MADELEINE JAMES, LENNY T. MENDONCA, JEFFREY PETERS AND GREGORY WILSON 

Every week brings news of another financial services acquisition in the United States. Such events act as a reminder, if one were needed, that this massive and diverse industry is undergoing unprecedented consolidation. Consider these facts: 

And so it goes for every sector of the financial services industry. 

Sweeping though the consolidation has been, this is only the beginning. In fact, enough excess capital remains in banking alone to fund up to $1 trillion in future deals. If a company's stock (or acquisition currency) is highly valued, it is often cheaper for it to acquire another company to gain access to valuable customers, a choice distribution network, and market-tested skills, rather than build these things from scratch. So the deals will keep coming. 

The pace of consolidation is accelerating. The next five years will make the past five look tame, as players jockey for position while the new industry structure locks into place. The most effective way to stake out territory in the new landscape will be by means of M&A, which puts this issue squarely at the top of the strategic agenda. Senior management should ask tough questions about where their company is going in the next five years; and seek brutally honest answers: 

In banking, for example, the removal of the remaining geographic barriers to acquisition in 1997 has set the stage for a truly national marketplace. To see what this might mean, consider California, Florida, and North Carolina, where internal barriers were dismantled a long time ago. In these states, the top three banks already control more than 50 percent of all deposits. In the developed world as a whole, that share is 58 percent. By contrast, the top three US banks command only 13 percent of the national market. 

Most of these mega-banks would be twice as big as today's largest bank, Chase Manhattan. Given the state of deregulation and the variety of banking licences and corporate structures available, these six or seven mega-banks could evolve over time into full-line financial service providers; the US equivalent of universal banks. 

As companies hunt for new products and channels in a consolidating environment, M&A activity will increasingly cut across artificially defined industry lines. Financial service firms of all types are discovering the need to provide investment management services to cater for the savings and retirement funding needs of baby boomers, for instance. Traditional banks have had to cross conventional industry borders to secure new revenue streams to meet these needs. The recent round of bank acquisitions of retail brokerage firms, such as Fleet Financial's acquisition of Quick & Reilly, were driven by the need to gain new fee income by cross-selling products. 

The same trend is also apparent in the wholesale arena. The acquisitions by NationsBank of Montgomery Securities and by Canadian Imperial Bank of Commerce (CIBC) of Oppenheimer epitomize revenue-driven acquisitions across separate but related industry lines. 

Travelers Group is a prime example of an institution built on cross-industry deals (Exhibit 3). Its recent acquisition of Salomon Brothers continues the trend, and is also likely to spark similar deals by national competitors. 

From the acquisition of Shearson in 1993 to that of BankAmerica's consumer finance division in 1997, Travelers' deals have garnered additional revenue of $16 billion (representing a compound annual growth rate of 43 percent) and created value to the tune of $31 billion (61 percent CAGR). The company shows great discipline in buying low (during down cycles or when companies are in trouble), spinning off unwanted businesses (such as Transport Holdings), and selling high (as with American Capital Management). It has proved it can cross-sell effectively across perhaps the largest distribution system in the industry, comprising Salomon Smith Barney Holdings, Commercial Credit, Primerica Financial Services, Travelers Life & Annuity, and Travelers P&C, among others. Over time, the model it embodies will become more and more powerful -- and more and more common. 

While size begets complexity and often impedes agility, the cost--benefit balance is tipping in favor of large institutions. As many financial products rapidly turn into commodity products, for instance, only the biggest players will be able to support the colossal advertising and promotion efforts -- anywhere from $100 million to $300 million a year -- that will be needed to build and support a truly national financial brand. So too with technology; on average, the top 10 banks today each lavish better than $1 billion on technology every year. 

Unlike past merger booms, this consolidation wave is less about empire building than about raising revenue, cutting costs, and locking in continuous productivity gains to boost shareholder value. 

Proof can be seen in the banking industry's cost curves (Exhibit 6). The lower a bank's efficiency ratio, the more revenue it keeps relative to its cost base, and hence the more efficient it is. Players on the wrong side of the cost curve -- the high-cost banks on the right-hand side of the exhibit -- account for much of the current overcapacity. Many of them can be expected to exit the industry, voluntarily or involuntarily. Long-term winners will strive continuously for greater efficiency, and will help take out costs via acquisition for those that cannot capture efficiency gains on their own. 

In an environment of deregulation and consolidation, managements that have demonstrated their efficiency will be more natural owners of these assets than players that have yet to get their costs under control. They understand that there is still ample scope for further cost savings to be captured as the endgame draws nearer. Management vision and productivity are thus the key success factors that will influence how -- and how quickly -- cost curves shift over time. They will also determine where individual companies are positioned on these curves. 

A sample of recent large deals shows that buyers are also superior to their targets in terms of efficiency ratio; skilled consolidators boast an advantage of almost 6 points on average (Exhibit 7). History reveals that high-cost players seldom succeed in tackling their cost problem on their own, no matter how severe it is. Even in transactions where the efficiency gap is smaller, such as First Union's purchase of Signet and Wachovia's of Central Fidelity, there are still substantial cost savings to be made. 

M&A is an attractive proposition from the earnings perspective, too. In recent large transactions, synergies from cost savings and revenue enhancements ranged from 45 to 100 percent of a seller's net income for in-market mergers. The figures for contiguous market mergers were 30 to 65 percent, and for out-of-market mergers 40 to 50 percent. When cost savings and revenue enhancements are put together, it's clear that the equation of 'one plus one equals three' is often within reach for skilled buyers. 

A natural result of consolidation and improved cost efficiency is higher competitive intensity and tighter pricing. The inefficient players at the far right of the cost curve in Exhibit 6 have to keep their prices high to turn a profit. As long as regulation protects them from competition, they provide a price umbrella for the rest of the industry. In the early days of deregulation, this price umbrella allows players with lower costs and higher productivity to earn huge profits. Soon, however, price competition takes over, and as margins get squeezed, the economics of inefficient players are destroyed, opening the door to further consolidation by productivity leaders. 

While it can be difficult to discern real pricing trends in financial services because of cross-subsidies and shifts in the yield curve and in the mix of fees and spread income, we are already seeing the results of the price squeeze. In retail products, for example, average spreads on 30-year mortgages have plunged from 250 to 129 basis points during the past ten years when compared to 10-year Treasuries -- a fall of almost 50 percent. Over the past four years, spread income on credit cards has declined by 10 percent and fees (or dollars per account) have plummeted by 60 percent in response to consolidation. 

Wholesale products tell much the same story. In mutual fund custody, for example, real pricing (fee income) has fallen by 11 percent during the past decade. Master trust and international custody have each declined by 8 percent, while basic custody has slumped by almost 19 percent. 

Our analysis suggests that a bank's independence may be in jeopardy if its efficiency ratio is currently above 55 to 60 percent -- unless that ratio is the temporary result of digesting an acquisition with higher costs. Those in the 50 to 55 percent range need to take immediate steps to improve their efficiency in order to keep pace with the expected downward shift in the cost curve. 

Ample evidence attests that this downward shift will continue. One of the industry's cost leaders, US Bancorp (formerly First Bank System), has announced a five-year efficiency improvement goal of 35 percent. If achieved, this will undoubtedly set a new industry standard. Banks will need to secure annual productivity improvements of roughly 5 percent over the next decade just to keep up with the pack. The best will set targets of more than double this figure. 

Because the consolidated endgame is driven by huge differences in productivity, many deals that appear at first sight to be overvalued or uneconomic will, we believe, ultimately prove to be value creating. This is not to say that some acquirers won't pay too much or be unable to realize the value latent in their targets; indeed, the recent history of M&A reveals that many deals fail to return their cost of capital. But highly skilled, productive players (those on the far left-hand side of the industry cost curve) and players with unique brands, distribution systems, and management talent will succeed in M&A. 

Who will win as consolidation transforms the financial services landscape? At present, many passive players are failing to stand out from the crowd, neither building the necessary skills nor achieving the critical mass they require to control their own destiny. 

For would-be winners with national and global aspirations, market capitalization is the metric to watch. It is the best indicator we have of how well managers are performing; indeed, recognizing this, many companies have now linked senior management compensation to shareholder value creation. As regulation falls away and competition intensifies, management talent and insight will become scarce commodities. 

Until recently, the structure of the financial services industry was the product more of regulation than of economics. Banking, insurance, and brokerage were governed at both state and federal levels by an arcane hodgepodge of protectionist rules that let uneconomic players thrive. In spite of underlying business economics, profound changes in consumer preferences, and the transformation of global capital markets, no real restructuring could take place. But today, regulation is finally succumbing to these powerful market forces, and restructuring is under way. 

In banking, current market competition and safety and soundness protections render anti-growth relics like the 1933 Glass-Steagall Act and the 1956 Bank Holding Company Act completely irrelevant. A variety of more market-oriented corporate structures and financial services licences (including retail bank charters such as a federal savings bank or an industrial loan company) permit sound customer strategies to be implemented without unnecessary worries about product, affiliation, or acquisition limitations. Consequently, the industry is undergoing vigorous restructuring, as recent acquisitions of retail bank charters by such companies as Merrill Lynch, the Travelers Group, and State Farm attest. 

The publicly owned or stock insurers have responded by purchasing other insurers with their appreciating stock, in an effort to spread more revenue over their cost base. In addition, they have issued stock options as incentives to agents and employees to improve growth and cut costs. 

Mutual insurance companies are a different story. Owned by their policyholders and with limited access to capital, they are unable to grow through acquisition. They also have a hard time hiring and retaining talented employees without the benefit of stock incentives. 

The map identifies four categories of player: 

Companies should ask themselves three basic questions about the strategic control map: 

•   Where are we today in relation to our current and future competitors? 

•   Where should we be five and 10 years from now as the market consolidates? 

M&A has become an increasingly important way to build market position at the expense of competitors, as the following case illustrates. In one region of the United States, there are three high-performing banks. Two of them are active acquirers. They employ slightly different consolidation strategies (extending geographic reach, moving into new businesses, building in-market presence), but both have a proven record in post-merger management. 

A look at the performance of these three banks over a five-year period demonstrates that a successful consolidation strategy makes a major contribution to shareholder value creation. Banks A and B are the two acquiring banks; bank C is their non-acquiring neighbor. At the outset, C enjoys the highest market value, even though A and B have already launched their acquisition strategies. 

Five years later, the tables have been turned. Having completed several large acquisitions, banks A and B have created more value for their shareholders than bank C, which has performed badly in comparison not only with its neighboring acquirers but also with the overall bank composite (Exhibit 11). In short, bank C has stalled. 

Executing acquisitions well can lead to a virtuous cycle that creates even higher shareholder value in the future (Exhibit 12). Getting your consolidation strategy right at the outset and then leveraging superior execution skills are two steps to set the virtuous cycle in motion. But successful M&A involves more than just waiting for that next deal to come along. 

When Travelers purchases a troubled company, for example, it vastly improves both management and cost structures. Its sense of urgency and strategic purpose is almost palpable. Its ability to meet ambitious cost and revenue goals is in part the result of high employee ownership (its goal is 20 percent after five years) and of the fact that a large proportion of compensation for senior management takes the form of restricted stock that cannot be sold for three years. 

Needless to say, the fundamental skill in doing deals is valuation. We believe that to value a target solely on the basis of discounted cash flow (DCF) is wrong, given the uncertainty of a dynamic market. In our view, options valuation represents the best way to capture the full value of financial engineering measures such as lowering the cost of capital, reducing unnecessary regulatory costs, gaining tax and accounting advantages, and restructuring assets through securitization. It is also the best way to evaluate unique synergies in distribution and product lines. 

Using this more sophisticated valuation technique reveals that there is no single “true” value for a company. The value -- and hence what an acquirer can rationally afford to pay -- depends on who the buyer is and what unique synergies it can capture. 

An acquirer can create value in three basic ways. Most obvious of these, and fully reflected in the price of most deals today, are universal synergies: the kinds of profit improvement that drove the bank roll-up deals of the 1980s. Examples include taking out excess costs, raising the yield on investments, or improving pricing. Any acquirer with access to state-of-the-art practices will in principle be able to achieve these gains, although managers with deep experience in post-merger integration can usually capture them more quickly and efficiently than novices. 

Also essential, but less often reflected in current deal pricing, are endemic synergies: gains that require real changes in the way things are done. The additional revenue that can be earned by selling the products of an acquired company is the best example. How much value is created will depend on the channels and products that the buyer and seller own, and how dominant they are in each. The better the fit, the more value an acquirer can create, and the more it can afford to pay for the acquisition. Often, however, this fit can be properly appreciated only by management teams that truly understand what consumers want and which channels best meet their needs. The options available and the value that can be created vary widely from one acquirer to another. 

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Given the skills of leading players, the underlying economics of the financial services industry, and the withering away of regulation around the world, we believe there is enough pent-up economic energy and capital to drive consolidation both within segments and across traditional industry borders at an accelerating rate for the foreseeable future. The trend is just beginning to gain momentum, and the industry, shareholders, and consumers will all benefit. Those aspiring long-term winners that first understand and then act to influence this process will have a head start in the race to the consolidated endgame.