“Naïve investors focus on the possible return on their investment without realizing a basic tenet in finance: if there is return, there has to be risk and vice versa,” said Arun Prakash, Knight Ridder Center for Excellence in Management research professor in finance in the College of Business Administration. Prakash and Suchismita Mishra, assistant professor of finance in the College, have been looking at just what the degree of risk might be for acquiring and acquired banks.
Focusing on banks with New York Stock Exchange (NYSE) profiles—for which trade data are available—the two researchers examined information from a three-year period to measure exactly what the risk is for bank mergers and acquisitions. Their contribution is important in part because of their shift in perspective.
studies have looked mostly at the return side of the issue,” said Mishra. “We focused on the other component of the equation: risk.”
As they had expected, the impact on the acquired—or target—bank was usually positive, since such entities typically are in trouble.
“An earlier study that looked at the return side of the equation for fifty or more banks found that the return was always positive for the target bank,” Prakash said. “In forty percent of the cases, there was value reduction for the acquiring firms. More refined research that followed showed about 26 percent value reduction for the acquiring firm, thirty percent remaining the same, and the remainder benefiting.”
When Prakash, Mishra, and two collaborators looked at risk, they found similar results. In an article titled “Risk Diversification as a Motive for Bank Mergers,” published in the International Journal of Finance, they evaluated data from thirty banks before and after an acquisition. They kept their focus on banks acquired through stock versus other methods, such as leveraged buy-out using debt, as well as on banks of sufficient asset size to make the NYSE list.
“True to our expectations, there was no clear-cut indication of risk,” Prakash said.
Of course, there is a significant challenge in such a study: once a bank has been acquired, it no longer exists. Therefore, it’s difficult to assemble data on it. But, in one of those exciting research breakthroughs, the researchers devised a way to compute risk to the banks before and after an acquisition—even though the targeted bank was gone.
In the recently-published “Bank Mergers and Components of Risk: An Evaluation” in the Journal of Economics and Finance, they applied their approach for looking at both target and acquiring banks.
“In this analysis, we saw that risk actually decreased,” Mishra said. “The acquired bank improved in terms of risk, which accorded with the earlier study that had focused on return.”
The research has far-reaching practical applications.
“Often, merger and acquisition decisions are made in a ‘seat of the pants’ manner,” Prakash said. “We looked at quantifiable risk factors and showed that the merger and acquisition tactic is good for both the target and acquiring firm.”