By studying the pre-crisis merger and acquisition activity of EU banks that received government assistance during the 2008–09 financial crisis, the authors investigate whether banks pay a premium in acquisitions that allow the banks to become “too systemically important to fail.” They find that rescued banks were more likely to have paid a premium for pre-crisis transactions that increased their safety net subsidies.
The authors find evidence that banks value being “too systemically important to fail” (TSITF). By looking at merger and acquisition activity prior to the 2008–09 financial crisis—a crisis that led to a number of banks being bailed out by governments—they determine that banks that received safety net subsidies were more likely to have paid acquisition premiums for pre-crisis transactions that increased their ability to receive safety net subsidies. In essence, banks appear to understand that there is value to making themselves too important to the financial system to have a government let them fail. Upon achieving such a distinction, a bank may have a perverse incentive to take on additional risk, knowing the safety net subsidies are likely to be available should their risk taking lead to poor outcomes.
How Is This Research Useful to Practitioners?
Practitioners benefit from recognizing situations where a set of firms becomes so essential to an economy that a government bailout in a time of crisis is almost assured and from understanding how that safety net can lead to increased risk taking. Being able to recognize such a situation has implications for investing in such firms and for regulating merger and acquisition activity.
Furthermore, being able to recognize when an acquisition premium is meant to make a firm in any industry TSITF may be helpful for investors and regulators alike. Depending on the regulatory climate, such an acquisition may be prohibited or scrutinized extensively (which is suggested by the authors in regard to the banking industry).
How Did the Authors Conduct This Research?
The authors collect data from between 1997 and 2007 for bank merger and acquisition activity (162 transactions with 54 acquirers taking full control—i.e., purchasing more than 50% of the target firm’s shares) in nine EU countries. Using stochastic cost frontier modeling, the authors separate acquisition premiums into different categories, including safety net subsidies, which are extracted from the error term. Some of the data are return data, and some of the data are balance sheet data.
In 2007, 4,318 banking firms were not involved in bank bailouts and 54 banks received bailout money. These 54 banks are contrasted against the nonbailout bank sample using a binary coefficient. Probit and logit regressions using safety net subsidy measures and regulatory environment measures indicate that firms receiving safety net subsidies were more likely to have paid a premium for such subsidies in a merger or acquisition prior to the financial crisis.
Further analysis demonstrates the authors’ results to be robust to other possible explanations and also demonstrates that TSITF banks do not create an interdependency with peer banks. The authors caution, however, that this result may be explained by a lack of appropriate data to study this issue; they recommend further investigation.
I find the research interesting; it reminds me of the “Fed put” paradox. The US Federal Reserve is obligated to sustain the banking industry even when it means bailing out reckless banks. This put makes the banking industry safer, but it also creates a perverse incentive for large/important banks to be more risk tolerant because the put exists. The question becomes, Should the put be eliminated to make banks more risk averse, or does the put need to exist to provide confidence in the banking industry? History seems to indicate that the benefit of the latter outweighs the benefit of the former despite the unpopularity of bailouts, which I suspect will not change in the future.