Too Big to Fail: How Mergers Can Protect Financial Institutions

In the name of liberalization, and because of relatively easy entry barriers, financial institutions have sprouted up all over the country. With just not more than two decades almost seventeen insurers, seventeen banks and thirty one micro financial institutions, of varying capabilities have joined the sector. Among these, state financial institutions most of which emerged from the old planned economy maintain a massive physical presence and top-heavy market share.

Is everyone benefiting?
In Ethiopia, a large proportion of the population is not served by the formal institutions. While the market entrants are increasing in number, the country’s record in creating access to finance and financial inclusion is still lagging behind other countries. To pursue cost efficiencies, the banks and insurers have left a vacuum of access to basic financial services in mostly rural areas and primarily among the poorest of the population. Informal, but largely unregulated, microfinance institutions are developing. Recent moves to regulate this industry are, however, showing some promise. Nevertheless, pressure is mounting on the financial system to play a bigger role in resolving the problem of access to finance by small, medium-sized and micro enterprises and potential sub-economic homeowners.

Informal Mergers
The way financial institutions are actually working, there already is a great deal of reciprocity and common ownership between banks and insurance companies. Some even have common ownership and they are becoming increasingly interdependent on each other. As the profits of banks are increasing so too are the profits of insurance companies, (mostly from investment income driven by the banks’ performance). We have also witnessed some beginnings in sharing technology.
Yet despite this interdependence most local financial institutions do not have the financial capacity that similar institutions in other counties have. When Ethiopia joins the WTO there will be pressure to liberalize the financial sector which likely would cripple local banks but one possible solution to this would be for them to greatly strengthen their capacity by merging into larger and more powerful institutions.
In the era of globalization, Ethiopia can no longer be isolated from the rest of the world. With the imminent WTO accession, restrictions on foreign operators’ will be removed. Foreign giants might be hungry to penetrate the Ethiopian market and take the ‘cream’ of this untapped potential financial services market. To remain competent and stand the pressure from the global giant financial institutions, Ethiopian companies may need to strengthen their capacity through merger. Other feasible options must also be thought over.
Banks from different emerging markets are now starting to team up. Most post merger performance reviews have proven successful in other countries. Merger benefits customers who will be able to enjoy full services from an even larger branch network countrywide. Customers will have longer and more convenient banking hours and wider product variety.

Mergers Defined
In the pure sense of the term, a merger happens when two financial institutions, agree to go forward as a single new company rather than remain separately owned and operated. In practice, however, mergers between equals occur during times of survival; but because being bought or being taken over carries negative connotations, the more palatable term “merger” is adopted. It is also a strategic direction towards sustainable business. In most instances, this has shown remarkable benefits to the shareholders, customers, staff, industry and the economy at large. The reasoning behind any corporate merger is that two companies are better than one because they increase shareholder value over and above that of the two separate firms. The motives behind mergers are economies of scale, increase in market share and revenues, taxation, synergy, geographical and other diversification. In a merger, one plus one makes three. This equation is the special alchemy of a merger. The companies will come together hoping to survive during hard times in order to meet requirements, gain greater market share and growth – or to achieve greater efficiency. All mergers have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts – this is the yardstick against which all mergers are judged.

Global Mergers
While the practice is new-fangled to the Ethiopian financial sector; the global trend shows that today’s financial climate is fueling a wave of mergers, particularly among financial institutions. Under this background, the mantra has become ‘bigger is better’. Mergers have for example, become a prominent feature in Kenya’s banking industry. The Central Bank of Kenya and shareholders of banking institutions in Kenya have a positive inclination to mergers and acquisitions. According to the report from the Central Bank of Kenya (2012), mergers and acquisitions are considered important in the financial sector to meet the increased levels of share capital; expand the distribution network and market share; and to benefit from best global practices. Accordingly, from the year 1989 to 2010, over 42 financial institutions were merged to secure such advantages.
Various studies in South Africa, West Africa and many others also advocate that institutions having weak capital base consolidate to create synergies so as to enjoy economies of scale as this will improve their profitability instead of going bankrupt. Those firms facing constraints on the market consolidated their energies by resorting to mergers so as to expand their profitability as the merger is not just for the best interest of the managers but also shareholders as it leads to an increase in shareholders’ wealth as opposed to each financial institution operating separately on its own. The study results in 2012 have convincingly shown an increment of return on asset (ROA), equity per share (EPS), and return on equity (ROE) following mergers. Moreover, the results indicate that the financial performance ratios that have legal implications (capital adequacy and solvency ratios) improved subsequent to the merger. This latest merger wave has been undertaken even among ‘very large corporations’.
When we read and hear about mega mergers and related success stories we wish to hear the same in our nation since most institutions are divided despite sharing the same mission and vison. Massive merger waves may lead to the rise of institutions “too big to fail”.
The trend in Ethiopia shows that state owned institutions form over 60Pct of the market share and many private firms with eight percent or less each. This disproportionate share could also be enhanced if consorted effort in amalgamations of the undersized institutions takes place. According to NBE 2012, the total capital of the banking system has reached Birr 18 billion of which the private banks jointly accounted for 49.3Pct. While the state giant CBE, accounted for 34.6Pct of the total capital of the banking system. The insurance stream is operating with a total capital of 1.2 billion. On the other hand, from the regulator’s side, regulating too many licensed but undersized financial institutions might create headaches and waste effort.
Challenges
Without a thoughtful plan mergers can be difficult and chaotic. If one company is just ‘treading water,’ and another one is not profitable, then merging them together will only make a company insolvent; as the saying goes: ‘two wrongs do not make a right’.
Proposals need to be evaluated to make sure that they benefit the economy, workers and the interest of shareholders. Companies each have their history and culture and how these two will mesh together must be considered as well. The larger effect on the country is another fear merging financial institutions must be aware of. If regulations are not enforced and strengthened based on the unique nature of the Ethiopian market then it is entirely possible that a few firms can band together and end up holding a majority of assets. This would create an oligopolistic marketplace which would end up tying the hands of regulators and causing reckless financial behaviors.
Mergers usually mean immediate changes on the company’s board. The mixture of experiences can be helpful as it can lead to joint problem solving.
Accordingly, strong Governance and infusing a strong culture to drive change in the industry could emanate. Unless strategic leaders take the driver’s seat, patriotism and sentiment alone will not lead to stronger financial institutions in Ethiopia. Unless the homework is done in due course, the national assets or indigenous companies will not be able to prepare themselves for the imminent and fierce competition that they will face with global competitors. These nationalistic predilections alone often cloud our thinking and do not lead us towards success. As a nation we tend to scrutinize judgmental anchors in reference to our history and our ability to manage our own institutions based on international standards. In the future, if handled correctly, we might even see Ethiopian companies merging with international ones.

2nd Year • January 2014 • No 11