Berger 2000

Globalization of Financial Institutions: Evidence from Cross-Border
Banking Performance
Allen N. Berger, Robert DeYoung, Hesna Genay, Gregory F. Udell
Brookings-Wharton Papers on Financial Services, 2000, pp. 23-120 (Article)
Published by Brookings Institution Press

DOI: 10.1353/pfs.2000.0001
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9550—04-Brks Wharton Ch 1 8/11/00 16:29 Page 23
Globalization of Financial
Institutions: Evidence
from Cross-Border
Banking Performance
ALLEN N. BERGER,
R O B E R T D E Y O U N G , H E S N A G E N AY,
a n d G R E G O RY F. U D E L L
M ERGERS AND ACQUISITIONS among very large financial institu-

tions are becoming more frequent in markets around the world, attracting
the attention of policymakers, researchers, and the financial press and con-
tinually reshuffling the rankings of the world’s largest financial services
firms. Most of these mega-mergers have combined commercial banking
organizations within a single nation. In the United States, recent mergers
and acquisitions (M&As) between large banking organizations—such as
Bank of America–NationsBank, Banc One–First Chicago, and Norwest–
Wells Fargo—rank among the largest M&As in terms of market values in
any industry in U.S. history. In Europe, mega-mergers like UBS–Swiss
Bank are similarly creating giant banking organizations that are much
larger than the world’s largest banks of just a few years past. In Japan, the
three-way combination of Fuji Bank, Dai-Ichi Kangyo Bank, and Industrial
Bank of Japan is creating the world’s first trillion-dollar bank.
The authors thank Bob McCormack and Raghu Rajan for their insightful comments;
Charles Calomiris, Ed Ettin, Bob Litan, Tony Santomero, and other participants at the
Brookings-Wharton conference for their clarifying remarks; Emilia Bonaccorsi, Nicola
Cetorelli, Gayle DeLong, Michel Dietsch, Carmine Di Noia, Larry Goldberg, Iftekhar
Hasan, Ana Lozano-Vivas, Loretta Mester, Laurence Meyer, Stewart Miller, Phil Molyneux,
Darren Pain, Darrel W. Parke, José Pastor, Linda Powell, Rudi Vander Vennet, Ingo Walter,
and Juergen Weigand for invaluable help with the preparation of this article; and Kelly
Bryant, Portia Jackson, Rita Molloy, and Ozlen Savkar for outstanding research assistance.
23
24 Brookings-Wharton Papers on Financial Services: 2000
More to the point of this paper, there also is a trend toward cross-border
M&As between large financial service firms in different nations. These
cross-border M&As often involve large universal-type institutions that
provide multiple types of financial services in multiple nations. One
prominent example is the Deutsche Bank–Bankers Trust mega-merger,
which provided a leading European universal bank with greater access to
wholesale commercial and investment banking resources in the United
States. In Europe, there has been considerable cross-border consolidation
of all types of financial institutions following substantial deregulation of
cross-border economic activity in both financial and nonfinancial markets.
For the securities and insurance industries, the market values of cross-
border M&As involving European financial institutions have actually
exceeded the values of within-nation M&As in recent years.1
The increased M&A activity raises important research and policy ques-
tions about the causes and consequences of consolidation and the future
structure of the financial services industry. There is an extensive research
literature on the motives for and consequences of consolidation, covering
efficiency, market power, and managerial topics. Presumably, much of
the increase in consolidation represents market responses to deregulation
that made it more possible and less costly to consolidate, such as the
Riegle-Neal Act in the United States and the Single Market Programme
in the European Union (EU). Future consolidation may be motivated by
recent policy changes, such as passage of the Gramm-Leach-Bliley Act in
the United States and creation of the monetary union in the European
Union. These policy changes may precipitate further consolidation of large
institutions, with important social consequences for systemic risk, the
safety net, and monetary policy as well as for efficiency and market power
in the financial services industry.
In this paper, we address these issues in three ways. First, we exten-
sively review several hundred research studies on the causes and conse-
quences of consolidation, covering the topics of efficiency, market power,
managerial and government motives, and consequences. Second, we pro-
vide a number of relevant descriptive statistics, including data comparing
financial systems in different nations, information on cross-border provi-
sion of financial services through both cross-border lending and the estab-
lishment of a physical presence in foreign nations, and the market values
1. Berger, Demsetz, and Strahan (1999).

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 25
of within-nation and cross-border M&As. The literature review and

descriptive statistics are intended in part to provide reference material to
promote future research. Third, we analyze cross-border banking effi-
ciency in five home countries. This analysis is designed to address our
main hypotheses about cross-border banking efficiency and may help to
foretell the extent to which global financial institutions may penetrate
financial markets around the world.
We broadly define the efficiency effects of consolidation to include
any cost, revenue, or risk factors that affect shareholder value other than
changes in the exercise of market power in setting prices. Although we
acknowledge the importance of factors other than efficiency in consolida-
tion decisions, our approach reflects a presumption that cross-border con-
solidation is sustainable in the long run only if it increases efficiency or
does not reduce efficiency substantially. In this framework, we expect
that foreign-owned institutions would be at least as efficient on average
as domestic institutions. Efficiently managed organizations would gain
shares in foreign markets and export their superior skills or policies and
procedures to other nations. However, the empirical evidence in the liter-
ature (and in our own analysis) typically finds the opposite result—foreign
institutions are generally less efficient than domestic institutions. We ana-
lyze this mysterious finding by developing and testing two main hypothe-
ses, the home field advantage hypothesis and the global advantage
hypothesis.
Under the home field advantage hypothesis, domestic institutions are
generally more efficient than institutions from foreign nations. This advan-
tage could occur in part because of organizational diseconomies to oper-
ating or monitoring an institution from a distance. Operating problems
could include turf battles between staff in different nations or high costs
and turnover in persuading managers to work abroad. Monitoring prob-
lems may make it difficult to evaluate the behavior and effort of managers
in a distant market or make it difficult to determine how well they are per-
forming relative to other institutions in that market. Organizational dis-
economies may also make it difficult to establish and maintain some retail
deposit relationships with households or lending relationships with small
and mid-size enterprises, because such accounts may require local infor-
mation and a local focus. The home field advantage could also occur in
part because of barriers other than distance, including differences in lan-
guage, culture, currency, regulatory and supervisory structures, other
country-specific market features, bias against foreign institutions, or other

explicit or implicit barriers. The home field advantage may be manifested
as disadvantages for foreign banks, such as higher costs of providing the
same financial services or lower revenues from problems in providing the
same quality and variety of services as domestic institutions.
Under the global advantage hypothesis, some efficiently managed for-
eign institutions are able to overcome these cross-border disadvantages
and operate more efficiently than the domestic institutions in other nations.
These organizations may have higher efficiency when operating in other
nations by spreading their superior managerial skills or best-practice poli-
cies and procedures over more resources, lowering costs. They may also
raise revenues through superior investment or risk management skills by
providing superior quality or variety of services that some customers pre-
fer or by obtaining diversification of risks that allows them to undertake
investments with higher risk and higher expected returns.
We consider two forms of the global advantage hypothesis. Under the
general form, efficiently managed foreign banks, regardless of the nation
in which they are headquartered, are able to overcome any cross-border
disadvantages and operate more efficiently than domestic banks in other
nations. Under the limited form of the hypothesis, only the efficient insti-
tutions headquartered in one or a limited number of nations with specific
favorable market, regulatory, or supervisory conditions can operate more
efficiently than domestic institutions in other nations. Home-country
favorable market conditions may include stiff product market competi-
tion that provides a proving ground for efficient organizations, an active
market for corporate control that prevents cross-border consolidation that
reduces shareholder value, access to a well-developed securities market
that allows for exploitation of scope efficiencies, or access to an educated
labor force with the ability to adapt to new technologies, new financial
instruments, and new techniques for risk management. Favorable regula-
tory or supervisory conditions may include access to universal banking
powers to offer multiple types of financial services or relatively relaxed
prudential regulation, relaxed supervision, or strong safety net guarantees
that allow the organizations to undertake financial strategies with high risk
and high expected returns. Alternatively, relatively tough supervision or
regulation at home may give some institutions global advantages by certi-
fying their quality or reducing the risks of their contractual counterpar-
ties. As will be seen, distinguishing empirically between these two forms
of the global advantage hypothesis is an important key to unlocking the

mystery of why foreign institutions are on average less efficient than
domestic institutions and to determining why prior studies may have
drawn a starkly different conclusion from our conclusion, given below.
We test the hypotheses using data from five home countries—France,
Germany, Spain, the United Kingdom, and the United States—countries
for which data on a significant number of foreign-owned commercial
banks are available. We also extend our analysis by including foreign
banks from other nations such as Canada, Italy, Japan, the Netherlands,
South Korea, and Switzerland. For each home country, we estimate sepa-
rate cost and profit frontiers from which we estimate domestic and for-
eign bank efficiency. The hypothesis tests compare the mean domestic
bank efficiency against the mean efficiency of banks from each foreign
nation.
Overview of the Paper
First we present some background information, including trends in

cross-border provision of financial services, regulatory changes that have
fostered cross-border consolidation, and trends in cross-border M&As. We
then review the extant research on the efficiency motives and conse-
quences of cross-border consolidation of financial institutions. This is
followed by a review of the research on nonefficiency motives for and con-
sequences of cross-border consolidation.
Then we report our tests of the home field advantage and global advan-
tage hypotheses for cross-border bank ownership in the five select home
countries. We find that domestic banks generally have higher cost and
profit efficiency than foreign banks on average, although these differ-
ences are not always statistically significant. This is consistent with most
of the findings in the literature, where it has been interpreted as supporting
the home field advantage hypothesis. However, we do not draw this same
conclusion. Rather, by digging deeper and disaggregating the results by
foreign nation of origin, we find that the data appear to reject the home
field advantage hypothesis in favor of the limited form of the global advan-
tage hypothesis. These results, should they continue to hold in the future,
may have important implications for the future structure of financial mar-
kets. The finding that foreign banks are less efficient on average than
domestic banks suggests that efficiency considerations may limit the

global consolidation of the financial services industry and leave substantial
market shares for domestic institutions. However, our finding in favor of
the limited form of the global advantage hypothesis also suggests that
additional cross-border consolidation may be in the offing and that finan-
cial institutions from some countries may capture disproportionate shares
of the global market.
Finally, we summarize our main results, draw conclusions based on
the results, qualify the conclusions with a number of caveats, and suggest
directions for future research. An appendix contains a comparative
overview of the structure of credit markets in major industrial nations.
Some Background on Cross-Border Financial

Services and Institutions
This section provides a backdrop for our investigation of the cross-

border consolidation of the financial services industry. We begin with a
brief discussion of recent trends in the cross-border provision of financial
services. Next we examine deregulation that has reduced the impediments
to cross-border ownership of financial institutions. Finally, we investigate
whether M&As of financial institutions have increased in the wake of this
deregulation.
Trends in the Cross-Border Provision of Financial Services

One of the factors motivating cross-border consolidation of financial
institutions may be the increase in the general level of economic integra-
tion across national borders. Reductions in trade barriers, declines in trans-
portation costs, and advancements in communications technology have led
to an acceleration of international economic integration in recent years.
International transactions in goods and services account for an ever-
increasing fraction of the world economy. For example, trade in goods
increased from 21 percent of world gross domestic product (GDP) in 1987
to 30 percent in 1997.2
2. World Bank (1999).

The recent increase in international commerce has created a demand for

international financial services. A financial institution can use a variety of
channels to deliver financial services to a business customer in a foreign
country. The institution can provide the services directly to the foreign
business from its home-country headquarters. The institution can partici-
pate in a syndicate that finances a large loan or securities issue that is
originated by another financial institution that is located in the foreign
country. Finally, the institution can obtain a physical presence in the for-
eign country (by acquiring a financial institution there or by opening a
branch or subsidiary) and provide the service in the foreign country.
Establishing a physical presence in a foreign country entails a number
of costs, such as the organizational diseconomies to operating or moni-
toring an institution from a distance. However, establishing a physical
presence in the foreign country offers some potentially offsetting advan-
tages, including (a) more effective servicing and monitoring of retail cus-
tomers and (b) an opportunity to compete for retail and wholesale
customers in the foreign country. Recent deregulation has reduced the
costs of this delivery channel.
Securities markets also reflect the trend toward globalization. Interna-
tional issues of debt securities, equity securities, and cross-border flows of
bank funds have all increased in recent years. From 1993 through 1998,
international bonds (bonds issued by foreign residents plus eurobond issues)
increased from a little over $1.3 trillion to more than $2.6 trillion, which
doubled from 8 to 16 percent the share of international bonds to total bonds
outstanding in world markets.3 International equity issues have also
increased substantially, from less than $50 billion in 1996 to more than $70
billion in 1998 in real terms. Despite these increases, the international flow
of bank funds remains at least as large as international bond issues and is
substantially larger than international equity issues. For example, in 1998
international syndicated loan facilities totaled $574 billion, compared with
about $413 billion for net debt security issues and a little over $70 billion for
international equity issues. Similarly, the international assets of banks
reporting to the Bank for International Settlements (BIS) totaled nearly $7
trillion in 1998, compared with $2.6 trillion of international debt securities.
In other words, banks are the largest conduit of international flows of capital.
3. All data in this paragraph are from Bank for International Settlements (1999) and are
stated in terms of 1982 dollars for purposes of comparisons.
Regulatory Changes That Have Fostered Consolidation

The deregulation of geographic restrictions and the harmonization of
regulatory and supervisory environments have boosted the consolidation
of financial institutions. A sequence of laws over the past two decades,
often referred to as the Single Market Programme, has made it more pos-
sible and less costly for financial institutions to operate across national
borders within the European Union. The First Banking Co-ordination
Directive of 1977 created a framework for establishing a single banking
market across the member states of the European Union. It established
minimum requirements for authorizing credit institutions; it introduced
(but did not implement) the concept of “national treatment” by which a
foreign branch is subject to the banking restrictions of its home country
rather than the host country; it forbade host countries from denying entry
of a foreign bank on the basis of “economic need”; and it began the
process of unifying prudential regulations across the member states. The
Single Europe Act of 1986 in effect created a single uninterrupted eco-
nomic marketplace stretching across the European Union. It went into
effect in February 1992 and eliminated all physical, legal, and technical
barriers to the cross-border movement of labor, goods, services, and capi-
tal (which is especially important for financial institutions). The Second
Banking Co-ordination Directive of 1989 liberalized the trade of finan-
cial services across EU borders. It introduced a single banking license
valid throughout the European Union, limited branching and product mix
restrictions to those imposed by a bank’s home-country regulators, ended
the practice of requiring cross-border branches to hold extra-normal lev-
els of capital, and harmonized minimum capital requirements across coun-
tries (although for purposes of monetary policy and prudential regulation
it allowed host countries to set liquidity ratios). Also important, the second
directive made universal banking the norm in the European Union by
default: any nation not allowing these powers risked putting its own banks
at a competitive disadvantage. The second directive was implemented in
1993 and 1994. At the same time, a series of directives was introduced to
achieve a European single securities market and to establish a “single pass-
port” for investment firms.4
4. Benink (1993); Molyneux, Altunbas, and Gardener (1996).

In the United States, a series of less well-coordinated deregulatory

actions has enabled increased consolidation of financial institutions. In the
1980s, most of the individual states began to pass laws permitting out-of-
state bank holding companies to enter into the state via acquisition of an
existing bank. These changes in state laws, which were often extended
only on a reciprocal basis to banking companies in states with similar
laws, gradually eroded the existing federal restrictions on interstate bank-
ing. The Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994 eliminated most of the remaining restrictions on interstate banking
and branching and thus legitimized and extended the changes in state laws.
Riegle-Neal was fully implemented in June 1997, although some states
opted-in early and other states enacted legislation to delay implementation.
Riegle-Neal did for geographic expansion in the United States what the
second directive did for geographic expansion in the European Union,
but until recently U.S. banking laws still forbade most types of universal
banking. Over time, however, the restrictions on separation of commer-
cial banking from securities and insurance activities were gradually erod-
ing. For example, in 1987 the Federal Reserve began allowing commercial
bank holding companies to underwrite corporate debt and equity on a
restricted basis through Section 20 affiliates. The initial revenue limit from
this underwriting was raised from 5 percent of the subsidiary’s total rev-
enue to 10 percent in 1989 and to 25 percent in 1996. The recently passed
Gramm-Leach-Bliley Act of 1999 effectively removed many of the
remaining restrictions on combining commercial banking, securities
underwriting, and insurance in consolidated organizations.
Trends in Cross-Border M&As of Financial Institutions

Figures 1 and 2 display the aggregate value (purchase price in 1998 dol-
lars) of financial institution M&As in the United States and the European
Union from 1986 to 1998 (two-year moving averages). The figures include
M&As both between and among commercial banks, insurance companies,
and securities firms.5 The figures show the annual trends for three types of
5. These figures were constructed from Securities Data Company’s database World-
wide Mergers and Acquisitions, which records all public and private corporate transactions
valued at $1 million or more that involved at least 5 percent of the ownership of a com-
pany. These figures will not exactly match those reported in other sources. For example,
small banks are seldom publicly traded, most securities firms are partnerships, and many
M&As. In figure 1, domestic M&As are combinations of two institutions

within the United States, entry M&As are acquisitions of U.S. firms by non-
U.S. firms, and expansion M&As are acquisitions of non-U.S. firms by U.S.
firms. In figure 2, the corresponding items are intra-EU M&As, entry
M&As, and expansion M&As. The figures reveal three similarities between
the M&A trends in the United States and the European Union. First, the
value of domestic or intra-EU M&As has generally exceeded the value of
cross-border (entry or expansion) M&As. Second, the values of all three
types of M&As have generally increased over time. Third, the value of
cross-border M&As has increased more rapidly in recent years than in the
past. However, there are some differences in exact timing and detail across
the two figures, and these differences are broadly consistent with the dif-
ferences in regulatory history and more recent changes in regulation.
The U.S. trends are dominated by domestic M&As throughout, reflect-
ing the changes in state and federal interstate banking rules during the
1980s and 1990s. The large jump at the end of the U.S. domestic M&A
time series is attributable primarily to a small number of very large M&As
(for example, Citicorp–Travelers, Bank of America–NationsBank, Banc
One–First Chicago, and Norwest–Wells Fargo). Cross-border M&As
involving U.S. financial institutions increased substantially after the mid-
1990s, although they are still small relative to domestic M&As.
M&A activity in the European Union was virtually nil at the start of our
sample period, but intra-EU M&As began to increase rapidly around 1987.
The value of intra-EU M&As began to decline around 1992 and then
increased again in the late 1990s. The two inflection points (1987 and
1992) correspond roughly with the passage and implementation of the Sin-
gle Europe Act and the second banking directive. Entry and expansion
M&As involving EU institutions were very small for most of the sample
but took off in the mid-1990s. By the end of the sample period, the value
of international M&As into and out of the European Union was on a par
with the value of intra-EU M&As.6
insurance firms are mutually owned by policyholders. Although this is an incomplete reck-
oning of all M&As, it does capture the majority of total M&A value.
6. About three-quarters of the value of the intra-EU acquisitions shown in figure 2 was
generated by “truly” domestic M&As (that is, both target firm and acquiring firm were from
the same EU member nation), indicative of domestic market consolidation similar to, but
occurring later than, the domestic consolidation in the United States. However, the truly
domestic M&As have declined as a fraction of total EU merger activity since the mid-1990s.

Figure 1. Value of Mergers and Acquisitions in the United States, 1986–98
$1998 millions, two-year moving averages
Domestic M&As (left)

$200,000 $40,000
$150,000 $30,000
$100,000 Expansion M&As a (right) $20,000
Entry M&As b (right)

$50,000 $10,000
1986 1988 1990 1992 1994 1996 1998
Source: Securities Data Company.

a. Acquisitions of foreign firms by domestic firms.
b. Acquisitions of domestic firms by foreign firms.
Cross-Border Consolidation: Efficiency Factors
Different economic agents have different motives for making consoli-

dation decisions. Shareholders may engage in cross-border consolidation
activity in order to maximize value by improving the financial institution’s
efficiency or increasing their market power in setting prices. Professional
Figure 2. Value of Mergers and Acquisitions in the European Union, 1986–98
$1998 millions, two-year moving averages
$25,000
Intra-EU M&As a
$20,000
$15,000
$10,000
Expansion M&As
$5,000 Entry M&As
1986 1988 1990 1992 1994 1996 1998

Source: Securities Data Company.
a. European Union is treated as a single economic region, so intra-EU M&As are analogous to domestic M&As in figure 1.
managers may have personal motives for engaging in cross-border con-

solidation when corporate governance structures do not sufficiently align
the incentives of managers with those of shareholders. In addition, gov-
ernments often play important roles in constraining or encouraging cross-
border consolidation activity by changing the explicit or implicit
regulatory or supervisory limits on consolidation, by directly approving or
disapproving individual M&As, or by providing M&A assistance during
periods of financial crisis. Consistent with the roles played by sharehold-
ers, managers, and governments, we divide our review of the motives for
and consequences of cross-border consolidation of financial institutions
into four categories: efficiency, market power, managerial, and govern-
ment. In this section, we review the extant evidence on efficiency as it
relates to cross-border consolidation. We review the evidence on the other
three categories in the next section.
We define efficiency improvements from consolidation in the broad-
est possible terms to include any effects that increase the consolidating
firms’ existing shareholder value other than increasing the exercise of
market power in setting prices. This definition includes the possibility
that cross-border consolidation may allow the institutions to achieve
superior scale, scope, or mix of output. Cross-border consolidation may
also be associated with changes in managerial behavior or organizational
focus that increase shareholder value by improving X-efficiency. To the
extent that cross-border consolidation improves scale, scope, product
mix, or X-efficiency, the global advantage hypothesis may be supported.
To the extent that cross-border consolidation decreases these types of effi-
ciency, the home field advantage hypothesis may be supported. One type
of efficiency analysis—the X-efficiency of foreign versus domestic insti-
tutions within the same country—is particularly relevant for testing our
two main hypotheses.
Scale, Scope, and Product Mix Efficiency

Efficiency gains from exploiting scale economies are often cited as a
motivation for financial institution consolidation. Potential improvements
in scope and product mix efficiencies may also be a motivating factor, par-
ticularly for universal-type consolidation. We consider cost (scale, scope,
and product mix) efficiencies, revenue efficiencies, and, finally, efficien-
cies related to the risk–expected return trade-off.
COSTS. Practitioners often refer to the need for large scale to reduce
average costs to competitive levels. However, most of the research on bank
scale economies finds that the average cost curve has a relatively flat
U-shape, with medium-size banks being slightly more cost scale efficient
than either large or small banks. Average costs are usually found to be min-
imized somewhere in the wide range between about $100 million and
$10 billion in assets.7 Similar U-shaped average cost curves or conflicting
cost scale results are found for securities firms and insurance companies.8
These findings generally suggest no gains and perhaps even losses in cost
scale efficiency from further consolidation of the type of large institu-
tions typically involved in international activity. Consistent with this, a
recent study that simulated pro forma M&As between large banks in dif-
ferent nations in the European Union finds that these M&As are more
likely to increase costs than to decrease them.9
Most of this research uses data on financial institutions from the 1980s,
and it is possible that recent technological progress may have increased
scale economies in producing financial services and thus created opportu-
nities to improve cost scale efficiency through consolidation, even for large
institutions. The tools of financial engineering, such as derivatives con-
tracts, off-balance-sheet guarantees, and risk management may be
exploited more efficiently by large institutions. In addition, financial and
regulatory innovations in securities activities (such as 144A private place-
ments and the shift toward bought deals in underwriting) may be relevant
only for large commercial and investment banks.10 Moreover, some new
7. Hunter and Timme (1986); Berger, Hanweck, and Humphrey (1987); Ferrier and
Lovell (1990); Hunter, Timme, and Yang (1990); Noulas, Miller, and Ray (1990); Berger
and Humphrey (1991); Mester (1992b); Bauer, Berger, and Humphrey (1993); Clark (1996).
8. For securities firms, see Goldberg, Hanweek, Keenan, and Young (1991). For insur-
ance companies, see Grace and Timme (1992); Yuengert (1993); Gardner and Grace (1993);
Hanweck and Hogan (1996); Rai (1996); Toivanen (1997); McIntosh (1998); Cummins
and Zi (1998). It is also sometimes argued that scale efficiency gains from consolidation will
be most prevalent when the combining institutions have substantial local market overlap,
allowing for the closing of retail branch offices and consolidation of back-office opera-
tions. However, studies of the scale efficiency effects of bank in-market M&As and research
on scale efficiency of branch offices suggest little or no gain from this source. See Berger
and Humphrey (1992b); Rhoades (1993); Akhavein, Berger, and Humphrey (1997); Berger,
Leusner, and Mingo (1997); Berger (1998).
9. Altunbas, Molyneux, and Thornton (1997).
10. Unlike conventional private placements, 144A private placements can be traded
and underwritten on a firm commitment basis. A “bought deal” occurs when an investment
bank makes a firm commitment, underwriting before syndicating the risk.
methods for delivering customer services, such as Internet banking, phone

centers, and automated teller machines, may also exhibit greater
economies of scale than traditional branching networks. 11 As well,
advances in payments technology may also create scale economies in
back-office operations and network economies that may be exploited more
easily by large institutions.12 Consistent with these arguments, some recent
research on bank cost scale efficiency using data from the 1990s suggests
that there may be substantial scale economies even at the largest banks,
possibly due in part to technological progress.13 An important caveat is that
technologies embodying scale economies may currently or in the future be
accessed at low cost by small institutions through franchising or outsourc-
ing to firms specializing in the technologies or through shared access to
networks.
A number of studies have examined the cost scope and product mix effi-
ciencies of providing multiple products within a single type of financial
institution, for example, providing deposits and loans within a commercial
bank. Scope efficiencies are often difficult to estimate because there are
usually no specializing firms in the data sample, creating extrapolation
problems for evaluating the costs of hypothetical specializing firms with
zero outputs for some products. As a result, many studies use measures of
product mix efficiencies that evaluate at points near zero outputs or use
concepts such as expansion-path subadditivity that combine scale and
product mix efficiencies. Although there are exceptions, these studies
usually find very little evidence of substantial cost scope or product mix
economies or diseconomies within the banking, securities, or insurance
industries.14
For cross-border consolidation, it is particularly important to evaluate
the scope and product mix efficiencies of universal-type institutions—
that is, the effects of combinations among commercial banks, securities
11. Radecki, Wenninger, and Orlow (1997).

12. Bauer and Hancock (1993, 1995); Bauer and Ferrier (1996); Hancock, Humphrey,
and Wilcox (1999).
13. Berger and Mester (1997).
14. Kellner and Mathewson (1983); Berger, Hanweck, and Humphrey (1987); Mester
(1987, 1993); Hunter, Timme, and Yang (1990); Berger and Humphrey (1991); Goldberg,
Hanweck, Keenan, and Young (1991); Grace and Timme (1992); Ferrier, Grosskopf, Hayes,
and Yaisawarng (1993); Hanweck and Hogan (1996); Noulas, Miller, and Ray (1993); Pul-
ley and Humphrey (1993); Rai (1996); Toivanen (1997); Meador, Ryan, and Schellhorn
(1998); Berger, Cummins, Weiss, and Zi (1999).
firms, and insurance companies—because the institutions engaging in

cross-border consolidation are often of this type. Cost economies from
universal-type combinations may be realized by sharing physical inputs
like offices or computer hardware; employing common information sys-
tems, investment departments, account service centers, or other operations;
obtaining capital by issuing public or private debt or equity in larger issue
sizes that reduce the impact of fixed costs; or reusing managerial exper-
tise or information. For example, a consolidated commercial bank and
insurer may lower total costs by cross-selling, using each other’s cus-
tomer database at a lower cost than building and maintaining two data-
bases. Similarly, information reusability may reduce costs when a
universal bank acting as an underwriter conducts due diligence on a cus-
tomer with whom it has had a lending or other relationship.15 The evidence
on the underwriting activities of Section 20 subsidiaries of U.S. bank hold-
ing companies is consistent with this hypothesis—these companies cer-
tify their private information about companies with whom they have had
a lending relationship when they are underwriting their securities.16
However, cost scope and product mix diseconomies may also arise
because of coordination and administrative costs from offering a broad
range of products, often outside the senior management’s area of core
competence.17 Universal banking may also be associated with less finan-
cial innovation because commercial banks and investment banks may have
fewer incentives to produce innovative financial solutions to attract cor-
porate customers from one another.18
It is not known how well the research just reviewed on cost scope and
product mix efficiencies within a certain type of financial institution rep-
resents the efficiencies across types of institutions. The relatively few
studies of the scope and product mix efficiencies associated with univer-
sal banking in continental Europe are mixed. One study of European uni-
versal banking finds very small scope economies, one study finds some
limited evidence of scope economies but no consistent evidence of
expansion-path subadditivity, and one study finds mostly diseconomies
of producing loans and investment services within German universal
15. Greenbaum, Kanatas, and Venezia (1989); Rajan (1996).

16. Gande, Puri, Saunders, and Walter (1997).
17. Winton (1999).
18. Boot and Thakor (1996).
banks.19 However, these studies may not be good predictors of universal

banking as it evolves in the future. Specifically, commercial banking and
underwriting in the banking-oriented continental Europe of the past may
bear little resemblance to commercial banking and underwriting activities
in market-oriented financial systems such as the United States, the United
Kingdom, and possibly continental Europe and elsewhere in the future.
REVENUES. It is important to consider revenue efficiencies as well as
cost efficiencies when evaluating cross-border or global consolidation. The
increase in scale associated with consolidation may create revenue scale
economies because some customers may need or prefer the services of
larger institutions. For example, large wholesale customers may need loan
facilities or issue public debt or equity in quantities that small institutions
cannot handle. However, some small customers may prefer the more per-
sonalized or relationship-based services often associated with small finan-
cial institutions, creating revenue scale diseconomies.
A related revenue efficiency effect that is particularly relevant for cross-
border consolidation concerns the benefits from serving customers that
operate in multiple nations, which often require or benefit from the ser-
vices of financial institutions that operate in the same set of nations. That
is, multinational nonfinancial firms may want to do business with multi-
national financial institutions. Presumably, the cross-border consolidation
of financial institutions in recent years derives at least in part from the
cross-border consolidation of nonfinancial industries (and vice versa as
well). Part of this revenue efficiency comes from financial institutions
following their existing customers across international borders, maintain-
ing the benefits of existing relationships. For example, some analyses find
that many foreign banks initially entered the United States to help service
home-country clients that were starting U.S. operations.20 One analysis
finds that foreign direct investment in a U.S. state is a positive determinant
of foreign banking assets in the state, also consistent with follow-your-
customer behavior.21
Financial institutions may also be able to exploit revenue scope and
product mix economies by cross-selling different types of financial serv-
19. Allen and Rai (1996); Vander Vennet (1999); Lang and Welzel (1998), respectively.
20. Goldberg and Saunders (1981); Budzeika (1991); Grosse and Goldberg (1991);
Seth and Quijano (1993); Terrell (1993).
21. Goldberg and Grosse (1994).
ices. These revenue scope economies may occur because of consumption

complementarities arising from reductions in consumer search and trans-
action costs. For example, some customers may be willing to pay more
for the convenience of one-stop shopping for their commercial banking
and insurance needs. Similarly, a corporate customer may prefer to reveal
its private information to a single consolidated entity that provides its com-
mercial and investment banking needs. Revenue economies can also arise
from sharing the reputation that is associated with a brand name that cus-
tomers recognize and prefer. These reputation economies might arise, for
instance, if a universal bank levers off its reputation built in commercial
banking when forging a stronger reputation in investment banking, or
vice versa.22
Consolidation of different types of financial institutions alternatively
may create revenue scope diseconomies. Such diseconomies may arise if
specialists from different types of financial services have better knowl-
edge and expertise in their areas, can better tailor products for individual
customers, and thereby can charge higher prices than joint producers.
Revenue scope diseconomies might also arise to the extent that combining
commercial banking and investment banking creates the appearance of
conflicts of interest. The market may underprice securities underwritten
by a universal bank for its existing loan customers because of concerns
that the proceeds from the issue will be used to pay off (or otherwise
enhance the value of) distressed loans extended to that customer by the
bank. As a result, commercial loan customers might shy away from using
the underwriting services of their own universal bank. The empirical
research suggests that universal banks have successfully addressed this
problem.23
A few recent studies have examined the effects of financial institution
scale, scope, and product mix on revenue efficiency and profit efficiency
(which incorporates both cost and revenue efficiency). The scale results
are ambiguous, with some evidence of mild ray scale efficiencies in terms
of joint consumption benefits for customers and profit efficiency sometimes
highest for large institutions, sometimes highest for small institutions, and
22. Rajan (1996).

23. See, for example, Ang and Richardson (1994); Kroszner and Rajan (1994, 1997);
Puri (1994, 1996); Gande, Puri, Saunders, and Walter (1997); Gande, Puri, and Saunders
(1999).
sometimes about equal for large and small institutions.24 One study finds lit-
tle or no revenue scope efficiency between deposits and loans from charg-
ing customers for joint consumption benefits, while another study finds
revenue scope diseconomies from providing life insurance and property-
liability insurance together, consistent with a greater ability of specialists to
tailor products to their customers’ needs.25 Studies of profit scope efficien-
cies both within banking and within insurance find that joint production is
more efficient for some firms and specialization is more efficient for oth-
ers.26 One study finds that universal banks in Europe typically have both
higher revenues and higher profitability than specializing institutions.27
RISK–EXPECTED RETURN TRADE-OFFS. The prospect of efficiency gains
from improvements in the risk–expected return trade-off may also moti-
vate cross-border consolidation. The greater scale, more diverse scope or
mix of financial services, or increased geographic spread of risks associ-
ated with cross-border consolidation may improve the institutions’
risk–expected return trade-off. This improved trade-off fits into our broad
definition of efficiency gains to the extent that the increased diversification
reduces the impact on shareholder wealth of the expected costs associ-
ated with financial distress, bankruptcy, and loss of franchise value.
Taking the risk–expected return trade-off into account also allows for
possible scale, scope, and product mix efficiencies in managing risk. For
example, larger institutions may be able to deploy sophisticated models
of credit and market risks more efficiently. In addition, for commercial
banks and other regulated or supervised financial institutions, regulatory
rules like prompt corrective action and supervisors with discretion may
restrict the activities or impose other costs on institutions in poor finan-
cial condition, giving additional value to keeping risks low. An improve-
ment in the risk–expected return trade-off does not necessarily mean that
the institutions would have lower risk—they may still choose a higher-risk,
higher-expected-return point on the improved frontier.28
24. Berger, Hancock, and Humphrey (1993); Berger, Humphrey, and Pulley (1996);
DeYoung and Nolle (1996); Berger and Mester (1997); Clark and Siems (1997); Berger,
Cummins, Weiss, and Zi (1999); the paper by Cummins and Weiss in this volume;
25. Berger, Humphrey, and Pulley (1996); Berger, Cummins, Weiss, and Zi (1999).
26. Berger, Hancock, and Humphrey (1993); Berger, Cummins, Weiss, and Zi (1999).
27. Vander Vennet (1999).
28. Of course, some combinations of financial institutions can worsen risk–expected
return trade-offs. For example, a commercial bank may be more likely to fail or have higher
These risk considerations would not affect shareholder value and there-
fore would not be included in our definition of efficiency under an assump-
tion of perfect capital markets with no informational opacity, no distress,
bankruptcy, or franchise costs, and no regulatory or supervisory interven-
tion. Investors in perfect capital markets would diversify their own risks by
owning shares of different institutions and thereby would negate any diver-
sification value that arises when the institutions they own purchase other
institutions.
However, capital market imperfections may be quite important for
financial institutions. Under the modern theory of financial intermediation,
financial institutions are delegated monitors with economies of scale or
comparative advantages in the production of information about informa-
tionally opaque assets.29 These institutions exist to solve these information
problems, and part of the solution is to diversify large pools of the opaque
assets. In addition, many small financial institutions are owner-managed,
and the owner-managers have invested a substantial portion of their per-
sonal or family wealth in their institution. Diversifying this risk away by
selling a substantial portion of their investment is problematic because it
results in loss of control and because investments in these institutions are
typically illiquid. Thus these institutions are likely managed in a way that
reflects the risk aversion of their owners.30
Financial institutions are also concerned with risk because of govern-
ment regulation and supervision. Governments typically provide a safety
net for at least some of their nation’s financial institutions, and this safety
net absorbs some of the losses or provides liquidity in the event of the
failure or distress of the institutions. The safety net may include deposit
insurance, unconditional payment guarantees, access to the discount win-
dow, help in arranging private sector funding or M&A partners, forbear-
ance, or other explicit or implicit government guarantees. It is often argued
that the safety net provides moral hazard incentives to take on more risk
bankruptcy costs in the event of failure if it is combined with another type of financial
institution with lower expected return or higher variance of returns that are highly correlated
with those of the bank.
29. For example, Diamond (1984, 1991); Boyd and Prescott (1986); Boot and Thakor
(1997).
30. Consistent with this, Sullivan and Spong (1998) find evidence that owner-managers
of small banks who have a substantial portion of their wealth invested in their banks tend
to pursue safer strategies.
than would otherwise be the case and that this incentive to risk taking
becomes stronger as an institution’s equity capital or charter value gets
very low.31 However, prudential regulation and supervision works in the
opposite direction, imposing costs on risk taking and giving incentives
for value-maximizing institutions to reduce risk to avoid penalties. Pru-
dential regulations designed to deter risk taking include risk-based capital
requirements, risk-based deposit insurance premiums, prompt correct
action rules, and legal lending limits. Prudential supervision includes reg-
ularly scheduled examinations backed by threats of cease-and-desist
orders, withdrawal of deposit insurance, closure, limits on growth, and
prohibition of dividend payments.
Some empirical evidence suggests that large U.S. banking organizations
act in a risk-averse fashion, trading off between risk and expected return.32
However, it is difficult to determine whether this trade-off is for the bene-
fit of shareholders or managers of professionally managed institutions who
are protecting their own job security at the expense of shareholder value.
Managerial incentives with regard to risk are discussed below.
The available empirical research also suggests that at least some types
of cross-border consolidations are likely to improve the risk–expected
return trade-off. The literature on commercial banks in the United States
generally finds that larger, more geographically diversified institutions
tend to have better risk–expected return trade-offs.33 Similarly, interna-
tional diversification has been found to improve the risk–expected return
trade-off and profit efficiency in the reinsurance industry.34 More relevant
to the issue of universal-type financial institutions, some simulation-type
studies have combined the rates of return earned by U.S. banking organi-
zations and other financial institutions from the 1970s and 1980s with
mixed results.35 Another study of U.S. firms also finds that risk can be
reduced by combining banks with securities firms and insurance compa-
nies.36 Other studies of combining commercial banking organizations with
31. For example, Merton (1977); Marcus (1984); Keeley (1990).

32. For example, Hughes, Lang, Mester, and Moon (1996, 1997); Hughes and Mester
(1998).
33. For example, McAllister and McManus (1993); Hughes, Lang, Mester, and Moon
(1996, 1997, 1999); Hughes and Mester (1998); Demsetz and Strahan (1997).
34. For example, the paper by Cummins and Weiss in this volume.
35. Kwast (1989); Rosen, Lloyd-Davies, Kwast, and Humphrey (1989); Boyd, Gra-
ham, and Hewitt (1993).
36. Saunders and Walter (1994).
insurance companies in the United Kingdom and of combining commer-

cial banking organizations with securities firms in the United States show
favorable results for the risk–expected return frontier.37
To get further insight into the potential for improvements in the
risk–expected return frontier from geographic diversification, table 1 gives
information about the distribution of bank earnings across nations. The
table shows the correlations of average bank earnings across international
borders, giving information for the United States, Japan, and all but one
of the EU nations (insufficient data were available for Ireland). The data
are for 1979–96, except as noted. The correlations across nations are quite
low. These nations often had changes in regulatory or supervisory structure
that were not coordinated, they had different currencies, and their
economies were usually not well integrated. However, it is surprising just
how much lower the correlations among bank earnings across these
nations are and how many of the correlations are negative. Even within the
European Union, which has moved closer to the model of the U.S. national
market by harmonizing regulatory and supervisory structures, beginning
the process of monetary union, and removing tariffs and entry barriers,
the correlations are surprisingly low. For each of the fourteen EU nations
shown, there are at least three negative correlations of bank earnings with
those of the thirteen other EU nations. These data suggest very strong
possibilities to diversify and opportunities to improve the institutions’
risk–expected return trade-offs through cross-border consolidation, even
within the European Union.
X-efficiency
Improvements in X-efficiency may also be an important motive for and
consequence of cross-border consolidation. Improvements in X-efficiency—
movements toward the optimal point on the best-practice efficient frontier—
may be accomplished through consolidation if the M&A improves the
managerial quality of the organization or changes its focus. X-efficiency
may be improved, for example, if the acquiring institution is more efficient
37. For the United Kingdom, see Llewellyn (1996). For the United States, see Kwan
(1998). Institutions may also achieve risk diversification through cross-border lending or
investments, or through a secondary market in financial instruments. They may buy loans,
nonasset-backed or original or primary securities, or asset-backed securities issued in other
countries, or they may engage in derivatives contracts with foreign institutions.
Table 1. Correlation Analysis of Bank Return on Equity among Select Countries, 1979–96a
Luxem- Nether- United United
Country Spain France Austria Belgium bourg lands Germany Kingdom Italy Portugal Denmark Finland Greece Sweden Japan States
Spain 1.000
France 0.742 1.000
Austria 0.274 0.586 1.000
Belgium –0.573 –0.654 0.019 1.000
Luxembourg –0.463 –0.854 –0.324 0.705 1.000
Netherlands 0.170 0.223 0.768 0.185 0.102 1.000
Germany –0.286 –0.236 0.229 0.188 –0.336 0.210 1.000
United
Kingdom –0.460 –0.543 –0.137 0.798 0.648 0.084 0.384 1.000
Italy 0.518 0.926 0.519 –0.436 –0.912 0.126 0.248 –0.473 1.000
Portugal 0.158 0.514 –0.250 –0.364 –0.229 –0.673 –0.176 –0.386 –0.025 1.000
Denmark –0.240 –0.154 0.213 0.358 0.080 0.475 0.527 0.532 –0.182 –0.024 1.000
Finland 0.419 0.519 0.526 0.077 –0.404 0.533 0.465 0.089 0.533 0.035 0.562 1.000
Greece 0.123 0.117 –0.296 –0.260 –0.329 –0.685 0.336 –0.075 0.099 0.475 –0.201 –0.207 1.000
Sweden 0.207 –0.084 –0.283 0.013 0.292 –0.296 –0.203 0.082 –0.362 0.085 –0.005 –0.114 0.675 1.000
Japan 0.268 0.740 0.654 –0.362 –0.783 0.314 0.393 –0.460 0.885 0.045 –0.017 0.455 –0.027 –0.473 1.000
United
States –0.588 –0.815 –0.522 0.477 0.585 –0.182 0.206 0.761 –0.686 0.079 0.243 –0.307 –0.278 0.015 –0.490 1.000
Source: OECD (1998). Annual data for Denmark, Finland, Germany, Japan, Luxembourg, Portugal, Spain, Sweden, and the United States are for 1979–96. Annual data for Belgium are for 1981–96. Annual
data for Italy and the United Kingdom are for 1984–96. Annual data for Austria and the Netherlands are for 1987–96. Annual data for France are for 1988–96. Annual data for Greece are for 1989–96.
a. Return on equity is aggregate commercial profit after taxes divided by aggregate commercial bank capital and reserves.
ex ante and brings the efficiency of the target up to its own level by spread-
ing its superior managerial expertise or policies and procedures over more
resources. Alternatively, the M&A event itself may awaken management to
the need for improvement or may provide an excuse to implement substan-
tial unpleasant restructuring.38
We consider both cost and profit X-efficiency.39 Cost X-efficiency im-
provements occur when an institution moves closer to what a best-practice
institution’s cost would be for producing the same output bundle using
the same input prices and other environmental conditions. Profit X-efficiency
improvements occur when an institution moves closer to the profit of a best-
practice institution under the same conditions. Profit X-efficiency is a more
inclusive concept than cost X-efficiency. Profit X-efficiency incorporates cost
X-efficiency, the effects of scale, scope, and product mix on both costs and
revenues, and to some degree the effects of changes in the risk–expected
return trade-off. Profit X-efficiency also corresponds better to the concept of
value maximization than cost X-efficiency, since value is determined from
both costs and revenues.
We review the results of four types of X-efficiency studies. First we
examine research on the effects of M&As on financial institution
X-efficiency. These are important to the prospects for X-efficiency gains
from cross-border consolidation, given that cross-border market pene-
trations usually are performed via M&As rather than via the opening of
new branch offices. Second, we examine the research on international
comparisons of financial institution X-efficiency. This bears on our
hypotheses, in that the institutions from one or a few nations are more
likely to expand across borders under the limited form of the global
advantage hypothesis if the institutions from these nations are much
more X-efficient than those from other nations. Third, we review the
research on the X-efficiencies of foreign versus domestic institutions
within a single nation. This is the most important type of evidence in
our opinion for evaluating the global advantage versus home field advan-
tage hypotheses because it is the only direct evidence on the extent to
38. M&As that diversify the institution may also improve X-efficiency in the long term
through expanding the skill set of managers (Milbourn, Boot, and Thakor 1999).
39. Some efficiency analyses using linear programming techniques such as data envel-
opment analysis do not use prices and so do not calculate costs or profits. Instead of using
cost or profit X-efficiency, they focus on minimizing inputs for given outputs or maximizing
outputs for given inputs, but the concepts are similar.
which financial institutions are able to monitor and control their sub-
sidiaries operating in other nations. Finally, we examine evidence on
the effects of deregulation, especially the reduction of entry barriers.
This may contribute to the debate on the hypotheses, given that this type
of deregulation precedes most cross-border consolidation.
THE EFFECTS OF FINANCIAL INSTITUTION M&As. The extant research
suggests a substantial potential for improved X-efficiency from consolida-
tion. Average X-inefficiencies on the order of about 25 percent of costs and
about 50 percent of potential profits are typical findings. 40 Simulation
evidence also suggests that large X-efficiency gains are possible if the
best-practice acquirers reform the practices of inefficient targets.41
The research also suggests that many institutions engage in M&As for
the purpose of improving X-efficiency. Many studies have found that
acquiring institutions are more efficient ex ante than targets.42 Also, acquir-
ing 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-off and increase profit X-efficiency.43
A number of studies measure the change in cost X-efficiency after
M&As. Studies of U.S. commercial banking generally show very little or
no improvement in cost X-efficiency, on average, from the M&As of the
1980s, on the order of 5 percent of costs or less.44 Studies of U.S. banks
and other types of financial institutions using 1990s data are mixed, but
some show more gains in cost efficiency.45 Studies of M&As of credit
institutions in Europe find that some groups of M&As, particularly cross-
border consolidations, tend to improve cost efficiency, whereas other types
tend to decrease cost efficiency.46 Studies of Italian banks and U.K. build-
ing societies find significant cost efficiency gains following M&As.47
40. Berger and Humphrey (1997), pp. 185, 201.

41. Savage (1991); Shaffer (1993).
42. Berger and Humphrey (1992b); Altunbas, Maude, and Molyneux (1995); Focarelli,
Panetta, and Salleo (1998); Pilloff and Santomero (1998); Rhoades (1998); Vander Vennet
(1998); Cummins, Tennyson, and Weiss (1999); Fried, Lovell, and Yaisawarng (1999); the
paper by Cummins and Weiss in this volume.
43. Benston, Hunter, and Wall (1995).
44. Berger and Humphrey (1992b); Rhoades (1993); DeYoung (1997); Peristiani (1997).
45. Berger (1998); Rhoades (1998); Cummins, Tennyson, and Weiss (1999); Fried,
Lovell, and Yaisawarng (1999).
46. Vander Vennet (1996, 1998).
47. For Italy, see Resti (1998). For the United Kingdom, see Haynes and Thompson
(1999).
Studies of profit X-efficiency usually paint a more favorable picture of

M&As. Studies of the profit efficiency effects of U.S. bank M&As in the
1980s and early 1990s find that M&As improved profit efficiency and
that this improvement could be linked to an increased diversification of
risks and an improved risk–expected return trade-off.48 After consolida-
tion, the institutions tended to shift their asset portfolios from securities
to loans, to have more assets and loans per dollar of equity and to raise
additional uninsured purchased funds at reduced rates, consistent with a
more diversified portfolio. Other studies using similar measures of profit
X-efficiency find consistent results.49
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 for the acquiring
and target institutions together (adjusted for changes in overall stock mar-
ket values) provides an estimate of the effect of the M&A on shareholder
value, which embodies the present value of expected future changes in all
types of efficiency plus changes in the expected exercise of market power
over prices. Although these effects cannot be disentangled, in some cir-
cumstances, inferences can be made about whether the market expects
improvements in efficiency. Specifically, since it is unlikely that M&As
would reduce market power, a decrease in market value would suggest an
expected deterioration in efficiency, and no change in market value would
signal either no change or a decrease in expected efficiency.
The empirical results for U.S. data are mixed. Some studies find
increases in the combined value around the times of M&A announce-
ments, others find no improvement in combined value, while still others
find that the measured effects depend on the characteristics of the M&A.50
A study of domestic and cross-border M&As involving U.S. banks finds
that cross-border M&As create more value than domestic M&As, although
it also finds that more concentrated geographic and activity focus has pos-
itive effects on value.51 One study finds that foreign banks that enter the
United States via acquisition tend to acquire domestic banks that already
have performance problems and, despite achieving some performance
48. Akhavein, Berger, and Humphrey (1997); Berger (1998).

49. Fixler and Zieschang (1993); Berger and Mester (1999); Hughes, Lang, Mester,
and Moon (1999).
50. Hannan and Wolken (1989); Cornett and Tehranian (1992); Houston and Ryngaert
(1994, 1996, 1997); Zhang (1995); Pilloff (1996); Siems (1996).
51. DeLong (1999).
improvements at the target bank, generally are not successful in raising the
acquired banks’ performance up to the levels of their domestic peers.52
There is some evidence that M&As in Europe increase combined value.
One study that examines M&As among banks and between banks and
insurers in Europe finds positive combined returns mostly driven by
domestic bank-to-bank deals and diversification of banks into insurance.53
This study attributes the differences in findings from many of the U.S.
studies to differences in structure and regulation in Europe. However,
another study of European bank M&As finds that abnormal combined
returns are not significantly different from zero.54
INTERNATIONAL COMPARISONS. A number of studies compare the aver-
age X-efficiency of institutions in different nations, focusing on the oper-
ations of institutions operating within each nation, rather than
cross-border. For example, one study evaluates the efficiency of banks
operating within Norway, within Sweden, and within Finland relative to a
common frontier made up of the best-practice institutions from the three
nations.55 Similar studies compare the average X-efficiencies of institu-
tions across different sets of nations.56 The results often show that some
institutions of some nations are substantially more efficient than the insti-
tutions of other nations, although the ordering among nations sometimes
differs across the studies. Swedish banks tend to be measured as superior
performers, despite the fact that these banks suffered a crisis in the early
1990s requiring substantial government intervention and that U.S. banks
sometimes are measured as inferior performers, despite the common cross-
border result that U.S. banks tend to be more efficient than foreign com-
petitors in the United States.
Although these studies may be informative, they are not helpful for
evaluating the global advantage versus the home field advantage hypothe-
ses for two main reasons. First, the economic environments faced by finan-
cial institutions differ across nations in important ways. It is likely that
52. Peek, Rosengren, and Kasirye (1999).

53. Cybo-Ottone and Murgia (1998).
54. van Beek and Rad (1997).
55. Berg, Forsund, Hjalmarsson, and Suominen (1993).
56. For example, Fecher and Pestieau (1993); Bergendahl (1995); Bukh, Berg, and
Forsund (1995); Allen and Rai (1996); Ruthenberg and Elias (1996); Economic Research
Europe (1997); Pastor, Pérez, and Quesada (1997); Bikker (1999); Maudos, Pastor, Pérez,
and Quesada (1999a); Wagenvoort and Schure (1999).
measured X-efficiency would vary considerably with the amount of super-

visory and regulatory intervention in the financial system. As well, nations
differ significantly in the intensity of competition among their financial
institutions, in the level and quality of service associated with their finan-
cial products, in their capital market development, and in their markets
for labor and other factors of production, all of which may affect measured
efficiency. As a result, a finding of greater X-efficiency for institutions in
one nation does not necessarily imply that they would be more efficient
in the environments of other nations.
Second, and more important, even if all of the environmental differ-
ences do not exist or are well controlled for with econometric procedures,
the performance of institutions within their own borders may not be rep-
resentative of how well they may perform as foreign-owned entities in
other nations, which is the information most pertinent to testing our
hypotheses. Even if institutions are very efficient in their home country,
they may have difficulty in other nations in part because of organizational
diseconomies to operating or monitoring an institution from a distance or
because of difficulties in overcoming differences in language, culture, cur-
rency, regulation, and other barriers.
Some recent studies have made progress in dealing with the first prob-
lem by controlling for some of the environmental differences across
nations. These studies include variables measuring banking market con-
ditions (for example, income per capita, population, deposit, and branch-
ing densities) and market structure and regulation (for example,
concentration ratio, average equity capital ratio, risk, and firm specializa-
tion).57 Of course, control variables for a firm’s environment, risk, and spe-
cialization are often specified in efficiency measurement, but these recent
studies have taken this further by investigating the effects of these vari-
ables on measured efficiency. In one case, these environmental variables,
along with the efficiency scores, are used to predict what the efficiency of
institutions from one country would be if they operated in another coun-
try.58 These authors study commercial banks in ten European nations (Bel-
gium, Denmark, France, Germany, Italy, Luxembourg, the Netherlands,
57. Pastor, Lozano-Vivas, and Pastor (1997); Maudos, Pastor, Pérez, and Quesada
(1999b); Pastor (1999); Pastor, Lozano-Vivas, and Hasan (1999); Dietsch and Lozano-Vivas
(2000).
58. Pastor, Lozano-Vivas, and Hasan (1999), p. 7.
Portugal, Spain, and the United Kingdom) and predict, for example, that
banks from Spain, Denmark, Portugal, and Belgium would have high effi-
ciency scores if they crossed into other European nations.
Although this research is interesting, we caution against drawing such
strong conclusions about cross-border performance from it. It is difficult to
control for environmental differences across nations. More important, not
even perfect environmental controls address the second problem of poten-
tial organizational diseconomies and other difficulties in operating or mon-
itoring financial institutions across borders.
FOREIGN VERSUS DOMESTIC INSTITUTIONS WITHIN A SINGLE NATION.
Some recent studies have compared the X-efficiencies of foreign versus
domestic institutions operating within the borders of a single nation. This
avoids the econometric problem of controlling for all the environmental
differences across nations, since all of the institutions studied face essen-
tially the same environmental conditions. More important for our pur-
poses, this is direct evidence only on the extent to which financial
institutions are able to monitor and control operations on a cross-border
basis, which is critical to distinguishing between the home field advan-
tage and global advantage hypotheses.
Studies of U.S. data generally find that foreign-owned banks are sig-
nificantly less cost efficient on average than domestic banks and less profit
X-efficient on average than domestic institutions.59 Unfortunately, this type
of evidence alone cannot distinguish between our hypotheses. The data are
consistent with both the home field advantage hypothesis and with a case
of the limited form of the global advantage hypothesis in which U.S. banks
tend to be the most efficient. The data are also consistent with another case
of the limited form of the global advantage hypothesis in which foreign
banks from a limited group of other nations tend to be more efficient than
domestic U.S. banks, but this cannot be determined because the authors do
not break out their data by foreign nation of origin. More evidence is
needed to differentiate among these hypotheses—data from more home
countries and disaggregation of the results by nation of foreign ownership.
Some of the research on other nations finds that foreign institutions
have about the same average efficiency as domestic institutions. One study
59. For cost efficiency, see Hasan and Hunter (1996); Mahajan, Rangan, and Zardkoohi
(1996); Chang, Hasan, and Hunter (1998). For profit efficiency, see DeYoung and Nolle
(1996).
finds that foreign banks in EU countries that were acquired in the past
three years have about the same cost efficiency as domestic banks, one
study finds that foreign banks in Spain are about equally as profit effi-
cient as domestic banks, and one study finds that foreign banks in India are
somewhat more efficient than domestic banks held by private sector
investors but that both are less efficient than domestic banks held by the
government.60 Again, the results are not reported by nation of origin, mak-
ing it difficult to determine which hypotheses are consistent with the data.
If the banks from some of the foreign nations tend to have higher effi-
ciency than those from the home country and other foreign nations, this
would support the limited form of the global advantage hypothesis.
Some other research using data from non-U.S. countries finds very dif-
ferent results. These studies measure profit efficiency for fourteen home
countries (Australia, Belgium, Canada, Chile, Denmark, France, Germany,
Italy, Mexico, the Netherlands, Portugal, Spain, Switzerland, and the
United Kingdom), classified into four groups based on banking system
development and regulatory and supervisory environment.61 They find that
domestic banks are more efficient on average than foreign institutions
(including U.S.-owned banks), although foreign banks from the same
type of environment as the host nation generally fare better than other
foreign institutions. Although they appropriately measure separate fron-
tiers for the institutions located in each country, they pool 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). This may create problems of comparison because of
differences in the environments of these nations. Their logit analysis of
whether foreign bank efficiency is above or below the mean takes into
account the signs, but not the magnitudes, of the efficiency differences.
THE EFFECTS OF DEREGULATION. One of the most important issues in
the current policy debate is the effect of deregulation on efficiency, given
that much of the observed cross-border consolidation has followed sig-
nificant deregulation. For example, much of the consolidation within the
European Union has followed reductions in its cross-border entry barriers
and harmonization of its regulatory structures.
60. Vander Vennet (1996); Hasan and Lozano-Vivas (1998); Bhattacharyya, Lovell, and
Sahay (1997).
61. Miller and Parkhe (1999), p. 22; Parkhe and Miller (1999), p. 25.
Most of the studies measuring changes in performance over time use the
concept of productivity change, rather than X-efficiency change. Produc-
tivity change is a measure of the change over time in the performance of an
industry as a whole (rather than an individual institution); it incorporates
both changes in managerial best practice in the industry and changes in
cross-sectional X-efficiency or dispersion from best practice.
A number of studies examine productivity change during the banking
deregulation in the United States.62 It is often found that measured cost
productivity declined in the 1980s primarily because depositors got the
benefit of higher interest rates after the deposit rate ceilings were lifted.
The increase in competition appears to be primarily a social good,
although it is measured as poorer performance for the banking industry.63
Recent research suggests that the decline in measured cost productivity
may have continued well into the 1990s, but that improvements in rev-
enues more than offset the higher costs, yielding improved profit produc-
tivity.64 The data are consistent with the hypothesis that banks offer wider
varieties or higher quality of financial services that raise costs but also
raise revenues by more than the cost increases and that banks involved in
M&As are responsible for much of these findings.
The results of deregulation in other individual nations are sometimes
found to be favorable to financial institution performance, as in Norway and
Turkey, and are sometimes found to be mixed or unfavorable, as in Spain.65
Finally, one study of the changes in productivity, cost X-efficiency, and
profit X-efficiency in a number of EU nations from 1992 to 1996 finds
small improvements in efficiency and attributes most of the changes
in productivity to technological progress, rather than the effects of EU
deregulation.66
62. For example, Hunter and Timme (1991); Berger and Humphrey (1992a); Bauer,
Berger, and Humphrey (1993); Humphrey (1993); Elyasiani and Mehdian (1995); Devaney
and Weber (1996); Wheelock and Wilson (1996); Humphrey and Pulley (1997); Alam
(1998); Berger and Mester (1999).
63. Consistent with this conclusion, one study finds a positive external effect of consol-
idation following interstate banking deregulation. Out-of-state entry is associated with
increased cost X-efficiency in the long term (DeYoung, Hasan, and Kirchhoff 1998).
64. Berger and Mester (1999).
65. For Norway, see Berg, Forsund, and Jansen (1992). For Turkey, see Zaim (1995). For
Spain, see Lozano-Vivas (1998); Grifell-Tatje and Lovell (1996); Hasan, Hunter, and
Lozano-Vivas (2000).
66. Dietsch, Ferrier, and Weill (1998).
IMPLICATIONS OF THE EFFICIENCY RESEARCH. The efficiency research

reviewed here, while extensive, suggests very few strong conclusions
regarding the efficiency effects of cross-border consolidation. The litera-
ture on scale efficiency is somewhat uncertain, but it suggests that there
may be gains from large-scale consolidation based on technological, finan-
cial, and regulatory changes in the 1990s. The literature on scope and
product mix efficiencies also provides mixed results and very little infor-
mation on cross-industry efficiencies. The literature on scale, scope, and
product mix also provides little information on cross-border performance,
which may differ from the scale, scope, and mix effects within a single
nation without significant internal entry barriers or differences in lan-
guage, culture, and regulation that may raise the costs of becoming large.
The X-efficiency research reviewed here is more promising, but it does
not provide solid evidence regarding cross-border efficiency nor does it
distinguish well between our home field advantage and global advantage
hypotheses. The literature on the effects of M&As on financial institu-
tion X-efficiency often suggests efficiency gains, but most of the evidence
is based on within-nation consolidation, which does not take into account
organizational diseconomies or other difficulties in operating or moni-
toring across borders. The literature on international comparisons of
X-efficiency has significant problems in estimating efficiency against a
common frontier because market, regulatory, or supervisory differences
are so great. More important, this literature does not address the issue of
potential organizational diseconomies and other difficulties of cross-
border operations. The literature on the X-efficiency effects of deregula-
tion finds somewhat mixed results but focuses mostly on deregulation
within a nation, rather than on the types of deregulation that facilitate
cross-border consolidation.
The evidence on the X-efficiencies of foreign versus domestic institu-
tions within a single nation is the most important type of evidence for eval-
uating our hypotheses, because it is the only direct evidence on the extent
to which financial institutions are able to monitor and control their sub-
sidiaries operating in other nations. However, the extant literature does not
provide much guidance for distinguishing between the hypotheses because
these studies (a) examine foreign and domestic efficiency in only one
country, which cannot alone distinguish between the hypotheses because
the institutions from that home country might have a global advantage,
(b) do not distinguish among nations of foreign ownership, which cannot
test the limited form of the global advantage hypothesis that institutions
from only one or a limited number of foreign nations have an advantage,
or (c) combine efficiency information from different home countries,
which creates problems of comparison because of significant differences
in the market, regulatory, or supervisory environments of these nations.
None of the studies has all three of these drawbacks, but all have at least
one, to our knowledge. We address these drawbacks in the next section.
Cross-Border Consolidation: Topics Other Than Efficiency
We complete our review of the extant research on cross-border consol-

idation by covering topics other than efficiency. Specifically, we cover
market power motives and consequences, managerial motives and conse-
quences, and government motives and social consequences.
Market Power Motives and Consequences

Most of the research on the market power effects of consolidation
focuses on M&As within a single nation and their effects on small retail
customers. More specifically, the focus is typically on the effects on small
depositors and small businesses of M&As between institutions in the same
local market. These in-market M&As may increase local market concen-
tration and allow the consolidated institution to increase shareholder value
by setting prices less favorable to small retail customers (lower deposit
rates, higher small business loan rates). Consistent with this focus, it has
been found that U.S. households and small businesses almost always
choose a local financial institution.67
MARKET POWER OVER RETAIL CUSTOMERS . Cross-border consolida-
tion does not directly increase local market concentration for the prod-
ucts typically purchased by small retail customers. Nonetheless, it may
affect the exercise of market power over these customers by (a) affecting
consolidation within nations, (b) changing the competitive dynamic
among cross-border institutions, or (c) enhancing competitive rivalry by
increasing the contestability of domestic banking markets. We discuss
each of these possibilities in order.
67. Kwast, Starr-McCluer, and Wolken (1997).

Cross-border consolidation or the threat of it may lead to consolidation

of financial institutions within nations, raising local market concentration.
To protect previously existing market power or entrenched management,
institutions within nations may engage in M&As to help fend off poten-
tial foreign competitors. In addition, efficiency motives may help to moti-
vate local M&As. When reductions in cross-border entry barriers create
opportunities to improve scale, scope, product mix, or X-efficiencies by
invading the markets in other nations, institutions may first engage in
within-nation M&As to grow large enough to compete in international
markets.
The research evidence generally suggests that higher local market con-
centration created by consolidation within a nation is likely to raise market
power in setting prices on retail financial services. Studies on the effects of
bank M&As on pricing find that M&As that involve very substantial
increases in local market concentration tend to raise market power in set-
ting prices but that the effects of other M&As are ambiguous.68 Other stud-
ies usually find that banks in more concentrated markets charge higher
rates on small business loans and pay lower rates on retail deposits and that
their deposit rates are “sticky” or slow to respond to changes in open-
market interest rates, consistent with the exercise of market power.69 It
has been suggested that market power over small customers may have
declined in recent years because of an increase in the degree of contesta-
bility of financial services markets and new technologies for delivering
financial services, but the empirical evidence on this issue is mixed.70
Cross-border consolidation may also affect the exercise of market
power within individual markets even if there is no change in local mar-
ket concentration. First, at least to some extent, institutions tend to charge
uniform prices throughout the organization, even when the local market
structures differ substantially across the markets in which they compete.
For example, one study finds that large U.S. banks often set uniform rates
for deposits and loans across geographic markets within a state or region,
although the reasons for this are not clear.71 Uniform pricing may occur
68. Akhavein, Berger, and Humphrey (1997); Sapienza (1998); Simons and Stavins
(1998); Prager and Hannan (1999).
69. For example, Berger and Hannan (1989, 1997); Hannan (1991, 1994); Hannan and
Berger (1991), Neumark and Sharpe (1992); Jackson (1997).
70. Hannan (1997); Cyrnak and Hannan (1998); Radecki (1998).
71. Radecki (1998).
because it is easier to administer, because of public relations concerns

about fairness, or because of other factors.
Evidence on bank fees for retail deposit and payments services shows
very little relationship with measures of local market concentration in the
1990s and a tendency of multistate bank holding companies to charge
higher fees to retail customers than other banks.72 These results similarly
suggest that factors other than local market concentration are important
in the exercise of market power. For example, this pricing strategy may
be designed to engineer a shift from serving small customers toward serv-
ing large customers.
In addition, cross-border consolidation may result in the same institu-
tions competing against each other in multiple countries. The theory of
multimarket contact suggests that if firms face each other in multiple mar-
kets, there could be either more or less exercise of market power. There
could be more exercise of market power because the firms may mutually
forbear. That is, they may set high prices rather than compete to avoid
retaliation in other markets. There could also be less exercise of market
power, at least in the short run, if firms price strategically to signal their
costs or to drive competitors out of business. The data are mixed as to the
effects of multimarket contact on prices for retail banking products.73
Finally, cross-border consolidation or the threat of cross-border entry
may reduce the exercise of market power because of increased market con-
testability. One way this may occur is if the existing financial institutions
in a market alter their limit pricing behavior, setting prices more favor-
able to customers in an effort to deter foreign entry. This may also occur
if efficient foreign producers enter and provide services at more favorable
prices and take market share away from inefficient local producers that
were formerly protected by cross-border entry barriers. In the European
Union, a key prediction of the 1988 Cecchini study on the impact of the
Single Market Programme was that cross-border competition would create
considerable potential for prices to converge and fall to the level of the
lowest-cost producers.74
Indeed, the creation of a single market for financial services in the
European Union is an important test of this phenomenon. Since the adop-
72. Hannan (1998).

73. Mester (1987, 1992a); Pilloff (1999).
74. Commission of the European Communities (1988a, 1988b).
tion of the Treaty of Rome in 1957, the European Union has adopted leg-
islation designed to promote competition in financial services through the
creation of a single banking license and harmonization of regulation.75 The
adoption of a single currency is likely to increase financial institution com-
petition further by reducing entry barriers and by lowering currency risk,
which may increase the willingness of some customers to shop for finan-
cial services in other nations. The deepening of capital markets in the
European Union is likely to provide additional competition to banks in
the most banking-oriented nations of continental Europe. This encroach-
ment of securities markets may increase the competitive pressure on banks
by giving business customers additional opportunities to raise capital by
issuing commercial paper, public debt, or public equity in place of bank
loans and by giving savers additional opportunities to invest in money mar-
ket funds, mutual funds, or other traded assets in place of bank deposits.76
There has been some recent empirical investigation into the issue of
whether the single market for financial services in the European Union has
achieved this policy objective. The evidence generally suggests that the reg-
ulatory changes have had only a modest impact on loan, fee, and deposit
prices.77 The impact does not appear to be uniform across countries. Specif-
ically, the decline in prices tends to be greater in countries where regulation
was tightest prior to implementation of the second banking directive in
1993, such as Greece, Portugal, and Spain. Also, the modest decline in
prices was somewhat greater for corporate services than for retail services.
Several studies analyze changes in market power using econometric
models. One study uses the Rosse-Panzar statistic to evaluate changes in
competitive conditions in banking in major EU nations between 1986 and
1989 and finds that the monopolistic competition prevailing at the begin-
ning of the period did not change substantially over time.78 Another study
of the EU uses similar methodology and finds no major change in com-
petitive banking conditions between 1989 and 1996.79 However, one study
finds more price competition that is linked to interest rate deregulation in
individual countries.80
75. Molyneux, Altunbas, and Gardner (1996).

76. De Bandt and Davis (1998).
77. Economic Research Europe (1997).
78. Molyneux, Lloyd-Williams, and Thornton (1994).
79. Bikker and Groeneveld (1998).
80. Cerasi, Chizzolini, and Ivaldi (1998).
A caveat to this analysis is that there may not be a single uniform mar-
ket for financial services even in one nation. For example, one study finds
that foreign banks in Switzerland exercise more market power than domes-
tic banks, suggesting that foreign and domestic financial services might be
at least somewhat differentiated products.81 Such differentiation tends to
limit the potential for reductions in market power and price convergence as
a result of lower barriers to entry.
MARKET POWER OVER WHOLESALE CUSTOMERS. The impact of cross-
border consolidation on the wholesale market for financial services might
be quite different from its impact on retail markets. One the one hand, it
may be difficult to exercise market power against large wholesale cus-
tomers. These customers often have sufficient resources to choose among
many suppliers on a global basis, and product differentiation may be less
important in wholesale commercial banking, securities, and insurance
service markets than in retail markets. On the other hand, the number of
suppliers in wholesale markets is considerably smaller than in retail mar-
kets, and cross-border consolidation may reduce the number of wholesale
financial institutions. For example, the ten-firm concentration ratios in
U.S. domestic corporate stock and bond underwriting and in Euromarket
underwriting exceed 80 and 50 percent, respectively.82 Evidence from the
1980s also suggests the presence of some market power in the securities
industry.83
More recent work sheds further light on this market. A study of the mid-
size initial public offering (IPO) market in the United States finds that
more than 90 percent of the issues paid precisely the same 7 percent under-
writing fee.84 The authors argue that, in the absence of market power, the
percentage fee would be declining with issue size due to economies of
scale in spreading fixed costs. In addition, IPO fees in other areas (such
as Australia, Europe, Hong Kong, and Japan) are approximately half as
high.85 These data suggest that market power is exercised in pricing for this
mid-issue-size range in the U.S. market. However, for large deals, spreads
81. Shaffer (1999).

82. “1998 Underwriting League Tables,” Investment Dealers Digest, October 11, 1999,
pp. 18, 30.
83. Hayes, Spence, and Van Praag Marks (1983); Pugel and White (1985).
84. Chen and Ritter (2000), p. 24.
85. Lee, Lochhead, Ritter, and Zhao (1996).
are found to be lower, and clustering is absent.86 Arguably, the mid-issue-

size range may be more of a national market, while the large-size range
may be more of a global market.
Deregulation may have affected the competitiveness of the wholesale
securities industry. As noted, the Federal Reserve began allowing bank
holding companies to underwrite corporate debt and equity through Sec-
tion 20 affiliates in 1987, and the restrictions were later further relaxed.
While bank holding companies have not had as much impact on the equity
side of the market, they have made a significant impact on the debt side.
For example, in 1998 six bank holding companies were listed among the
top fifteen underwriters of investment-grade debt.87 Recent studies have
found evidence that a decline in underwriting fees is associated with the
entry of bank holding companies into this market.88 This evidence, com-
bined with the data on high prices in the United States, suggests that cross-
border consolidation may have the potential to reduce the exercise of
market power in the mid-issue-size IPO market and other national whole-
sale financial markets. However, it is also possible that cross-border con-
solidation might increase the exercise of market power in the large-size
IPO market and other global wholesale financial markets.
An additional concern is how cross-border M&As between commercial
banking organizations and investment banks (for example, Deutsche
Bank–Morgan Grenfell and Bankers Trust–Alex. Brown) will affect pric-
ing given that universal-type organizations simultaneously operate in two
key markets in which wholesale customers raise funds. These combina-
tions create universal banks that may potentially acquire power over cus-
tomer access to both the private and public markets, although the effect
may be limited if at least one of the markets is competitive.89
Managerial Motives and Consequences

Cross-border consolidation may be driven in some cases by manage-
rial motives rather than the goal of maximizing shareholder value. In pro-
fessionally managed organizations, entrenched managers may make
86. Chen and Ritter (2000).
87. “1998 Underwriting League Tables,” Investment Dealers Digest, October 11, 1999,
pp. 18, 30.
88. For example, Beatty, Thompson, and Vetsuypens (1998); Gande, Puri, and Saun-
ders (1999).
89. Rajan (1994, 1996).
decisions regarding cross-border consolidation based on their own prefer-

ences for compensation, perquisites, power, and job security. Cross-border
consolidation may either strengthen or weaken the hands of entrenched
managers directly, by affecting the market for corporate control or gover-
nance or, indirectly, by changing the market power of their firms.
MANAGERIAL MOTIVES. Consistent with the presence of these agency
problems, there is evidence that banking organizations may overpay for
acquisitions when corporate governance structures do not sufficiently align
the incentives of managers with those of owners. For example, acquiring
banks that have addressed control problems through high levels of man-
agerial shareholdings or concentrated ownership experience higher (or less
negative) abnormal returns around the time of the acquisition than other
acquirers. In addition, abnormal returns at bidder banks increase when
the pay of the chief executive officer (CEO) is based on the performance of
the firm and when the share of outsiders on the board of directors is large.90
Moreover, bank managers with more stock-based wealth or compensa-
tion tend to make fewer acquisitions. 91 This evidence suggests that
entrenched managers with little pay sensitivity to performance or few con-
straints imposed by outside directors may engage in M&As that do not
maximize shareholder wealth.
The literature on corporate finance has identified size-related compen-
sation and perquisites as key motives behind the decisions of professional
managers, and these may play important roles in the cross-border consol-
idation decisions of some financial institution managers.92 However, to the
extent that the compensation boost from consolidation is linked to firm
performance, consolidation in general is value maximizing and does not
reflect exploitative behavior on the part of management. Compensation
studies in both corporate finance and in banking generally show positive
links between managerial compensation and both firm performance and
firm size, consistent with both the efficiency and managerial motives for
consolidation.93 Also consistent with managerial motives, a recent study
finds that CEO compensation rose after bank M&As, even if the stock
90. Allen and Cebenoyan (1991); Subrahmanyam, Rangan, and Rosenstein (1997);
Cornett, Hovakimian, Palia, and Tehranian (1998).
91. Bliss and Rosen (1999).
92. For example, Murphy (1985); Jensen and Murphy (1990).
93. For corporate finance, see Jensen and Murphy (1990); Hall and Liebman (1998). For
banking, see Barro and Barro (1990); Hubbard and Palia (1995).
price fell.94 However, the personal compensation motive may not be as

great in cross-border consolidation decisions in banking as it formerly
was, or as it is elsewhere. Research has found that the sensitivity of pay
to performance in banking has increased since deregulation, that compen-
sation in banking may be more sensitive to performance than it is in other
industries, and that pay-performance sensitivity may be greater at large
banks, which tend to engage in cross-border consolidation.95
Perquisite consumption by managers may likewise be a motive behind
some cross-border consolidation of financial institutions. Evidence of
expense preference behavior has been found in banking in a number of
studies.96 This literature often finds that the data are consistent with man-
agers exercising preferences for additional employees, and of course con-
solidation is the most straightforward way to increase the number of
employees. There is also some evidence that consumption of perquisites
and reduced work effort by managers may be related to market power, so
there may be additional incentives to engage in types of consolidation
that increase market power. Similarly, managers may engage in cross-
border consolidation because of the prestige or hubris associated with
managing a larger or more expansive empire.97
The corporate finance literature has also identified diversification of
personal risk as a motive behind the decisions of professional managers.98
Financial institution managers may engage in cross-border consolidation
that diversifies the risks of the institution beyond the point that would be in
the interest of shareholders for the purpose of enhancing their own job
security and protecting the value of their firm-specific human capital.
There is evidence that large commercial banking organizations act in a
risk-averse fashion, although this evidence does not by itself necessarily
imply nonvalue-maximizing behavior. However, other work has linked
managerial control specifically to bank behavior and found that manage-
rially controlled banks exhibit less risk.99
94. Bliss and Rosen (1999).

95. Crawford, Ezzell, and Miles (1995); Hubbard and Palia (1995); Houston and James
(1995); Demsetz and Saidenberg (1999).
96. For example, Hannan and Mavinga (1980); Smirlock and Marshall (1983); James
(1984); Brickley and James (1987); Mester (1989, 1991).
97. Roll (1986).
98. For example, Amihud and Lev (1981); Morck, Shleifer, and Vishny (1990); May
(1995).
99. Saunders, Strock, and Travlos (1990).
In some circumstances, however, maximizing job security could

encourage management to increase institution risk. If the financial insti-
tution is in a declining industry, managers may have incentives to increase
risk in order to increase the probability that their institution is one of the
survivors.100
Managers may also try to enhance their job security by preventing some
cross-border consolidation that would otherwise be in the interest of share-
holders. Managers may try to protect their jobs by engaging in domestic
M&As. This may help to fend off hostile takeovers or prevent foreign
entry by creating institutions that are too large to be taken over easily or by
taking over the market niche of potential foreign entrants. Other evidence
also suggests that managers may try to prevent their institution from
becoming takeover targets. One study finds that banks in which managers
hold a greater share of the stock are less likely to be acquired, consistent
with the possibility that managers with large ownership stakes block out-
side acquisitions to protect their job.101
CONSEQUENCES FOR THE PURSUIT OF MANAGERIAL GOALS . Cross-
border consolidation or its threat could also affect the magnitude of the
corporate governance problems in the financial services industry, although
the net impact could go either way. As the evidence suggests, managers
may be able to exercise their own preferences rather than maximize share-
holder wealth because of weaknesses in corporate control systems. These
weaknesses may occur for regulated financial institutions more often than
for nonfinancial corporations, since regulatory requirements may inhibit
an active takeover market for institutions that are not maximizing value. In
the United States and other nations that have prohibited or significantly
constrained universal banking, there may be substantial barriers to the
acquisition of commercial banks by other types of institutions. The regu-
latory approval and disapproval process and other prudential requirements
may also deter some acquirers. The evidence is consistent with these argu-
ments. Hostile takeovers that replace management are rare in U.S. bank-
ing, although they do occur (for example, Wells Fargo–First Interstate).102
An alternative explanation for the paucity of hostile takeovers of large,
publicly traded U.S. banks is that strong internal corporate controls at
100. Gorton and Rosen (1995).

101. Hadlock, Houston, and Ryngaert (1999).
102. Prowse (1997).
these firms prevent entrenchment by adequately disciplining managers,

making private market discipline less necessary.103
Cross-border consolidation may address these control problems by
improving managerial incentives and monitoring, particularly if more effi-
ciently controlled organizations tend to acquire less efficiently controlled
institutions. However, it is also possible that the monitoring of managers
may worsen after cross-border consolidation. One explanation for the
home field advantage hypothesis is that it may be difficult for organiza-
tions to monitor the managers of their foreign subsidiaries.
Cross-border consolidation may also strengthen or weaken the hands of
entrenched managers by affecting the market power of financial institu-
tions. Market power might complicate corporate governance by giving
managers more leeway to pursue their own goals. The exercise of market
power in setting prices may increase profits, raise shareholder value, and
allow managers to proceed according to their own objectives without being
easily detected. Consistent with this, one study finds that U.S. banks in
more concentrated local markets have substantially lower cost effi-
ciency.104 Also consistent with this argument, a number of studies find lit-
tle effect of concentration on bank profits, even though concentration tends
to increase market power in pricing.105 Presumably, some of the profits
from the exercise of market power are diverted to higher perquisite
consumption, other expense preference behavior, or a reduced effort to
maximize efficiency or a “quiet life” for the managers. Cross-border con-
solidation or its threat may increase or decrease the exercise of market
power.
The net effect of cross-border consolidation on the behavior of man-
agers in pursuing their own objectives directly through corporate control
or indirectly through market power is unknown. However, if the effect of
removing cross-border entry barriers is similar to the effect of removing
state barriers in the United States, the data suggest that these actions are
likely to refocus managers toward improving efficiency in place of satis-
fying their personal goals. Corporate control appears to have improved as
intrastate and interstate banking deregulation increased the number of
103. Demsetz, Saidenberg, and Strahan (1997).

104. Berger and Hannan (1998).
105. For example, Berger (1995); Maudos (1996); Berger and Hannan (1997); Berger,
Bonime, Covitz, and Hancock (2000).
potential acquirers, reduced the market share of poorly run banks, and gen-
erally improved performance.106
Government Motives and Social Consequences

Governments also play important roles in constraining or encouraging
consolidation activity. Governments often restrict the types of M&As per-
mitted by putting explicit limits on cross-border M&As or M&As between
different types of financial institutions (such as commercial banks with
investment banks). Similarly, governments may require that foreign entry
occur by M&A with existing domestic institutions, rather than by open-
ing new offices, to help protect the franchise value of domestic institutions.
Governments also affect consolidation directly through the decision to
approve or disapprove individual M&As. During periods of financial cri-
sis, governments sometimes provide financial assistance or otherwise aid
in the consolidation of troubled financial institutions or acquire these insti-
tutions in part or in whole themselves.
Governments may also affect decisions regarding cross-border consol-
idation in less explicit ways. Any decisions that affect the cross-border
consolidation of nonfinancial firms or international trade—such as imple-
mentation of the European Monetary Union or imposition of tariffs and
quotas on other nations—affect the efficiency motives behind cross-border
consolidation. Revenue efficiency may increase from cross-border consol-
idation as the consolidated institutions can better serve customers that
operate in multiple nations. Government actions that harmonize or fail to
harmonize financial systems or payments systems may affect decisions
regarding cross-border consolidation as well. It has been argued that
despite the removal of many of the explicit cross-border entry barriers
within the European Union, cross-border consolidation of commercial
banks in Europe may have been relatively sparse because of differences
in the use of paper versus book entry, settlement cycles and methods, and
payments systems.107 As well, European and other cross-border consolida-
tion may be tempered by structural differences among the capital mar-
kets, tax, and regulatory regimes of the nations.108
106. Schranz (1993); Hubbard and Palia (1995); Jayaratne and Strahan (1996, 1998).
107. Giddy, Saunders, and Walter (1996); White (1998).
108. Lannoo and Gros (1998).
There are a number of potential motives underlying some of these gov-

ernment actions or inactions. In some cases, governments may block for-
eign takeovers or permit M&As within the nation for reasons of national
pride—governments may wish to ensure that the largest institutions in
their nations are domestically owned.109 In contrast, harmonization and
other government actions to permit more cross-border entry may reflect an
increased strength of interest groups that benefit from technological inno-
vations and globalization of financial services. 110 Alternatively, these
actions may simply reflect regulators’ official acquiescence to de facto
entry that was already occurring.111
Consolidation of banks across state and industry borders within the
United States and across international borders in Europe and elsewhere
have been driven in significant part by government deregulation. The time
series presented in figures 1 and 2 show an association between geographic
market deregulation and the volume of financial institution M&A activ-
ity, especially in the European Union. In the United States, the removal
of restrictions on interstate banking that started in the 1980s and concluded
in 1994 with the Riegle-Neal Act (which permits interstate branching in
almost all states) permitted the managers of commercial banks to pursue
efficiency, market power, and other goals through consolidation. Much of
the consolidation was related to this deregulation.112 In addition, the lib-
eralization of Glass-Steagall restrictions on banking powers—in which the
Federal Reserve allowed bank holding companies to underwrite corpo-
rate debt and equity through Section 20 affiliates within limits—permit-
ted a number of M&As between bank holding companies and securities
firms.113 Although real limits remain on nationwide interstate consolidation
in the United States, the recently passed Gramm-Leach-Bliley Act
removed many of the remaining restrictions on combining commercial
banking, investment banking, and insurance activities.114 If this U.S. expe-
rience is representative, similar consolidation across borders in the Euro-
pean Union may be forthcoming as a result of the banking directives and
109. Boot (1999).
110. Kroszner (1999).
111. Kane (1999a).
112. Berger, Kashyap, and Scalise (1995); Jayaratne and Strahan (1998).
113. Gande, Puri, and Saunders (1999); Saunders (1999).
114. Regarding restrictions on nationwide interstate banking, the Riegle-Neal Act caps
the total bank and thrift deposits that any organization may reach by M&A to 30 percent in
a single state and 10 percent nationally.
other harmonizations of regulatory and supervisory structures. The imple-

mentation of monetary unions may also increase cross-border consolida-
tion by increasing trade, by reducing the currency conversion costs of
institutions operating in multiple nations, and by reducing costs to con-
sumers of purchasing services from foreign institutions.115
In the remainder of this section, we discuss the research findings for
some of the major social consequences of cross-border consolidation:
systemic risk and the government safety net, availability and prices of
financial services for small retail customers, availability and prices of
financial services for large wholesale customers, banking-oriented finance
versus market-oriented finance, and other macroeconomic effects. Other
government goals and policies (such as enforcement of the Community
Reinvestment Act) are excluded.
SYSTEMIC RISK AND THE GOVERNMENT SAFETY NET. Systemic risk may
be broadly defined as the risk that credit or liquidity problems of one or
more financial market participants will create substantial credit or liquid-
ity problems for participants elsewhere in the financial system. The con-
tagion effects can be transferred through the financial system through
failures to settle in the payments system, through panic runs that follow the
revelation of problems affecting one or more institutions, or through
falling prices, liquidity problems, or markets that fail to clear when large
volumes of securities are offered for sale simultaneously.
Changes in systemic risk from cross-border consolidation have impor-
tant potential social consequences, including possible financial market
gridlock, problems in the payments system, and difficulties in implement-
ing monetary policy, as well as the costs of financial distress, bankruptcy,
and loss of franchise value to other institutions caught up in the conta-
gion. Much of the overall justification for the government safety net and
other government involvement in supervision and regulation rests on con-
cerns about systemic risk.
Cross-border consolidation may affect systemic risk and the govern-
ment’s cost of maintaining the safety net if the consolidation changes the
risks of individual institutions involved in the M&As. It may also affect
115. The effects of monetary union on financial institutions and capital markets have
been examined extensively elsewhere. See, for example, Dermine (1999a, 1999b, 1999c,
2000); De Bandt (1999); De Bandt and Davis (1998); Morgan Stanley Dean Witter (1998);
McCauley and White (1997); White (1998); Dermine and Hillion (1999); European Cen-
tral Bank (1999); Hurst and Wagenvoort (1999); Merrill Lynch (1999).
systemic risk by increasing the size of the institutions. This may increase
systemic risk because the systemic consequences of the failure of larger
and larger institutions may be increasingly more severe. However, sys-
temic risks may also decrease if the smaller number of larger institutions
increases the efficiency of monitoring by government supervisors or other
market participants.
Systemic risk may also either increase or decrease with cross-border
consolidation. On the one hand, the effects of a systemic crisis within one
nation may be mitigated because some of the institutions are diversified
across national borders and can use their foreign operations as a source of
strength. On the other hand, these transfers of funds may help to spread a
crisis by weakening the institutions in the other nations.
Cross-border consolidation may also expand the safety net and raise the
government’s cost of maintaining the safety net in at least four other ways.
First, if the government provides more safety net protection to larger insti-
tutions because they may be considered “too big to fail” or for other rea-
sons, then safety net costs are increased by consolidation, which creates
larger institutions that receive stronger explicit or implicit government
guarantees. Thus, in addition to the moral hazard incentive to take on more
risk, the presence of the safety net also may encourage consolidation by
institutions trying to become too big to fail.116 To offset these costs, gov-
ernments use prudential regulation and supervision to try to control risk
taking and may block or discourage M&As that appear likely to increase
substantially the costs of safety net or systemic risk.
Second, cross-border consolidation may expand the safety net by
extending government guarantees to types of financial institutions that nor-
mally receive much less safety net protection. Consolidation that creates
universal-type institutions by combining commercial banks with securities
firms or insurance companies may extend the safety net because commer-
cial banks typically receive much more protection than these other types of
institutions. Much of the current debate over operating structure centers on
the issue of how best to control this potential extension of the safety net.117
The potential costs of extending the safety net may be the greatest for com-
binations of commercial banks with nonfinancial firms, which typically
receive much less government protection.118
116. Kane (1999b); Saunders and Wilson (1999).
117. For example, Kwast and Passmore (2000); Whalen (2000).
118. Boyd, Chang, and Smith (1998).
Third, cross-border consolidation may expose one government’s safety

net to losses incurred by the offices or subsidiaries of its institutions oper-
ating in other nations. That is, when a domestic institution acquires offices
or subsidiaries in other nations, the home-country safety net may be
exposed to the risk that those foreign entities will bear losses and drain
some or all of the equity of the home-country parent institution. This may
be particularly costly in some small nations in which the size of potential
losses from abroad and at home are very large relative to the nation’s
GDP.119 However, to some extent, these additional safety net exposures are
offset by reduced exposures in the host foreign nations.
Fourth, cross-border consolidation may increase the cost of coordinat-
ing the regulatory responses among various national authorities to the fail-
ure of large banking organizations. For instance, national central banks in
the European Union, rather than the European Central Bank, have the
lender-of-last-resort responsibilities under the Maastricht Treaty. The cost
of resolving future failures among pan-European banking organizations
might be higher due to differences in the incentives of national govern-
ments to bail out various institutions and the impact of these policies on
European monetary policy.120
AVAILABILITY AND PRICES FOR SMALL RETAIL CUSTOMERS . Cross-
border consolidation may also raise social concerns about the availabil-
ity and prices of financial services for retail customers who often depend
on locally based financial institutions. Cross-border consolidation may be
associated with increases or decreases in efficiency or with increases or
decreases in the market power of financial institutions over small retail
depositors and borrowers. These changes in efficiency or market power
may in turn result in services that are either more or less available at
prices that are more or less favorable for these customers. Rather than go
into detail on all of the possible causes and consequences, we concentrate
here on three specific ways in which cross-border consolidation may
affect financial institutions’ supply of retail services: (a) increases in
financial institution scale, (b) increases in organizational complexity,
and (c) dynamic changes in focus or organizational behavior associated
with the process of cross-border consolidation itself. We discuss each of
these in order.
119. Dermine (1999b).

120. Dermine (1999b); Wihlborg (1999).
The increases in financial institution scale associated with cross-border

consolidation may induce the institutions to shift away from providing cer-
tain services to small retail customers. This may occur because large insti-
tutions may encounter Williamson-type organizational diseconomies from
providing these retail services alongside the capital market services pro-
vided to wholesale customers that typically purchase services from multi-
national financial institutions. 121 This may be particularly the case for
relationship-based services to small retail customers, such as some types
of small business loans that demand intimate knowledge of the customer,
business owner, and local market.122 It may be costly to provide these ser-
vices in institutions that primarily provide wholesale services to customers
operating in global markets. In addition, if the financial institutions face
upward-sloping supply curves of funds, the improved opportunities to pro-
vide funds to large wholesale customers may crowd out funding to small
retail customers.
It is also possible that the large, diversified financial institutions that
result from cross-border consolidation may provide an efficient, stable
flow of retail services to small customers, particularly during times of
financial stress. The institutions that consolidate across borders may be
better able to withstand financial crises in any one nation and to continue
providing services to its households and small businesses. In contrast,
small, undiversified institutions may more often have to withdraw credit
and other services from small customers in times of financial stress. More-
over, even in periods without financial stress, the large institutions cre-
ated by cross-border consolidation may act as efficient internal capital
121. Williamson (1967, 1988).

122. Research evidence supports the notion that banks use relationships to garner infor-
mation about small businesses and that small businesses benefit from these relationships.
U.S. small businesses with stronger banking relationships generally have been found to
receive loans with lower rates and fewer collateral requirements, to be less dependent on
trade credit, to enjoy greater credit availability, and to have more protection against the inter-
est rate cycle than other small businesses. See, for example, Lang and Nakamura (1989);
Hoshi, Kashyap, and Scharfstein (1990); Petersen and Rajan (1994, 1995); Berger and Udell
(1995); Blackwell and Winters (1997); Angelini, Di Salvo, and Ferri (1998); Berlin and
Mester (1998); Cole (1998); Elsas and Krahnen (1998); Harhoff and Körting (1998); Hub-
bard, Kuttner, and Palia (1999); Ongena and Smith (1999). The data also suggest that banks
gather valuable private information from depositors and in some cases use this information
in credit decisions. See Allen, Saunders, and Udell (1991); Nakamura (1993); Frieder and
Sherrill (1997); Mester, Nakamura, and Renault (1998). For a detailed review of the rela-
tionship literature, see Berger and Udell (1998).
markets that allocate financial resources across borders where and when
they are most productive.
The research is consistent with the prediction that increases in finan-
cial institution scale are associated with reduced supplies of small busi-
ness credit from these institutions. Several studies have found that large
U.S. banks devote lesser proportions of their assets to small business
lending than do small institutions.123 As banks get larger, the proportion
of assets devoted to small business lending (measured by domestic com-
mercial and industrial loans to borrowers with bank credit less than
$1 million) declines from about 9 percent of assets for small banks
(assets below $100 million) to about 2 percent for very large banks
(assets above $10 billion).
Some evidence also suggests that it is specifically relationship-
dependent small business borrowers that tend to receive less credit from
large banks. One study finds that large banks tend to charge about 1 per-
centage point less on small business loans and require collateral about
25 percent less often than small banks, other things being equal.124 These
data suggest that large banks tend to issue small business loans to higher-
quality transaction-based credits, rather than relationship-based loans that
tend to have higher interest rates and collateral requirements. Similarly,
one study finds that large U.S. banks tend to base their small business loan
approval decisions more on financial ratios, whereas the existence of a
prior relationship with the borrowing firm matters more to decisions by
small banks.125 Consistent with this, another study finds that large U.S.
banks more often lend to larger, older, more financially secure businesses,
consistent with the predicted focus on transaction-driven lending; the
reverse is true for small banks focusing on relationship-driven lending.126
The data are also consistent with the argument that large financial insti-
tutions may provide efficient, stable flows of retail credit services. One
study finds that during the U.S. credit crunch of the early 1990s, a $1
decline in equity capital at a small bank reduced business lending more
than $1 at a large bank, and the financial distress of large financial insti-
123. For example, Berger, Kashyap, and Scalise (1995); Keeton (1995); Levonian and
Soller (1996); Berger and Udell (1996); Peek and Rosengren (1996); Strahan and Weston
(1996); Berger, Saunders, and Udell (1998).
124. Berger and Udell (1996), p. 622.
125. Cole, Goldberg, and White (1999).
126. Haynes, Ou, and Berney (1999).
tutions had fewer adverse effects on the health of small businesses in their
states.127 Other studies find that loan growth by banks in multibank bank
holding companies is constrained less by the banks’ own financial condi-
tions than by the financial condition of the holding company, consistent
with the argument that bank holding companies serve as internal capital
markets to provide efficient, stable loan funding.128
The arguments about the effects of increased organizational complexity
from cross-border consolidation are similar to those for increased financial
institution scale. Many of the institutions engaging in cross-border con-
solidation are likely to (1) add layers of management, (2) expand the num-
ber of nations in which they operate, or (3) increase the number of
different types of wholesale financial services they provide. Similar to the
effects of increases in financial institution scale, it may be difficult to
maintain strong local relationships and process relationship-based infor-
mation when (1) there are more layers of management through which to
pass the local information, (2) there are more local conditions to monitor,
or (3) there are more wholesale businesses drawing the attention of the
institution. Also similar to the arguments for scale, the increased organi-
zational complexity may improve stability in the delivery of retail credit
and other services, as risks may be better diversified or more sources of
financial strength are available.
Two dimensions of complexity that have been studied are out-of-state
ownership and multibank affiliation of bank holding companies in the
United States. Out-of-state ownership is analogous to foreign ownership,
and multibank affiliation is analogous to being a separately chartered
entity in a multinational financial institution. Out-of-state ownership is
usually found to have a negative effect on small business credit, although
one study finds no effect and one study finds that recent interstate acqui-
sitions may provide at least a temporary offsetting boost to small busi-
ness lending. 129 Multibank affiliation is also generally found to have a
negative effect on small business lending.130 However, empirical analysis
127. Hancock and Wilcox (1998), pp. 996, 997, 1006.
128. Houston, James, and Marcus (1997); Houston and James (1998).
129. Keeton (1995), Berger and Udell (1996), Berger, Saunders, and Udell (1998), and
Berger, Bonime, Goldberg, and White (1999) find a negative effect from out-of-state own-
ership. Whalen (1995) finds no effect. Berger, Saunders, and Udell (1998) find a temporary
offsetting boost from recent acquisitions.
130. Berger and Udell (1996); Berger, Bonime, Goldberg, and White (1999); DeYoung,
Goldberg, and White (1999).
that specifies simultaneously multiple dimensions of organizational com-

plexity generally finds mixed results, with some dimensions of complexity
positively associated with small business lending and other dimensions
negatively associated.131
The process of cross-border consolidation itself may be associated with
dynamic changes in the treatment of retail customers. M&As are dynamic
events that often involve significant changes in organizational focus that
might shift the organizations away from or toward serving retail cus-
tomers. Also, disruptions may affect the ability to serve retail customers
during the transition period and may drive away some retail customers.
Other changes in organizational focus and managerial behavior may also
alter the availability and pricing of services to small customers. For exam-
ple, the consolidated institution may change the policies and procedures of
the foreign subsidiary to bring them into accord with the acquirer’s pre-
consolidation focus on either retail or wholesale services.
Also important are the external effects of cross-border consolidation or
the dynamic reactions of other institutions in the same markets as the con-
solidating institutions. The changes in competitive conditions may affect
the behavior of rival institutions, which may either augment or offset the
actions of the consolidating firms. For example, if consolidating institu-
tions reduce the availability of credit to some small businesses, other
institutions may pick up some of the dropped credits if it is value-
maximizing for them to do so. Only by including these external effects
can the total effects of cross-border consolidation be determined.
A number of studies analyze the effects of U.S. bank M&As on small
business lending of the consolidating institutions.132 The measured out-
comes include any effects of the changes in the institutions’ scale and orga-
nizational complexity as well as any changes in focus or managerial
behavior associated with the consolidation process. The most relevant
results for predicting the effects of cross-border consolidation are those for
M&As in which one or more of the banking organizations are large, given
that the institutions involved in cross-border consolidation are typically
quite large. The literature generally finds a reduction in small business
131. For example, Berger and Udell (1996); Berger, Saunders, and Udell (1998); Berger,
Bonime, Goldberg, and White (1999).
132. For example, Keeton (1996, 1997); Peek and Rosengren (1996, 1998); Strahan
and Weston (1996, 1998); Craig and Santos (1997); Kolari and Zardkoohi (1997a, 1997b);
Zardkoohi and Kolari (1997); Walraven (1997); Berger, Saunders, and Udell (1998).
lending from this type of M&A (although M&As between small organi-
zations are often found to increase small business lending).
Some research also measures the external effect or dynamic responses
to consolidation of other financial institutions in the same local markets.
One study finds that increases in small business lending of other banks in
the same local market tend to offset much, if not all, of the negative effects
on small business lending of M&As, although this external effect is not
precisely measured.133 In contrast, another study finds a very small exter-
nal effect of M&As on the lending of small banks in the same market,
and the measured effect depends on the age of the bank, with the positive
effect primarily occurring for more mature small banks.134
Another way the external effect may be manifested is through increased
market entry. That is, there may be an external effect in terms of additional
provision of services by institutions that were not in the market prior to
consolidation. One way that this might occur is that loan officers who
leave the consolidated institution may take some of their relationship-
based loan portfolios with them and start a de novo bank. This effect may
be substantial, given that studies have found that recent entrants tend to
lend much more to small businesses than do other banks of comparable
size. 135 However, the research on the effects of M&As on entry are
mixed—one study finds that M&As increase the probability of entry, and
another finds that M&As decrease the probability.136
Finally, some studies have examined the treatment of small business
borrowers and depositors based on the consolidation of their banks, that of
other banks in the market, or the size distribution of banks in their mar-
ket. Their results indicate the net effect of consolidation on the supply of
retail services, inclusive of the effects of the consolidating institutions
and the external reactions of other preexisting and entering firms. One
study examines the probability that small business loan applications will
be denied by consolidating banks and other banks in their local market and
finds no clear positive or negative effects.137 Another study examines a
133. Berger, Saunders, and Udell (1998).

134. Berger, Bonime, Goldberg, and White (1999).
135. Goldberg and White (1998); DeYoung (1998); Berger, Bonime, Goldberg, and
White (1999); DeYoung, Goldberg, and White (1999).
136. Berger, Bonime, Goldberg, and White (1999) find an increased probability, while
Seelig and Critchfield (1999) find a decreased probability.
137. Cole and Walraven (1998).
number of dimensions of how well the borrower is treated after its lender
is acquired and finds mixed results for the effects of consolidation on sat-
isfaction of borrowing needs, loan approval or rejection, shopping for
lenders, and loan rates.138 A third study finds that the probability that a
small firm will obtain a line of credit or pay late on its trade credit does not
depend in an important way on the presence of small banks in the mar-
ket.139 A fourth study examines the effects of M&As on the number of
bank branches in local markets in the United States and finds that only in-
market M&As reduce the number of branches per capita, but that other
M&As that would be analogous to cross-border consolidation have little
effect on the availability of branch offices.140 The results of these studies
and the other evidence summarized here suggest that the total effects of
consolidation on retail customers may be relatively small.
AVAILABILITY AND PRICES FOR LARGE WHOLESALE CUSTOMERS. Cross-
border consolidation of the financial services industry may also raise
issues about the availability and prices of financial services for wholesale
customers. Two separate trends may affect wholesale customers and must
be distinguished. The first is the consolidation of the institutions associated
with wholesale capital markets. These institutions include securities firms,
universal banks, commercial banks, and other institutions that underwrite
securities, act as brokers, traders, and market makers in the secondary mar-
kets, or offer other wholesale corporate financing products such as deriv-
atives or M&A advisory services. There is also consolidation of the stock,
bond, and derivatives exchanges, the institutions that comprise the sec-
ondary market on which the securities are traded.
The second trend is the globalization of wholesale capital markets,
which may occur without the consolidation of financial institutions. This
trend arguably began with the first eurobond underwriting in 1964. The
market for eurobonds began in London and has now spread to other loca-
tions such as the Bahamas, Bahrain, Hong Kong, Japan, Singapore, and the
United States. There has also been a trend toward globalization in the
corporate securities and derivatives markets. For example, the New York
Stock Exchange and the London Stock Exchange now both list substan-
tial numbers of foreign companies.
138. Scott and Dunkelberg (1999).

139. Jayaratne and Wolken (1999).
140. Avery, Bostic, Calem, and Canner (1999).
The trends toward consolidation of institutions and globalization of

markets are intertwined. For example, some of the consolidation of whole-
sale institutions may be associated with economies of scale in the global
markets into which the customers issue new securities. With the advent of
the “bought deal” in the eurobond market and its spread to the United
States (facilitated by the Rule 415, shelf registration), investment banks are
required to commit large sums of capital nearly instantaneously. Cross-
border consolidation provides an important avenue for financial institu-
tions to amass the scale and scope needed to raise capital to underwrite in
this global market. Wholesale customers, in turn, may benefit from a lower
issuance cost in the primary market.
Institution consolidation and market globalization are also intertwined
in the secondary markets, where larger markets beget larger institutions
and vice versa. Examples of this are the signing of the strategic alliance
between the London Stock Exchange and the Deutsche Börse in July 1998
and the signing of a memorandum of understanding among eight European
exchanges (Amsterdam, Brussels, Frankfurt, London, Madrid, Milan,
Paris, and Zurich) in May 1999 to work to harmonize their markets and
establish a pan-European equity market. In these two cases, the introduc-
tion of the euro may have been a key facilitating event, reducing the seg-
mentation of wholesale capital markets along national lines. There have
also been other efforts to consolidate exchanges across national and cur-
rency boundaries (for example, Eurex and the Chicago Board of Trade),
and more may be forthcoming.
There may be considerable benefits to issuers and investors when
exchanges consolidate. Viewed as networks, exchanges can increase the
utility of their customers as they increase their size.141 Greater size may
create economies of scale in clearing and settlement and improve liquidity,
which may, in turn, lower the cost of capital to the customers that list
their securities on these exchanges. Modeled as networks, integration
among stock exchanges, particularly in the form of “implicit” mergers,
may promote social welfare. 142 Implicit mergers involve agreements
among exchanges to cross-list but do not involve total and legal integra-
tion. Benefits arise out of network externalities (customer utility rises with
exchange membership), and some competition is preserved because the
141. Economides (1993, 1996).

142. Di Noia (1999, 2000).
mergers are not explicit. Cross-border mergers and alliances can also allow
participants to defray transaction and operating costs and enable them to
introduce new technologies.143 Technological advances that provide alter-
native delivery channels (for example, electronic links and screen trad-
ing) may also create new sources of competition and lead to specialization
in the provision of exchange services.144 In either case, increased compe-
tition and consolidation among exchanges can lead to more efficient pro-
vision of listing and trading services, increase the attractiveness of capital
markets to investors, and lower the cost of capital to listing firms. The
evidence on scale economies associated with the size of exchanges them-
selves (as opposed to ancillary activities such as clearing and settlement)
suggests that they may be limited, although significant X-efficiency gains
may be available from consolidation.145 However, estimation of economies
of scale in securities exchanges is problematic because it is difficult to
determine the inputs and the outputs and because many of the M&As have
not yet reached fruition.
Another segment of the customer market that may benefit from con-
solidation of the securities markets is high-growth, often technology-
based, start-up firms, although such firms do not fit our classification of
wholesale customers. High-growth start-ups often require substantial pri-
vate external equity financing in the early stages of their growth cycle from
individual investors (“angels”) or from formal venture capitalists.146 As a
condition for investment, both types of private equity investors require a
viable exit strategy, a market where they can sell their equity stake via an
IPO if the firm is successful. An IPO, in turn, requires a vibrant small-cap
stock market—something that is currently absent in continental Europe.
The development of such a market (possibly out of Easdaq or EuroNM)
could lead to a significant increase in high-tech entrepreneurial activity
similar to that in the United States.
BANKING - ORIENTED FINANCE VERSUS MARKETS - ORIENTED FINANCE .
An analysis of the effects of consolidation on wholesale customers must
also be viewed in the context of a separate but closely related phenome-
non—changes in the mix of funding between intermediated markets (inter-
mediated finance) and securities markets (direct finance). The principal
143. European Central Bank (1999); Steinherr (1999).

144. Dermine (1999c); Di Noia (1999, 2000); Steinherr (1999).
145. See the paper by Cybo-Ottone, Di Noia, and Murgia in this volume.
146. Berger and Udell (1998).
contrast is between a markets-oriented financial system like the United

States and a banking-oriented system like Germany.
Tables 2 and 3 indicate the differences among countries in the mix
between intermediated and direct finance. Specifically, they demonstrate
that the U.S. financial system lies substantially closer to the markets-
oriented end of this spectrum than the financial systems of other indus-
trial nations. Table 2 shows that in 1997 total banking assets in the United
States were only 52 percent as large as the market capitalization of the
U.S. stock and bond markets, while the ratio for all of the other countries
(excepting Luxembourg) was considerably greater, indicating that the
financial systems in other industrial nations are much more bank-oriented.
Table 3 provides corroborating evidence from corporate balance sheets.
In 1994 debt securities provided more than four times as much financing
for U.S. corporations as did bank loans (82 and 18 percent, respectively).
In contrast, bank loans were more important sources of financing than debt
securities in Canada, Japan, and most European countries. U.S. securities
markets are more developed than those of other nations and thus are rela-
tively more important than banks as a source of external finance for U.S.
corporations.
These differences also reflect a trade-off between liquidity and corpo-
rate governance mechanisms.147 In the United States, highly developed
securities markets reduce the cost of capital by increasing liquidity to
investors. However, managerial control problems are exacerbated by the
atomistic ownership of large corporations. This problem is addressed in
the U.S. system primarily through the market for corporate control (that is,
the takeover market), through performance-based managerial compensa-
tion, and through monitoring by market outsiders and institutions (that is,
large bondholders and bond rating agencies). In Japan and Germany, how-
ever, the corporate governance problem is addressed by the consolidation
147. Tables 2 and 3 give only a rough indication of this trade-off. Specifically, in table 2
the size of the stock market itself is not as important as the ownership of stock. In addition,
it does not account for double counting such as in Germany and Japan where banks own a
significant fraction of stocks. The ideal would be a breakdown of external finance (both
private and public debt and equity) in terms of whether they are passively or actively owned.
This would take into account the strong individual ownership of equity in the United States
and the proxy ownership of equity in Germany by banks. Data limitations, however, pre-
vent such an analysis. The closest to this type of breakdown is a study that estimates this just
for the equity side (Prowse 1995). According to that study, the United Kingdom is similar to
the United States in being skewed toward individually owned and passively owned equity.

Table 2. Credit Market Intermediation and Capital Markets, 1997
Total assets of credit institutions divided by (equity
Country plus bond market capitalization)
Austria 3.41
Belgium 2.04
Canada 0.92
Denmark 0.97
Finland 1.13
France 2.35
Germany 1.88
Italy 1.26
Japan 2.31
Luxembourg 0.33
Netherlands 1.03
Portugal 2.87
Spain 2.91
Sweden 1.04
United Kingdom 1.41
United States 0.52
Sources: For total assets of credit institutions, European Central Bank (1999), Board of Governors of the Federal Reserve Sys-
tem (1999), Bank of Canada (1999), Bank of Japan (1999). For capitalization of bond and equity markets, International Federa-
tion of Stock Exchanges (1999).
of corporate ownership in large financial institutions rather than the stock

market. This reduces the incentive (free-rider) problem that arises in mon-
itoring management when ownership is diffuse. The parallel growth of
these two types of systems among developed economies, it has been
argued, may have been principally due to the evolution of different legal
environments. 148 For example, regulatory constraints in Germany and
Japan against issuing corporate bonds and commercial paper were major
factors in promoting bank dependence among large firms. It can also be
argued that banking-oriented systems may be better suited to solve moral
hazard and adverse selection problems in lending. This suggests that a
banking-oriented system may be the preferred architecture for countries
with poor information infrastructures such as the formerly centrally
planned economies of Eastern Europe.149 Banking-oriented systems may
also offer better intertemporal risk sharing at the cost of less cross-
sectional risk taking than markets-oriented systems.150
148. Prowse (1995).

149. Udell and Wachtel (1995).
150. Allen and Gale (1997).

Table 3. Relative Shares of Bank Loans and Debt Securities at Nonfinancial Firms in
Select Countries, Various Years, 1983–95
Percent
Country and year Bank loans a Debt securities b
Belgium
1983 84.6 15.4
1994 91.0 9.0
Canada
1983 68.6 31.4
1994 61.9 38.1
Finland
1983 69.9 30.1
1994 57.4 42.6
France
1989 44.1 55.9
1995 21.6 78.4
Germany
1985 51.1 48.9
1994 56.9 43.1
Italy
1983 74.4 25.6
1995 85.7 14.3
Japan
1983 94.5 5.5
1995 90.4 9.6
Netherlands
1983 92.9 7.1
1994 82.7 17.3
Norway
1983 29.7 70.3
1994 10.8 89.2
Spain
1983 83.7 16.3
1994 80.0 20.0
United Kingdom
1983 83.9 16.1
1994 72.8 27.2
United States
1983 36.4 63.6
1994 18.0 82.0
Sources: For the United Kingdom, data supplied by Darren Pain, Bank of England. For Germany, Bauer and Domanski (1999).
For all other countries, OECD (1996).
a. Includes all short- and long-term loans from depository institutions.
b. Includes all short- and long-term bills, notes, bonds, and debentures.
The legal and economic institutions that determine whether a coun-

try’s financial system is markets-oriented or banking-oriented can change
over time. For example, legislative changes in France between 1978 and
1984 were designed to increase the role of capital markets and reduce the
dependence of French companies on bank financing. The reduction in
bank finance in France between 1983 and 1994 suggests that those changes
were effective. Equity and bond markets in most European countries have
grown significantly in recent years, due in part to regulatory changes like
the “Big Bang” in the United Kingdom and the deregulation of guilder-
denominated bond issues in the Netherlands.151
While financial institution consolidation and changes in financing mix
are often discussed together, they need not occur together. It is conceiv-
able, for example, that continental Europe could experience considerable
consolidation of both its securities markets and its banking markets while
remaining predominantly a banking-oriented system. Alternatively, con-
solidation could be accompanied by a shift in mix toward the securities
markets and away from the intermediated markets. Similarly, the pro-
portions of funding through universal-type institutions versus separate
commercial banks, securities firms, and insurance companies could
conceivably either increase or decrease, depending in part on the type of
consolidation.
A shift from a banking-oriented system to a markets-oriented system
in continental Europe or Japan could have a significant impact on large
companies. Such a shift could arise, for example, if the network and scale
efficiency benefits from consolidation of the securities markets are suffi-
ciently large relative to the benefits from consolidation of banks and other
financial intermediaries that they drive a shift in the mix toward direct
finance at the expense of intermediated finance. The net benefit to large
companies would depend in part on whether the reduction in the cost of
capital from the issuance of liquid securities is greater than any increase in
the cost of capital from a shift in governance mechanisms.
Of course a shift toward a markets-oriented financial system would
likely be facilitated by growth—possibly through consolidation—of the
investment banking industry that provides wholesale services in the pri-
mary and secondary markets. This growth may be skewed toward univer-
sal banking if universal banking is characterized by economies of scope. A
151. Bisignano (1991); Bowen, Hoggarth, and Pain (1999).

wave of nonfinancial M&A activity in Europe has already precipitated

fierce competition for advisory business. Intra-European merger and
acquisition activity between 1985 and 1988 averaged $43 billion a year
versus $280 billion a year between 1995 and 1998.152 In order for Euro-
pean universal banks to compete for this business—particularly against
U.S. investment banks that have acquired substantial expertise in the M&A
advisory business—they either have to develop this expertise internally
or have to acquire it externally. It appears, for example, that in part
Deutsche Bank has acquired this expertise by purchasing British and U.S.
investment banks (Morgan Grenfell and Alex. Brown). Similarly, domes-
tic institutions in Asia may seek to acquire foreign investment banks to
compete in the burgeoning Asian IPO business. To the extent that these
types of acquisitions in the securities industry improve scale and scope
efficiency or increase overall competitiveness, the cost of capital to larger
companies should decline as a result of lower underwriting spreads and
advisory fees.
A change in financial mix might also have an impact that operates
through a link between mix and firm capital structure. However, the evi-
dence on the impact of different financial systems on capital structure of
firms is ambiguous. One study suggests that the differences between
banking- and markets-oriented systems are reflected more in the sources
of financing and less in the capital structure of firms.153 In contrast, two
other studies find significant differences in the capital structures of com-
panies across European countries.154
However, there is also evidence that this type of disintermediation away
from banking-based finance to markets-based finance has not occurred in
Europe. One study of flow of funds data in France, Germany, and the
United Kingdom finds no general trend (except in France) toward disin-
termediation or a markets-oriented system.155 In contrast, there may be a
lengthening of the intermediation chain. It may be argued that the devel-
opment of new financial products has primarily created markets for inter-
mediaries rather than end users of these products.156 Consistent with this
152. According to the Securities Data Company.

153. Rajan and Zingales (1995).
154. Rivaud-Danset, Dubocage, and Salais (1998); Delbreil, Cano, Friderichs, Gress,
Paranque, Partsch, and Varetto (1998).
155. Schmidt, Hackethal, and Tyrell (1999).
156. Allen and Santomero (1998).
argument, most of the European funds (nearly 80 percent in some coun-

tries) are controlled by banking organizations, and banks distribute more
than half of these funds.157
OTHER MACROECONOMIC CONSEQUENCES . The consolidation of the
financial services industry may have a number of macroeconomic effects.
The most obvious of these would be the effects of any improvements in the
efficiency of financial institutions, which may affect the economy through
a reduction in the cost of capital. Depending on the degree of competition
in financial markets, some of any gains may accrue to the issuers of finan-
cial claims in the form of a reduced cost of capital or to savers in the form
of higher returns on their investments. In the intermediated markets, inter-
est rates on loans might decrease, and interest rates on deposits might
increase. In the securities markets, trade execution, liquidity, access, and
price may improve.
Other potential impacts of consolidation on the macroeconomy may
operate through monetary policy. Traditional monetary theory argues that
the transmission mechanism of monetary policy operates through either an
interest rate or a money channel. For the most part, this traditional theory
was built on models of the economy in which there were only two assets,
(noninterest-bearing) money and (interest-bearing) securities. Banks play
a very passive role as benign caretakers of the money supply constrained
by reserve requirements. Under the traditional theory, consolidation would
have very little effect on the operation of monetary policy.
Relatively recently, however, a competing theory has emerged in which
banks play a critical role. Under this “bank lending view,” monetary policy
operates in part through bank lending behavior.158 The reduction in bank
reserves that accompanies a tightening of monetary policy results in some
banks reducing their supplies of loans. This reduction in loan supply forces
some borrowers to reduce real spending and slows the macroeconomy
because alternative means of funding are unavailable or unaffordable, at
least in the short term.159 The effect is disproportionately greater on small
bank-dependent companies that do not have access to the securities
markets.160
157. Otten and Schweitzer (1999); European Central Bank (1999).
158. See Kashyap and Stein (1997a) for a more detailed summary of the bank lending
view and a survey of the empirical literature.
159. Bernanke and Blinder (1988).
160. Under an alternative credit channel mechanism—the “balance sheet channel” or
“financial accelerator”—the tightening of monetary policy works in part because the asso-
Under the bank lending view, the impact of the monetary policy may
depend on the structure of the banking industry. Small banks may be much
more sensitive to shifts in monetary policy because their access to non-
deposit money market funding is significantly less than that of large banks.
The evidence suggests that small bank lending is more sensitive to changes
in monetary policy than large bank lending and that this sensitivity is
greatest for those small banks that are the least liquid.161 It has been argued
that countries with a higher fraction of bank-dependent borrowers, weaker
banking systems, and fewer market alternatives to intermediated finance
may be much more sensitive to monetary policy shocks.162 The nations of
the European Union are ranked according to these criteria. Belgium, the
Netherlands, and the United Kingdom appear to be the least sensitive to
the lending channel, whereas Italy and Portugal appear to be the most
sensitive.163 These asymmetric responses across member countries will
likely continue under the common monetary policy of the European Cen-
tral Bank.
Bank consolidation may reduce the effect of the lending channel in
part by creating larger institutions with greater access to capital markets.
In addition, cross-border consolidation may also reduce the effect of mon-
etary policy through the lending channel by diversifying the effects of
any one nation’s monetary policy. To the extent that monetary policies
are independent, the multinational banks can use more of the reserves from
their operations in the nation with the looser monetary policy to lend in the
nation with the tighter monetary policy. Of course, this effect is nullified to
the extent that monetary policies tend to be coordinated or, in the case of
the European Union, there is a common monetary policy for multiple
nations.
Consolidation of the financial services industry might also affect non-
financial firms’ access to funding and the macroeconomy by affecting
the number of potential sources of funding. While consolidation does
ciated higher interest rates impair collateral values or otherwise reduce the net worth of
certain borrowers, diminishing their ability to obtain funds. This channel differs from the
bank lending channel in that it implies a reduction in the demand for credit, rather than a
reduction in the supply of credit in response to monetary policy tightening (Bernanke and
Gertler 1995; Bernanke, Gertler, and Gilchrist 1996).
161. Kashyap and Stein (1995, 1997a, 1997b); Gibson (1996)
162. Kashyap and Stein (1997a).
163. Kashyap and Stein (1997a).
reduce the number of financial institutions, it may also increase the num-
ber of options available. If consolidation is associated with a shift from a
banking-oriented system to a markets-oriented system, this could increase
the menu of alternative markets in which firms may obtain financing.
For example, the highly developed private placement market and the junk
bond market in the United States represent alternatives to bank loan
financing for lower-quality firms. For investment-grade firms, the com-
mercial paper market and the medium-term note market represent alter-
natives to the bank loan market. There is some evidence to suggest that
firms shift their funding sources as macroeconomic conditions change,
such as shifting from bank loans to commercial paper in the United
States. 164 Small firms may also benefit to the extent that larger firms
increase their issuance of commercial paper to finance more trade credit
to small firms.165 More generally, the impact of macroeconomic crises
on economic activity may be mitigated by diversification across funding
sources, as firms shift sources when one source of funding fails.166 How-
ever, credit crunches may be correlated across markets. For example,
evidence suggests that a contraction of supply occurred simultaneously in
the early 1990s in the United States across three different markets—the
bank loan market, the junk bond market, and the below-investment-grade
segment of the private placement market.167
Tests of Home Field Advantage versus Global Advantage

Using International Data
In this section, we present our efficiency analysis of cross-border bank-

ing. We evaluate the relative efficiency of foreign versus domestic com-
mercial banks in five home countries—France, Germany, Spain, the
United Kingdom, and the United States. For each home country, we esti-
mate separate cost and alternative profit frontiers and compare the effi-
ciency of foreign and domestic banks. We also extend our tests by
164. Kashyap, Stein, and Wilcox (1993, 1996).

165. Calomiris, Himmelberg, and Wachtel (1995).
166. Alan Greenspan, “Lessons from the Global Crises,” speech to the World Bank
Group and the International Monetary Fund, September 27, 1999.
167. Carey, Prowse, Rea, and Udell (1993).
including foreign banks from other nations, presenting efficiency statistics

in all cases for which we have data for at least three banks from a given
foreign nation. We use these relative efficiency comparisons to test the
home field advantage hypothesis versus the two forms of the global advan-
tage hypothesis. We test these hypotheses in light of the extant research
on cross-border X-efficiency, which often finds that foreign banks are
less efficient than domestic banks and concludes that the evidence supports
the home field advantage hypothesis. However, the methodologies used
in previous studies may not be able to distinguish properly among the
hypotheses. We address the drawbacks in the prior methodologies by
(a) examining the performance of foreign and domestic banks in five dif-
ferent home countries, (b) distinguishing among nations of origin of for-
eign institutions to test the limited form of the global advantage
hypothesis, and (c) conducting separate analyses of data from banks
located in different countries to avoid problems of comparison because of
differences in the economic environments across nations.
A Brief Summary of the Estimation Methods

Performing separate efficiency estimations in each of the five home
countries allows us to specify the cost and alternative profit functions dif-
ferently in each of these countries, depending on the activities in which
banks are permitted to engage. This is especially relevant for universal
banking powers, which were present more often in European nations than
in the United States. Separate treatment also allows us to adjust the speci-
fication and the estimation procedures when certain variables are available
for one country, but not for others.
Although our approach offers a number of methodological improve-
ments, it does tax the availability of the data. Since we do not pool data
across countries, each of our home-country efficiency frontiers is esti-
mated with fewer degrees of freedom. We limit our analysis to home coun-
tries for which our data sets contain (a) data on enough banks to estimate
the cost and profit frontiers with reasonable accuracy and (b) data for at
least three foreign banks from at least two foreign nations during the sam-
ple period. Fortunately, these data limitations do not pose major prob-
lems. We are still able to test domestic versus foreign efficiency for a
large number of nation-pairs, many of which yield statistically and eco-
nomically significant results.
ESTIMATING X-EFFICIENCY FOR BANKS IN THE UNITED STATES. In this

subsection, we present a nontechnical overview of the procedures used to
estimate cost and alternative profit X-efficiency for banks in the United
States. In the following subsection, we describe how we altered these
estimation procedures for the other four home countries. A more detailed
technical appendix is available from the authors.
Both cost efficiency and alternative profit efficiency measure how well
a bank performs relative to a best-practice institution that produces the
same output bundle under the same environmental conditions. Cost effi-
ciency is measured from a standard cost function that specifies the quan-
tities of four variable outputs (consumer loans, business loans, real estate
loans, and securities), the quantity of one fixed output (off-balance-sheet
activity), the quantities of two fixed inputs (physical capital and financial
equity capital), the prices of three variable inputs (purchased funds, core
deposits, and labor), and the ratio of market-average nonperforming loans
to total loans (to control for business environment of the bank). The cost
function is estimated using the Fourier-flexible functional form, which has
been shown to fit banking data better than more conventional functional
forms.168 Because this functional form fits the data globally, rather than just
around the mean of the data, it allows us to measure more accurately the
relative performance of banks with starkly different output bundles or
other characteristics.
Alternative profit efficiency is derived from a profit function with the
same right-hand-side variables as the cost function and is estimated using
the same functional form. As described elsewhere, alternative profit effi-
ciency is a particularly useful concept when some of the standard assump-
tions of perfect markets do not hold.169 Alternative profit efficiency may
capture some of the revenue effects of differences in investment or risk
management skills that are not captured in cost efficiency, which neglects
differences in revenue across banks. Alternative profit efficiency may also
168. McAllister and McManus (1993); Mitchell and Onvural (1996); Berger, Cum-
mins, and Weiss (1997); Berger and DeYoung (1997); Berger, Leusner, and Mingo (1997).
169. Berger and Mester (1997). Alternative profit efficiency generally yields similar find-
ings to standard profit efficiency, which specifies output prices rather than quantities in the
profit function (Berger and Mester 1997). Standard profit efficiency is more problematic to
estimate because output prices have to be approximated by balance sheet and income state-
ment ratios. In addition, by controlling for output prices, standard profit efficiency may not
account as well for advantages that cross-regional organizations may have in terms of risk
diversification and enhanced quality or variety of services.
capture some of the revenue benefits of cross-border risk diversification if

banks use these diversification gains as an opportunity to invest in higher-
risk, higher-expected-return projects. Finally, alternative profit efficiency
may reflect revenue differences associated with service quality or product
variety. For example, banks may “skimp” on loan underwriting, loan mon-
itoring, cross-selling, customer convenience, or other activities important
for producing high-quality financial services and high levels of interest and
noninterest revenue.170 Since it is difficult to control for service quality, this
skimping may mistakenly be measured as high cost efficiency (that is,
lower costs for a given quantity of output) but may be captured at least in
part as low alternative profit efficiency, which includes both costs and
revenues.
These efficiency measures have a fundamental advantage over simple
accounting-based cost and profit performance ratios. The efficiency mea-
sures statistically remove the effects of differences in output bundles, input
prices, and so forth that affect accounting-based performance ratios but are
not necessarily related to the efficiency or managerial quality of the orga-
nization. This may be particularly important when comparing foreign and
domestic banks, which often have different output mixes. Thus we reduce
the potential problem of “comparing apples to oranges” by controlling
for output mix and other nonefficiency factors when comparing the per-
formance of foreign and domestic banks within a home country.
We use alternative profit efficiency as our main measure of performance
to test the home field and global advantage hypotheses, because it is a
more comprehensive measure that includes both costs and revenues. We
use cost efficiency as an ancillary measure to diagnose whether differences
in profit efficiency are rooted in cost control, revenue generation, or both
and to compare our results to those of the previous cross-border cost effi-
ciency literature.
We estimate the U.S. cost and alternative profit functions using data on
2,123 banks with greater than $100 million in gross total assets (1998 U.S.
dollars) and continuous, complete annual data for the six-year period from
1993 through 1998. Using the results of these estimations, we calculate
cost efficiency and alternative profit efficiency for every bank in the data
set (1,940 domestic banks and 43 foreign banks) using the distribution-free
method, which distinguishes efficiency differences from random error by
170. Berger and DeYoung (1997).

Table 4. Summary Statistics for Data Used in U.S. Efficiency Estimationsa

Variable Domestic banks Foreign banks
Profits to assets 0.0269 0.0170
(0.00950) (0.0118)
Costs to assets 0.0413 0.0416
(0.00846) (0.00910)
Consumer loans to assets 0.0952 0.0488
(0.101) (0.0872)
Business loans to assets 0.140 0.242
(0.0925) (0.181)
Real estate loans to assets 0.353 0.274
(0.137) (0.190)
Securities to assets 0.3970 0.4220
(0.132) (0.180)
Off-balance sheet to assets 0.0197 0.0895
(0.0399) (0.124)
Equity to assets 0.0929 0.1050
(0.0272) (0.0696)
Market nonperforming
loans to assets 0.0000 0.0000
(0.00000543) (0.00000506)
Price of purchased funds 0.0400 0.0416
(0.00883) (0.00599)
Price of core deposits 0.0221 0.0168
(0.00771) (0.0102)
Price of labor
(thousands of 1998 U.S. dollars) 39.3000 60.2000
(8.41) (14.6)
Gross total assets
(millions of 1998 U.S. dollars) 1,277.7220 4,472.7890
(9,798.282) (8,571.339)
Number of banks 1,940 43
Number of observations 11,640 258
Source: U.S. Call Reports of the Federal Financial Institutions Examination Council.
a. The costs, profits, variable outputs, fixed outputs, and fixed inputs were scaled by gross total assets in the table, but not in
the regressions.
averaging the cost or profit function residuals over time.171 We exclude

small banks from the analysis because the vast majority of banks owned by
international banking organizations are large and because the efficiency
data for the other four home countries generally include only large banks.
The data are taken from the U.S. Call Report. Table 4 displays summary
statistics for the data used in the U.S. efficiency estimations.
171. Berger (1993).

ESTIMATING X - EFFICIENCY FOR BANKS IN FRANCE , GERMANY, SPAIN ,

AND THE UNITED KINGDOM. We alter the U.S. specification in a number of
ways to estimate efficiency for banks in France, Germany, Spain, and the
United Kingdom. First, we take our data from the Fitch-IBCA database,
which presents data on financial statements from financial institutions in
different nations using internally consistent accounting definitions. This
database reports a more limited amount of financial information than does
the U.S. Call Report and does so for a sample of (mostly large) financial
institutions in each country. Second, we specify the European cost and
profit functions using the quantities of four variable outputs (total loans,
total nonequity securities, total equity securities, and commission rev-
enues), the quantity of one fixed input (equity capital), and the prices of
two variable inputs (labor and borrowed funds). This different specifica-
tion partly reflects the broader insurance and securities powers of Euro-
pean banks (which we capture in the equity securities and commission
revenues variables) and partly reflects the reduced level of detail in the
IBCA database. Third, we use definitions supplied by IBCA to identify
and retain commercial banking firms and to identify and discard other
types of financial institutions. This further ensures that we are estimating
performance and testing our hypotheses based on a relatively homoge-
neous group of firms across nations. Fourth, we observe commercial banks
in these countries annually over the six-year time period from 1992
through 1997 (rather than 1993 through 1998 in the United States) and
include in the estimations any commercial bank that appears in the data-
base in at least four of those six years. Our final samples include 215 com-
mercial banks in France (158 domestic and 57 foreign); 206 commercial
banks in Germany (121 domestic and 85 foreign); 76 commercial banks
in Spain (60 domestic and 16 foreign); 124 commercial banks for the profit
function in the United Kingdom (63 domestic and 61 foreign); and
57 banks for the cost function in the United Kingdom (26 domestic and
31 foreign). Table 5 displays summary statistics for the data used in these
estimations.
OVERALL X-EFFICIENCY ESTIMATES. Our overall cost efficiency esti-
mates (that is, not differentiating between domestic and foreign owner-
ship) are consistent with those found in the previous literature. The
average estimated cost efficiency is 70.9 percent for banks in France,
79.3 percent for banks in Germany, 91.5 percent for banks in Spain,
79.1 percent for banks in the United Kingdom, and 77.4 percent for banks
Table 5. Summary Statistics for Data Used in European Efficiency Estimations, 1992–97a
France Germany Spainb United Kingdomc
Domestic Foreign Domestic Foreign Domestic Foreign Domestic Foreign
Variable banks banks banks banks banks banks banks banks
Profits to assets 0.0143 0.0088 0.0142 0.0111 0.0188 0.0081 0.0121 0.0037
(0.0194) (0.0299) (0.0174) (0.0191) (0.0256) (0.0135) (0.0206) (0.0282)
Costs to assets 0.0969 0.0963 0.0790 0.0845 0.0959 0.1018 0.0289 0.0624
(0.0572) (0.0496) (0.0356) (0.0439) (0.0445) (0.0382) (0.0327) (0.0441)
Loans to assets 0.5365 0.4572 0.5996 0.3572 0.4508 0.5563 0.4429 0.2565
(0.2778) (0.2991) (0.2290) (0.2752) (0.2299) (0.2116) (0.3182) (0.2325)
Nonequity securities 0.4131 0.5114 0.3951 0.6463 0.5206 0.4403 0.4923 0.6475
to assets (0.2620) (0.2989) (0.2211) (0.2790) (0.2373) (0.2165) (0.3285) (0.2608)
Equity securities 0.0239 0.0121 0.0092 0.0033 0.0348 0.0069 0.0323 0.0189
to assets (0.0700) (0.0236) (0.0160) (0.0085) (0.0877) (0.0101) (0.1352) (0.0809)
Commission income 0.0170 0.0102 0.0103 0.0164 0.0118 0.0097 0.0118 0.0057
to assets (0.0312) (0.0257) (0.0188) (0.0333) (0.0099) (0.0104) (0.0397) (0.0200)
Equity to assets 0.0879 0.1040 0.0732 0.1329 0.1399 0.0842 0.1506 0.1708
(0.0899) (0.1069) (0.0647) (0.1416) (0.1386) (0.0869) (0.1810) (0.1345)
Price of borrowed funds 0.0056 0.0595 0.0498 0.0515 0.0674 0.0689 0.0514 0.0509
(0.0138) (0.0131) (0.0107) (0.0117) (0.0163) (0.0159) (0.0102) (0.6669)
Price of labor (thousands 61.8500 65.8220 110.7222 133.8141 17.7960 16.7892 31.1824 36.7001
of 1997 home currency) (7.4410) (4.1122) (19.8552) (15.7091) (3.2683) (3.3591) (9.6702) (6.2216)
Total assets (millions of 8,126.00 1,435.67 16,970.70 3,106.06 5,824.16 1,741.76 6,181.40 2,730.37
1997 home currency) (32,727.00) (2,533.53) (65,489.12) (6,580.76) (14,121.72) (1,683.17) (16,023.29) (6,095.86)
Number of banks 158 57 121 85 60 16 26 31
Number of observations 867 312 642 439 329 83 231 238
Source: Data from Fitch-IBCA.
a. The costs, profits, variable outputs, fixed outputs, and fixed inputs were scaled by gross total assets in the table, but not in the regressions.
b. The price of labor equals salaries and benefits to total assets.
c. Costs are included only for fifty-seven banks.
in the United States. An average cost efficiency of 70.9 percent as in

France indicates that a best-practice bank producing the same output bun-
dle under the same environmental conditions as the average bank could
do so for an estimated 70.9 percent of the costs. The average estimated
alternative profit efficiency is 44.2 percent for banks in France, 52.2 per-
cent for banks in Germany, 67.1 percent for banks in Spain, 66.1 percent
for banks in the United Kingdom, and 66.7 percent for banks in the United
States. An average alternative profit efficiency of 44.2 percent as in France
indicates that the average bank earns only an estimated 44.2 percent of
the profits of a best-practice bank producing the same output bundle under
the same environmental conditions.
We again emphasize that the efficiency estimates for one home coun-
try are not comparable to the efficiency estimates for the other four home
countries. For example, the 91.5 percent mean cost efficiency for banks
operating in Spain does not indicate that the average bank operating in
Spain is more cost efficient than the average bank operating in the other
home countries. The efficiency differences across home countries reflect
market factors (for example, the degree of competition, the development of
securities markets, and the quality of the labor force), regulatory and
supervisory factors (for example, the enforcement of prudential limits on
risk taking), and differences in specification of the frontier. In our tests, we
evaluate the home field advantage and global advantage hypotheses only
by comparing domestic bank efficiency versus foreign bank efficiency
within each of our home countries. Although this approach allows us to
distinguish better among the main hypotheses, it unavoidably reduces sam-
ple sizes and statistical significance.
The Relationship between the Cross-Border Efficiency

Results and the Hypotheses
Although we estimate ten separate efficiency frontiers (cost and profit
for five home countries) and use the results to test the comparative effi-
ciencies of a large number of nation-pairs, we can classify our results into
four simple possible outcomes. In this section, we identify each of these
four possible outcomes, map each outcome into support for or rejection
of the home field versus global advantage hypotheses, and identify the
implications of each outcome for the future of global integration of the
financial services industry.
The first possible outcome is that foreign institutions are generally

found to be less efficient than domestic institutions. This would support the
home field advantage hypothesis that organizational diseconomies of oper-
ating or monitoring an institution from a distance or other advantages for
domestic banks (for example, language, culture, regulation, and other
barriers) are too difficult to overcome in most cases, even for efficiently
operated cross-border organizations. This outcome, if it extrapolates to the
future, may suggest that efficiency problems could limit the degree of
globalization of financial institutions.
The second possible outcome is that foreign institutions are generally
found to be more efficient than domestic institutions. This would sup-
port the general form of the global advantage hypothesis that efficiently
managed foreign banks headquartered in many nations are able to over-
come any cross-border disadvantages and operate more efficiently than
the domestic banks. The higher efficiency occurs as a result of spreading
superior managerial skills or best-practice policies and procedures,
of obtaining diversification of risks that allows for higher-risk, higher-
expected-return investments, or of providing services of superior quality
or variety that raises revenues. This second outcome, if it extrapolates to
the future, may suggest that efficient institutions from many nations could
successfully expand on a global basis, limited only by nonefficiency con-
straints, such as regulatory or supervisory intervention or other barriers to
entry.
The third possible outcome is that foreign institutions headquartered
in one or a limited number of nations are found to be more efficient than
domestic institutions. This would support the limited form of the global
advantage hypothesis in which only efficiently managed foreign banks
headquartered in nations with specific favorable conditions in their home
countries are able to overcome any cross-border disadvantages and to
operate more efficiently than the domestic banks. This third outcome, if it
extrapolates to the future, may suggest that efficient institutions from this
limited group of nations could successfully expand on a global basis if
the conditions fostering their higher efficiency remain intact and if non-
efficiency barriers do not prevent their expansion.
Finally, if neither domestic nor foreign institutions are found to be sys-
tematically more efficient—which essentially corresponds to all outcomes
other than the first three listed here—then neither the home field advantage
hypothesis nor the global advantage hypothesis is supported by the data.
This final potential outcome, if it extrapolates to the future, may suggest

that global consolidation will be more likely to turn on issues other than
efficiency maximization, such as managerial motives and government
actions.
Empirical Results
Table 6 shows the results of our cross-border alternative profit effi-
ciency tests. Each of the five columns of the table corresponds to an alter-
native profit frontier estimated only for banks operating in that home
country. The first row displays efficiency results for the domestic banks
in each home country. The second row displays efficiency results for all the
foreign banks in each home country. The other rows correspond to sub-
sets of foreign banks, grouped according to their nation of ownership.
Table 7 displays estimates of cost efficiency. The results can be summa-
rized as follows. In most countries, domestic banks are found to have both
higher mean profit efficiency and higher mean cost efficiency than the
mean of all foreign banks operating in that country, although these differ-
ences are not always statistically significant. This result, consistent with
most of the findings in the literature, has been interpreted as supporting the
home field advantage hypothesis, but we do not draw this same conclusion.
Rather, by disaggregating the results by foreign nation of origin, we find
that the data appear to reject the home field advantage hypothesis in favor
of the limited form of the global advantage hypothesis. As shown below,
the disaggregated results suggest that domestic banks may be more effi-
cient than banks from most foreign countries, may be about as efficient as
banks from some foreign countries, but may be less efficient than banks
from one of the foreign countries.
DOMESTIC VERSUS FOREIGN BANK EFFICIENCY. In France, Germany,
and the United Kingdom, cost efficiency and alternative profit efficiency
are both higher on average for domestic banks than for foreign banks.
Some of these differences are small, although in Germany and the United
Kingdom the difference in profit efficiency is economically large, over
4 percent of potential profits.
In Spain and the United States, domestic banks exhibit either higher
cost efficiency than foreign banks or higher profit efficiency than foreign
banks, but not both. In Spain, mean domestic cost efficiency is about
2.1 percent of costs higher than mean foreign bank cost efficiency, but on
Table 6. Cross-Border Alternative Profit Efficiency
United United
Bank France Germany Spain Kingdom States
All domestic banks
Mean 0.4459 0.5404 0.6596 0.6833 0.67394
Number of observations 158 121 60 63 1,940
Standard error 0.0214 0.0231 0.0232 0.0270 0.0034
All foreign banks
Mean 0.4308 0.4946 0.7138 0.6373 0.418#
Number of observations 57 85 16 61 43
Standard error 0.0279 0.0240 0.0340 0.0273 0.041
All other EU banks
Mean 0.4082 0.4545 0.7465* 0.6627 0.628
Standard error 0.0327 0.0446 0.0395 0.0948 0.0675
Belgian banks
Mean 0.2619# — — — —
Number of observations 6
Standard error 0.0505
Canadian banks
Mean — — — — 0.532#
French banks
Mean — 0.5539 0.7699* — —
Number of observations 5 6
Standard error 0.0847 0.0399
German banks
Mean 0.4866 — — — —
Italian banks
Mean 0.6178* 0.4517 — — —
Japanese banks
Mean — 0.4591 — 0.6406 0.258#
Number of observations 17 10 14
Standard error 0.0487 0.0462 0.069
Luxembourgian banks
Mean — — — 0.5669 —
Netherlandic banks
Mean 0.3884 0.3571# — — 0.628
Standard error 0.0720 0.0789 0.1396
South Korean banks
Mean — — — — 0.257#
Swiss banks
Mean 0.6059 0.4196# — 0.648 —
Standard error 0.2066 0.0569 0.1111
U.K. banks
Mean — 0.3368# — — —
U.S. banks
Mean 0.6485** 0.5845 0.7243 0.5801 —
Number of observations 6 17 3 12
Standard error 0.1230 0.0536 0.0469 0.0679
Source: Authors’ calculations.
— Fewer than three foreign banks.
* Significantly higher than the domestic bank mean at the 5 percent level.
** Significantly higher than the domestic bank mean at the 10 percent level.
# Significantly lower than the domestic bank mean at the 5 percent level.
Table 7. Cross-Border Cost Efficiency
United United
Bank France Germany Spain Kingdom States
All domestic banks
Mean 0.7122 0.7966 0.9195 0.8061 0.773
Number of observations 158 121 60 26 1,940
Standard error 0.0126 0.0099 0.0062 0.0158 0.0019
All foreign banks
Mean 0.6995 0.7889 0.899 0.7792 0.801*
Standard error 0.0211 0.0120 0.0128 0.0234 0.0141
All other EU banks
Mean 0.7189 0.7648 0.9088 0.75 0.855*
Standard error 0.0274 0.0197 0.0139 0.0709 0.0381
Belgian banks
Mean 0.675 — — — —
Canadian banks
Mean — — — — 0.833*
French banks
Mean — 0.7453 0.8979 — —
German banks
Mean 0.7294 — — — —
Italian banks
Mean 0.6566 0.7847 — — —
Japanese banks
Mean — 0.8195 — 0.7939 0.754
0.0246
Luxembourgian banks
Mean — — — — —
Number of observations
Standard error
Netherlandic banks
Mean 0.9117* 0.8172 — — 0.867
0.0729
South Korean banks
Mean — — — —
0.866*
Standard error
0.0431
Swiss banks
Mean 0.7517 0.7576 — — —
U.K. banks
Mean — 0.7177# — — —
U.S. banks
Mean 0.7169 0.768 0.8598 0.7769 —
Standard error 0.0752 0.0276 0.0450 0.0598
— Fewer than three foreign banks.
* Significantly higher than the domestic bank mean at the 5 percent level.
# Significantly lower than the domestic bank mean at the 5 percent level.
average domestic banks are less profit efficient than foreign banks by about
5.4 percent of potential profits. This implies that while domestic Spanish
banks may have a slight cost advantage over their foreign rivals, their
lower revenues overwhelm their lower costs. This may be due to poor
investment choices, to poor risk diversification that requires a relatively
low risk, low-expected-return choice of investments, or to poor service
quality such as skimping on expenditures necessary to monitor and service
customers.
In the United States, domestic banks are more profit efficient on aver-
age than foreign banks by a wide margin, 25.5 percent of potential prof-
its, but domestic banks are on average slightly less cost efficient than
foreign banks by 2.8 percent of costs. Both differences are statistically
significant. The much higher profit efficiency suggests that the extra
spending by U.S. domestic banks likely is not due to waste or ineffi-
ciency—rather, these higher expenses more likely reflect efforts to pro-
duce a quality or variety of financial services that generates substantially
greater revenues.172
DISAGGREGATING FOREIGN BANK EFFICIENCY BY NATION OF OWNER-
SHIP. Thus far, our results are consistent with the main finding of the prior
research in this field, that is, the average domestic bank is generally more
efficient than the average foreign bank. In four of our five home coun-
tries, mean domestic bank profit efficiency is higher than mean foreign
bank profit efficiency. In some cases, particularly the United States, this
efficiency edge is also economically large, accounting for a substantial
percentage of potential profits. However, we cannot draw conclusions
about our hypotheses without also disaggregating these results by nation of
origin for the foreign banks. We show this disaggregation in tables 6 and 7.
In France, domestic banks have slightly higher mean cost and profit effi-
ciency than foreign banks on average, but this masks considerable hetero-
172. Our findings for the United States differ notably from prior efficiency studies of for-
eign banks in the United States. A number of studies using 1980s data find relatively low
cost efficiency or relatively low profit efficiency for foreign banks operating in the United
States. Our results suggest that foreign-owned banks in the United States have improved
their cost efficiency over the past decade, but that their profit efficiency has continued to lag,
possibly due in part to turnover of these institutions. Since the 1980s, foreign banks from
some countries (for example, Japan) have reduced their U.S. presence, while foreign banks
from other countries (for example, the Netherlands) have increased their U.S. presence.
Thus, while domestic U.S. banks appear to continue to be more efficient than foreign-owned
banks, the underlying characteristics of this difference may have changed.
geneity across the foreign banks by nation of origin. For example, U.S.-
owned banks in France have the highest mean profit efficiency of 64.85
percent, which is more than 20 percent of potential profits higher than
domestic French banks, and the difference is statistically significant. The
Netherlandic-owned banks in France have much higher measured cost effi-
ciency but lower measured profit efficiency than domestic French banks,
suggesting poor revenue performance. In contrast, Italian-owned banks in
France have much higher measured profit efficiency, but lower cost effi-
ciency, than domestic French banks.
In Germany, as in France, heterogeneity among foreign institutions is
again apparent once the results are disaggregated by nation of origin.
Again, the U.S.-owned banks have the highest mean profit efficiency of all
foreign institutions, and again the U.S.-owned institutions post a higher
mean profit efficiency than domestic banks (although the difference is not
statistically significant). Domestic German banks have statistically higher
mean profit efficiency than foreign banks from the Netherlands, Switzer-
land, and the United Kingdom, although the foreign U.K. banks have sta-
tistically higher cost efficiency than the domestic German banks. Again,
these mixed cases suggest that studies using only the less-comprehensive
cost efficiency measure can be misleading, because this measure does not
account for differences in the ability to generate revenues. There is weak
evidence that the strong profit efficiency of German domestic banks carries
over to their foreign operations in France, although this result is not sta-
tistically significant and we do not have any data from German banks in
foreign nations other than France to determine whether German banks
have a global advantage.
In Spain, our database contains only two foreign nations (France and
the United States) operating three or more banks. On average, both of
these sets of foreign banks are more profit efficient than the domestic
banks, providing further evidence against the home field advantage
hypothesis in Spain. The cost efficiency results continue to differ from
the profit results in Spain, suggesting that most of the profit efficiency
advantage of the foreign banks is on the revenue side.
In the United Kingdom, domestic banks have higher mean cost effi-
ciency and higher mean profit efficiency than all of the foreign nations
operating in the United Kingdom. However, none of these differences is
statistically significant, and they do not suggest that U.K. banks have a
global advantage. U.K. banking organizations have only three or more
banks in one other home country in our data set, Germany, where the cost
efficiency and profit efficiency of U.K. banks are both statistically and eco-
nomically significantly lower than those of domestic German banks. Thus,
although it may be hard for foreign banks to do business in the United
Kingdom, U.K.-owned banks do not appear to be particularly efficient
players outside their home country.
In the United States, domestic banks have higher mean profit efficiency
than the foreign banks from all other nations, and the difference is usu-
ally statistically significant and economically large. The much higher profit
efficiency and somewhat lower cost efficiency of domestic U.S. banks
relative to foreign banks in the United States suggest a strong advantage
for U.S. domestic banks on the revenue side of the ledger. Furthermore,
unlike the results for the other home countries, the domestic profit effi-
ciency advantage of U.S. banks does not disappear when these banks go
abroad—U.S.-owned banks earn higher-than-domestic levels of profit effi-
ciency in France, Germany, and Spain.
Overall, these disaggregated data tend to support rejection of the home
field advantage hypothesis in favor of the limited form of the global advan-
tage hypothesis. In three of the five home countries, foreign banks from
at least one other nation are more efficient on average than domestic banks,
contrary to the predictions of the home field advantage hypothesis. Banks
from one nation, the United States, exhibit mean efficiency levels that are
higher than those of domestic banks in all but one of the other home coun-
tries, supporting the limited form of the global advantage hypothesis.
Banks from Germany also exhibit high mean efficiency levels both at
home and abroad, although the foreign performance of German banks is
based on a single, statistically insignificant result in only one foreign coun-
try. These data suggest that some efficient institutions from the United
States (and perhaps Germany) may have overcome the difficulties imposed
by distance, language, and culture to operate in foreign countries above the
mean domestic efficiency levels, possibly because of specific favorable
market or regulatory and supervisory conditions at home. However, deter-
mining which home-market conditions might give these banks an advan-
tage is beyond the scope of this study.
A potential problem with our finding of support for the limited form of
the global advantage hypothesis is that a banking organization may use
transfer pricing or other accounting methods to shift profits from an affil-
iate in one country to an affiliate in another country for tax, regulatory, or
other reasons. Thus the generally high efficiency performance of U.S.

banks in other nations could reflect a shifting of net cash flow out of the
domestic banks in the United States toward their foreign affiliates, and
the poor performance of domestic Spanish banks could reflect a shifting of
net cash flow to the Spanish-owned institutions in other nations. How-
ever, three pieces of evidence suggest that this is not the case and that
banks performing well abroad also tend to perform well at home. First,
we find that U.S. banks are more profit efficient at home as well as abroad.
This suggests a true efficiency advantage for U.S. banks, rather than sim-
ply a shift of net cash flow overseas. Second, we find some evidence that
the poor performance of Spanish banks at home is mirrored by similarly
poor performance abroad. Our French data set contains two Spanish-
owned banks (not displayed in tables 6 or 7 because we constrained our
tests to include only foreign-owned banks in groups of three or more),
and these two banks had relatively low average profit efficiency (0.320)
and relatively high average cost efficiency (0.850), figures that are con-
sistent with the domestic performance of Spanish banks. Third, another
study of cross-regional bank efficiency in the United States has found
that banking organizations that do well in other regions also tend to do
well in their home region.173 This supports a national advantage hypothe-
sis similar to the global advantage hypothesis tested here.
Robustness Tests Using U.S. Regional Data

Although our main finding supports a global advantage for U.S. banks,
we also find that domestic banks tend to have higher efficiency on aver-
age than foreign banks, consistent with previous studies of cross-border
efficiency. In this section, we use the larger and more detailed U.S. bank
data set to investigate the reasons for this result. First, we examine whether
the higher average efficiency of domestic banks is caused by the dis-
economies of operating or monitoring subsidiaries located far from head-
quarters or by the difficulties of overcoming cross-border differences such
as language, culture, and regulations. Second, we examine whether the
higher average efficiency of domestic banks arises simply because for-
eign banks tend to locate in regions where it is difficult for both foreign
and domestic banks to earn high profits.
173. Berger and DeYoung (2000).

We address the first question by dividing the United States into eight
distinct geographic regions and evaluating the “cross-regional efficiency”
of U.S. domestic banks. That is, we compare the estimated efficiency of
1,883 within-region banks (domestic U.S. banks operating in the region
in which their organization is headquartered) to the estimated efficiency of
57 out-of-region banks (domestic U.S. banks operating in a region differ-
ent from the one in which their organization is headquartered). The results
of these tests, which are shown in table 8, suggest a modest efficiency
advantage to cross-regional ownership. Large banks owned by out-of-
region organizations have a statistically significant cost efficiency edge of
3.1 percent of costs and a statistically insignificant profit efficiency edge of
2.3 percent of potential profits over banks owned within the region. 174
Given that the United States is a relatively homogeneous nation with
potentially large distances between banks and their headquarters, these
results suggest that efficient organizations can overcome any organiza-
tional diseconomies of operating or monitoring subsidiaries from a dis-
tance. If these results extrapolate to the cross-border context, they suggest
that other barriers—such as differences in language, culture, regulatory
or supervisory structures, currency, or monetary policy—more likely
explain why domestic banks tend to be more efficient than foreign banks
on average.
We address the second of these questions by comparing the efficiencies
of foreign and domestic banks in the United States within each of these
geographic regions. The results of these tests, which are shown in table 9,
are consistent with the results in tables 6 and 7 that suggested an advan-
tage for U.S. banks. The forty-three foreign banks operate in just four of the
eight U.S. regions (Mideast, Great Lakes, Southeast, and Far West) and
are located predominantly in the regions that include the international bank-
ing centers of New York (Mideast), Chicago (Great Lakes), and San Fran-
cisco (Far West). In three of these four regions, the average foreign bank has
significantly lower profit efficiency than the average domestic bank, the
only exception being the Southeast region, with only two foreign banks.
Furthermore, in three of the four regions there is no significant difference
between foreign bank and domestic bank cost efficiency. Foreign banks’
locational choices do not appear to be driving our results.
174. This result may be stronger than it at first appears, because the extra operational cost
of a multibank holding company (a required organizational structure for interstate banks
during most of our sample period) biases against finding cross-regional efficiency.

Table 8. Cross-Regional Cost and Profit Efficiency of Domestic Banks
in the United States
Location of bank Cost efficiency Alternative profit efficiency
Same region as its headquarters
Mean efficiency 0.767 0.672
Number of observations 1,883 1,883
Different region than its headquarters
Mean efficiency 0.798* 0.695
* Significantly higher than the mean at the 5 percent level.
Implications of the Tests

If the results of this research extrapolate to the future, they may have
important implications for the structure of globalized financial markets.
The finding here and in the literature that foreign banks are less efficient on
average than domestic banks in most countries, if it continues into the
future, suggests that efficiency considerations may limit the global con-
solidation of the financial services industry. Domestically based institu-
tions would continue to play a large role in the provision of financial
services. Nonetheless, our results also suggest that some banking organi-
zations can operate in foreign countries at or above the efficiency levels
of domestic banks, paving the way for additional global consolidation.
Furthermore, the ability to operate efficiently across borders appears to
be linked to nation of ownership—only the U.S. banks were able to oper-
ate efficiently across borders on a reasonably consistent basis. If this U.S.
advantage continues, U.S.-based organizations may capture a significant
share of any future globalization of financial institutions.
A potential goal of future research might be to determine which condi-
tions in the United States might foster the apparent efficiency advantage of
U.S. banks. If it is based on market conditions like securities market devel-
opment, then policymakers can do little to affect financial institution effi-
ciency. If, instead, it is based on regulatory or supervisory factors like the
deregulation of geographic restrictions, deposit interest rates, and rela-
tively easy bank chartering, then policymakers may have an important
influence. If deregulation is important, then this might predict strong cross-
Table 9. Regional Analysis of Alternative Profit and Cost Efficiency of Domestic versus Foreign Banks in the United States
New Great Rocky Far
Type of bank England a Mideast b Lakes c Plains d Southeast e Southwest f Mountaing West h
Alternative profit efficiency
Domestic banks
Mean efficiency 0.612 0.614 0.645 0.667 0.7010 0.746 0.800 0.647
Standard error 0.0206 0.0099 0.0058 0.0080 0.0058 0.0101 0.0183 0.0137
Foreign banks
Mean efficiency — 0.221# 0.554# — 0.859* — — 0.481#
Standard error 0.0622 0.0416 0.0572 0.0598
Cost efficiency
Domestic banks
Mean efficiency 0.798 0.779 0.785 0.780 0.765 0.749 0.792 0.748

Standard error 0.0111 0.0053 0.0039 0.0049 0.0034 0.0055 0.0132 0.0081
Foreign banks
Mean efficiency — 0.808 0.828* — 0.738 — — 0.770
Standard error 0.0277 0.0172 0.0550 0.0248
Source: Authors’ calculations. Regional definitions are from the U.S. Bureau of Economic Analysis.
* Significantly higher than the domestic mean at the 5 percent level.
# Significantly lower than the domestic mean at the 5 percent level.
a. Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, Vermont.
b. Delaware, District of Columbia, Maryland, New Jersey, New York, Pennsylvania.
c. Illinois, Indiana, Michigan, Ohio, Wisconsin.
d. Iowa, Kansas, Minnesota, Missouri, Nebraska, North Dakota, South Dakota.
e. Alabama, Arkansas, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina, Tennessee, Virginia, West Virginia.
f. Arizona, New Mexico, Oklahoma, Texas.
g. Colorado, Idaho, Montana, Utah.
h. Alaska, California, Hawaii, Nevada, Oregon, Washington.
border efficiency gains from the Single Market Programme in the Euro-
pean Union and other liberalizations in other parts of the globe.
Our results may also have important implications for research method-
ology. While the aggregated results in the top two rows of tables 6 and 7
alone appear to support the home field advantage hypothesis, the more
detailed results in these two tables appear to support the limited form of
the global advantage hypothesis. These results suggest disaggregation by
foreign nation of ownership in future research.
Our results also suggest that it is important to include a substantial num-
ber of different nations in the analyses. If we had only used European
data in this study, our results may have supported the home field advantage
hypothesis, since the nation with the global advantage would have been
excluded. If we had only used data from a single home country, our results
would have supported either the home field advantage, the global advan-
tage, or the limited global advantage hypothesis, depending on which
country we investigated. And if we had been able to expand our database
to include additional home countries, we may have found global advan-
tages for banks from additional countries as well.
Finally, our results support the future use of complete separate analy-
ses of data from each home country. Estimating efficiency jointly or pool-
ing the efficiency estimates from institutions in different countries may
create problems of comparison because of significant differences in the
environments of these countries.
Summary and Conclusions
In this paper, we address the causes and consequences of the cross-

border consolidation of financial institutions and the implications of this
consolidation for the integration of global financial markets. First, we
extensively review several hundred research studies on the causes and con-
sequences of consolidation. Second, we provide comparative data on
financial systems in different nations, trends in cross-border financing by
banks and other financial institutions, and trends in cross-border M&As of
financial institutions. Third, we perform an original analysis of cross-
border banking efficiency in France, Germany, Spain, the United King-
dom, and the United States during the 1990s. On average, we find that
domestic banks in these countries have both higher cost efficiency and
higher profit efficiency than foreign banks operating in the country. This
result is consistent with most of the findings in the extant literature, where
it has been interpreted as supporting the home field advantage hypothe-
sis. However, after disaggregating our results by foreign nation of origin,
we find that the data appear to reject the home field advantage hypothesis
in favor of the limited form of the global advantage hypothesis. The dis-
aggregated results suggest that domestic banks may be more efficient than
foreign banks from most foreign countries, may be about equally efficient
with foreign banks from some foreign countries, but may be less efficient
than foreign banks from one (the United States) of the foreign countries.
These results, should they continue to hold in the future, may have
important implications for the structure of globalized financial markets, for
financial institution policy, and for future research. First, the finding here
and in the extant literature that foreign banks are less efficient on average
than domestic banks suggests that efficiency considerations may limit the
global consolidation of the financial services industry. Thus domestically
based institutions would continue to play a large role in the provision of
financial services. Second, our finding that some banking organizations
can operate in foreign countries at or above the efficiency levels of domes-
tic banks suggests that additional global consolidation of financial markets
may be in the offing. Third, our finding that banking organizations from
some countries, particularly the United States, are better able to operate
efficiently across borders suggests that financial institutions from these
countries may capture disproportionate shares of international financial
services business in the future. Fourth, if future research finds that U.S.
banks derive their apparent efficiency advantage from U.S. regulatory or
supervisory conditions (for example, easy geographic mobility) rather than
from U.S. market conditions (for example, a well-developed securities
market), then one might predict cross-border efficiency gains from simi-
lar liberalizations in other nations, such as the Single Market Programme
in the European Union. Finally, our results suggest that future empirical
investigations in this area should include a substantial number of home
countries and institutions from a substantial number of foreign nations.
The results also suggest that researchers should disaggregate their analysis
by foreign nation of ownership. These changes appear to be important for
discerning between the home field advantage and the global advantage
hypotheses.
Because we base our conclusions on empirical results generated over a

relatively short period of time, for a relatively short list of countries, and
for a relatively small number of foreign banks, we make them cautiously
and propose a number of important caveats. First, all five of the home
countries we analyze are advanced economies; banks in many less-
advanced economies may be less likely to have home field advantages.175
Similarly, the patterns of relative domestic versus foreign bank efficiency
may be substantially different in important countries that we were not able
to include in our analysis due to data limitations (for example, China,
Japan, and Russia). Second, the pattern of home field and global advan-
tages that we reveal in our tests is likely to change over time. For exam-
ple, the introduction of a common European currency, the full
implementation of laws allowing expanded powers for banks, and the con-
tinued trend of M&As away from domestic deals and toward cross-border
deals could alter the balance of home field and global advantages. Third,
while we focus on the performance of financial institutions that have
acquired or established a physical presence in foreign countries, financial
institutions can also provide cross-border financial services at a distance
from their home-country headquarters. Financial institutions that excel in
one of these cross-border delivery channels might not excel in the other,
and in the future we may see institutions from different countries choosing
different combinations of these channels, perhaps depending on whether
they seek to provide retail services abroad. Fourth, because our tests
employ accounting data for banks that are in most cases subsidiaries of
larger banking organizations, our results may be capturing the effects of
transfer pricing that shifts profits from an affiliate in one country to an
affiliate in another country for tax, regulatory, or other reasons. However,
our results contain several pieces of evidence that run counter to this argu-
ment. For example, we find that banks with the best domestic performance
also perform well abroad and that banks with the weakest performance
abroad also perform poorly at home, suggesting that the underlying effi-
ciency advantages and disadvantages of these banks may overwhelm the
effects of any tax or regulatory profit shifting.
175. Claessens, Demirgüc-Kunt, and Huizinga (2000) find that foreign banks outperform
domestic banks in less-developed economies.

APPENDIX
The Structure of Credit Markets in Different Countries
This appendix provides a brief overview of regulatory changes,

describes the structure of credit markets, and presents descriptive statis-
tics for domestic and foreign banks in different nations.176
Regulatory Changes
Traditionally, financial service firms have been heavily regulated and
protected from competition. As a result, credit markets in most countries
have been highly fragmented and specialized on the basis of region, prod-
uct line, or clientele. In the United States, the operations of credit unions,
thrifts, commercial banks, securities firms, and insurance companies were
kept separate, and banks were restricted to a single state. In Japan, separate
entities provided commercial banking, securities, and insurance services.
Banking services were highly segmented by both region and product line
and were provided by major Japanese banks (city, long-term credit, and
trust banks), regional banks, financial institutions for small business, gov-
ernment financial institutions, financial institutions for agriculture,
forestry, and fisheries, and the post office. In France, universal banks
belonging to the French Bankers Association were distinct from mutual
banks, cooperative banks, and savings and provident banks with narrow
business or regional focus and also were distinct from finance companies,
securities houses, brokerage firms, and other specialized institutions. The
German system contained large universal banks, regional banks (and their
central giro organizations), private banks, savings banks (and their cen-
176. Other studies provide more detailed descriptions of credit markets in these and
other countries. Berger, Kashyap, and Scalise (1995) discuss the U.S. market. Beduc,
Ducruezet, and Stephanopoli (1992), de Boissieu (1993), Matherat and Cayssials (1999),
and Pfister and Grunspan (1999) discuss the French market. Bauer and Domanski (1999)
and Pozdena and Alexander (1992) cover the German system. Bruni (1993), Fazio (1999a,
1999b), and Szego and Szego (1992) discuss the Italian system. Cargill and Royama (1992),
Genay (1998), Hoshi and Kashyap (2000), and Toyama (1999) cover the Japanese market.
Caminal, Gual, and Vives (1993), Pastor (1993), and Fuentes and Sastre (1999) discuss the
Spanish market. Birchler and Rich (1992) and Braun, Egli, Fischer, Rime, and Walter (1999)
discuss the Swiss market. Bowen, Hoggarth, and Pain (1999) and Llewellyn (1992) dis-
cuss the U.K. market.
tral organizations), credit cooperatives, and specialized credit institutions

like the postal system and building loan associations. In Italy, the opera-
tions of public law banks, private banks, cooperative banks, savings and
pledge banks, rural banks, and special credit institutions (for example,
industrial credit, real estate, agriculture, and fishery institutions) were sep-
arate. In Spain, regulation limited the competition among commercial
and savings banks, as well as credit cooperatives. In Switzerland, a uni-
versal banking country, financial services were provided by large banks,
cantonal and savings banks, rural banks, specialized credit institutions, and
finance companies. In the United Kingdom, clearing banks, investment
banks, and building societies served distinct markets.
In addition to functional and geographic separation of credit institu-
tions, credit markets were often characterized by interest rate regulations,
restrictions on the form and composition of the assets and liabilities of
institutions, and barriers to entry and exit. In a number of countries, such
as France, Germany, Italy, and Switzerland, the central and local govern-
ments were involved directly in the provision of financial services by fiat
or through direct ownership of banks.
Over the past two decades, there has been considerable deregulation of
the activities of credit institutions. In the United States, deposit interest
rates were deregulated, the restrictions on interstate banking were mostly
removed, thrift powers were expanded, and most of the Glass-Steagall
restrictions on banking powers were recently removed. Since the 1980s,
the lines separating various types of commercial banks in Japan have
blurred, and competition has intensified, as interest rates were deregulated,
rules governing security issues were liberalized, and the permissible range
of products was expanded. The Japanese “Big Bang” reforms that began to
be implemented in 1997, and still continue, will tear down the barriers sep-
arating commercial banks, securities firms, and insurance companies.
In Europe, the Single Market Programme effectively removed many of
the cross-border restrictions on financial institutions. Individual nations
also engaged in their own deregulation. During the late 1970s and early
1980s, legal changes in France encouraged the development of capital
markets and the introduction of new financial products. The major changes
introduced by the Banking Act of 1984 overhauled the banking markets
and greatly diminished the distinctions among the different types of insti-
tutions. In Italy, a legal framework for investment funds was introduced
in 1983, branching restrictions were relaxed in 1989, the Banking Law of
1993 eliminated operational distinctions among credit institutions, and the

Consolidated Law on Financial Intermediation of 1998 provided flexibility
in the portfolio management activities of credit institutions. In Spain, a
series of deregulations starting in the 1970s liberalized interest rates and
branching, expanded the permissible activities of savings banks, removed
operational differences between commercial and savings banks, removed
restrictions on the activities of foreign banks, and (through changes in the
tax laws) provided the framework for the development of investment
funds. In the United Kingdom, credit and exchange controls were removed
during the 1970s and 1980s, permissible activities of building societies
were expanded during the 1980s and 1990s, and securities markets were
deregulated with the “Big Bang” in 1986.
The Structure of Credit Markets

Tables A-1 and A-2 show market structure in the Group of Ten coun-
tries. Owing to historical restrictions on branching and unit banking laws,
the U.S. banking market appears to be more fragmented than markets in
other nations. In 1997 the United States had the largest number of credit
institutions (22,331) and the smallest number of inhabitants per institu-
tion (11,997).
Among commercial banks, the number of institutions and branches
varies across countries (tables A-3 through A-9). In France, Spain, and
the United States, the number of banks and their branches exceeds the
number of other institutions. In France, financial companies and commer-
cial banks accounted for 53.4 and 29.7 percent, respectively, of all credit
institutions in 1998. In Spain, commercial banks account for the majority
of institutions and branches. Similarly, in the United States, insured com-
mercial banks outnumber insured savings institutions, credit unions, and
other banks. In contrast, in Germany, Italy, and Japan, commercial banks
and their offices represent a small fraction of the total banking markets.
In Germany, commercial banks account for 9.5 percent of the total number
of institutions and 11.4 percent of the total number of branch offices; credit
cooperatives and their central institutions, savings banks, regional giro
institutions, and special credit institutions account for the remainder. Sim-
ilarly, in Italy, limited company banks and foreign banks account for
29.6 percent of the total number of institutions, while cooperatives and
mutual banks constitute the bulk of the remainder of institutions. In Japan,
Table A-1. Number of Credit Institutions, Market Share of the Five Largest Institutions, and Number and Market Share of Branches and
Subsidiaries of Foreign Banks in the Group of Ten Countries, 1990–97
Five largest institutions Branches and subsidiaries
Credit institutions in total assets of foreign banks
Number, Number, Percentage Percent of total Percent of total Number, Percent of Percent of
Country 1990 1997 change, 1990–97 assets, 1990 assets, 1997 1997 assets, 1995 assets, 1997
Belgium 122 136 11.48 48 57 71 28.4 36.3
Canada 2,920 2,413 –17.36 55 78 n.a. n.a. n.a.
France 779 519 –33.38 52 57 305 12.2 n.a.
Germany 4,594 3,409 –25.79 13.9 16.1 153 4.2 4.3
Italy 1,065 937 –12.02 24 25 61 5.4 6.8

Japana 6,279 4,266 –32.06 30 31 142 2.1 4.9
Netherlands 153 127 –16.99 73 79 49 9.7 7.7
Sweden 138 125 –9.42 70 90 18 9.8 1.6
Switzerland 458 362 –20.96 45 49 18 11.8 n.a.
United Kingdom 637 553 –13.19 22 28 387 51.6 52.1
United Statesb 31,842 22,331 –29.87 9 17 448 21.7 20.7
Source: For number of credit institutions and branches, Bank for International Settlements (1995, 1998). For market share of the five largest institutions in Germany, De Bandt (1999); for market share of the five
largest institutions in the other countries, Bank for International Settlements (1999). For branches and subsidiaries of foreign banks in Europe excluding Switzerland, European Central Bank (1999); in Switzerland,
Bank for International Settlements (1995, 1998); in Japan, Bank of Japan (1997, 1999); in the United States, Board of Governors of the Federal Reserve System (1995, 1997).
n.a. Not available.
a. Total banking assets are calculated as the sum of the banking and trust assets of domestically chartered banks and foreign banks and exclude the assets of credit cooperatives and other financial intermediaries.
b. Does not include the agencies or representative offices of foreign banks. The numbers including these offices are 864 in 1996 and 828 in 1997.
Table A-2. Number of Branches of Credit Institutions and Number of Inhabitants per Institution and Branch in the Group of
Ten Countries, 1990–97
Branches Inhabitants per institution Inhabitants per branch
Percentage Percentage Percentage
Number in Number in change, Number in Number in change, Number in Number in change,
Country 1990 1997 1990–97 1990 1997 1990–97 1990 1997 1990–97
Belgium 13,452 9,041 –32.79 81,815 74,853 –8.51 742 1,126 51.75
Canada 13,269 13,642 2.81 9,188 12,598 37.11 2,022 2,228 10.19
France 42,536 46,639 9.65 72,677 113,102 55.62 1,331 1,259 –5.41
Germany 77,326 59,695 –22.80 17,354 24,083 38.77 1,031 1,375 33.37
Italy 32,162 39,936 24.17 54,056 61,366 13.52 1,790 1,440 –19.55
Japan 68,142 69,022 1.29 19,686 29,578 50.25 1,814 1,828 0.77
Netherlands 8,161 7,071 –13.36 98,092 123,261 25.66 1,839 2,214 20.39
Sweden 5,136 3,624 –29.44 62,227 70,800 13.78 1,672 2,442 46.05
Switzerland 8,021 6,995 –12.79 14,746 19,604 32.94 842 1,015 20.55
United Kingdom 41,431 35,234 –14.96 90,082 106,691 18.44 1,385 1,675 20.94
United States 107,703 73,538 –31.72 7,881 11,997 52.23 2,330 3,643 56.35
Source: For number of credit institutions and branches, Bank for International Settlements (1995, 1998). For branches and subsidiaries of foreign banks in Europe excluding Switzerland, European Central Bank
(1999); in Switzerland, Bank for International Settlements (1995, 1998); in Japan, Bank of Japan (1997, 1999); in the United States, Board of Governors of the Federal Reserve System (1996).
special-purpose financial institutions (for financing small businesses, agri-

culture, and fisheries) account for the majority of institutions and
branches; Japanese commercial banks account for only 6.7 percent of the
total number of institutions and 19.2 percent of the branches. However, in
all markets, commercial banks have the largest market shares in terms of
assets.
Banks in Belgium, France, the Netherlands, and the United Kingdom
appear to have the most branches per institution. The smaller number of
branches per institution in Italy and the United States is a remnant of his-
torical restrictions on branching. In fact, since the 1989 deregulation of
limits on branching, Italy has seen a 24 percent increase in the number of
branches. Similarly, while the number of branches of U.S. institutions
declined significantly over the 1990–93 period, there has been a slight
increase in more recent years.
The number of institutions and their branches declined overall in the
1990s, with a corresponding increase in the number of inhabitants per
institution and per branch (tables A-1 and A-2).177 France, Germany, Japan,
and the United States experienced the largest declines in the number of
institutions in percentage terms, on the order of 25 to 35 percent. In most
countries, the majority of restructuring occurred among small institu-
tions. The number of German and Japanese institutions declined primar-
ily among cooperative and rural banks. In the United Kingdom, most of
the restructuring occurred as a result of M&A activity among domestic
banks, primarily smaller institutions.178 Similarly, of the forty-four exits
from the Italian banking market that occurred in 1997, thirty-two involved
mutual and cooperative banks.179
The share of total banking assets held by the five largest institutions has
increased in all major countries except Norway. Canada, Finland, Portugal,
177. In some countries, such as France and Italy, the restructuring also involved signifi-
cant decreases in the role of the state in the banking industry. For instance, in France, the
number of public institutions declined from ninety-two in 1984 to twenty-three in 1997
(Matherat and Cayssials 1999, p. 171). In Italy, the share of total banking assets held by
banks in which the state has a majority control declined from 68 percent in 1992 to 20 per-
cent in 1998 (Fazio 1999a, p. 9).
178. Another notable development in the U.K. markets has been the demutualization of
building societies and the conversion of these societies into banks. Also, while the number
of domestic institutions declined over 1990–97, the number of foreign banks operating in the
United Kingdom increased significantly (Bowen, Hoggarth, and Pain 1999).
179. Bank of Italy (1998), p. 318.

Table A-3. Credit Markets in France, 1998
Percent Total assets Percent
Number of of all (billions of of total
Type of institution institutions institutions French francs) assets
All Banks 359 29.67 9,952.0 48.90
Domestic banks 172 14.21 n.a. n.a.
Majority foreign-
owned banks 98 8.10 n.a. n.a.
Branches of
foreign banks 89 7.36 n.a. n.a.
Mutual and
cooperative banks 124 10.25 3,240.0 15.92
Savings and
provincial institutions 34 2.81 3,988.5 19.60
Financial companies 646 53.39 1,996.4 9.81
Specialized
financial institutions 26 2.15 1,172.9 5.76
Municipal credit banks 21 1.74 n.a. n.a.
Total 1,210 100.00 20,349.8 100.00
Source: Bank of France (1996, 1997, 1998a, 1998b).
n.a. Not available.
and Sweden have experienced the largest increases in market concentra-

tion, while concentration ratios have been more stable in France, Japan,
and Switzerland. Overall, concentration ratios in Germany, Italy, the
United Kingdom, and the United States are lower than in other countries.
Although national markets within continental Europe are fairly concen-
trated, the shares held by the top five institutions in continental Europe as
a whole are relatively small (about 12 percent, not shown in tables).180 It
Table A-4. Credit Markets in Spain, 1996

Total assets
Number of Number of (millions of Percent of
Type of institution institutions branches pesetas) total assets
Commercial banks 107 17,523 42,306 57.11
Savings banks 50 15,863 27,837 37.58
Credit cooperatives 97 3,289 2,560 3.46
Foreign banks 56 134 1,377 1.86
Total 310 36,809 74,080 100.00
Source: Data provided by Ana Lozano-Vivas, Universidad de Málaga, Spain.
180. De Bandt (1999).

Table A-5. Credit Markets in the United States, 1998
Total assets (billions of U.S. dollars)
Number of institutions a
Percent of
Type of institution Domestic Foreign Total Domestic Foreign Total total assets
Commercial banksb 8,627 497 9,124 5,095.93 1,118.21 6,214.14 79.80
Savings and loan institutions 519 0 519 151.97 0 151.97 1.95
Insured savings banksc 1,087 6 1,093 882.95 44.64 927.59 11.91
Federally insured credit unionsd 11,206 0 11,206 454.92 0 454.92 5.84

Cooperative and industrial banks 142 0 142 38.18 0 38.18 0.49
Total 21,581 503 22,084 6,623.94 1,162.86 7,786.80 100.00
Percent of total 97.72 2.28 100.00 85.07 14.93 100.00
Uninsured banks 472 17 489 4.10 0.55 4.65
Source: Federal Reserve System, National Information Center.
a. Excludes institutions in the territories. Unless otherwise noted, domestic institutions include only insured institutions.
b. Foreign-owned commercial banks include U.S. subsidiaries, branches, and agencies of foreign banks, but exclude Edge Act and Agreement corporations.
c. Insured savings banks include federal and state savings banks.
d. Federally insured credit unions include federal and state credit unions.
Table A-6. Credit Markets in Germany, 1998
Total assets Percent of
Number of Number of Number of (billions of business
Number of branch foreign foreign Deutsche volume,
Banking group institutions offices branches subsidiaries marks) 1997 a
Commercial banks 325 6,833 197 229 3,337 24.8
Large banks 4 4,353 148 183 1,729b 9.8
Regional banks and others 187 2,179 49 46 1,355 12.7
Branches of foreign banks 84 75 n.a. n.a. 196 1.7
Private banks 50 226 n.a. n.a. n.a. 0.6
Savings banks 594 18,327 3 1 1,780 18.6

Regional giro institutions 13 443 43 45 1,838 18.3
Cooperatives 2,249 16,139 9 2 1,017 10.7
Cooperative central institutions 4 26 9 16 394 3.8
Special-purpose credit institutions 221 18,175 n.a. n.a. n.a. 9.4
Majority foreign-owned banksc 69 630 n.a. n.a. 441 2.7
Source: Data provided by Juergen Weigand, Indiana University, and supplemented with data from Deutsche Bundesbank (1999); Bauer and Domanski (1999).
n.a. Not available.
a. Business volume is the sum of balance sheet total plus endorsement liabilities arising from rediscounted bills and bills sent for collection from the banks’ portfolio prior to maturity.
b. Total assets were available only for the Big Three.
c. Majority foreign-owned banks that are classified in the following categories: regional banks and other commercial banks, private banks, and mortgage banks.

Table A-7. Credit Markets in Italy, 1997
Number of Number of
Number of branches branches
Type of institution banks in Italy abroad
Limited company banks
accepting short-term funds 190 18,026 93
Limited company banks
accepting medium and
long-term funds 32 98 n.a.
Cooperative banks 69 4,357 9
Mutual banks 586 2,659 n.a.
Central credit and
refinancing institutions 6 28 n.a.
Branches of
foreign banks 55 82 n.a.
Total 938 25,250 102
Source: Bank of Italy (1997).
n.a. Not available.
Table A-8. Credit Markets in Japan, March 1998

Total assets Percent
Number of Number of (billions of total
Type of institution institutions branches of yen) assets
Domestically licensed
banksa 174 16,380 886,619.0 66.67
City banks 10 3,348 457,340.8 34.39
Regional banks 64 7,902 200,288.9 15.06
Second-tier regional
banks 64 4,675 69,867.1 5.25
Trust banks 33 385 73,113.6 5.50
Long-term credit banks 3 70 85,962.8 6.46
Foreign banks 93 144 60,285.5 4.53
Financial institutions for
small businessesb 752 12,301 188,931.5 14.21
Financial institutions for
agriculture, forestry,
and fisheryc 2,796 16,172 194,082.0 14.59
Government financial
institutions 2 211 n.a. n.a.
Post office 1 24,638 n.a. n.a.
Total 3,818 69,846 1,329,918.0 100.00
Source: Bank of Japan (1999).
n.a. Not available.
a. Assets in the banking accounts only, including the assets of overseas branches of domestic banks.
b. Includes Shinkin banks, the Zenshinren Bank, the Shoko Chukin Bank, credit cooperatives, the Shinkumi Federation Bank,
Labor Credit Associations, and the National Federation of Labor Credit Associations.
c. Includes the Norinchukin Bank, agricultural cooperatives, Credit Federations of Agricultural Cooperatives, fishery coopera-
tives, Credit Federations of Fishery Cooperatives, and Mutual Insurance Federations of Agricultural Cooperatives.

Table A-9. Credit Markets in the United Kingdom, 1996–97
Number of Percent of
Type of institution institutions, 1997 banking assets, 1996
Domestic banks (incorporated
in the United Kingdom) 212 43.5
Retail 37.9
Investment 2.2
Other 3.4
Foreign banks (incorporated
outside the United Kingdom) 342
Foreign banks with representative offices 215
Total foreign banks in the United Kingdom 557 56.5
United States 8.2
Japan 9.7
Other 38.6
Source: Bowen, Hoggarth, and Pain (1999).
has been argued that the potential impact of market integration and dereg-
ulation on the EU-wide concentration ratio is likely to be influenced by the
extent to which competition is based on fixed or variable costs.181
Activities of Domestic and Foreign Banks

In recent years, the share of banking assets held by foreign banks has
increased in most countries. In addition to providing more competition, the
presence of foreign banks can alter the types of services provided by bank-
ing organizations in individual markets. For instance, entry by foreign
banks that focus more on investment banking services might provide addi-
tional services to corporate customers. The data from France, Germany,
Spain, the United Kingdom, and the United States reveal three interesting
patterns in the operations of foreign banks (tables A-10 through A-14):
—In each banking market, there are significant differences in the oper-
ations and profitability of foreign versus domestic banks.
—In each country, there are significant differences in the business focus
and profitability of banks from different foreign nations.
—Banks headquartered in a single nation vary their business focus
across foreign markets.182
181. Gual (1999).

182. The samples used to construct tables A-10 through A-14 differ from the samples
used in our analysis in the paper. Although the data were obtained from the same raw data-
bases, the samples used in the tables were filtered in the following fashion. To remove the
Except for the United States, foreign banks are smaller than domestic
banks in every nation.183 With the exception of banks in Spain, foreign
banks invest a greater fraction of their assets in securities and have lower
ratios of loans to total assets than domestic banks. In France and Germany,
foreign banks finance a similar fraction of their assets with deposits as do
domestic banks. Foreign banks in Spain are more reliant on deposits than
domestic banks, while foreign banks in the United Kingdom and the
United States have a lower ratio of total deposits to total assets. In most
countries, domestic banks have more retail deposits (demand, time, and
savings) than foreign banks, where retail deposits rely more heavily on
“other deposits” that are composed mostly of interbank deposits. Further-
more, in most countries, foreign banks have lower net interest income than
domestic banks. The lower concentration of assets in loans, greater use of
interbank deposits, and lower levels of interest income for foreign banks
suggest that foreign banks focus less on traditional banking intermediation
and more on other banking services than domestic banks. The data also
suggest that domestic banks are generally more profitable than foreign
banks. This simple comparison of accounting profitability is consistent
with our evidence on profit X-efficiency.
Among foreign banks of different origin, there are significant differ-
ences in the operations of U.S., European, and Japanese banks in each
market. For instance, in France and Germany, foreign banks from other
European countries appear to focus more on traditional intermediation
than U.S. banks. European banks have higher ratios of loans to total assets
and deposits to total assets (particularly, demand deposits) than U.S.
banks. In addition, U.S. banks earn more commission income per unit of
assets than European banks in France, Spain, and the United Kingdom.
Japanese banks are less profitable, with the exception of Germany, and
focus more on security investments than their U.S. and European coun-
terparts. These patterns suggest that foreign banks in any given country are
impact of mergers, we excluded bank-year observations for which the annual growth in
inflation-adjusted assets was more than 50 percent in absolute value. We also excluded
banks that reported negative values of book-value capital and banks in the lower and higher
1 percent of the distributions of return on assets and return on equity to remove the influence
of these outliers on the mean values.
183. The large size of foreign banks relative to domestic banks in the United States
may be due to our sampling methodology. Our definition of large banks in the United States
(assets greater than $100 million) is small by international standards.
not homogeneous and that treating them as a group, as is often done in

the research literature, can obscure important differences.
The data also suggest that banks headquartered in a single nation vary
their business focus across foreign markets. For instance, U.S. banks oper-
ating in France, Germany, and the United Kingdom invest a greater frac-
tion of their assets in securities and finance a lower fraction of their assets
through deposits than U.S. banks operating in Spain. The extent to which
U.S. banks invest in equity securities also varies from market to market,
ranging from 0.38 percent of total assets in Germany to nearly 4 percent in
the United Kingdom. Similarly, European foreign banks operating in
France and Germany appear to focus more on traditional banking (loans,
retail deposits) than European banks in Spain, the United Kingdom, and
the United States. These results suggest that banks from the same country
alter their business focus across the foreign markets in which they operate.
Table A-10. Commercial Banks in France, 1991–97
Foreign banks
Domestic United All
Indicator banks Total States Japanese European other
Number of banks 198 67 10 2 41 14
Number of observations 982 352 43 9 212 88
Total assets (billions of 1982 U.S. dollars) 5.37 1.01# 1.39# 0.16# 1.24# 0.35#
As a percentage of total assets
Gross loans 51.11 41.38# 24.81# 18.17# 46.12# 40.44#
Net loans 51.04 41.19# 24.79# 18.17# 46.00# 39.97#
Securities 42.09 53.15* 65.19* 76.18* 48.69* 55.64*
Equity securities 1.91 1.08# 2.16 0.03# 1.17# 0.43#
Cash 0.60 0.49 0.09# 0.00# 0.32# 1.15#
Fixed assets 0.98 1.32* 1.07 0.87 1.41* 1.27
Other assets 5.31 3.85# 8.86 4.77 3.58# 1.97#
Total deposits 76.34 78.01 63.33# 57.65## 82.09* 77.43
Demand deposits 16.53 10.09# 3.07# 0.00# 12.23# 9.38#
Time deposits 6.84 2.14# 0.07# 0.00# 2.78# 1.82#
Savings deposits 26.08 25.54 20.72 0.13# 29.68* 20.51#

Other deposits 26.89 40.25* 39.48* 57.52* 37.41* 45.72*
Other debt 13.82 10.95# 16.89 18.89 10.01# 9.47#
Loan loss reserves 0.12 0.50* 0.04# 0.00# 0.24 1.41*
Equity capital 9.68 10.54 19.72* 23.46** 7.66# 11.69*
Net interest income 3.03 2.75## 3.27 1.69## 2.23# 3.86*
Net commission income 1.38 0.71# 1.33 0.94 0.74# 0.31#
Operating profits before provisions 1.38 0.94# 2.06** 0.57## 0.43# 1.68
Loan loss provisions 1.08 1.52** 0.27# –0.00# 1.75** 1.75**
Operating profits 0.30 –0.58# 1.78* 0.57 –1.32# –0.07
Salary expense 1.82 1.58# 1.25# 1.07# 1.76 1.59#
Return on assetsa 0.22 –0.03# 1.27* 0.06 –0.38# 0.18
Return on equity (percent)a –3.47 –5.64 7.67* 1.56** –11.85# 2.08*
Source: Fitch-IBCA’s Bankscope database, February 1999.
* Significantly higher values for foreign banks than domestic banks at the 5 percent level.
** Significantly higher values for foreign banks than domestic banks at the 10 percent level.
# Significantly lower values for foreign banks than domestic banks at the 5 percent level.
## Significantly lower values for foreign banks than domestic banks at the 10 percent level.
a. The numerator for return on assets and return on equity is after-tax net income, which equals operating profits plus net special income minus taxes.
Table A-11. Commercial Banks in Germany, 1991–97
Foreign banks
Domestic United All
Number of banks 116 84 14 19 30 21
Total assets (billions of 1982 U.S. dollars) 4.84 1.52## 3.53 0.73# 1.84## 0.46#
Gross loans 52.50 31.32# 29.63# 17.44# 42.45# 26.80#
Securities 43.86 64.90* 61.92* 81.08* 53.65* 70.21*
Equity securities 1.24 0.44# 0.38# 0.88 0.32# 0.25#
Cash 1.82 1.34# 0.58# 0.22# 2.16 1.53
Fixed assets 0.92 0.69# 0.63 0.42# 0.67# 1.04
Other assets 0.90 1.76* 7.24* 0.84 1.07 0.43#
Total deposits 80.58 79.76 78.35 65.09# 85.98* 84.88*
Demand deposits 10.31 8.37# 9.35 2.24# 12.45 6.80#
Time deposits 10.37 1.49# 0.79# 0.00# 2.55# 1.57#
Savings deposits 23.41 15.98# 19.38 7.64# 18.94# 17.20#
Other deposits 36.49 53.92* 48.82* 55.20* 52.04* 59.30*

Other debt 3.55 1.07# 0.76# 1.09# 1.24# 0.94#
Equity capital 11.81 15.12* 9.83 31.88* 8.42# 13.00
Net interest income 2.58 2.10# 2.14 2.22 2.05# 2.02#
Net commission income 0.66 1.32* 1.26 1.68* 1.36* 0.89*
Operating profits before provisions 0.77 0.76 0.63 0.88 0.59 1.05
Loan loss provisions 0.46 0.30## 0.46 –0.09# 0.48 0.28
Operating profits 0.31 0.46 0.17 0.96* 0.11 0.77*
Salary expense 1.41 1.71* 1.96 1.63 1.95* 1.20#
Return on assetsa 0.20 0.17 0.08# 0.32** 0.07# 0.27
Return on equity (percent)a 1.91 1.17# 1.01# 1.12# 0.82# 1.98

Table A-12. Commercial Banks in Spain, 1991–97
Foreign banks
Domestic United
Indicator banks Total a States European
Number of banks 66 18 3 14
Total assets (billions of 1982
U.S. dollars) 4.13 1.28# 1.30# 0.96#
Gross loans 40.39 50.69* 57.16* 50.45
Net loans 39.99 50.44* 57.01* 50.18*
Securities 50.76 42.49# 32.67# 43.32#
Equity securities 2.85 0.68# 1.25# 0.55#
Cash 3.56 2.24# 1.40# 2.32#
Fixed assets 2.74 2.25# 2.79 2.14#
Other assets 2.95 2.58 6.13* 2.04#
Total deposits 76.24 88.09* 83.17* 88.75*
Demand deposits 8.66 8.34 4.35 9.19
Time deposits 15.41 15.06 4.69# 16.40
Savings deposits 2.13 0.43# 0.09# 0.49#
Other deposits 50.04 64.27* 74.04* 62.67*
Other debt 4.33 3.62## 6.86** 3.05#
Loan loss reserves 0.40 0.25# 0.15# 0.27
Equity capital 18.06 7.42# 8.67# 7.40#
Net interest income 3.81 2.67# 2.26# 2.77#
Net commission income 0.83 0.83 1.19 0.76
Operating profits before
provisions 1.90 0.78# 0.46# 0.82#
Loan loss provisions 0.42 0.34 0.25 0.34
Operating profits 1.48 0.44# 0.21# 0.48#
Salary expense 1.63 1.70 1.89 1.66
Return on assetsb 1.14 0.37# 0.28 0.37#
Return on equity (percent)b 8.65 2.24# –9.96# 2.15#
a. Includes the U.S. and European banks from the last two columns of the table plus one Arab bank.
b. The numerator for return on assets and return on equity is after-tax net income, which equals operating profits plus net spe-
cial income minus taxes.
Table A-13. Commercial Banks in the United Kingdom, 1991–97
Foreign banks
Domestic United All
Number of banks 34 36 6 7 4 19
Total assets (billions of 1982
U.S. dollars) 8.21 3.12# 12.73 1.50# 0.20# 0.90#
Gross loans 44.15 27.47# 30.57# 9.90# 28.61# 30.29#
Net loans 42.81 26.51# 30.12# 9.75# 27.39# 29.07#
Securities 53.18 61.84* 51.16 66.52* 61.07* 64.21*
Equity securities 0.99 1.89 3.83 3.28 4.01 0.17#
Cash 2.56 2.54 1.99 1.09 1.66 3.37
Fixed assets 0.82 0.85 0.51## 0.22# 0.81 1.12
Other assets 3.29 8.27* 16.21* 22.42* 9.07* 2.23#
Total deposits 79.37 66.98# 54.77# 45.16# 71.29## 74.21#
Demand deposits 22.73 6.44# 2.19# 1.70# 7.04# 8.63#

Other deposits 24.81 37.09* 47.06* 39.97* 30.38 35.93*
Other debt 11.46 22.52* 44.32* 63.67* 16.37 8.52#
Loan loss reserves 0.22 0.02 0.00 0.00 0.00 0.03
Equity capital 12.47 15.57* 7.58# 9.05# 14.82 19.80*
Net interest income 2.26 1.33# 0.82# 0.54# 1.33# 1.66#
Net commission income 0.80 0.41# 0.84 0.02# 0.56## 0.33#
Operating profits before provisions 1.00 0.59# 0.73 0.08# 0.75 0.61#
Loan loss provisions 0.44 0.14# 0.01# 0.01# 0.14# 0.20##
Operating profits 1.39 0.71# 0.80# –0.23# 0.99 0.82#
Salary expense 0.82 0.87 0.78 0.24# 1.46 0.82
Return on assetsa 1.09 0.56# 0.60# –0.16# 0.68## 0.67#
Return on equity (percent)a 12.83 5.32# 10.17 –1.32# 5.39# 5.41#
Table A-14. Large Commercial Banks in the United States, 1993–98a

Foreign banks
Domestic All
Indicator banks Total Japanese European other
Number of banks 1,940 43 14 9 20
Number of observations 11,640 258 84 54 120
Total assets
(billions of 1982
U.S. dollars) 0.79 2.77* 2.54* 7.66* 0.73
As a percentage
of total assets
Gross loans 58.66 56.35# 56.83 50.48# 58.64
Net loans 57.74 55.20# 55.41 49.46# 57.64
Securities 27.27 26.20 24.08# 29.97 25.98
Equity securities 0.16 0.15 0.14 0.30 0.09#
Cash 4.83 9.09* 13.02* 9.75* 6.05*
Fixed assets 1.69 1.54 0.53# 0.81# 2.59*
Other assets 7.40 6.68 5.40## 8.69 6.66
Total deposits 83.49 74.20# 57.57# 74.51# 85.70*
Demand deposits
(domestic only) 24.62 19.82# 13.71# 17.06# 25.34
Time and savings
deposits 52.89 36.66# 20.48# 37.81# 47.47#
Other deposits 5.97 17.72* 23.38* 19.64* 12.89*
Other debt 6.29 14.20* 26.06* 17.07* 4.61#
Loan loss reserves 0.92 1.14* 1.42* 1.02 1.00*
Equity capital 9.29 10.46* 14.94* 7.40# 8.69#
Net interest income 4.07 3.14# 2.44# 2.90# 3.73#
Other fee income 0.34 0.34 0.34 0.31 0.36
Operating profits
before provisions 2.00 1.56# 1.72# 1.54# 1.45#
Loan loss provisions 0.24 0.33** 0.21 0.22 0.45*
Operating profits 1.76 1.23# 1.51## 1.32# 1.00#
Salary expense 1.54 1.43# 1.22# 1.19# 1.68*
Return on assetsb 1.23 0.79# 0.90# 0.93# 0.64#
Return on equity (percent)b 13.57 8.86# 6.33# 13.01 8.77#
Source: U.S. Call Reports and National Information Center.
a. Large is defined as more than $100 million in gross assets (real 1998 U.S. dollars) in each of the six years.
b. The numerator for return on assets and return on equity is after-tax net income, which equals operating profits plus net spe-
cial income minus taxes.
Comments and
Discussion
Comment by Raghuram G. Rajan: This is an exhaustive and exhaust-

ing book masquerading as a paper. It presents everything you ever wanted
to know about banking, but did not dare to ask. It is a very nice read
despite its size. I am going to address some issues that the authors did not
spend much time on and then discuss their results.
Why do banks go cross-border? To some managers, it seems self-
evident: there are cost savings in mergers. You can close branches that face
each other across the street. You can share back offices. There also are ben-
efits of cross-selling, which means selling socks and stocks in the same
place—a strategy once tried by Sears. Merging also offers the benefits of
diversification and risk reduction. Finally, and this is where cross-border
may matter, there are advantages of “globalization,” a vague word that
means all things to all people. It could mean, for example, that your clients
are going abroad. It certainly is offered as a rationale for Japanese banks
going cross-border: to follow their traditional clients. Some people argue
that another reason for going cross-border is to keep abreast of the latest
trends. People argue, for example, that you have to have a foot in the
United States where a lot of innovation is occurring. Having a physical
presence is essential to obtain information about what is going on and to
transmit that information to the rest of your operations.
This is a partial list, but it includes some important reasons that practi-
tioners offer for merging. Academics, and to some extent analysts, are a lit-
tle more skeptical about some of these reasons. We have learned to be
skeptical because a large amount of our research shows that mergers typi-
cally are not done for the best motives.
126
For example, consider scale economies. The evidence is that scale

economies tend to be exhausted pretty soon. By the time you reach a bank
of $10 billion, there are very few economies left to exploit. Since many
of these cross-border mergers involve giants that are already much bigger
than $10 billion in assets, it is not clear what scale economies are being
achieved.
Information technology could also reduce, rather than enhance, mini-
mum optimal scale. For example, think about phone banking. People say
that you need hardware and software to implement a phone banking sys-
tem and that it will cost a packet. But in practice small banks estimate
that these costs are on the order of $50,000 to $100,000 for an off-the-shelf
system. You certainly do not need a $100 billion bank to implement a
phone banking system. Also the alliances and networks that banks can
belong to obviate the need for a branch banking system. For example, I can
withdraw money from my Citibank account at an automated teller machine
(ATM) in Heathrow airport in London, but I can also withdraw it from
my account in tiny Hyde Park Bank using the same ATM. So the alliances
tend to equalize the playing field, and again scale economies do not matter
then.
Also, there are some diseconomies of merging really big banks. In
Japan, for example, Dai-Ichi Kangyo took more than twenty years to
merge the operations of the different parts of the bank. And in some big
bank mergers the information systems in each bank cannot talk to one
another. In fact, the systems sometimes run in parallel rather than being
merged because the costs of merging them are enormous. So there might
be some diseconomies of scale also.
Perhaps most important are issues of management. Even when you have
a merger in the United States across fields, a whole set of new conflicts
arises between traders and investment bankers, between investment
bankers and commercial bankers, and so on. A cross-border merger intro-
duces cultural differences, creating yet another reason for conflict.
There is this myth that, after a merger, employees will live together hap-
pily, will cooperate, and will sell services together, when in fact a lot of
conflict arises.
In addition to the conflict, you also have the issue of inter-firm equity.
The investment bankers in Germany do not like the investment bankers in
England being paid much more than they are, even if they come from
different labor markets. So there is a lot of heartbreak. If you try to force

the investment bankers in England to work for less pay, you are operating
a human capital–intensive firm, and human capital can leave at any time.
That is precisely what Deutsche Bank has been facing. It bought a lot of
banks at extremely high costs and lost a lot of people very soon after.
There also are operational risks. The Japanese banks discovered this at
extremely high cost. Some trader sitting in New York made unsupervised
bets using the bank’s capital and nearly sank the bank. It is also not clear
that cross-border mergers increase diversification nor that more diversifi-
cation necessarily reduces bank risk.
And finally, in all of these mergers, there is never a well-articulated plan
as to where the cost savings are going to come from and what kinds of
benefits clients will get. Why do your clients care that you can serve them
in Japan as well as the United States? Is it because of frictions in pay-
ment systems? How long is that advantage going to last? Synergies are
always more apparent before a merger than after.
In this paper, the authors point out that one of the unstated reasons for
cross-border acquisitions is, for example, overconfidence. Because you
think you can do things better than anybody else, you go out and buy firms.
There is certainly some evidence for managerial hubris in the United States.
Banks find new ways to lose money every ten years. It might well be
that cross-border mergers are the new way. Bank managers need a seat
when the music stops. The one way to ensure that management has a place
is for it to do the acquiring before it gets acquired by somebody else. So
are mergers a way for banks to get rid of their excess capital? I do not
know the answer.
Now consider this paper. The paper presents evidence suggesting that
foreign-owned banks are less efficient than domestic banks, which sug-
gests either that the efficiencies have been mismeasured or that banks have
been merging for all of the wrong reasons.
The authors do two things. First, they break up the banks in particular
countries based on the owner’s country of origin. This is a nice way of
carving up the data. Second, they look within the United States and try to
see these effects across states. If they can see these cross-state effects in
the United States, perhaps we can learn more about the cross-border
effects.
Let me talk about the results in the United States. The authors do not see
any systematic effect of distance in the United States. They see some
effects going this way, and some effects going that way. But the fact that
you are on one side of the country and you own a bank on the other side
of the country does not have much effect on the operations of the bank on
the other side of the country. This does not necessarily mean that you can
run a bank efficiently sitting on the opposite side of the country, but it
may mean that the way in which you selected the bank to buy compensates
for whatever lack of efficiency you may have. Conversely, it might be that
the acquired bank has competent management who can work indepen-
dently, which is why you bought it in the first place.
In short, the systematic underperformance of foreign-owned banks in
another country does not have a cross-state counterpart in the United
States. Physical distance does not seem to matter a lot. This implies that
currency and language differences may well be key. Another possibility
is that the underperformance we find internationally is mismeasurement.
Also, unlike previous papers, this study does not simply find that all
foreign-owned banks are less efficient than domestic banks. It offers a
more nuanced view. Some foreign-owned banks are more efficient. So
U.S. banks are generally more efficient in other countries than domestic
banks. Japanese banks are particularly inefficient in other countries. It may
well be that U.S. banks have been more efficient since they cleaned up
their act in the late 1980s and that Japanese banks have been doing the
wrong thing at the wrong time. They have been buying at the peak in the
United States and getting out in the trough, and this might account for the
fact that they have been less efficient.
I would like to see more on this subject. For example, the Spanish
domestic banks are less efficient than foreign banks in Spain. So perhaps if
we had more data, we could look at Spanish banks in other countries and
ask if they underperform in other countries also. This approach is consis-
tent with the U.S. evidence; for example, U.S. domestic banks typically are
more efficient than foreign banks in the United States, but it would be
nice to see if this holds for other countries.
Even with the caveats, this study finds that foreign-owned banks under-
perform in a country. Before concluding that cross-border mergers are a
mistake, we should recognize the limitations of the analysis. For example,
the nature of banking business may be different for banks from different
countries. Perhaps U.S. banks take more risks than other banks in part
because they have learned to manage these risks. When we look at profit
efficiency, are we capturing the greater risks that banks might be taking?
Another problem is that of transfer pricing. Let me give an example.

Suppose that a Japanese firm interacts with a Japanese bank in Japan, and
as a favor to that Japanese firm it provides a service at low cost in the
United States. The service is provided in the United States, and the prof-
its are recognized in Japan. And the U.S. operations look really inefficient,
because profits show up in the home country. Neither of these issues is
important cross-state, which again highlights the importance of under-
standing that finding.
One way of substantiating the conclusion that cross-border mergers
are generally inefficient is to examine the effect of a change in nationality
of ownership on the operational efficiency of a bank. While such a fixed-
effects regression would not fully address the issues of greater risk and
transfer pricing, it would at least address some issues of selection.
The bottom line is that the virtues of cross-border mergers still are not
obvious, a conclusion with which I heartily agree.
Comment by Robert McCormack: Most of my response is going to be

taken from the slant of commercial and wholesale banking and invest-
ment banking, because that is where I lived for so long. The paper has
some important strengths. First of all, it is a great compendium of the lit-
erature. Just the bibliography alone would be valuable to anyone who
wants to understand the trends affecting efficiency in business. Second,
by and large, the paper confirms that efficiencies are important in mergers,
but the data in the end do not really confirm the home field advantage.
The paper is very interesting to read, but I would like to offer a few com-
ments from a practitioner’s point of view.
First, you cannot tell much about a global business by looking at local
banks. I was surprised by the example of Spain that was used in the paper.
I used to have a manager in Spain who took great pride in pointing out how
well his business did against the Spanish banks in Spain. And, in fact, the
corporate bank in Spain always was the number one bank in terms of
returns, profitability, and everything you could possibly measure with
regard to efficiencies. The problem was that we had a horrible business in
Spain. We did not have a large enough customer base, and after adding in
the cost of serving Spanish customers all around the world, we did not
make much money in Spain.
One of the reasons that we did not make much money was essentially
that our cost base in Spain was too high relative to the business that we
would get out of it; we could not compete with the Spanish banks. The
Spanish banks were telling us that they would give away the business in
Spain to keep their customers. They had a tremendous home field advan-
tage in that sense, and we did not have much to offer. It was very difficult
to make money in Spain. From a business point of view, it is interesting
that the articles reviewed said that Citibank was great, but this fact had no
actual impact on the way we ran our business.
In contrast, in Japan, Citibank makes no money at all in local corpo-
rate banking, yet we have one of the most successful global businesses
with regard to Japanese corporations. Japanese corporations are a big piece
of our corporate income. We do business with them all over the world
because we are the only bank that is active globally as well as in Japan.
This means that corporations can receive service from their home. So we
do not make much money in Japan, but we do make money all over the
world. So judging that bank through the dimension of the local numbers
is quite difficult and, I think, a stretch.
Another example is the cards business in Europe Citibank. All of that
business is managed out of South Dakota. When you put your card in one
of the machines in London, it is picked up in South Dakota, and it is run
there. The advantages of doing that globally are tremendous for the bank,
so the geographic dimension does not measure global businesses, and it
is very hard to draw conclusions from it.
Regarding efficiencies in mergers, I would be very surprised if the evi-
dence showed that there were not some efficiencies in mergers. I also
would be really surprised if some chief executive officer went to his board
of directors and said, “We are going to merge with Alpha Bank over there.
And, by the way, we are going to spend more money.” It just is not going
to happen.
In almost any merger, you are going to get some assistance when you
combine head offices. At this stage of the game and in this day and age,
getting the efficiencies is just part of the game. It is like making your num-
bers. It is something that you have to do, but it is not why these mergers are
happening. And I would disagree with the paper’s conclusion that it is a
driving force.
I think that the driving force in the banking business is fundamentally—
and we use this term in Citibank—that corporate banking, meaning com-
mercial and investment banking together, is a tricky business. The math
problem is very simple. In order to attract capital in today’s world capital
markets, you have to build 10 to 12 percent growth into your business,

and you have to make somewhere between 15 and 20 percent return on
equity. If you do not do that over time, you are going to have a problem.
This is very difficult to do in a world that is growing on a real basis of
about 3 percent. You try to run the numbers and figure out how you are
going to do it. You have got to get the business someplace. You have to do
something different. And that is the math problem that not only banks but
all businesses face, especially on a global scale.
The industry has excess capacity. There is huge excess capacity in the
banking business brought on by history of the way that banks are created,
by all of the geographic barriers that are put on banks, and by a lot of rea-
sons. There are basically too many bankers, and there is too much capital
in the industry. Getting the kind of returns that you need in order to sat-
isfy your owners and shareholders is very, very difficult in an industry with
too much capacity.
The real field of study here is determining the cause of this excess
capacity in the banking business and how it is going to play out in the
future. The first issue is the size of the excess capacity. No bank has pric-
ing power. It is almost impossible for a bank through price actions to gen-
erate anything on the top line. Because immediately the competitors come
in and kill you. And that is true across almost every product in the busi-
ness. There is no pricing power in the business. There is a lot of crazy com-
petition, which is a sure indication that the business has excess capacity.
When you think about it, charging fees for automated teller machines is
nuts. It really is. It is antithetical to the .com world, where essentially what
you want to do is attract customers. And you do not attract customers by
charging them for something that they obviously do not believe is worth
the money.
Mergers essentially are a reaction to this excess capacity of the busi-
ness, which happens in every industry that has excess capital. People are
looking for what I would call some sort of strategic accretion.
The mergers need to create some differentiating factor that will allow
them to put up barriers to competition strategically, merging cross-border
itself and finding businesses that are complementary. There was almost
no overlap of businesses in the Citicorp-Travelers merger. And the major
reason for that merger was to create complementarity, not efficiencies. The
same was true of bankers in Deutsche Bank, who also were looking for
strategic mergers rather than just efficiencies.
What are some of the causes of this excess capacity of the industry?
First and foremost is the technology itself. When I joined the bank,
decisionmaking was done by telex and maybe by phone, but the phone was
very expensive. Today, it is done on the Internet, and it is done in groups
on the Internet; it is done instantaneously, and it is done asynchronously,
and it is done asymptotically. You do not have to be in the same place,
and you do not have to do it at the same time, but you can get it done
almost instantaneously, if you have to.
The speed of the technology in a business that is fundamentally nothing
more than an information arbitrage is creating the excess capacity of the
industry. Most of the industry basically was involved in dealing with the
information arbitrage. In banking the arbitrage concerns what is in the
marketplace against what the customer’s needs are and what the cus-
tomer’s needs are as a group against what is in the marketplace.
If the information becomes ubiquitous and free, there is no more value
for the people who are using it to break the arbitrage. In the foreign
exchange business, which is the heart and soul of Citibank’s business glob-
ally, we used to know what was going on in the market, and the customer
maybe knew what was going on in the market, and we could always make
a spread between the two.
Now the customer knows absolutely as much as, if not more than, what
the trader knows, and he can see the market by just turning on his com-
puter. There is no spread in the effects business. The only way that you can
make money in the effects business is to front run your customers or to
position and gamble in the business.
What happens to all of those folks who were in the effects business
and are no longer there? If you look at foreign exchange as a business
alone, the number of competitors and the number of true players in the for-
eign exchange business have shrunk dramatically over the past fifteen
years simply because the arbitrage is no longer there.
Every single business that the banks do is suffering from the same phe-
nomenon, and this is creating the excess capacity. The second thing that
has created the excess capacity are the turf issues that have all gone away
or are about to go away. Certainly, doing away with Glass-Stegall broke
down some more turf barriers. It was probably long after the horse was out
of the barn, but certainly the turf issues are all gone. Couple that with the
technology, and it does not matter where you are anymore. You can deliver
services just about anywhere.
Finally, efficiencies are going to become even less important in the

future, while strategic interests are going to become much more important.
For example, NationsBank, before it became Bank of America, paid, I
believe, more than four times book value for Barnett Bank in Florida. Even
assuming some good efficiency numbers, it is impossible to believe that
more than four times book value makes sense in the world of 15 to 20 per-
cent return on equity. It only makes sense if you say to yourself, “There
is only one Barnett Bank in Florida, and there are only 1.5 million cus-
tomers, or whatever the actual number of customers, and if I do not buy
it, I do not have Florida. And if I do not have Florida, I have lost my strate-
gic position.” So the price does not matter because it is driven much more
by the strategy of the business than by efficiencies.
I believe that the banking business is subject to Moore’s Law. It is no
longer more or less a steady-state operation; rather, we are looking at
doubling capacity and cost in a relatively short period of time, and the
modes of doing the arbitrage that we take as our bread and butter are
changing very, very rapidly.
So speed—being the first to market—and investment up-front in the
technology are going to determine the success of banks. What is going to
drive the mergers is whether or not they can get those kinds of advantages.
General Discussion: Charles Calomiris suggested that some of the

authors’ findings were surprising, if not counterintuitive. The study
showed that French banks operating in Spain are more efficient than Span-
ish banks. The study also showed that Dutch banks operating in France and
Germany are less efficient than domestic French and German banks, but
Dutch banks operating in the United States are not very different from
domestic U.S. banks. Calomiris speculated that a reason for these oddi-
ties is that the authors were making “apples to oranges” comparisons when
contrasting bank performance in different countries. An alternative com-
parison would match, for example, Fleet Bank (a major U.S. bank) that has
no foreign operations with ABN Amro (a Dutch bank) operating in the
United States. Edward Ettin added that, when making global comparisons,
one should be cautious not to compare banks that have large wholesale
banking operations with banks that concentrate on retail operations.
Berger and DeYoung both acknowledged the need for matched sam-
pling in future research, although they noted that assembling the data
would require a tremendous effort if it were conducted on a systematic
international basis. DeYoung added that although their study did not eval-
uate the organizational performance of banks on a worldwide basis due to
limitations of the data, the study did address at least one organizational
issue by examining the relative performance of U.S. banks operating in
different regions.
A difference of views was expressed during the discussion on whether
European banks had less or more incentive to engage in consolidations
than their U.S. counterparts. Those arguing that they had fewer incentives
pointed to the fact that European banks no longer need to be physically
located in other European countries to operate and retain profit. Those tak-
ing the opposite position asserted that European banks could reduce their
overall risks by diversifying into other countries. On this view, it was sug-
gested that the authors in their future work use the consolidated results of
banks rather than their profitability only in specific locations.
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Globalization of Financial Institutions: Evidence from Cross-Border

Brookings-Wharton Papers on Financial Services, 2000, pp. 23-120 (Article)

Published by Brookings Institution Press

For additional information about this article

Accessed 8 May 2014 12:41 GMT GMT

M ERGERS AND ACQUISITIONS among very large financial institu-

24 Brookings-Wharton Papers on Financial Services: 2000

1. Berger, Demsetz, and Strahan (1999).

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 25

of within-nation and cross-border M&As. The literature review and

26 Brookings-Wharton Papers on Financial Services: 2000

country-specific market features, bias against foreign institutions, or other

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 27

of the global advantage hypothesis is an important key to unlocking the

Overview of the Paper

First we present some background information, including trends in

28 Brookings-Wharton Papers on Financial Services: 2000

domestic banks suggests that efficiency considerations may limit the

Some Background on Cross-Border Financial

This section provides a backdrop for our investigation of the cross-

Trends in the Cross-Border Provision of Financial Services

2. World Bank (1999).

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 29

The recent increase in international commerce has created a demand for

30 Brookings-Wharton Papers on Financial Services: 2000

Regulatory Changes That Have Fostered Consolidation

4. Benink (1993); Molyneux, Altunbas, and Gardener (1996).

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 31

In the United States, a series of less well-coordinated deregulatory

Trends in Cross-Border M&As of Financial Institutions

32 Brookings-Wharton Papers on Financial Services: 2000

M&As. In figure 1, domestic M&As are combinations of two institutions

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 33

$1998 millions, two-year moving averages

Domestic M&As (left)

$100,000 Expansion M&As a (right) $20,000

Entry M&As b (right)

1986 1988 1990 1992 1994 1996 1998

Source: Securities Data Company.

Cross-Border Consolidation: Efficiency Factors

Different economic agents have different motives for making consoli-

Figure 2. Value of Mergers and Acquisitions in the European Union, 1986–98

$1998 millions, two-year moving averages

1986 1988 1990 1992 1994 1996 1998

34 Brookings-Wharton Papers on Financial Services: 2000

managers may have personal motives for engaging in cross-border con-

Scale, Scope, and Product Mix Efficiency

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 35

36 Brookings-Wharton Papers on Financial Services: 2000

methods for delivering customer services, such as Internet banking, phone

11. Radecki, Wenninger, and Orlow (1997).

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 37

firms, and insurance companies—because the institutions engaging in

15. Greenbaum, Kanatas, and Venezia (1989); Rajan (1996).

38 Brookings-Wharton Papers on Financial Services: 2000

banks.19 However, these studies may not be good predictors of universal

A. N. Berger, R. DeYoung, H. Genay, and G. F. Udell 39

ices. These revenue scope economies may occur because of consumption

22. Rajan (1996).