Doing Diligence

It's merger season again in retail/commercial banking. With capital at record levels and much room for consolidation remaining, many banks continue to view M&As as their best means of growth. Last year's 82 percent rise in M&A activity in the banking industry - which gave the top three retail/commercial banks control of approximately 44 percent of all banking assets - still leaves approximately 7,700 U.S. institutions for the taking.

But as acquisitive banks strive for cost synergies, many make a critical error that undermines the success of these transactions. In cutting costs, often through integrating IT systems, they reduce customer service - still the sine qua non of competitive retail/commercial banking. From slower ATMs and more complicated on-line procedures to duplicative product offerings and closed office locations, service issues translate directly into lost deposits following a merger, studies show.

Such losses help explain why bank mergers often fail to achieve synergy targets, which are often set too high to begin with. Realistic synergy goals should reflect a clear understanding of IT systems and capabilities in both the target and acquiring banks, as well as the costs and challenges of integrating the two.

Banks should approach due diligence, particularly around technology, with the customer in mind. For example, acquirers should be asking whether their internal IT systems have the scale or reliability to take on a target's business.

Target Practice

Other key questions concern the quality and capability of the target's systems. In banking, technology touches all aspects of the business. Thus, a rigorous bottom-up approach is essential to quantifying cost reduction and scale opportunities. A few leading banks have learned to do this. So far, though, most retail/commercial banks neither plan nor execute technology due diligence as well as other industries or private equity investors. Most lack the methodology, core diligence team, expectation or ability to link valuation to complex technology issues.

For stronger M&A outcomes, banks also must do a better job of engaging in technology integration planning - the flip side of the due diligence coin. Often, they begin planning too late, move too slowly or underestimate the investment needed to train employees and align products, services and systems post-merger. Failure to communicate the rationale of the merger to employees and other constituencies can compound the problems.

The aftermath of a merger is a demanding time. In addition to combining and rationalizing operations, merged banks need to stay focused on seamless delivery. Service reductions or technical glitches alienate customers, while competitors view the post-merger timeframe as an opportunity to poach customers. Successful acquirers put in place customer retention and other "competitive defense" plans.

Overall, despite potential M&A pitfalls, U.S. banking is in a very healthy place by all historical comparisons. Return on equity is high, while the number of troubled institutions remains low. How to use record levels of excess capital and grow is an enviable problem to have.

Still, attempts to buy growth through M&As take forethought and care. At its best, an effective bank merger is a backstage production - smooth, well-orchestrated and invisible to an audience of consumers.

Kerrie MacPherson is the leader of E&Y's Transaction Advisory Services Financial Services practice in New York; Jeffery Perry is the transaction integration practice leader of E&Y's Transaction Advisory Services practice in Chicago; and Larry Phelan is the operations and technology due diligence practice leader of E&Y's Transaction Advisory Services practice in New York.