Cross-Border M&As and Bank Stability: Evidence From the Bond Market

1. Cross-Border M&As and Bank Stability: Evidence From the Bond Market Sungho Choi*, Bill B. Francis*, andIftekhar Hasan*, ** * Rensselaer Polytechnic Institute, ** Bank of Finland

2. Cross-Border Bank M&As - Motivation Popular Business Strategy • Charting new territory: • Different portfolio management, new financing sources. • Numerous barriers, e.g., distance, currencies, language, culture, regulatory and supervisory norms • In case of M&As – which country’s regulation should prevail? Lack of concrete rules of regulation!

3. Cross-Border Bank M&As - Motivation • Uncertainty associated with the new environment changes the risk perspective of banks and therefore impacts all stakeholders - shareholders, bondholders, and regulators. • Empirical evidence on the impact of cross-border M&As on bank stakeholders is sparse.

4. Research Questions • How does the bond market react to the cross-border M&Asusing the changes in bond yield (or change in bank risk) as the metric? • Additionally, we also trace the impact on the other stakeholders - shareholders and regulators • We also examine how these changes are affected by institutional factors that are known to impact both bond and share value (moral hazard, investor protection, etc.)

5. Preview of Results • There is a significant increase in yield spread on the announcement of cross-border M&As. • Investor protection, moral hazard, transparency, and information costs between acquirer’s and target’s countries are important determinants of the impact on the abnormal changes in yield spread. • For the full sample, we find evidence of wealth transfer between bondholders and shareholders. Additionally, when sort on positive and negative abnormal changes in yield spread, there is evidence of wealth transfer from regulators to bondholders. • Results show that investor protection and moral hazard, are important in explaining abnormal changes in bond yield spreads.

6. Cross Border M&A and Risk Mixed views on the Impact of M&A on Bank Risk Risk Decreasing: • Reduce risk of bank insolvency - Vander Vennet(1996) and Berger (2000). Risk Increasing: • Distance and differences in languages and cultures, regulatory and supervisory norms (Berger DeYoung, and Udell (2001)). • Diversification into new sectors or regions (also the managerial risk shifting incentives) which are likely to perform worse (Winton (1999), and Repullo (2001)).

7. Empirical Evidence • Amihud, Delong, and Saunders. (2002) – Cross-border M&A do not lead acquirers to engage in post-merger risk shifting or risk increasing behavior, evidence through the stock return data. • Penas and Unal (2004)– Domestic mergers are risk reducing, evidence through bond return. • Our paper provides much needed empirical evidence on this important issue.

8. Data • Thomson Financial SDC Platinum, 1995 to2002. • Use only mergers where the acquirer’s stock is publicly traded and bond yield spreads are available through Datastream. • Acquiring bank needs to have at least one bond outstanding with a remaining maturity of greater than 2 years. • 147 cross-border bank M&As.

9. Data - Continued • Fitch-IBCA Bankscope database. • Individual bond data and the government bond data of acquiring bank’s country are from Datastream. • Country specific, regulatory and supervisory variables are obtained from Barth, Caprio, Levine (2001) and the World Bank database (2004).

10. Data - Continued • Rich mix of countries. • 15 Acquiring and 54 Target Countries. • Frequency of mergers are quite uniform across sample years.

11. Institutional factors that impact bank risk Institutional and Country Characteristics • Investor Protection • Moral Hazard • Toughness • Transparency • Information Costs (income, law, and language)

12. Investor Protection • Extent of legal protection of investor is a key determinant of asset valuation(La Porta et al. (2002)) -- strong legal protection of investors is associated with higher valuation of corporate assets. -- support for the existence of expropriation of minority shareholders as well as the role of the law in limiting such expropriation. • The higher investor rights could be interpreted as less risk to investor. -- assuming all things are equal, if a bank takes over a financial institution in a country where there is a higher investor legal protection, the change in the acquiring bank’s risk should at least be non-positive.

13. Moral Hazard • Having an extensive deposit insurance may lead to greater moral hazard for bank managers (Bhattacharya and Thakor (1993), Bhattacharya, Boot, and Thakor (1998), and Demirguc-Kunt and Detragiache (2002). • A generous deposit insurance of target countries against acquirer countries may shift the risk of bank, impacting the yield spreads.

14. Regulation and Supervision • Regulation and supervision significantly influence cross-border bank M&As (Berger, DeYoung, Genay, Udell (2000), Focarelli and Pozzolo (2001), Buch and Delong (2004), Jayaratne and Strahan (1998)). -- governmental regulations and supervision may reduce information symmetries and are often essential to ensure the solvency of whole banking system. -- higher and tougher regulations and supervisions in acquiring banks’ countries relative to target countries’ increase the chance of better performance and thus reduce the risk of bank failure, resulting in lower yield spreads.

15. Methodology • Yield spreads - the difference between the yield on a bank bond and a government security of that country with comparable maturity (Gande, Puri and Saunders (1999)). • Based on weekly yield data. • Combine all firms’ bond yields into a single yield by value weighted averages of individual bonds. • Methodology to measure the abnormal announcement effect on bond yield spreads is adopted and modified from Eckbo Maksimovic and Williams (1990).

16. Methodology – Continued • Abnormal effects on yield spreads are estimated directly as the parameter βjin the model: SPjt = αj+ βjdjt + ejt (1) - where - SPjtis the market value weighted average yield spread of a bank j’s bond djtis a dummy variable which takes on a value of 1 if week t is the week of the announcement. • Estimation period typically previous 30 weeks plus event window weeks. • Abnormal effects are averaged with equal weights across banks to form the average abnormal effects.

17. Results • Mean Yield Spread = 80 Basis Points; Range (~2 to 288 basis points). • Mean Number of Bonds used in the SP Estimation = 3.7; (Range 1 to 15). • Average Remaining Maturity=5.4 years and Average Market Value of Bonds = 461 million.

26. Regression of Announcement Week Abnormal Effects on Yield Spreads • Abnormal effects on yield spreads are estimated directly as the parameter βjin the model: • AESPj = αj+ β1Investori + β2Hazardi + β4Toughi + β5Transi + Σ βjZj + εj -where AESPjis the announcement abnormal effect on yield spread and is estimated as the parameter βjin equation 1. We use the natural logarithm of one plus parameter βjsince it is characterized by high kurtosis. • We estimate AESP based on several announcement windows as well as estimation windows of previous 30 or 52 weeks plus announcement event windows.

27. Independent Variables • Investor Protection= 1 if Target has Better Investor Protection than Acquirer; otherwise=0 • Hazard = Index – World Bank • Tough = Index on Regulation and Supervision – World Bank • Trans=Relative transparency – World bank • Z=others including Recovery = 1 if Target has Better Recovery Rate than Acquirer; otherwise=0 Creditor Rights (Target/acquire index), C Concent=1 if target has a higher banking concentration, Law (target – acquirer same legal origin=1); Income=1 if same income level; DFX (target – acquirer same currency=1; D100CS=1 if all payments is cash transaction; LogTAcq=Logarithm of Total Assets of the Acquiring Bank; ROEacq=ROE of the acquiring bank, TETAcq=equity to assets past year of acquiring bank LLRacq=Loan Loss Reserve prior year to Total Loan of Acquiring Bank

28. Regression Results • Investor Protection= Negative and Significant • Hazard = Positive and Significant • Tough, Creditor Rights, Concentration = Positive, Marginal Significance in Some of the Equations • Recovery, Trans, Law, Income, Size, ROE, Equity/Asset = Not Significant • Method of payment matter

29. Summary of Results • There is a significant increase in yield spread on the announcement of cross-border M&As. • Investor protection, moral hazard, and information costs variables between acquirer’s and target’s countries are important determinants of the impact on the abnormal changes in yield spreads. • For the full sample, we find evidence of wealth transfer between bondholders and shareholders. However, when we sort on positive and negative abnormal changes in yield spread (AESP), there is evidence of wealth transfer from regulators to bondholders • Results show that investor protection (-) and moral hazard (+) are important in explaining abnormal changes in bond yield spreads.

30. Implications • Since cross-border bank M&As increase the risk of acquiring banks, the home country regulator(s) may require acquiring banks to increase their reserves to better protect the banks’ stakeholders - depositors, bond holders, and shareholders. • Regulators should especially consider institutional characteristics in both the home- and the host-country in judging the sufficiency of the banks’ reserve positions.