaining deals were never completed, and the M&A failure rate, including the banking industry, was 60–80%. In fact, the number of M&A failures increased both during, and immediately after, the financial crisis. The average number of M&A deal failures in the U.S. banking sector increased from 2.75 in 2000–2007, to 48.8 in 2008–2012, before dropping again to 7.0 in 2013–2018. M&A deal failures in banking are mostly attributable to the uncertainty of macro-level dynamics, the inability to accurately value M&A targets, and the imminent change of regulatory policy.
Banks need M&A to counter their vulnerability to volatile financial markets and macro-level uncertainty, as the efficacy of the banking sector depends on the mitigation of systemic risks. That said, banking M&A appears as another critical tool underlying stress resilience of banks and ensuring the continuum of financial intermediation if the instruments of organic growth are exhausted.
Indeed, unsuccessful M&A detract value creation and may cause a domino effect of insolvency in the banking sector. The larger the bank, the greater the potential for that effect. At the same time, M&A trends are an indicator of market dynamics — an increase in M&A is associated with a positive financial markets outlook, while a decrease may reflect a perceived escalation of systemic risks. Unfortunately, M&A-related risks are frequently understated due to ‘short-termism,’ that is, the prioritization of quantitative post-M&A benefits over qualitative aspects. Qualitative aspects include an organization’s culture and client relationships. Although qualitative aspects are often underprioritized, they play a significant role in containing systemic risks. A failure to balance the trilemma between the value drivers of the quantitative and qualitative aspects of M&A, and short-termism, may ultimately erode the fundamentals of M&A, especially during post-M&A integration (PMI).
Post-M&A synergy has always been at a higher risk in the banking sector. Presently, the sweeping overhaul of international banking regulation has created tougher prudential requirements with which pre and post-M&A banks must comply with — failure to do so creates additional risks for post-M&A banks. Achieving synergies in cross-border M&A is made all the more difficult by different home and host country regulatory requirements. Our understanding of the extent to which M&A in emerging economies are affected by current financial markets is still limited. When less is known about the variables of M&A, the synergetic effect is reduced and there is a greater risk of M&A failure.
A combination of adverse economic and behavioral aspects may inhibit post-crisis recovery and severely downplay market optimism. Fallouts in cross-border M&A hinder the internationalization of Basel III, leaving loopholes for regulatory arbitrage. Moreover, M&A risks are associated with the degree of their opaqueness to the public.
To reduce M&A inconsistencies, M&A-related risks should be quantified. This will not only expand our understanding of the sources and variety of risks, but can also enhance the objectivity and accuracy of risk assessment.
M&A and Systemic Risk
Despite the fact that the banking industry is vulnerable to, and remains the main source of, systemic risk, this phenomenon has received scant academic attention. Its significance for stakeholders is proven by a high (20–30%) contribution to corporations’ aggregate return, without which PMI may be seriously weakened. Academic debates in the field take place between proponents of the view that related M&A can withstand systemic risk and those who see unrelated M&A as being more resilient to macroeconomic uncertainties. Other scholars doubt that conglomerates can mitigate systemic risk.
Supported by evidence from unrelated M&A in the U.S. banking industry in the 2000s, recent investigations into conglomerate banks have produced more plausible results. Unrelated M&A decrease systemic risk due to less erratic profit fluctuations, which secures liquidity, cost-efficiency and competitiveness. Moreover, acquirers with heterogeneous operating models experience comparatively higher synergy than their peers from horizontal M&A. Other observations substantiate the view that conglomerate M&A enjoy reduced risk and enhanced performance. This suggests a positive ‘conglomerate M&A-risk mitigation’ linkage.
Many experts associate the Great Recession with deregulation which paved the way to conglomerate M&A. These conglomeration measures were later restricted by the Dodd-Frank Act. However, strategizing synergy, generated from different financial market segments and economic branches, seems to effectively immobilize systemic risks. In other words, conglomerates mitigate systemic risk through cross-border diversification and enhanced capability for resource redeployment. But that was the case with comparatively looser banking regulation regimes. In the context of the current interconnectedness between financial institutions and volatile financial markets, a lack of M&A-related regulation may diminish their outcome and become a channel of system-wide crises.
While bringing together M&A risks and M&A efficiencies seems to be a micro-level reality, systemic risk may threaten financial stability. This in turn challenges the post-crisis regulatory concept in its ability to measure the effect of systemic risk on financial sector parameters and perspectives. Regulatory transformation has affected almost all aspects of regulatory policy and supervisory standards. However, banking M&A still lacks regulatory mechanisms, and this circumstance is further aggravated by the inability of regulators to substantiate critical linkages between banks and macro-level parameters. This diminishes the validity of macro-finance management and the usability of macroprudential policy instruments and, as such, strengthens the destabilizing effect of M&A on the economic environment.
The M&A regulatory gap will likely increase the number of ‘white spots’ during PMI, which, in turn, will deplete the balance between M&A objectives and the capabilities of the M&A-engaged banks. Unless the regulatory gap addresses links between prudential standards and M&A-related risk metrics, M&A will remain highly dependent on macro-level uncertainty and will be at higher risk of failure. Further, a lack of understanding of the relationships between M&A and financial stability may discourage M&A and trigger the ‘localization’ of banking regulation. This would severely limit the perspectives of regulatory globalization and global financial stability.
M&A Regulation as an Impending Reality
Weaknesses in addressing systemic risks and deficiencies in measuring the consistency of M&A will further threaten financial markets if consolidations are not managed by a special regulatory mechanism which is empowered by an independent regulatory authority. This increasingly demands specially tailored regulatory elements to maximize M&A synergy and minimize M&A-related risks in order to reduce the adverse effect of M&A on the economy as a whole.
To reduce the odds of M&A disruptions, M&A will need a principally new governance model, based on macro-finance and risk-management-centered regulation covering all phases of banking M&A deal – from origination to closure/completion of the deal to PMI. Regardless of whether the M&A regulatory authority is national or global, the M&A regulatory mechanism should be based on a single conceptual platform in the form of an M&A-related rulebook. The need for global governance of M&A regulation (or ‘mergulation’) is driven by the fact that global financial interconnectedness is associated with the increasing complexity of regulation. Thus, mergulation must be a separate domain. Mergulation should be supervised by a designated institution in the form of a federally/centrally/globally chartered/mandated, not-for-profit and member-funded authority.
While it is too early to discuss the details of the conceptual framework of mergulation, it is already apparent that it should be focused on risk alarmism and risk management, and should be supported by the advanced tools and techniques of M&A modeling, part of which could be redesigned into specific regulatory tools (for example, M&A stress-testing). This should also include PMI synergy assessment, evaluation of spillover effects and matrix linkage between mergulation and traditional regulation, among others. In the same way that the deposit insurance authority is responsible for the safety of deposited money, this authority’s mission should focus on increasing the safety of M&A through improved ‘implementability.’ This is distinct from the approach taken by external consultants, whose responsibility is limited to advising M&A and not by M&A outcomes. Additionally, mergulation will naturally administer more rigorous information disclosure requirements.
Filling the M&A regulatory gap requires a model based on a single risk-approach methodology, complemented by a risk-sharing mechanism, embedded with heterogeneous variables that can address the sources of M&A-related risks grouped according to the core concept of mergulation. Furthermore, mergulation allows for the quantification of system-wide risks and the development of a risk matrix that can help to unwrap other risks. Maximization of M&A factors and risks and their inclusion in the model will help regulators understand whether mergulation can become a self-powered, but integral, part/branch of the post-crisis regulatory order, and can contribute to its credibility in tailoring the roadmap towards financial stability.
Mergulation should not be considered a panacea for all M&A inconsistencies. Nor should anybody expect the concept to accelerate M&A activity or ensure financial stability. However, it may work to curtail the actions of ambitious but shortsighted dealmakers. The safety net offered by mergulation is the creation of a level playing field in risk-taking. This leveling of risks to the limits of micro and macroprudential regulation will fuel consistent PMI and regulatory compliance. By highlighting risks, mergulation will help alleviate PMI flaws and keep them to an acceptable level given that M&A will be better protected against poor governance and mismanagement. Mergulation also ensures equal access for all banks in the name of professional expertise and provides focused guidance during M&A. In fact, this one-size-fits-all approach will benefit smaller banks by eliminating the need to hire external consultants.
The smooth running of M&A is one of the pillars of systemic risk alarmism and financial stability, and in this context mergulation could become its risk management platform. Although occasional setbacks associated with M&A are unavoidable, mergulation could make the impact of such setbacks less dramatic. It may also make the implementation of M&A less erratic and the results more pragmatic. Theeffect of mergulation on M&A-making will be commensurate with ability of micro and macroprudential regulation to improve the stress resilience of banks and to police optimism in the global financial arena.
The value of withdrawn M&A peaked at $837 billion in 2016 to become the highest in the post-crisis period.
Failures in M&A include lack of post-M&A operating and/or financial synergy, a lower than expected level of shareholder return and deal abandonment. Among the primary reasons for failure are the mismanagement/oversight of M&A-related risks, strategy, pricing policy and the process of cultural integration, as well as inadequate due diligence.
Also known as the Wall Street Reform and Consumer Protection Act of 2010.