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Case Study: Mergers of banks

The past fifteen years have seen numerous mergers of banks in every part of the US. Invariably, bank managers point to significant cost reduction (increasing returns to scale) associated with consolidation of computer systems, combining neighbouring branch outlets and reduction of corporate overhead expenses as justification. Many of these mergers involved multibillion dollar banks, which appeared to be inconsistent with existing empirical research on bank costs that showed significant diseconomies of scale for banks with more than $25-50 million in deposits. Unfortunately, these studies used data only for banks with less than $1 billion in deposits. In a more recent study, Sherrill Shaffer and Edmond David used data for large banks ( those with $2.5 to $121 billion in deposits) and found increasing returns to scale (i.e., declining per unit costs) up to a bank size of $15 to $37 billion. Clearly, the owners and managers of the merged banks knew more about their actual cost functions than did the earlier economic analysts. The consistent pattern of mergers of banks much larger than $24 to $50 million in deposits was strong evidence that the existing research was incorrect.

Questions

1. How can mergers in the banking industry result in economies of scale (cost reduction)?

The mergers in the banking industry result in economies of scale (cost reduction) because of the Cost Efficiency. The most common rationale for Mergers and Acquisitions activity is believed to be increased cost efficiency. Many mergers have been motivated by a belief that a significant quantity of redundant operating costs can be eliminated through the consolidation of activities.

2. Do you think the same factors can lead to economies of scale in the banking sector in India?

Mergers can result in increased market power. Banks may buyout each other just to enter new geographic markets or to cut down competition. The recent example of this is the acquisition of UTI bank with Axis bank. Hence, the same factors can lead to economies of scale in the banking sector in India.

3. What are the other factors that can lead to economies of scale in the banking sector?

The other factors that can lead to economies of scale in the banking sector include:

Technical factors: These are often comprised of changing the product design and manufacturing so that average costs in the long run are minimized.
Organizational factors: As firms grow they can afford managerial staff such as a HR and financial department to develop ways of improving productivity and division of labor. These groups will become more efficient at keeping the books, (other tasks) than an normal worker would.
Market Power: As a business expands and becomes a bigger competitor in a the market it can lower its marketing costs by demanding discounts for products when bought in large quantities (bulk buying).
External Returns: This is when one firm benefits from lower average unit costs by taking advantage of the market industry growth.

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