Abstract The efficiency effects of a single market

services in Europe q

Allen N.Berger

a,b,*

a

Board of Governors of the Federal Reserve System,Mail Stop 153,Federal Reserve Board,20th and C Streets NW,

Washington,DC 20551,USA

b

Wharton Financial Institutions Center,Philadelphia,PA 19104,USA

Abstract

This paper examines the potential efficiency effects of a single market for financial services in Europe.The topics covered include universal banking,the merger and acquisition process itself,cross-border ownership and management of financial institutions,and the effects of consolidation of financial institutions on the supply of relationship lending services to informationally opaque small businesses.The research reviewed here suggests that the creation of a single market for the European financial services industry is not likely to bring about strong efficiency gains and that cross-border efficiency barriers may prevent the single market from becoming a reality.Ó2002Elsevier B.V.All rights reserved.

Keywords:Banks;Securities firms;Insurance;Mergers;Efficiency;International finance

1.Introduction

It has been predicted for some time that the European financial services industry would be-come a single market.The landscape in which fi-nancial institutions had most of their operations in their home nation and customers purchased fi-nancial services almost exclusively from home

nation suppliers would be replaced by a single consolidated market for financial services.The process of moving from segmented markets to a single market would require a substantial amount of mergers and acquisitions (M&As),particularly M&As between institutions in different nations.Both market and regulatory actions may drive financial institutions to consolidate into a single European market.Market forces may include in-centives to engage in M&A activity to improve efficiency,to boost market power in setting prices,or to satisfy the personal goals of managers.Some dynamic market forces that may have accelerated financial services consolidation in recent years in-clude improvements in information processing,telecommunications,and financial technologies and the international consolidation of nonfinan-cial markets.Regulatory actions in Europe include

q

The opinions expressed do not necessarily reflect those of the Federal Reserve Board or its staff.A preliminary version of this paper was presented at the EURO Working Group on Financial Modeling,New York,November,2000.*

Address:Board of Governors of the Federal Reserve System,Mail Stop 153,Federal Reserve Board,20th and C Streets NW,Washington,DC 20551,USA.Tel.:+1-202-452-2903;fax:+1-202-452-5295.

E-mail address:aberger@frb.gov (A.N.Berger).

0377-2217/03/$-see front matter Ó2002Elsevier B.V.All rights reserved.

doi:10.1016/S0377-2217(02)00772-5

European Journal of Operational Research 150(2003)

466–481

www.elsevier.com/locate/dsw

While there has been substantial consolidation of the Europeanfinancial services market in recent years,most of the M&A activity has been within individual European nations,rather than between institutions in different European nations or be-tween institutions in Europe and the rest of the world.The reasons for the lack of international M&A activity despite the reductions in market and regulatory barriers are not well understood,al-though as discussed below,there may be barriers to operating efficiently on a cross-border basis.

This paper looks at some of the likely efficiency effects of European-wide consolidation,if and when it occurs.The methodology is to review the available evidence from efficiency studies around the globe,although we emphasize the European findings.Our approach is quite different from other papers that survey the efficiency or consoli-dation literatures in terms of which topics are covered and not covered.We spend very little ef-fort summarizing static scale efficiency,scope effi-ciency,and X-efficiency with providing a single main line offinancial services,such as commercial banking,securities services,or insurance.It is not that these types of efficiency are unimportant,but rather that they have been reviewed thoroughly elsewhere.1We instead focus on what is likely to be important looking forward to Europeanfinan-cial services consolidation.We mainly consider the likely efficiency consequences of:

1.Universal banking,or the provision of multiple

lines offinancial services,which is effectively permitted throughout the EU;

2.The M&A process itself,which may result in

dynamic changes in efficiency due to changes in managerial focus and/or disruption from the gestation process beyond the simple static efficiency effects;

3.Cross-border ownership offinancial institu-

tions,which may present efficiency barriers as-sociated with differences in language,culture, currency,and regulatory/supervisory structures, explicit or implicit rules or supervisory barriers faced by foreign competitors,or diseconomies to operating or monitoring from a distance; 4.The effects of consolidation offinancial institu-

tions on the supply of relationship lending services to informationally opaque small busi-nesses.

This last item warrants some additional expla-nation because it is generally not discussed within the context offinancial institution efficiency.If consolidation results in institutions that are very large or foreign owned,this may disrupt the supply of some services to small customers,such as rela-tionship-based small business loans.As discussed below,this may occur for a number of reasons, including possibly organizational diseconomies from providing these services together with thefi-nancial market services in which these large or multinational institutions tend to specialize,diffi-culties of these institutions in dealing with‘‘soft’’information about thefirm,its owner,and local market,or disruptions associated with the con-solidation process.If the customers bear extra costs of switching to otherfinancial institutions, borrowing from multiple banks,or have difficulty getting credit as a result,this may be a significant efficiency loss for thefinancial system,although it does not reduce the measured efficiency or per-formance of the consolidating institutions.Some recent literature has tried to detect these effects for informationally opaque small businesses,although the research does not quantify the social costs.

1As examples,see Berger et al.(1999)for a review of the

financial institution consolidation literature,see Berger and

Humphrey(1997)for a general review of thefinancial institu-

tion efficiency literature,and see Goddard et al.(2001)for a

review of bank efficiency in Europe.

A.N.Berger/European Journal of Operational Research150(2003)466–481467Nonetheless,the potential costs of consolidation borne by these customers may be an important consequence of interest to policy makers,so we include it here.

We also offer a more general caveat that the measured efficiency effects of consolidation in the extant research literature reviewed here focus on the measured performance of the institutions themselves and do not include the benefits or costs that may directly accrue to the customers of the financial institutions.Changes in prices,variety of services,available of credit,and other effects on customers of consolidation,while important,are not included in measured efficiency effects.Thus, any increase or decrease in prices from changes in productivity or market power are not included in measured efficiency effects.Similarly,any in-creased variety of services or improved access to market-based sources offinance from universal banking or cross-border market penetration are also excluded.Thus,other than the effects of consolidation on the supply of relationship lending services to informationally opaque small busi-nesses,the analysis here focuses exclusively on traditional efficiency effects that are captured in the performance of thefinancial institutions.

Section2reviews the available research on the efficiency of universal banking.Sections3and4 give the corresponding information for the M&A process and for cross-border ownership/manage-ment offinancial institutions,respectively.Section 5discusses the effects of consolidation offinancial institutions on the supply of relationship lending services to informationally opaque small busi-nesses.Section6draws conclusions.

2.The efficiency effects of universal banking

Under the Single Market Programme,universal banking powers are effectively the norm through-out the EU––financial institutions may engage in commercial banking,investment banking,and in-surance if they wish,and a number of institutions currently exercise all of these powers.As well,fi-nancial holding companies in the US now have these powers under the Gramm–Leach–Bliley Act. The key efficiency issue we deal with in this section is whether there are economies or diseconomies of scope among these main lines offinancial services and include both cost scope efficiency and revenue scope efficiency effects of universal banking.2 Universal banking can create scope efficiency gains from sharing physical inputs,from issuing debt or equity in larger issue sizes,or by reusing managerial expertise or information.Financial institutions may also be able to make cost im-provements from combining the production of different categories offinancial services by im-proving their risk-expected return tradeoffs.This may occur because the returns associated with commercial banking,securities activities,and in-surance may have relatively low or negative cor-relations.Risk diversification may reduce the cost of capital in imperfect capital markets and lessen the costs of compliance with prudential regulation/ supervision.3

Cost scope efficiency losses may also arise from universal banking because of organizational dis-economies from offering a broad range of prod-ucts.For example,it may be difficult to operate or monitor commercial banking,investment banking, and insurance underwriting operations because senior managers may each have expertise in only 2We also note that universal banking is usually associated with very large institutions.The extensive research on scale efficiency generally found no consistent,strong scale economies or diseconomies beyond the scale of medium-sized institutions for banks,securitiesfirms,or insurance companies on either the cost size(e.g.,Goldberg et al.,1991;Cummins and Zi,1998)or the revenue side(e.g.,Berger et al.,1987,1993,1996,2000a).

3Under an assumption of perfect capital markets,risk considerations would not affect shareholder value and would not be included in efficiency.Investors would simply diversify their own risks.However,there are a number of market imperfections that encourage institutions to diversify risks.One imperfection is informational opacity.Under the modern theory offinancial intermediation(e.g.,Diamond,1984),financial institutions are delegated monitors who produce information about informationally opaque assets,and diversi-fication of large pools of these assets is part of the solution to the information problems.In addition,there are nontrivial costs associated withfinancial distress,bankruptcy,or loss of franchise value in the event offinancial institution failure or closure––risk diversification may reduce the expected costs of these problems.Finally,government prudential regulation and supervision imposes costs on risk-taking which may be mitigated by diversification.

468 A.N.Berger/European Journal of Operational Research150(2003)466–481one of thesefields.It may be more efficient for managers to focus on core businesses and their core competencies,rather than trying to manage or monitor unfamiliar lines of business.Under certain circumstances,the diversification of activ-ities may result in a reduction of the monitoring incentive by thefinancial institution,which could, in turn,raise risk premiums paid by the institution and increase its costs of compliance with pruden-tial regulation/supervision(Winton,1999).Uni-versal banking may also be associated with less financial innovation because of reduced incentives of commercial banks,investment banks,and in-surance companies to produce innovativefinancial solutions to attract corporate customers from one another(Boot and Thakor,1996).

Cost scope efficiencies are evaluated empirically by comparing the costs of joint production of a given output vector under given environmental conditions against the combined costs of two hy-pothetical specializingfirms that produce the same total output vector under the same conditions.4 The relatively few studies of cost scope efficiencies associated with universal banking in continental Europe are mixed.One study of European uni-versal banking found very small scope economies (Allen and Rai,1996),one study found some limited evidence of scope economies,but no con-sistent evidence of expansion-path subadditivity (Vander Vennet,1999),and one study found mostly diseconomies of producing loans and in-vestment services within German universal banks (Lang and Welzel,1998).However,as discussed below,these studies of universal banking in banking-orientedfinancial systems may not be good predictors of universal banking as it evolves in the future in more market-oriented systems.

Some inference about the efficiency of universal banking may be taken from the research measuring the effects of providing multiple products within a single category offinancial institution.These stud-ies usually found evidence of at most very mild cost economies or diseconomies(e.g.,Berger et al.,1987, 2000a;Goldberg et al.,1991).We expect that cost scope efficiency effects would be less favorable for universal banking than for a single category of in-stitution because universal banks use less similar inputs and likely face greater organizational dis-economies of operating or monitoring less similar technologies.Overall,this research suggests very little,if any,cost scope efficiency from universal banking and possibly some efficiency losses.

Universal banks may be able to make revenue efficiency gains by combining distribution systems and cross-selling different categories offinancial services.These economies may occur because of consumption complementarities arising from re-ductions in consumer search and transactions costs,as some customers may be willing to pay more for the convenience of one-stop shopping for multiplefinancial services.Similarly,a corporate customer may prefer to reveal its private infor-mation to a single consolidated entity that pro-vides its commercial and investment banking needs.Revenue efficiency gains can also arise from sharing the reputation that is associated with a brand name that customers recognize and prefer. These reputation economies might arise,for in-stance,if a universal bank levers offits reputation built in commercial banking when forging a stronger reputation in investment banking,or vice versa(Rajan,1996).Financial institutions may also be able to diversify risks by combining different categories offinancial services,raising revenues because of the enhanced values and capabilities of issuingfinancial guarantees and by improving their opportunities to make high risk-higher expected return investments.5

Universal organizations may alternatively face revenue scope efficiency losses or diseconomies. Such diseconomies may arise if specialists in

4These efficiencies are often difficult to estimate because there may be no specializingfirms in the data sample,creating extrapolation problems for evaluating costs of hypothetical specializingfirms with zero outputs for some products.As a

result,many studies use measures that evaluate at points near zero outputs(but within the bounds of the data)or use concepts such as expansion-path subadditivity which combine scale and product mixefficiencies.

5As noted above,under an assumption of perfect capital markets,risk considerations would not be included in efficiency, but a number of important market imperfections exist in the financial services market.

A.N.Berger/European Journal of Operational Research150(2003)466–481469different categories offinancial services have better knowledge and expertise in their areas of core competence and can better tailor products for in-dividual customers,and thereby charge higher prices than joint producers.Revenue scope dis-economies might also arise to the extent that combining commercial banking and investment banking creates the appearance of conflicts of in-terest.The market may underprice securities un-derwritten by a universal bank for its existing loan customers because of concerns that the proceeds from the issue will be used to enhance the value of distressed loans extended to that customer by the bank.As a result,commercial loan customers may prefer not to use their own universal bankÕs un-derwriting services,although some evidence sug-gests that universal banks have been able to successfully address this problem(e.g.,Puri,1996; Kroszner and Rajan,1997;Gande et al.,1997).

Finally,universal organizations may suffer revenue scope efficiency losses if the combination of differentfinancial services worsens the risk-expected return tradeoffand lowers expected reve-nues.For example,an institution may be more likely to fail or have higher bankruptcy costs in the event of failure if it is combined with another category offinancial institution with a low ex-pected return and a high variance of returns that are highly correlated with the returns of thefirst institution.Similarly,an institution that is exposed to very high potential losses in a particular state of nature(e.g.,an insurance company that is over-exposed to one earthquake fault)can bankrupt a much larger universal organization into which it is combined if this state of nature occurs.Universal organizations may also have lower expected reve-nues if the lack of knowledge and expertise of se-nior management in categories offinancial services outside their core competence results in worse operating performance and poorer risk manage-ment,requiring the organization to engage in lower risk-lower expected return activities to keep risks under control.

There is very little research available on the revenue scope efficiency effects of universal bank-ing.One study of universal banks in Europe found that they typically had both higher revenues and higher profitability than specializing institutions (Vander Vennet,1999).Some simulation-type studies combined the rates of return earned by US banking organizations and otherfinancial institu-tions from the1970s and1980s with mixed results (Kwast,19;Rosen et al.,19;Boyd et al.,1993). Another study of USfirms also found that risk could be reduced by combining banks with secu-ritiesfirms and insurance companies(Saunders and Walter,1994),although another recent study found an increase in systematic risk when creating synthetic universal organizations comprised of banking,securities,and insurance activities(Allen and Jagtiani,2000).Other studies of combining commercial banking and insurance companies in the UK(Llewellyn,1996)and combining com-mercial banking organizations with securitiesfirms in the US(Kwan,1998)showed favorable results for the risk-expected return frontier.

As was the case for cost scope efficiency,some inference about the revenue efficiency effects of universal-type operations may be taken from the research that uses data fromfirms producing a single category offinancial services.These studies generally found little or no revenue scope econo-mies and sometimes found diseconomies(e.g., Berger et al.,1996,2000a)and sometimes found that joint production is more efficient for somefirms and specialization is more efficient for others(Ber-ger et al.,1993,in press).We expect that revenue scope efficiency effects may be more favorable for universal organizations than within a category of financial services because the correlations of returns across industries is generally much lower than the returns within one industries,giving better oppor-tunities to diversify risks.However,as above,it is also possible that organizational problems to managingfirms in industries outside the core com-petence of senior managers could offset this ad-vantage.Overall,the research on revenue scope efficiency suggests that there may be modest revenue benefits from the universal banking,although we again caution that much more research is needed.

3.The efficiency effects of the M&A process

There are likely to be dynamic efficiency effects associated with the M&A process itself beyond the

470 A.N.Berger/European Journal of Operational Research150(2003)466–481simple static scale and scope efficiency effects. M&As are dynamic events that often involve changes in organizational focus or managerial behavior that change the X-efficiency of the or-ganizations––moving them toward or away from the optimal point on the best-practice efficient frontier.X-efficiency may be improved,for exam-ple,if the acquiring institution is more efficient ex ante and brings the efficiency of the target up its own level by spreading its superior managerial expertise or policies and procedures over more resources.The M&A event itself may also improve X-efficiency by awakening management to the need for improvement or by being used as an ex-cuse to implement substantial unpleasant restruc-turing.Alternatively,X-efficiency be worsened because of the costs of consummating the M&A (legal expenses,consultant fees,severance pay, etc.)or any disruptions from downsizing,meshing of corporate cultures,or turf battles.X-efficiency may also decline because the management spreads inferior expertise or policies and procedures or because focus shifts away from maximizing effi-ciency toward other goals,such as increasing in-stitution size.

The extant research suggests that many insti-tutions engage in M&As for the purpose of im-proving X-efficiency.Many studies have found that acquiring institutions are more efficient exante than targets in the banking,insurance,and credit union industries(Berger and Humphrey, 1992;Altunbas et al.,1995;Pilloffand Santomero, 1998;Rhoades,1998;Vander Vennet,1998; Cummins et al.,1999;Fried et al.,1999;Cummins and Weiss,2000;Focarelli et al.,in press),al-though the reverse sometimes holds(Ralston et al., 2001).It has also been found that acquiring banks bid more for targets when the M&A would lead to significant diversification gains,consistent with a motive to improve the risk-expected return trade-offand increase revenue and profit X-efficiency (Benston et al.,1995).

A number of studies measured changes in dif-ferent types of efficiency after M&As.Some cave-ats apply to this literature.First,the efficiency gains or losses associated with M&A activity may take a very long period of time to be realized,but the studies can generally only focus on a few years of data before and after each M&A.Second,ag-gressive institutions tend to engage in M&As on an on-going basis,so that the effects of a second or third M&A may obscure the measured effects of afirst M&A.Third,the institutions may make undergo other significant changes after consoli-dation,such as growing,shrinking,changing product mix,etc.,it difficult to isolate the effects of an M&A.

Some studies focused on the change in cost X-efficiency after M&As.Studies of US banks gen-erally showed very little or no cost X-efficiency improvement on average from the M&As of the 1980s,on the order of5%of costs or less(Berger and Humphrey,1992;Rhoades,1993;DeYoung, 1997;Peristiani,1997).Studies of US banks and otherfinancial institutions using1990s data are mixed,but sometimes showed more cost efficiency gains(Berger,1998;Rhoades,1998;Cummins et al.,1999;Fried et al.,1999).Studies of M&As of credit institutions in Europe found that some groups of M&As tended to improve cost efficiency, whereas other types tended to decrease cost effi-ciency(Vander Vennet,1996,1998).Studies of Italian banks(Resti,1998)and UK building so-cieties(Haynes and Thompson,1999)found sig-nificant cost efficiency gains following M&As.6 Studies of profit X-efficiency more often found gains from M&As.Studies of the profit efficiency effects of US bank M&As from the1980s and early 1990s found that M&As improved profit X-effi-ciency,and that this improvement could be linked to an increased diversification of risks and an im-proved risk-expected return tradeoff(Akhavein et al.,1997;Berger,1998).After consolidation,the institutions tended to shift their asset portfolios 6M&As may also affect efficiency indirectly by changing the exercise of market power in pricing.In most cases,it may be expected that M&As offinancial institutions in the same local markets would increase the exercise of market power,although cross-border or cross-market M&As could reduce the exercise of market power by bringing new competition to bear in previously concentrated markets.It has been found that banks in more highly concentrated local markets have lower cost efficiency,all else equal(Berger and Mester,1997;Berger and Hannan,1998).This presumably because of reduced effort or pursuit of other goals by managers when competition is laxand corporate control mechanisms are weak.

A.N.Berger/European Journal of Operational Research150(2003)466–481471

from securities to loans,have more assets and loans per dollar of equity,and to raise additional uninsured purchased funds at reduced rates,con-sistent with a more diversified portfolio that allows them to shift into higher risk-higher expected re-turn investments.Other studies using similar measures to profit X-efficiency found consistent results(Fixler and Zieschang,1993;Hughes et al., 1999;Berger and Mester,in press).

There are also a number of event studies of the effects of M&As on stock market values.The change in the total market value of the acquiring plus the target institution(adjusted for changes in overall stock market values)associated with an M&A announcement embodies the present value of expected future changes in both efficiency and market power.Although these effects cannot be disentangled,the change in market value may be viewed as an understatement of the expected effi-ciency improvement,since it is unlikely that M&As would reduce market power significantly.

The empirical results are mixed.Some studies of US bank M&As found increases in the com-bined value around the times of M&A an-nouncements(Cornett and Tehranian,1992; Zhang,1995),others found no improvement in combined value(Hannan and Wolken,19; Houston and Ryngaert,1994;Pilloff,1996),while still others found that the measured effects de-pended upon the characteristics of the M&A (Houston and Ryngaert,1996,1997;Siems,1996).

A study of domestic and cross-border M&As in-volving US banks found more value created by the cross-border M&As,although it also found that more concentrated geographic and activity focus had positive effects on value(DeLong, 2001).One study of European bank M&As found positive abnormal combined returns,but these returns were not statistically significant(van Beek and Rad,1997).Another study examined M&As among banks and between banks and insurers in Europe and found positive combined returns mostly driven by domestic bank-to-bank deals and diversification of banks into insurance(Cybo-Ottone and Murgia,2000).Finally,one study of European bank M&As since the late1990s found the combined values of bidders and targets to increase for domestic M&As,but to decrease for cross-border M&As on average(Beitel and Schiereck,2001).

4.The efficiency effects of the international consol-idation offinancial service providers

The Single Market Programme is intended to make the EU into a single market forfinan-cial services,irrespective of international borders among the individual EU nations.In reality,con-solidation offinancial institutions across these borders may have very different efficiency conse-quences than consolidation within an individual nation,even for institutions of similar preconsoli-dation size and efficiency.

First,there may be some barriers that may in-hibit foreign-owned institutions from operating efficiently and competing against domestically owned institutions.These barriers may include differences in language,culture,currency,and regulatory/supervisory structures,and explicit or implicit rules or supervisory barriers faced by foreign competitors.In addition,institutions in different nations are sometimes located at signifi-cant distances from one another,which may be associated with organizational diseconomies to operating or monitoring from a distance.7If these barriers are sufficiently high,they may reduce the efficiency of foreign-owned institutions and pre-vent substantial international consolidation.If these barriers are sufficiently low,efficiently man-aged foreign institutions may often be able to overcome them and operate relatively efficiently in many nations.8

7One study evaluated the cost and profit X-efficiency effects of the distance within the US between banks in multibank holding companies and the senior management of their organi-zations,assumed to be located at the largest bank in the holding company.This procedure has the advantage of focusing on the effects of distance,since there are fewer difference in language, culture,etc.in the US than in Europe(Berger and DeYoung, 2001).The measured effects of distance on efficiency were quite small,suggesting that some efficient organizations can export efficient practices to their affiliates and overwhelm any agency costs or other efficiency effects of distance.

8For more extensive discussion of these efficiency barriers, see Berger et al.(2001a).These barriers to efficient cross-border opera-tions can be modified significantly by government policy.The Single Market Programme and Euro-pean Monetary Union may reduce some of the barriers to cross-border consolidation within the EU,and within the subset participating in mone-tary union,respectively.These policies reduce or eliminate differences in currency,regulatory/ supervisory structures,and explicit rules against foreign competitors from other EU nations. However,these actions may not lower other bar-riers,such as differences in language and culture, implicit rules or supervisory barriers against for-eign institutions,and distances between nations.

Another offset to the cross-border efficiency barriers may be cost and revenue efficiency bene-fits associated with risk diversification.These benefits may be substantially greater on average for cross-border consolidation than within-nation consolidation because nations differ greatly in their macroeconomic cycles,government policies, and trade and investment barriers.Within Europe, the correlations of bank earnings across nations are often quite low,and many of these correla-tions are negative(Berger et al.,2000b;Table1).

There may be additional revenue X-efficiency effects from cross-border consolidation because it allows the institution to serve customers that op-erate in multiple nations.Multinational customers often benefit from the services offinancial insti-tutions that operate in the same set of nations,and may be willing to pay more for doing business with multinationalfinancial institutions.Part of this revenue X-efficiency comes fromfinancial institu-tions following their existing customers across in-ternational borders,maintaining the benefits of existing relationships.A number of studies have found evidence that some banking organizations engage in the‘‘follow-your-customer’’strategy of setting up offices in nations in which their home nation corporate customers have foreign affiliates (e.g.,Goldberg and Saunders,1981;Grosse and Goldberg,1991;Goldberg and Grosse,1994;Ter Wengel,1995;Brealey and Kaplanis,1996). However,some evidence indicates that foreign-owned banks may not cater primarily tofirms headquartered in the home nation,lending mostly to other business borrowers(Stanley et al.,1993;Seth et al.,1998).The revenue X-efficiency effects of the follow-your-customer strategy cannot be easily measured because this is generally only a small part of the loan portfolio and because some of the benefits may accrue to the headquarters of the bank in the home country.

Cross-border efficiency may also be affected in important ways by the market conditions and policies of the home nation.Some nations may have specific favorable market or regulatory/ supervisory conditions at home that allow insti-tutions headquartered there to operate more effi-ciently in other nations than domestic institutions in those nations.

A number of studies compared the efficiency of institutions in different nations,focusing on the operations of institutions operating within each nation,rather than cross-border operations.Most of these studies have included multiple European nations(e.g.,Berg et al.,1993;Fecher and Pestieau, 1993;Bergendahl,1995;Bukh et al.,1995;Allen and Rai,1996;Ruthenberg and Elias,1996;Eu-ropean Commission,1997;Pastor et al.,1997a,b; Bikker,1999;Maudos et al.,1999a,b;Pastor,1999; Wagenvoort and Schure,1999;Dietsch and Lozano-Vivas,2000;Cavallo and Rossi,2001; Lozano-Vivas et al.,2001).While these studies are informative,they may not be very helpful for evaluating the efficiency effects of cross-border consolidation for two main reasons.First,the economic environments faced byfinancial institu-tions differ across nations in important ways that may affect measured efficiency and cannot be well controlled for by econometric techniques.Second, the performance of institutions within their own borders may not be representative of how well they may perform as foreign-owned entities in other nations,given the cross-border efficiency barriers discussed above.

Some studies have compared the X-efficiencies of foreign versus domestic institutions operating within the borders of a single country,which avoids the problem of environmental differences across nations and directly tests whetherfinancial insti-tutions are able to operate or monitor subsidiaries efficiently on a cross-border basis,which is critical to determining whether international consolidation can be successful in increasing efficiency.Studies of US data generally found that foreign-owned banks are significantly less cost efficient on average than domestic banks(Hasan and Hunter, 1996;Mahajan et al.,1996;Chang et al.,1998)and less profit X-efficient on average than domestic institutions(DeYoung and Nolle,1996).Unfortu-nately,this type of evidence alone cannot distin-guish all of the important alternative hypotheses. The data are consistent with the possibilities that (1)foreign institutions generally have lower effi-ciency than domestic institutions;(2)US institu-tions are just more efficient than institutions from other nations;and(3)foreign banks from some other nations are more efficient and some are less efficient than the domestic US banks.More evi-dence is needed to differentiate among these hy-potheses––data from more home countries and disaggregation of the results by nation of foreign ownership.

Some of the research on other nations found that foreign institutions have about the same av-erage efficiency as domestic institutions.One study found that foreign banks in EU countries that were acquired in the past three years had about the same cost efficiency as domestic banks(Vander Vennet,1996);one study found that foreign banks in Spain are about equally profit efficient to do-mestic banks(Hasan and Lozano-Vivas,1998), and one study found that foreign banks in India were somewhat more efficient than domestic banks held by private sector investors,but that both were less efficient than domestic banks held by the government(Bhattacharya et al.,1997).Again,the results were not reported by foreign nation of origin,making it difficult to determine whether institutions from some nations tend to be more efficient when they operate across borders.

Other research took a different approach.These studies measured profit efficiency for14home countries,classified by banking system develop-ment and regulatory/supervisory environment (Miller and Parkhe,1999;Parkhe and Miller,1999). They found that domestic banks were more efficient on average than foreign institutions(including US-owned banks),although foreign banks from the same type of environment as the host nation gen-erally fared better than other foreign institutions. Although they appropriately measured separate frontiers for the institutions located in each coun-try,they pooled the efficiency estimates from the foreign and domestic banks in the several nations in each group(after normalizing the estimates to have a common mean and standard deviation), which may create problems of comparison because of the different environments of these nations.

Finally,one study addressed some of the methodological drawbacks in the other studies by examining the cost and profit X-efficiency in a number of home countries,by distinguishing among nations of origin of foreign institutions, and by conducting completely separate analyses of data from banks located in different countries (Berger et al.,2000b).They used data fromfive home countries––France,Germany,Spain,the UK,and the US,but also included foreign banks from other nations.Consistent with most of the literature,they found that domestic banks usually had higher mean profit X-efficiency than the mean of all foreign banks operating in that country. They also found that in most EU nations,there was very little penetration by foreign banks headquartered in other EU nations,and those that did penetrate typically had slightly lower efficiency on average than domestic banks.

This research as a whole tends to suggest that at least for the recent past,barriers to cross-border operating efficiency offset most of any potential efficiency gains from cross-border consolidation in EU,despite the Single Market Programme.How-ever,other explanations of thefindings are also possible.Thefinding of relatively inefficient for-eign-owned banks could reflect cross-subsidies from the foreign-owned banks to their home-nation bank headquarters.Alternatively,foreign or-ganizations may tend to buy host nation banks that already have performance problems that have not yet been resolved(Peek et al.,1999),or use these acquisitions as‘‘toeholds’’to earn long-run bene-fits from establishing presences in the foreign na-tions.As well,the efficiency of foreign-owned bank affiliates does not necessarily capture all of the ef-ficiency benefits and costs associated with foreign ownership because the entire operations of the banking organizations are not analyzed.For ex-ample,any relationship benefits of a follow-your-customer strategy that accrue to the headquartersof the bank in the home country are excluded from these analyses.9

5.The effects offinancial institution consolidation on the supply of relationship lending services to informationally opaque small businesses

Financial institutions,particularly commercial banks,provide relationship loans to information-ally opaque small businesses that often have diffi-culty obtaining external credit in similar quantities and at similar contract terms(interest rate,col-lateral requirements,etc.)elsewhere.Under rela-tionship lending,the bank typically gathers information through contact over time with the firm,its owner,and its local community on a va-riety of dimensions,and uses its proprietary access to this information to make credit decisions.Re-lationship information is often‘‘soft’’data,such as the information about character and reliability of thefirmÕs owner,that is difficult for the loan officer to quantify and credibly transmit to others,even to other employees of the bank.

If an informationally opaque small business loses its banking relationship,thefirm may incur significant search costs or temporary funding problems infinding another lender,and may face less favorable loan terms(e.g.,higher rates,greater collateral requirements)until its new relationship matures.That is,some of the relationship infor-mation built up over the course of the relationship may be destroyed and the new lender needs time to gather the relevant data.In some cases,thefirm may not be able to obtain replacement funding.If afirm perceives that its lending relationship is in jeopardy,it may react by borrowing from multiple banks,raising borrowing costs and losing some of the benefits from its exclusive relationship.Thus, even the threat of relationship loss may create significant costs.

Banking industry consolidation may cause dis-ruptions in the supply of credit to informationally opaque small businesses by creating larger banking organizations.We use the term‘‘disruption in supply’’rather than‘‘reduction in supply’’because there may be external effects in which other lenders eventually supply the credit to thefirm,as discussed below.Large organizations may have difficulty extending relationship loans to thesefirms because of Williamson-type organizational diseconomies of providing relationship lending services along with providing transactions lending services and other wholesale capital market services to the large cor-porate customers generally served by large banking organizations(Williamson,1967,1988).That is,it may be too costly to provide relationship services to small businesses together with wholesale services to large businesses.Large banks may also have diffi-culties extending relationship credit because this type of lending often requires‘‘soft’’information about thefirm,its owner,and the local market that may be particularly difficult to transmit through the communication channels of large organizations. These large organizations may require standard-ized credit policies based on easily observable, verifiable,and transmittable‘‘hard’’data(Stein,in press).

Large banks may also be disadvantaged in re-lationship lending because they are more often headquartered at a substantial distance from po-tential small business borrowers,making it difficult to acquire soft local information.The consolida-tion process itself and the problems associated with consummating M&As discussed above may also affect the ability to serve customers during the transition period and result in the loss of some relationships.

When the M&A crosses international borders, there may be even greater disruptions in the supply of credit to informationally opaque small busi-nesses.The efficiency barriers faced by foreign-owned institutions discussed above––differences in language,culture,etc.––may make it costly to gather and process locally based,soft relationship information and compound the problems associ-ated with bank size and distance.

Despite these arguments about the potential unfavorable effects of bank size,the consolidation

9It is also possible that the cross-border expansion is associated with an increase in market power(particularly over ‘‘follow-your-customer’’customers)that compensates the bank-ing organization for the efficiency problems in foreign nations, although it seems more likely that market power may be decreased from cross-market expansions.process,and foreign bank ownership,it is alter-natively possible that a more consolidated industry could provide a more stableflow of funding to bank-dependent relationship borrowers.This could occur if the consolidated institutions are safer because of risk diversification or stronger government safety net protection.Banks that are infinancial distress may reduce their lending to informationally opaque small businesses because of pressure from government supervisors/regula-tors,capital market investors,and/or risk-averse managers to reduce the risk profile of the bank. Similarly,in the event of bank failure,the rela-tionship information may be lost,and it may take time for a new lender to build up its information set.To the extent that consolidation reduces bank risk,there may be fewer disruptions in credit to relationship borrowers,and less need for these firms to borrow from multiple banks to insure themselves against a credit disruption.

A number of studies found that large banks tend to devote lower proportions of their assets to small business lending than smaller institutions(e.g., Berger et al.,1995).Some studies also examined the type of small business loans that are extended by large banks.They found that relative to small banks,large banks tend to(a)lend to larger,older, morefinancially secure businesses(Haynes et al., 1999),(b)charge lower rates(Berger and Udell, 1996;Berger et al.,2001e),(c)have shorter and less exclusive relationships(Berger et al.,2001c,d),(d) base their lending decisions more onfinancial ra-tios rather than the existence of a prior relationship (Cole et al.,1999;Berger et al.,2001d),and(e)lend at greater distances and have less personal contact with borrowers(Berger et al.,2001d).All of these findings are consistent with comparative disad-vantages of large banks in extending relationship credit,assuming that relationship borrowers tend to(a)be smaller,younger,and less secure,(b)pay relatively high rates(reflecting high risk),(c)have longer and more exclusive banking relationships, (d)borrow on the basis of relationships,and(e) borrow at shorter distances and have more per-sonal contact with their bankers.

A number of studies also examined the effects of bank M&As on small business lending,which could involve changes in bank focus or disruptions caused by the consolidation process,as well as changes in bank size(e.g.,Peek and Rosengren, 1998;Strahan and Weston,1998;Berger et al., 1998;Avery and Samolyk,2000;Bonaccorsi di Patti and Gobbi,2000).These studies usually found that M&As involving large banking organizations reduced small business lending sub-stantially,although M&As between small organi-zations often increased small business lending. Finally,one study found that foreign-owned banks tend to have more difficulty than domestically owned banks in lending to informationally opaque small businesses(Berger et al.,2001c).

There is some limited evidence on the effects of bank distress on lending to informationally opa-que small businesses.One study found that bank distress appears to have no greater effect on small borrowers than on large borrowers,although even smallfirms may react to bank distress by bor-rowing from multiple banks,raising borrowing costs and destroying some relationship benefits (Berger et al.,2001c).Another study found that bankfinancial capital shortfalls appear to affect small business lending more than large business lending primarily because smaller banks reduce their lending more than large banks when con-fronted with a capital shortfall(Hancock and Wilcox,1998).

Importantly,even if the larger,more distant, and increasingly foreign-owned banks involved in the M&A process sever some of their lending re-lationships with informationally opaque small businesses,these business may oftenfind alterna-tive sources of external funding.There may be ‘‘external effects’’or general equilibrium effects in which other banks react to any reduced supply of credit by the consolidating institutions by in-creasing their own supply.Several studies found that other banks in the same local markets in-creased their small business lending after M&As (Berger et al.,1998,2001b;Avery and Samolyk, 2000).There may also be an external effect in the form of an increase in de novo entry––new banks that form in markets where M&As occur––although the evidence is mixed on this issue(Seelig and Critchfield,1999;Berger et al.,in press).

Thus,consolidation of the banking industry seems likely to cause at least some disruptions inthe supply of credit to some informationally opa-que small businesses.Although many of these firms mayfind alternative sources of externalfi-nance,they may still bear significant search costs, face less favorable loan terms,or set up costly multiple lending arrangements in advance of these expected problems.These costs are not tradition-ally counted as efficiency losses from consolidation of thefinancial services industry perhaps because they do not affect the performance of thefinancial institutions themselves and because these costs are very difficult to measure.

6.Conclusions

The research reviewed here suggests that the creation of a single market for the Europeanfi-nancial services industry is not likely to bring about strong efficiency gains,and that cross-border effi-ciency barriers may prevent the single market from becoming a reality.The research to date suggests very little cost scope economies from universal banking,and possibly some cost scope disecono-mies from the organizational problems in manag-ing very different types offinancial institutions.On the revenue side,there may be modest revenue economies from diversification gains,brand reputation,or‘‘one-stop shopping’’convenience. However,the evidence on universal banking from the past may not be a good indicator of the future becausefinancial markets have changed so much in Europe.In the last few years,stock and debt markets have matured and M&As among nonfi-nancialfirms have increased,greatly expanding the market for investment banking services.To predict the efficiency effects of a single market in Europe in the future,research is needed on universal banking in more market-oriented systems.

The literature onfinancial institution M&As mostly measures the effects of the consolidation of the same type of institution within a single nation, and tends tofind slight efficiency gains,mostly on the revenue side due to risk-diversification gains. However,for creating a single market in Europe,it is cross-border consolidation that is most relevant. Here,the data suggest that there may significant efficiency barriers associated with differences in language,culture,currency,and regulatory/su-pervisory structures,explicit or implicit rules or supervisory rulings against foreign competitors,or distance that prevent foreign-owned institutions from operating efficiently.These barriers may also serve as a drag on the creation of a single market. The Single Market Programme and European Monetary Union may reduce or eliminate some of these barriers––differences in currency,regulatory/ supervisory structures,and explicit rules against foreign competitors––but these regulatory actions may not lower other barriers––differences in lan-guage and culture,implicit rules or supervisory barriers against foreign institutions,and distances between nations.

Finally,the consolidation of the banking in-dustry into large,international banking organiza-tions may result in disruptions in the supply of relationship credit to informationally opaque small businesses and the loss of relationship information built up over time.The small businesses may incur significant search costs,face less favorable lending terms until new relationships mature,and possibly be unable to obtain alternative funding.In some cases,the threat of relationship loss may create extra costs ex ante for the borrower of obtaining loans from multiple banks.These potential costs from consolidation are usually not considered to be efficiency losses,since they are not borne by the consolidating institutions.There are also no mea-sures of the size of these costs.

Importantly,we offer the caveat that much more research is needed to draw definitive con-clusions for most of the topics covered here.In particular,there is too little study of the efficiency effects of universal banking,particularly given the movement of thefinancial system towards greater dependence onfinancial markets.More research is also needed on the efficiency effects of cross-border operations,and on the effects on informationally opaque small businesses offinancial services in-dustry consolidation.

Acknowledgements

The author thanks the editors,Anoop Rai and Nico van der Wijst,the anonymous referees,and

Dave Humphrey and Greg Udell for helpful sug-gestions.

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