Jasmine Karimzada, Chenming Li, Aditya
Image Source: https://www.centralbank.ie/consumer-hub/explainers/what-is-financial-regulation-and-why-does-it-matter
In the second half of 2020, the number of M&A deals that were executed worldwide was 44,926, valued at $2817 billion (M&A Statistics - Worldwide, Regions, Industries & Countries, 2021). Within these numbers is a wave of consolidating acquisitions in the Financial Institutions Group (FIG) industry, including the S&P Global’s acquisition of IHS Markit ($44.5 billion), the London Stock Exchange Group’s (LSEG) acquisition of Refinitiv ($27 billion) and the InterContinental Exchange’s (ICE) acquisition of Ellie Mae ($11 billion).
In the specific case of the LSEG’s acquisition of Refinitiv, the deal needed to be approved by multiple international regulatory bodies, including the US Department of Justice, the UK Panel of Takeovers and Mergers, and more. It is a key provider of financial infrastructure and home to over 1,100 companies around the world (amounting to a market cap of £3 trillion) (Main Market | London Stock Exchange, 2021). In fact, the last regulator, the EU Commission, only approved the deal two years after its announcement in January 2021.
The wave of consolidation has raised questions about the effectiveness of regulation in preventing systematic failures and promoting fair competition. In this article, we will be debating the aspects of consolidation in the FIG industry that require new regulations to be placed and those that do not.
Systematic and operational risk
The consolidation of stock exchanges raises two main concerns that need to be addressed by regulators. The first is the systematic risk that they pose to financial markets, and the second is the operational risks that arise with foreign exchange activities, e.g. judicial differences. The inability to address these concerns effectively would result in negative effects on all parties, including the exchanges themselves.
Another such risk that such consolidations pose for the financial market is the effect it has on competition. If large exchanges are able to gain a bigger market share via mergers, smaller exchanges may be unable to provide liquidity in their markets, especially as large exchanges can attract larger order flows. A long term consequence of this is lower competitiveness of the market. Financial institutions such as hedge funds and asset managers, which are customers of these exchanges, will have to accept higher fees in exchange for lower service quality. This issue was also pointed out by the US Department of Justice during its review of the NYSE’s proposed acquisition of Archipelago in 2005. The NYSE controlled 80% of the trading of its listing stocks and hoped to expand it through this merger. Consequently, the exchange market would become even less competitive while the bargaining power of customers diminished, which regulatory bodies should be cautious with.
The operational risks regarding consolidation are mainly due to the fact that exchanges tend to operate across borders and jurisdictions, for which variance in financial and legal systems exists. For example, countries have different listing requirements and accounting practices. The basis for Germany’s practises is statutory law, whereas the approach taken by the UK is less rigid (Choi and Levich, 1996). Another difference is different clearing and settlement systems across countries - this is the process that takes place after the execution of trades, entailing details of confirmation of terms of trade and other information. In Europe, the organisations for these actions are currently divided by national borders, which hinders the smooth processes of stock markets and their consolidation (McAndrews and Stefanadis, 2002).
New policies need to address potential difficulties caused by cross-border transactions for investors and firms. In general, they should be developed with the aim to increase homogeneity within legal requirements across borders.
An active takeover market
Deregulation is the process of reduction or elimination of a law or directive made by a governing authority of a particular industry. It can stimulate a more active takeover market that heightens firm valuations.
Brook, Hendershott and Lee reported on deregulation in the form of the Interstate Banking and Branching Efficiency Act of 1994 (IBBEA). Deregulation is expected to accelerate consolidation already occurring within institutions, leading to $85bn in value creation (Yaron Brook, 1998). This is because it allows for better utilisation of potential scale and scope economies. It also increases the frequency of explicit and implicit takeover threats. Manne (1965) argues that increased risk of takeover managers to solve problems and meet short- and long-term targets consistently in order to avoid redundancy through the process of consolidation. Furthermore, James (1984) found that banks tend to be less efficient when takeovers are restricted.
On the other hand, regulation encourages complexity that leads to vicious practices by institutions to function. A clear example of this is through the 1927 McFadden Act in the US, where the consolidation and acquisition of in-state banks by out-of-state banks was restricted, forcing restrictive practices. Under this, institutions formed bank holding firms to acquire out-of-state banks, essentially operating under a single umbrella. This loophole was later eliminated by the 1956 Bank Holding Company Act, making bank expansion relatively impossible.
These forms of regulation add to the transaction costs of banks, making the system of financial institution groups (FIG) and consolidation less fluid and dynamic by reducing efficiency and the capacity for long term growth within the industry. This was confirmed by Cornett and Tehranian (1992) who found a 120-basis point average increase in return-on-assets post fifteen interstate mergers during periods of deregulation within the mid-1980s (Cornett, 1992).
Therefore, deregulation contributes to increases in efficiency and firm values in the FIG industry, since the stocks of these firms would be backed by better structured and dynamic institutions.
In conclusion, the greatest risks imposed on the FIG industry by consolidation is systematic failure (becoming ‘too big’) and inefficiency. Minimal regulation may result in over-consolidation, where institutions may start to experience diseconomies of scale, leading to harmful inefficiencies for households and the institutions themselves. It would also reduce competitiveness as smaller institutions may not be able to access economies of scale from deal flows, further solidifying the market power of institutions having high market share. Meanwhile, over-regulating this sector adds to the institutions’ transaction costs, making growth slow and, in some cases, preventing institutions to follow changes in consumer preferences.
Choi, Frederick D. S., and Richard M. Levich. 1996. “Accounting Diversity.” In Benn Steil, ed., The European Equity Markets, 259-312. London: European Capital Markets Institute.
McAndrews, J. and Stefanadis, C. (2002) ‘The Consolidation of European Stock Exchanges’, p. 6.
Press Release, U.S. Dep’t of Justice, Statement on the Closing of Its Two Stock Exchange Investigations (Nov. 16, 2005) [hereinafter DOJ Exchange Mergers Statement], available at http://www.justice.gov/atr/public/press_ releases/2005/213062.htm.
Cornett, M. M. H. T., 1992. Changes in corporate performance associated with bank acquisitions, Journal of Financial Economics. Volume 31, pp. 211-234.
Institute for Mergers, Acquisitions and Alliances (IMAA). 2021. M&A Statistics - Worldwide, Regions, Industries & Countries. [online] Available at: <https://imaa-institute.org/mergers-and-acquisitions-statistics/>
James, C., 1984. An analysis of the effect of state acquisition laws on managerial efficiency: The case of the bank holding company acquisitions, Journal of Law and Economics. Volume 27, pp. 211-226.
Londonstockexchange.com. 2021. Main Market | London Stock Exchange. [online] Available at: <https://www.londonstockexchange.com/raise-finance/equity/main-market>
Manne, H., 1965. Mergers and the market for corporate control, Journal of Political Econ- om. Volume 73, pp. 110-120.
Yaron Brook, R. H. a. D. L., 1998. The Gains from Takeover Deregulation: Evidence from the End of Interstate Banking Restrictions. 53(6), p. 20.