Mergers predicated on scale often fail to yield promised efficiencies

There are many measures that summarize banking performance, but in terms of the immediate effectiveness of a financial institution, one of the most insightful measures is the efficiency ratio. Whereas measures such as return on equity remain dependent on the institution’s capital structure at the time and return on assets gives no insight into the scale of expenditures required to generate those returns, the efficiency ratio neatly captures both sides of the income equation.

There are only two primary ways to increase earnings in the banking industry: sell more or spend less. The efficiency ratio is therefore an important measurement for institutions to consider when evaluating future growth strategies – including organic expansion or a prospective merger.

Bankers have often justified mergers in the name of efficiency, and theoretically, that makes sense. In fact, on most earnings calls in which two banks are announcing a merger, the reasoning provided is the expectation of tremendous efficiencies. However, the reality often diverges from this assumption and at best, efficiency is a step function rather than a function of continuous improvement. As a result, many financial institutions fail to generate the efficiencies on which the mergers were predicated.

 

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