Cross-Border Bank M&As and Bank Risk: Evidence from Bond Yield Spreads Sungho Choi*, Bill B. Francis*, and Iftekhar Hasan*, ** * Rensselaer Polytechnic Institute, ** Bank of Finland

2 Cross-Border Bank M&As - Motivation Popular Business Strategy Charting new territory: Different portfolio management, new financing sources. Numerous barriers, e.g., distance, currencies, language, culture, regulatory and supervisory norms In case of M&As – which country’s regulation should prevail? Lack of concrete rules of regulation!

3 Cross-Border Bank M&As - Motivation Uncertainty associated with the new environment changes the risk perspective of banks and therefore impacts all stakeholders - shareholders, bondholders, and regulators. Empirical evidence on the impact of cross-border M&As on bank stakeholders is sparse.

4 Research Questions What is the impact of cross-border M&As on bond holders? In addressing this question we use the changes in bond yield (or change in bank risk) as the metric. Additionally, we also trace the impact on the other stakeholders - shareholders and regulators We also examine how these changes are affected by institutional factors that are known to impact both bond and share value (moral hazard, investor protection, recovery rate, regulation and supervision, creditor rights, and information cost).

5 Preview of Results There is a significant increase in yield spread on the announcement of cross-border M&As. Investor protection, moral hazard, recovery rate, creditor rights, and income levels between acquirer’s and target’s countries are important determinants of the impact on the abnormal changes in yield spread. For the full sample, we do not find any evidence of wealth transfer between bondholders and shareholders. However when sort on positive and negative abnormal changes in yield spread (AESP) there is evidence of wealth transfer - Positive AESP – wealth transfer from bondholders to shareholders - Negative AESP - wealth transfer from regulators to bondholders Results show that investor protection and moral hazard, are important in explaining abnormal changes in bond yield spreads.

6 Cross Border M&A and Risk Mixed views on the Impact of M&A on Bank Risk Risk Decreasing: Reduce risk of bank insolvency - Vander Vennet(1996), Berger (2000). Risk Increasing: Distance and differences in languages and cultures, regulatory and supervisory norms (Berger DeYoung, and Udell (2001)). Diversification into new sectors or regions which are likely to perform worse [Winton (1999)].

7 Empirical Evidence Amihud, Delong, and Saunders. (2002) – Cross-border M&A announcements result in negative and significant CAR to share holders of bidder banks. These mergers do not lead acquirers to engage in post-merger risk shifting or risk increasing behavior. Penas and Unal (2004) – Domestic mergers are risk reducing, evidence through bond return. Our paper provides much needed empirical evidence on this important issue.

8 Data Thomson Financial SDC Platinum, 1995 to Use only mergers where the acquirer’s stock is publicly traded and bond yield spreads are available through Datastream. Acquiring bank needs to have at least one bond outstanding with a remaining maturity of greater than 2 years. 147 cross-border bank M&As.

9 Data - Continued Fitch-IBCA Bankscope database. Individual bond data and the government bond data of acquiring bank’s country are from Datastream. Country specific, regulatory and supervisory variables are obtained from Barth, Caprio, Levine (2001) and the World Bank database (2004).

10 Moral Hazard Having an extensive deposit insurance may lead to greater moral hazard for bank managers (Bhattacharya and Thakor (1993), Bhattacharya, Boot, and Thakor (1998), and Demirguc-Kunt and Detragiache (2002). A generous deposit insurance of target countries against acquirer countries may increase the risk of bank failure, resulting in a higher yield spread.

11 Investor Protection Extent of legal protection of investor is a key determinant of asset valuation (La Porta et al. (2002)) -- strong legal protection of investors is associated with higher valuation of corporate assets. -- support for the existence of expropriation of minority shareholders as well as the role of the law in limiting such expropriation. The higher investor rights could be interpreted as less risk to investor. -- assuming all things are equal, if a bank takes over a financial institution in a country where there is a higher investor legal protection, the change in the acquiring bank’s risk should at least be non-positive.

12 Recovery Rate The recovery rate is defined as how many cents on the dollar claimants recover from an insolvent firm (Djankov et al. (2005)). The credit spread of risky bonds and loans depend inversely on the recovery rates on the bonds under consideration (Acharya and Bharath (2004)). Higher recovery rates imply a high probability of a bank recouping its loans, thus mitigating the risk to lenders.

13 Regulation and Supervision Regulation and supervision significantly influence cross-border bank M&As (Berger, DeYoung, Genay, Udell (2000), Focarelli and Pozzolo (2001), Buch and Delong (2004), Jayaratne and Strahan (1998)). -- governmental regulations and supervision may reduce information symmetries and are often essential to ensure the solvency of whole banking system. -- higher and tougher regulations and supervisions in acquiring banks’ countries relative to target countries’ increase the chance of better performance and thus reduce the risk of bank failure, resulting in lower yield spreads.

14 Methodology Yield spreads - the difference between the yield on a bank bond and a government security of that country with comparable maturity (Gande, Puri and Saunders (1999)). Based on weekly yield data. Combine all firm’s bond yields into a single yield by value weighted averages of individual bonds. Methodology to measure the abnormal announcement effect on bond yield spreads is adopted and modified from Eckbo Maksimovic and Williams (1990).

15 Methodology – Continued Abnormal effects on yield spreads are estimated directly as the parameter β j in the model: SP jt = α j + β j d jt + e jt (1) - where - SP jt is the market value weighted average yield spread of a bank j’s bond d jt is a dummy variable which takes on a value of 1 if week t is the week of the announcement. Estimation period typically (-30, -4) weeks; event window (-1,+1) weeks. Abnormal effects are averaged with equal weights across banks to form the average abnormal effects.

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24 Regression of Announcement Week Abnormal Effects on Yield Spreads Abnormal effects on yield spreads are estimated directly as the parameter β j in the model: AESP j = α j + β 1 Investor i + β 2 Recovery i + β 3 Hazard i + β 4 Tough i + β 5 Trans i + β 6 Concentration + Σ β j Z j + ε j -Where AESP j is the announcement abnormal effect on yield spread and is estimated as the parameter βj in equation 1. We use the natural logarithm of one plus parameter βj since it is characterized by high kurtosis. We estimate AESP based on several announcement windows as well as estimation windows of (-30, -4) and (-52, -4) weeks.

25 Independent Variables Investor Protection= 1 if Target has Better Investor Protection than Acquirer; otherwise=0 Recovery = 1 if Target has Better Recovery Rate than Acquirer; otherwise=0 Hazard = Index – World Bank Tough = Index on Supervision – World Bank Trans=Relative transparency (target index/acquirer index) – World bank Concent=1 if target has a higher banking concentration Z=others including Creditor Rights (Target/acquire index), Law (target – acquirer same legal origin=1); Income=1 if same income level; DFX (target – acquirer same currency=1; D100CS=1 if all payments is cash transaction; LogTAcq=Logarithm of Total Assets of the Acquiring Bank; ROEacq=ROE of the acquiring bank, TETAcq=equity to assets past year of acquiring bank LLRacq=Loan Loss Reserve prior year to Total Loan of Acquiring Bank

26 Regression Results Investor Protection= Negative ** to *** in all 10 models Hazard = Positive ** to *** in all models Tough, Creditor Rights, Concentration = Positive, Marginal Significance in Some of the Equations Recovery, Trans, DFX, Law, Income, Size, ROE, Equity/Asset = Not Significant D100CS= Positive ** to *** in all models LLR= Positive ** in Most Equations

27 Summary of Results There is a significant increase in yield spread on the announcement of cross-border M&As. Investor protection, moral hazard, recovery rate, creditor rights, and income levels between acquirer’s and target’s countries are important determinants of the impact on the abnormal changes in yield spread. For the full sample, we do not find any evidence of wealth transfer between bondholders and shareholders. However when sort on positive and negative abnormal changes in yield spread (AESP) there is evidence of wealth transfer - Positive AESP – wealth transfer from bondholders to shareholders - Negative AESP - wealth transfer from regulators to bondholders Results show that investor protection (-) and moral hazard (+) are important in explaining abnormal changes in bond yield spreads.

28 Implications Since cross-border bank M&As increase the risk of acquiring banks, the home country regulator(s) may require acquiring banks to increase their reserves to better protect the banks’ stakeholders - depositors, bond holders, and shareholders. Regulators should especially consider institutional characteristics in both the home- and the host-country in judging the sufficiency of the banks’ reserve positions.