Strategic Positioning: M&A`s New Frontier

In the nearly two decades since the banking industry was deregulated, thousands of institutions large and small have been absorbed or shuttered. The waves of consolidation that nearly halved the number of U.S. banks since the mid-1980s were driven by relentless competitive pressures and the unceasing push for improvements in efficiency and greater economies of scale.But the transformation remains far from complete. For bankers and their customers standing at the dawn of the millennium, the breakdown of barriers through technological advances and the overhaul of the nation`s financial services laws have again altered the industry`s fundamental dynamics.The bigger is better strategy is no longer, in itself, sufficient. In an ever-more tightly wired world, data mining, cross selling, and product line extension are the new bywords. One-stop shopping, industry experts say, will increasingly be the financial services norm. Bankers seeking growth already have begun to look beyond the traditional boundaries of their business toward insurance sales, asset management, and innovative marketing techniques. Strategic mergers across product lines, analysts and investment bankers say, are here to stay.Consolidation will be as robust in the next 10 years as it has been in the last 10 years, says Eric D. Hovde, president of Hovde Financial in Washington. Where in the last 10 years we have seen a massive amount of consolidation within industry groups, that is, banks buying banks and thrifts buying thrifts, we are now going tosee massive consolidation across industry linesu00e2u20acu00b9banking with insurance and, as we`ve already started to see, banks with investment services.What we are witnessing, Hovde asserts, is the creation of true financial supermarketsu00e2u20acu00b9because of deregulation and, now, because of the passage of the financial modernization bill.For more than a decade, the majority of bank mergers have been predicated largely on a pair of intertwined motivations. Banks have sought to bulk up both as an aggressive competitive posture and as a means of defense against being swallowed by faster-expanding rivals. As a corollary, they have sought operating efficiencies and economies of scale by building networks of branches, particularly after acquisitions across state lines were permitted, whose back-office functions could be effectively centralized under the buyer`s systems umbrella.Until two or three years ago, most mergers were done for cost-savings purposes, and there wasn`t much revenue enhancement built in, says Stephen Biggar, a banking analyst with Standard & Poor`s Equity Group in New York. But that has begun to change.Especially for smaller institutions, there wereu00e2u20acu00b9and still areu00e2u20acu00b9substantial opportunities to achieve operating efficiencies by merging with another institution, according to Richard Rosen, an assistant finance professor at Indiana University`s Kelley School of Business. For small banks, there is considerable evidence that there are economies of scale, especially when you think about things like ATM networks, he says.The burden of making vital investments in technology and the need to rationalize those investments points to another motivation for mergers that has gained in importance over the last decade.Banks realize that they need to substantially increase their budgets for technology, says Michael Mayes, managing director and head of the financial institutions merger and acquisition group at Advest Inc. in New York. As a small community bank, that is a very difficult thing to do, and getting together makes it easier.The technological advances that made it possible to consolidate the back-office operations of networks of branch officesu00e2u20acu00b9in effect, facilitating the consolidation of the industry as a wholeu00e2u20acu00b9have been pushed in a new direction by the rise of the Internet. Money is needed for technology investments, and that`s not going to go away, says Mike McKeon, a New York-based partner in the financial services and health practice at Booz Allen & Hamilton. What we are seeing now, in addition to the startup of the online bank, is traditional banks like First Union and Citigroup developing their online presence, he adds. We think the opportunities online for many banks are tremendous.Beyond the strategic considerations that have underlain the majority of bank mergers over the last 15 years, however, is the ego and personal ambition that have often been the cement that held deals together. Realistically, there`s a bit of an empire-building angle, observes Greyson Williams, director of bank merger and acquisition research at SNL Securities in Charlottesville, Virginia.Rosen says his research has demonstrated that the salaries of chief executives at acquiring institutions have a tendency to rise after mergers are completed. That`s a nice perk, he notes. I don`t think that higher salaries are foremost in the minds of most chief executives considering acquisitions, he says, but it certainly doesn`t hurt.Merger activity throughout the banking industry slowed sharply in 1999 for a variety of reasons, including worries about computer problems related to the millennium. Analysts say another cause underlying the slowdown was the erosion of bank stock prices, which diminished the ability of would-be purchasers to offer the premiums that many sellers had come to expect as a matter of course in the last few years. According to a review by SNL Securities, the slowdown continued in the third quarter. While the number of bank mergers announced increased by about 10% from the previous quarter, the dollar values of the purchase prices, assets sold, and deposits sold, all fell to their lowest levels in more than three years.But there are signs that the pace will soon begin to pick up. Benjamin C. Bishop Jr., president of investment bank Allen C. Ewing & Co. in Jacksonville, Florida, acknowledges that the slowdown in deal volume in Florida this year has been pretty dramatic. But Bishop says the approaching demise of pooling-of-interest accounting by the end of 2000 is almost certain to motivate many sellers who were hesitant last year.Banking institutions that have been thinking about a merger sometime in the next two or three years probably should consider accelerating their plans, and we`re seeing that many of them are, Bishop says. We`re talking to several institutions that [previously] didn`t think they would be interested in a merger for even three years. So we should see an acceleration in the first half of 2000.There`s no question that the options available to banks today are greater than they ever have been, says Richard Maroney, a principal with Austin Associates in Toledo, Ohio. However, he and others say that it is likely to be a while before smaller banks venture into the kinds of cross-industry deals now enabled by the legislation.The preeminent model for the financial service conglomerate of the future, Citigroup, was created in April 1998 with the combination of Citicorp and Travelers Group and legitimized when President Clinton signed the Gramm-Leach-Bliley Act on Nov. 12. Citigroup has been one of the strongest-performing bank stocks of the year, and the merged company`s management is praised by analysts for having moved quickly and effectively to exploit potential synergies between the giant banking, insurance, and brokerage operations it consolidated under one corporate roof.Beyond its pioneering structure, Citigroup has demonstrated leadership in management organizationu00e2u20acu00b9another area industry experts say is critical for success in the new environment. It has retained managers at every level, from the co-chairmen, John S. Reed of Citicorp and Sanford I. Weill of Travelers, on down, who have complementary expertise in the different aspects of the combined company`s far-flung business operations. Eileen Fahey of Duff & Phelps Credit Services in Chicago points to the fact that Mr. Weill and Mr. Reed have continued to operate their parts of the company and to integrate them as a significant factor in Citigroup`s success.Another major impetus for financial company consolidation is the need for new sources of revenue. With deposit growth slow or flat, alternative sources of funding are the biggest attraction for banks considering acquisitions of insurance, asset management, or other nonbanking entities.Over the last decade, growth in deposits has been diverted away from banks to mutual funds and investment managers, and, investment banker Bishop says, up until the passage of this legislation, there wasn`t much they could do about it. Now a lot of banks are going to be saying to themselves that they would like to keep part of that money that customers are moving out of deposits and into mutual funds and so on.Adds John Pottridge, president of Pottridge & Associates in Alexandria, Virginia, There is an element of competitive concern, particularly at the community bank level, when they see larger regional and money-center banks offering more services. There is a feeling that, to fend off that competition and to solidify relationships with customers, there is the need to offer a wider range of products and services.Questions about cross sales of investment, insurance, and other nondeposit products to bank customers already have moved from the realm of theory to practice. In its third-quarter earnings report, for example, Citigroup reported its cross-marketing pilot programs were gaining momentum throughout the consumer business: Through Sept. 30, consultants from its Salomon Smith Barney investment services unit had generated $420 million in Citibank mortgage products. Citigroup has also moved quickly to sell Travelers Group insurance products to credit card customers: A full range of personal lines and property/casualty products are now offered to credit card customers in 29 states through a pilot program, according to a the company. Another example is Chase Manhattan`s $1.35 billion agreement to buy Hambrecht & Quist, which was said to be partly predicated on using the huge bank`s global presence as a platform for expanding the San Francisco-based investment house`s underwriting operations.The financial community is trying to move away from finding customers to sell its products to, toward finding products to sell to its customers, from what I call a u00c5’product-centric` orientation to a u00c5’customer-centric` one, Booz Allen & Hamilton`s McKeon says. He contends that companies like Citigroup are betting they can shift from the product focus to one of customer relationship management.Unlike the scale play in the 1980s and 1990s, we`re now in a relationship play, McKeon says. Citigroup is trying to sell insurance, loans, deposits, investment services, and asset management services, and the only way that`s going to work is if it really does convince its customer base that a comprehensive set of services from one provider, given the service level that provider offers, is competitive.The goal, simply put, is revenue enhancement. In the last couple of years, there has been increasing emphasis on the top lineu00e2u20acu00b9expanding product offerings and enhancing revenues, says James C. Van Horne, Giannini Professor of Finance at Stanford University. There is some evidence in the Citigroup deal that that is happening, although more slowly than expected.The strategic issue now becomes, according to Jay Tejera, who follows large-capitalization banks for Ragen McKenzie in Seattle, is how banks can most effectively bundle the broadest array of financial services products for sale to their banking customers.The debate over how much to manufacture and how much to simply purchase and distribute is still going on, Tejera says. But either way, he adds, pretty soon everybody will have 100% of the content. There is clear evidence that cross sales can work. Tejera notes that before its merger with Wells Fargo, Norwest had developed one of the most effective cross sales programs in the banking industry. Its penetration ratios are as high as 10% in places like South Dakota, Minnesota, and Iowa, where the market for traditional banking services was at or past maturity.It`s a legitimate question whether an affluent customer who now does business with 13 [financial services] vendors will want to do business with just one, he says. However, Tejera continues, The answer in those markets was that customers would rather do business with a single vendor, as long as the product offerings are satisfactory.Of course, not everyone is convinced. Some of the hype on cross selling is just thatu00e2u20acu00b9hypeu00e2u20acu00b9and the benefits may not materialize, Van Horne warns. Still, he expects to see cross-industry mergers accelerate in coming years.While it is likely to be some time before community banks follow the industry`s giants toward converting themselves into financial supermarkets, some already have identified expansion across product lines as the most viable road to growth.We decided a while back that we wanted to create something of significance, says Raymond P. Davis, chief executive of the $360 million South Umpqua Bank in Roseburg, Oregon, and its parent, Umpqua Holdings. With the blurring of lines between all aspects of the financial industry, we realized that we couldn`t expand our business only horizontally. We knew we had to build it vertically as well. This conclusion was particularly poignant in light of a failed takeover attempt of an in-market competitor in 1998.Not only did Davis employ such innovative marketing techniques as putting coffee shops in South Umpqua branches, but the board moved forward last year with the acquisition of Portland retail brokerage firm Strand, Atkinson, Williams & York. Nor is the Strand, Atkinson deal the last Davis expects to make. He says the company is currently considering, among other things, expanding its existing insurance sales through a breakthrough technology and is investigating the leasing business.We`re not a big bank, but our attitude is that scale is relative, and there is no reason that we should not be able to generate the same type of holding-company products and services [as bigger banks], albeit at a smaller level, Davis explains. There is a long list of the types of organizations that might make sense for a bank [to buy if it was] looking to perpetuate itself in this type of market.Despite seemingly unbridled enthusiasm for cross-industry mergers, analysts and academicians say long-term returns to shareholders of acquiring institutions are far from certain. So far, market reaction to banking mergers, apart from the Citigroup deal, has been wary. Even the response to many large bank-to-bank mergers has been lukewarm. The reason: a factor known as integration riskA study by Keefe, Bruyette & Woods of the 15 largest banking acquisitions in 1997 and 1998 suggested that only two of the acquiring companies would meet per-share earnings goals for 1999. Keefe Bruyette analysts Thomas F. Theirkauf and Derek J. Statkevicus concluded that acquiring banks` stocks had underperformed the average bank in fully eight of the 10 largest deals announced over the past two years. This is a sobering statistic for bank directors who find themselves on the hot seat when shareholders hold them accountable for their merger strategies. It can also translate into downward spiraling stock prices when news that projected earnings wont`t be met.So what can bank directors count on? According to David Berry, director of research at Keefe, Bruyette, it is impossible to generalize about what makes bank mergers pay off in terms of per-share earnings growth. If a regional company like North Fork Bancorp on Long Island, New York, for example, acquires a bank and consolidates it into its branch network, the transition is essentially made by changing the signs over the weekend with very little integration risk. On a much grander scale, when Chase Manhattan absorbed Chemical Banking more than three years ago, the transition involved an enormously complex, carefully planned three-year integration process.Where you`ve seen people get into trouble, Berry says, is with some large regional bank mergers, where they have tried to move through [the integration] in too big a hurry. This is a more complex process than a simple local branch acquisition.Bank boards should avoid falling into a trap in which overly optimistic earnings projections are used as justification for payment of acquisition premiums. In many cases, pressures to meet those projections in turn lead to business decisions that are not good for the bank. Aggressive cost reductions, for instance, might be offset by the loss of customers unhappy with declining service.Claire M. Percarpio, a banking analyst with Janney Montgomery Scott in Philadelphia, agrees with the wait-and-see attitude of many on Wall Street. As far as the cross sell is concerned, this industry hasn`t been particularly successful at it, she says. I think there will be some mergers tried on that basis, of course. Citigroup is the biggest example, and it will be watched for its success. But I don`t know if there will be more such deals or how quickly they`ll come about.Over the last 18 months, Rick Childs, a corporate finance executive with Crowe Chizek & Co. in Indianapolis, has watched as a growing number of the big accounting firm`s community bank clients followed the lead of bigger banks around the country. In some cases they`ve purchased insurance agencies and investment management practices and even explored relationships with Internet service providers with the aim of expanding product offerings and customer rosters.With a data-processing partner or a standalone Internet product offering, any bank of any size can have some sort of e-commerce platform and can look at offering other products, Childs says. The three most common products are mortgages, insurance, and brokerage or money management.But Childs notes that there are aspects of the trend toward financial convergence that raise questions in his mind. The interesting thing is that all three of these industriesu00e2u20acu00b9banking, insurance and investments and brokerageu00e2u20acu00b9tend to be rather mature businesses, he says. So you have to wonder how much additional growth they`re going to be able to eke out of those kinds of relationships.Another concern is what will happen when the current cycle of economic expansion, which will soon become the longest in the nation`s history, comes to an end. A recession could quickly expose conceptual flaws in mergers that, up until then, were untested by adverse conditions. It`s hard to tell what is going to happen in the next major downturn, Rosen says. If these kinds of mergers help the industry to survive without the kind of problems it had in the early u00c5’90s, then we`ll say it was a good thing. Rosen and other academic theorists say there is a possibility that mergers could lead to increased concentration and higher prices. That could make things better for banks but worse for their customersu00e2u20acu00b9that is, consumers and businesses, he notes. It`s a tradeoff, and the jury`s still out on all of this.In the meantime, merger and acquisitions advisers say they caution their clients not to get carried away by all the talk of revenue enhancement, cross selling, and product extensions. I`m not trying to discourage anybody from diversification, says Charles Miller, managing director at Alex Sheshunoff & Co., an investment banking firm in Austin, Texas. But I would caution directors to evaluate every opportunity from a longer-term perspectiveu00e2u20acu00b9both retrospective and prospective. Don`t simply pursue these businesses because at the moment they are very attractive. (For more on how bank boards should evaluation merger opportunities, see sidebar page 20.)Bankers and consultants say there remains plenty of room for combinations of all types as the banking industry continues to evolve. The biggest obstacle for aggressive bankers like South Umpqua`s Davis, who laments the frustrations he has experienced in months of searching for a suitable merger partner, is compatibility. The problem? There just aren`t that many bankers that have a vision, Davis says. |BD|In the nearly two decades since the banking industry was deregulated, thousands of institutions large and small have been absorbed or shuttered. The waves of consolidation that nearly halved the number of U.S. banks since the mid-1980s were driven by relentless competitive pressures and the unceasing push for improvements in efficiency and greater economies of scale.

But the transformation remains far from complete. For bankers and their customers standing at the dawn of the millennium, the breakdown of barriers through technological advances and the overhaul of the nation`s financial services laws have again altered the industry`s fundamental dynamics.

The bigger is better strategy is no longer, in itself, sufficient. In an ever-more tightly wired world, data mining, cross selling, and product line extension are the new bywords. One-stop shopping, industry experts say, will increasingly be the financial services norm. Bankers seeking growth already have begun to look beyond the traditional boundaries of their business toward insurance sales, asset management, and innovative marketing techniques. Strategic mergers across product lines, analysts and investment bankers say, are here to stay.

Consolidation will be as robust in the next 10 years as it has been in the last 10 years, says Eric D. Hovde, president of Hovde Financial in Washington. Where in the last 10 years we have seen a massive amount of consolidation within industry groups, that is, banks buying banks and thrifts buying thrifts, we are now going to

see massive consolidation across industry linesu00c3’banking with insurance and, as we`ve already started to see, banks with investment services.

What we are witnessing, Hovde asserts, is the creation of true financial supermarketsu00c3’because of deregulation and, now, because of the passage of the financial modernization bill.

For more than a decade, the majority of bank mergers have been predicated largely on a pair of intertwined motivations. Banks have sought to bulk up both as an aggressive competitive posture and as a means of defense against being swallowed by faster-expanding rivals. As a corollary, they have sought operating efficiencies and economies of scale by building networks of branches, particularly after acquisitions across state lines were permitted, whose back-office functions could be effectively centralized under the buyer`s systems umbrella.

Until two or three years ago, most mergers were done for cost-savings purposes, and there wasn`t much revenue enhancement built in, says Stephen Biggar, a banking analyst with Standard & Poor`s Equity Group in New York. But that has begun to change.

Especially for smaller institutions, there wereu00c3’and still areu00c3’substantial opportunities to achieve operating efficiencies by merging with another institution, according to Richard Rosen, an assistant finance professor at Indiana University`s Kelley School of Business. For small banks, there is considerable evidence that there are economies of scale, especially when you think about things like ATM networks, he says.

The burden of making vital investments in technology and the need to rationalize those investments points to another motivation for mergers that has gained in importance over the last decade.

Banks realize that they need to substantially increase their budgets for technology, says Michael Mayes, managing director and head of the financial institutions merger and acquisition group at Advest Inc. in New York. As a small community bank, that is a very difficult thing to do, and getting together makes it easier.

The technological advances that made it possible to consolidate the back-office operations of networks of branch officesu00c3’in effect, facilitating the consolidation of the industry as a wholeu00c3’have been pushed in a new direction by the rise of the Internet. Money is needed for technology investments, and that`s not going to go away, says Mike McKeon, a New York-based partner in the financial services and health practice at Booz Allen & Hamilton. What we are seeing now, in addition to the startup of the online bank, is traditional banks like First Union and Citigroup developing their online presence, he adds. We think the opportunities online for many banks are tremendous.

Beyond the strategic considerations that have underlain the majority of bank mergers over the last 15 years, however, is the ego and personal ambition that have often been the cement that held deals together. Realistically, there`s a bit of an empire-building angle, observes Greyson Williams, director of bank merger

and acquisition research at SNL Securities in Charlottesville, Virginia.

Rosen says his research has demonstrated that the salaries of chief executives at acquiring institutions have a tendency to rise after mergers are completed. That`s a nice perk, he notes. I don`t think that higher salaries are foremost in the minds of most chief executives considering acquisitions, he says, but it certainly doesn`t hurt.

Merger activity throughout the banking industry slowed sharply in 1999 for a variety of reasons, including worries about computer problems related to the millennium. Analysts say another cause underlying the slowdown was the erosion of bank stock prices, which diminished the ability of would-be purchasers to offer the premiums that many sellers had come to expect as a matter of course in the last few years. According to a review by SNL Securities, the slowdown continued in the third quarter. While the number of bank mergers announced increased by about 10% from the previous quarter, the dollar values of the purchase prices, assets sold, and deposits sold, all fell to their lowest levels in more than three years.

But there are signs that the pace will soon begin to pick up. Benjamin C. Bishop Jr., president of investment bank Allen C. Ewing & Co. in Jacksonville, Florida, acknowledges that the slowdown in deal volume in Florida this year has been pretty dramatic. But Bishop says the approaching demise of pooling-of-interest accounting by the end of 2000 is almost certain to motivate many sellers who were hesitant last year.

Banking institutions that have been thinking about a merger sometime in the next two or three years probably should consider accelerating their plans, and we`re seeing that many of them are, Bishop says. We`re talking to several institutions that [previously] didn`t think they would be interested in a merger for even three years. So we should see an acceleration in the first half of 2000.

There`s no question that the options available to banks today are greater than they ever have been, says Richard Maroney, a principal with Austin Associates in Toledo, Ohio. However, he and others say that it is likely to be a while before smaller banks venture into the kinds of cross-industry deals now enabled by the legislation.

The preeminent model for the financial service conglomerate of the future, Citigroup, was created in April 1998 with the combination of Citicorp and Travelers Group and legitimized when President Clinton signed the Gramm-Leach-Bliley Act on Nov. 12. Citigroup has been one of the strongest-performing bank stocks of the year, and the merged company`s management is praised by analysts for having moved quickly and effectively to exploit potential synergies between the giant banking, insurance, and brokerage operations it consolidated under one corporate roof.

Beyond its pioneering structure, Citigroup has demonstrated leadership in management organizationu00c3’another area industry experts say is critical for success in the new environment. It has retained managers at every level, from the co-chairmen, John S. Reed of Citicorp and Sanford I. Weill of Travelers, on down, who have complementary expertise in the different aspects of the combined company`s far-flung business operations. Eileen Fahey of Duff & Phelps Credit Services in Chicago points to the fact that Mr. Weill and Mr. Reed have continued to operate their parts of the company and to integrate them as a significant factor in Citigroup`s success.

Another major impetus for financial company consolidation is the need for new sources of revenue. With deposit growth slow or flat, alternative sources of funding are the biggest attraction for banks considering acquisitions of insurance, asset management, or other nonbanking entities.

Over the last decade, growth in deposits has been diverted away from banks to mutual funds and investment managers, and, investment banker Bishop says, up until the passage of this legislation, there wasn`t much they could do about it. Now a lot of banks are going to be saying to themselves that they would like to keep part of that money that customers are moving out of deposits and into mutual funds and so on.

Adds John Pottridge, president of Pottridge & Associates in Alexandria, Virginia, There is an element of competitive concern, particularly at the community bank level, when they see larger regional and money-center banks offering more services. There is a feeling that, to fend off that competition and to solidify relationships with customers, there is the need to offer a wider range of products and services.

Questions about cross sales of investment, insurance, and other nondeposit products to bank customers already have moved from the realm of theory to practice. In its third-quarter earnings report, for example, Citigroup reported its cross-marketing pilot programs were gaining momentum throughout the consumer business: Through Sept. 30, consultants from its Salomon Smith Barney investment services unit had generated $420 million in Citibank mortgage products. Citigroup has also moved quickly to sell Travelers Group insurance products to credit card customers: A full range of personal lines and property/casualty products are now offered to credit card customers in 29 states through a pilot program, according to a the company. Another example is Chase Manhattan`s $1.35 billion agreement to buy Hambrecht & Quist, which was said to be partly predicated on using the huge bank`s global presence as a platform for expanding the San Francisco-based investment house`s underwriting operations.

The financial community is trying to move away from finding customers to sell its products to, toward finding products to sell to its customers, from what I call a u00c3″product-centric` orientation to a u00c3″customer-centric` one, Booz Allen & Hamilton`s McKeon says. He contends that companies like Citigroup are betting they can shift from the product focus to one of customer relationship management.

Unlike the scale play in the 1980s and 1990s, we`re now in a relationship play, McKeon says. Citigroup is trying to sell insurance, loans, deposits, investment services, and asset management services, and the only way that`s going to work is if it really does convince its customer base that a comprehensive set of services from one provider, given the service level that provider offers, is competitive.

The goal, simply put, is revenue enhancement. In the last couple of years, there has been increasing emphasis on the top lineu00c3’expanding product offerings and enhancing revenues, says James C. Van Horne, Giannini Professor of Finance at Stanford University. There is some evidence in the Citigroup deal that that is happening, although more slowly than expected.

The strategic issue now becomes, according to Jay Tejera, who follows large-capitalization banks for Ragen McKenzie in Seattle, is how banks can most effectively bundle the broadest array of financial services products for sale to their banking customers.

The debate over how much to manufacture and how much to simply purchase and distribute is still going on, Tejera says. But either way, he adds, pretty soon everybody will have 100% of the content.

There is clear evidence that cross sales can work. Tejera notes that before its merger with Wells Fargo, Norwest had developed one of the most effective cross sales programs in the banking industry. Its penetration ratios are as high as 10% in places like South Dakota, Minnesota, and Iowa, where the market for traditional banking services was at or past maturity.

It`s a legitimate question whether an affluent customer who now does business with 13 [financial services] vendors will want to do business with just one, he says. However, Tejera continues, The answer in those markets was that customers would rather do business with a single vendor, as long as the product offerings are satisfactory.

Of course, not everyone is convinced. Some of the hype on cross selling is just thatu00c3’hypeu00c3’and the benefits may not materialize, Van Horne warns. Still, he expects to see cross-industry mergers accelerate in coming years.

While it is likely to be some time before community banks follow the industry`s giants toward converting themselves into financial supermarkets, some already have identified expansion across product lines as the most viable road to growth.

We decided a while back that we wanted to create something of significance, says Raymond P. Davis, chief executive of the $360 million South Umpqua Bank in Roseburg, Oregon, and its parent, Umpqua Holdings. With the blurring of lines between all aspects of the financial industry, we realized that we couldn`t expand our business only horizontally. We knew we had to build it vertically as well. This conclusion was particularly poignant in light of a failed takeover attempt of an in-market competitor in 1998.

Not only did Davis employ such innovative marketing techniques as putting coffee shops in South Umpqua branches, but the board moved forward last year with the acquisition of Portland retail brokerage firm Strand, Atkinson, Williams & York. Nor is the Strand, Atkinson deal the last Davis expects to make. He says the company is currently considering, among other things, expanding its existing insurance sales through a breakthrough technology and is investigating the leasing business.

We`re not a big bank, but our attitude is that scale is relative, and there is no reason that we should not be able to generate the same type of holding-company products and services [as bigger banks], albeit at a smaller level, Davis explains. There is a long list of the types of organizations that might make sense for a bank [to buy if it was] looking to perpetuate itself in this type of market.

Despite seemingly unbridled enthusiasm for cross-industry mergers, analysts and academicians say long-term returns to shareholders of acquiring institutions are far from certain. So far, market reaction to banking mergers, apart from the Citigroup deal, has been wary. Even the response to many large bank-to-bank mergers has been lukewarm. The reason: a factor known as integration risk

A study by Keefe, Bruyette & Woods of the 15 largest banking acquisitions in 1997 and 1998 suggested that only two of the acquiring companies would meet per-share earnings goals for 1999. Keefe Bruyette analysts Thomas F. Theirkauf and Derek J. Statkevicus concluded that acquiring banks` stocks had underperformed the average bank in fully eight of the 10 largest deals announced over the past two years. This is a sobering statistic for bank directors who find themselves on the hot seat when shareholders hold them accountable for their merger strategies. It can also translate into downward spiraling stock prices when news that projected earnings wont`t be met.

So what can bank directors count on? According to David Berry, director of research at Keefe, Bruyette, it is impossible to generalize about what makes bank mergers pay off in terms of per-share earnings growth. If a regional company like North Fork Bancorp on Long Island, New York, for example, acquires a bank and consolidates it into its branch network, the transition is essentially made by changing the signs over the weekend with very little integration risk. On a much grander scale, when Chase Manhattan absorbed Chemical Banking more than three years ago, the transition involved an enormously complex, carefully planned three-year integration process.

Where you`ve seen people get into trouble, Berry says, is with some large regional bank mergers, where they have tried to move through [the integration] in too big a hurry. This is a more complex process than a simple local branch acquisition.

Bank boards should avoid falling into a trap in which overly optimistic earnings projections are used as justification for payment of acquisition premiums. In many cases, pressures to meet those projections in turn lead to business decisions that are not good for the bank. Aggressive cost reductions, for instance, might be offset by the loss of customers unhappy with declining service.

Claire M. Percarpio, a banking analyst with Janney Montgomery Scott in Philadelphia, agrees with the wait-and-see attitude of many on Wall Street. As far as the cross sell is concerned, this industry hasn`t been particularly successful at it, she says. I think there will be some mergers tried on that basis, of course. Citigroup is the biggest example, and it will be watched for its success. But I don`t know if there will be more such deals or how quickly they`ll come about.

Over the last 18 months, Rick Childs, a corporate finance executive with Crowe Chizek & Co. in Indianapolis, has watched as a growing number of the big accounting firm`s community bank clients followed the lead of bigger banks around the country. In some cases they`ve purchased insurance agencies and investment management practices and even explored relationships with Internet service providers with the aim of expanding product offerings and customer rosters.

With a data-processing partner or a standalone Internet product offering, any bank of any size can have some sort of e-commerce platform and can look at offering other products, Childs says. The three most common products are mortgages, insurance, and brokerage or money management.

But Childs notes that there are aspects of the trend toward financial convergence that raise questions in his mind. The interesting thing is that all three of these industriesu00c3’banking, insurance and investments and brokerageu00c3’tend to be rather mature businesses, he says. So you have to wonder how much additional growth they`re going to be able to eke out of those kinds of relationships.

Another concern is what will happen when the current cycle of economic expansion, which will soon become the longest in the nation`s history, comes to an end. A recession could quickly expose conceptual flaws in mergers that, up until then, were untested by adverse conditions. It`s hard to tell what is going to happen in the next major downturn, Rosen says. If these kinds of mergers help the industry to survive without the kind of problems it had in the early u00c3″90s, then we`ll say it was a good thing.

Rosen and other academic theorists say there is a possibility that mergers could lead to increased concentration and higher prices. That could make things better for banks but worse for their customersu00c3’that is, consumers and businesses, he notes. It`s a tradeoff, and the jury`s still out on all of this.

In the meantime, merger and acquisitions advisers say they caution their clients not to get carried away by all the talk of revenue enhancement, cross selling, and product extensions. I`m not trying to discourage anybody from diversification, says Charles Miller, managing director at Alex Sheshunoff & Co., an investment banking firm in Austin, Texas. But I would caution directors to evaluate every opportunity from a longer-term perspectiveu00c3’both retrospective and prospective. Don`t simply pursue these businesses because at the moment they are very attractive. (For more on how bank boards should evaluation merger opportunities, see sidebar page 20.)

Bankers and consultants say there remains plenty of room for combinations of all types as the banking industry continues to evolve. The biggest obstacle for aggressive bankers like South Umpqua`s Davis, who laments the frustrations he has experienced in months of searching for a suitable merger partner, is compatibility. The problem? There just aren`t that many bankers that have a vision, Davis says. |BD|