THE EFFICIENCY EFFECTS OF BANK MERGERS AND ACQUISITIONS IN A DEVELOPING ECONOMY: EVIDENCE FROM MALAYSIA

International Journal of Applied Econometrics and Quantitative Studies Vol.1-4(2004)
THE EFFICIENCY EFFECTS OF BANK MERGERS AND
ACQUISITIONS IN A DEVELOPING ECONOMY:
EVIDENCE FROM MALAYSIA
SUFIAN, Fadzlan*

Abstract

This paper utilises the non-parametric frontier approach, Data
Envelopment Analysis (DEA), to analyse the technical and scale
efficiency of domestic incorporated Malaysian commercial banks
during the merger year, pre-and post merger period. We found that
Malaysian banks have exhibit a commendable overall efficiency
level of 95.9% during 1998-2003 hence suggesting minimal input
waste of 4.1%. Our results suggest that the merger programme was
successful, particularly for the small and medium size banks, which
have benefited the most from the merger and expansion via
economies of scale. On the other hand our results suggest that the
larger banks should shrink to benefit from scale advantages.
Decision-makers hence ought to be more cautious in promoting
mergers as a means to enjoying efficiency gains.

JEL Classification: C13; G21; D24; O31
Keywords: Finance and Banking, Mergers, Efficiency Change, Data
Envelopment Analysis; Malaysia


1. Introduction

The purpose of the paper is to examine the effects of mergers and
acquisitions on the efficiency of Malaysian banks. Has the merger
results in better efficiency of Malaysian banks? The efficiency
estimates was performed using the non-parametric Data
Envelopment Analysis (DEA) methodology. The results of the study
suggest that the merger programme was successful, particularly for

* Sufian, Fadzlan (fadzlan@asmb.com.my) ASM Asset Management,
Amanah Saham MARA Berhad
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International Journal of Applied Econometrics and Quantitative Studies Vol.1-4(2004)
the small and medium size banks, which have benefited the most
from expansion via economies of scale, while on the other hand our
results suggest that the larger banks should shrink to benefit from
scale advantages. The study has important implications such as
guiding the government policy regarding deregulation mergers.
Decision-makers hence ought to be more cautious in promoting
mergers as a means to enjoying efficiency gains.

The motivation for this paper comes firstly, from the fact that
despite the substantial structural changes and importance of the
Malaysian banking sector, the sector has remained underresearched
compared to studies in other countries. To date, there has been only a
few microeconomics studies conducted in this field of studies with
respect to the Malaysian banking system.

Secondly, in order to appraise the success of the merger program
among the domestic incorporated Malaysian commercial banks, it is
essential to conduct a formal analysis. To our knowledge, there is no
study in the literature that has examined this important issue. The
present study thus addresses an important gap in the literature.

Thirdly, compared to earlier papers, this study has the following
merits. Firstly, unlike Katib and Mathews (2000) and Okuda and
Hashimoto (2004), which investigate Malaysian banks efficiency
during the 1989-1995 and 1991-1997 period respectively, we
investigates the efficiency of domestic incorporated Malaysian
commercial banks on a more recent data during the period of 1998-
2003. Although Krishnasamy et al. (2004), investigates Malaysian
banks productivity changes during the 2000-2001 period, they have
not examined the efficiency changes.

Lastly, the study has important public policy implications,
particularly with respect to the principal aim of the Malaysia
Financial Sector Master Plan (FSMP), to achieve a more competitive
and efficient financial system. The study could help the regulatory
authorities in determining the future course of action to be pursued to
further strengthen the Malaysian banking sector in particular the
domestic incorporated banks.

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Sufian, F. Effects of Bank Mergers and Acquisitions in a Developing Economy

The paper is set out as follows: the next section gives an overview
of the Malaysian banking system, section 3 reviews related studies in
the main literature with respect to the study of bank efficiency,
section 4 outlines the approaches to the measurement and estimation
of efficiency change, section 5 discusses the results and finally,
section 6 provides some concluding remarks.

2.Overview of Malaysian Banking

The Malaysian banking system has historically been characterised
by its large number of small institutions. Although the Malaysian
central bank, Bank Negara Malaysia (BNM) has always encouraged
banks to merge in order to achieve economies of scale and higher
level of efficiency, only a few mergers among the banking
institutions have taken place.

The urgency to consolidate the banking sector was apparent during
the Asian financial crisis that struck the region in 1997-1998, which
has exposed the vulnerabilities of the small banking institutions and
the need for these institutions to maintain a high level of capital.
Furthermore, given the fact that much of the required financing in
Malaysia was intermediated through the banking system, the risk
associated with cyclical downturn in the economy would be much
concentrated in the banking system.

In order to minimize the potential impact of systemic risks on the
banking sector as a whole, following the deepening of the financial
crisis, the Government took stronger measurers to promote (force)
merging of banking institutions. Subsequently, ten banking groups
were formed. The ten banking groups or anchor banks are: Malayan
Banking Berhad, RHB Bank Berhad, Public Bank Berhad,
Bumiputra-Commerce Bank Berhad, Multi-Purpose Bank Berhad,
Hong Leong Bank Berhad, Perwira Affin Bank Berhad, Arab-
Malaysian Bank Berhad, Southern Bank Berhad and EON Bank
Berhad. Each bank had minimum shareholders’ funds of RM2 billion
and asset base of at least RM25 billion.


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International Journal of Applied Econometrics and Quantitative Studies Vol.1-4(2004)
Table 1: Malaysian Banks Mergers and Acquisitions
Anchor
Banks
Anchor’s
Post-
% of
Banks
Acquired
30 June
Merger
Systems
’00 Total
Assets
Assets
Assets
RMb
RMb
Maybank
The Pacific
127
150
24.0
Bank
Phileo Allied
Bank
Bumiputra-
N.A.
63
67
10.7
Commerce
Bank
RHB Bank
N.A.
51
56
9.0
Public Bank
Hock Hua
43
50
8.0
Bank
Arab-
N.A.
11
39
6.2
Malaysian
Bank
Hong Leong Wah Tat Bank
29
35
5.6
Bank
Multi-
International
9
14
2.2
Purpose
Bank
Bank
Malaysia
Sabah Bank
Affin Bank
BSN
15
30
4.8
Commercial
Bank
Southern
Ban Hin Lee
24
25
4.0
Bank
Bank
EON Bank
Oriental Bank
14
25
4.0
Source: Bank Negara Malaysia


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3. Related Studies

In the past few years, DEA has frequently been applied to banking
industry studies. The first application analyzed efficiencies of
different branches of a single bank. Sherman and Gold (1985)
studied the overall efficiency of 14 branches of a U.S. savings bank.
DEA results showed that six branches were operating inefficiently
compared to the others. Similar study by Parkan (1987) suggested
that eleven branches out of thirty-five were relatively inefficient.

Rangan et al. (1988) shifted the unit of assessment from branches
to consolidated banking institutions. They applied DEA to a larger
sample of 215 U.S. banks and attempted to break down inefficiency
to that stemming from pure technical ineffic iency and scale
inefficiency. They employed the intermediation approach by using
three inputs (labor, capital and purchased funds) and five outputs
(three types of loans and two types of deposits). Their results
indicated that banks could have produced the same level of output
with only 70% of the inputs actually used, while scale inefficiencies
of the banks were relatively small, suggesting that the sources of
inefficiency to be pure technical rather than scale.

In addition to the heavy concentration on the US, DEA has fast
become a popular method in assessing financial institutions
efficiency among banking researchers in other nations. Fukuyama
(1993 and 1995) was among the early researchers particularly among
countries in Asia to employ DEA to investigate banking efficiency.
Employing labor, capital, and funds from customers as inputs and
revenue from loans and revenue from other business activities as
outputs, Fukuyama (1993) considers the efficiency of 143 Japanese
banks in 1990. He found that the pure technical efficiency to average
around 0.86 and scale efficiency around 0.98 implying that the major
source of overall technical inefficiency is pure technical inefficiency.
The scale inefficiency is found to be mainly due to increasing returns
to scale. He also found that banks of different organizational status
perform differently with respect to all efficiency measures (overall,
scale, pure technical). Scale efficiency is found to be positively but
weakly associated with bank size.

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International Journal of Applied Econometrics and Quantitative Studies Vol.1-4(2004)
3.1 The effects of mergers and acquisitions on bank’s efficiency

Bank mergers and acquisitions may enable banking firms to benefit
from new business opportunities that have been created by changes
in the regulatory and technological environment. Berger et al. (1999,
p 136) pointed the consequences of mergers and acquisitions, which
may lead to changes in efficiency, market power, economies of scale
and scope, availability of services to small customers and payments
systems efficiency.

Besides improvement in cost and profit efficiency, mergers and
acquisitions could also lead banks to earn higher profits through the
banks market in leveraging loans and deposit interest rates. Prager
and Hannan (1998) found that banks mergers and acquisitions has
resulted in higher banks concentration, which in turn leads to
significantly lower rates on deposits. Some evidence also suggested
that U.S. banks that involved in M&As improved the quality of their
outputs in the 1990s in ways that increased costs, but still improved
profit productivity by increasing revenues than costs (Berger and
Mester (2003, p 88)).

A note of caution however, encouraging or forcing banks to merge
in times of severe banking crisis as a measure to reduce bank failure
risk, would not only possibly create a weaker bank, but could also
worsen the banking sector crisis. As shown by Shih (2003), merging
a weaker bank into a healthier bank in many cases would result in a
bank even more likely to fail than both the predecessors bank. On the
other hand, he found that mergers between relatively healthy banks
would create banks that are less likely to fail.

3.2 Studies on Malaysian commercial banks efficiency and
productivity

Despite substantial studies performed on the U.S., Europe and
other Asia -Pacific banking industry in regard to the efficiency and
productivity of financial institutions in their countries, the Malaysian
banking industry has not followed suite in that there has been no
extensive study aimed at this area partly due to the lack of available

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Sufian, F. Effects of Bank Mergers and Acquisitions in a Developing Economy
data sources and the small sample of banks compared to the
countries mentioned above. As pointed by Kwan (2003), the reason
for the lack of research on the efficiency of Asian banks is due to the
lack of publicly available data for non-publicly traded Asian
financial institutions.

The most notable research conducted on Malaysian banks was by
Katib and Mathews (2000) which studied the characteristics of the
management structure and technical efficiency of the banking
industry in Malaysia by DEA from 1989 to 1995. Okuda and
Hashimoto (2004) conducted a research on the production
technology of Malaysian domestic commercial banks with Stochastic
Cost Functions approach adjusted to non-performing loans from the
year 1991 to 1997.

More recently, Krishnasamy et al. (2004) has investigated
Malaysian banks post-merger productivity changes. Applying two
inputs, namely labour and total assets and loans and advances and
total deposits as outputs, they found that during the period of 2000-
2001, post-merger Malaysian banks has achieved a total factor
productivity growth of 5.1%. They found that during the period,
eight banks posted positive total productivity growth ranging from
1.3% to 19.7%, one bank exhibit total factor productivity regress of
13.3% and a bank was stagnant. The merger has not resulted in better
scale efficiency of Malaysian banks as all banks exhibits scale
efficiency regress with exception of two banks. The results also
suggest rapid technological change of post-merger Malaysian banks
ranging from 5.0% to 16.8%. Two banks however experienced
technological regress during the period of study.

4. Methodology and Data

For the empirical analysis, ten domestic incorporated Malaysian
commercial banks that were engaged in the merger program from
1998-2003 would be used (see Table 2). Malaysian Islamic Banks,
Development Banks, Investment Banks, Export-Import Banks and
Cooperative Banks are excluded from the sample. Annual data were

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International Journal of Applied Econometrics and Quantitative Studies Vol.1-4(2004)
taken from published balance sheet information in annual reports of
each individual bank.

Following Berg et al. (1992), Fare et al. (1994) and Bhattacharya et
al. (1997), among others, a non-parametric method, DEA, will be
used in measuring the efficiency of the Malaysian banks. The
methods allows for the decomposition of the efficiency and
productivity differences into one representing the banks’ efficiency
and productivity levels relative to their peers best practice frontiers.
The DEA is a linear (mathematical) programming technique which
forms a non-parametric surface / frontier (more formally a
piecewise-linear convex isoquant) over the data points to determine
the efficiencies of each DMU relative to this frontier.

The main reason to choose the DEA is the expressed interest in the
Malaysian banking industry of reducing costs in the recent years
owing to the increased competition fostered by liberal policies.
Furthermore, DEA allows the study to focus on the input saving
(cost) efficiency, which can be detailed into technical and allocative
efficiency components. It also permits one to further detail technical
efficiency into its pure technical and scale efficiency components.
Hence, through input-oriented DEA, we can dwell on the sources of
input waste in Malaysian banking and draw some policy conclusions.

Nevertheless, DEA is less data demanding as it works fine with
small sample size and does not require knowledge of the proper
functional form of the frontier, error and inefficiency structures
(Evanoff and Israelvich (1991), Grifell-Tatje and Lovell (1997),
Bauer et al. (1998)). The stochastic models on the other hand,
necessitate a large sample size to make reliable estimations.
Although the sample includes the universe of Malaysian banks, the
total number of banks in the sample is relatively small, motivating us
to adopt DEA in this study.

The term Data Envelopment Analysis (DEA) was first introduced
by Charnes et al. (1978), (CCR), to measure the efficiency of each
Decision Making Units (DMUs), that is obtained as a maximum of a
ratio of weighted outputs to weighted inputs. This denotes that the

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Sufian, F. Effects of Bank Mergers and Acquisitions in a Developing Economy
more the output produced from given inputs, the more efficient is the
production. The weights for the ratio are determined by a restriction
that the similar ratios for every DMU have to be less than or equal to
unity. This definition of efficiency measure allows multiple outputs
and inputs without requiring pre-assigned weights. Multiple inputs
and outputs are reduced to single ‘virtual’ input and single ‘virtual’
output by optimal weights. The efficiency measure is then a function
of multipliers of the ‘virtual’ input-output combination.

The CCR model presupposes that there is no significant
relationship between the scale of operations and efficiency by
assuming constant returns to scale (CRS), and it delivers the overall
technical efficiency (OTE). The CRS assumption is only justifiable
when all DMUs are operating at an optimal scale. However, firms or
DMUs in practice might face either economies or diseconomies of
scale. Thus, if one makes the CRS assumption when not all DMUs
are operating at the optimal scale, the computed measures of
technical efficiency will be contaminated with scale efficiencies.

Banker et al. (1984) extended the CCR model by relaxing the CRS
assumption. The resulting “BCC” model was used to assess the
efficiency of DMUs characterized by variable returns to scale (VRS).
The VRS assumption provides the measurement of purely technical
efficiency (PTE), which is the measurement of technical efficiency
devoid of the scale efficiency effects. If there appears to be a
difference between the TE and PTE scores of a particular DMU, then
it indicates the existence of scale inefficiency.

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0 0




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j=1

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j=1





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International Journal of Applied Econometrics and Quantitative Studies Vol.1-4(2004)


n
??0j = 1
j=1

?0j ? 0

(j = 1, …..,n)




The first constraint states that output of the reference unit must be
at least at the same level as the output of DMU 0. The second
constraint tells that the efficiency corrected input usage of DMU 0
must be greater than or the same as the input use of the reference
unit. Since the correction factor is same for all types of inputs, the
reduction in observed inputs is proportional. The third constraint
ensures convexity and thus introduces variable returns to scale. If
convexity requirement is dropped, the frontier technology changes
from VRS to CRS. The efficiency scores always have smaller or
equal values in the case of CRS. Efficiency can also be measured
into output direction in the case of VRS.

Although the scale efficiency measure will provide information
concerning the degree of inefficiency resulting from the failure to
operate with CRS, it does not provide information as to whether a
DMU is operating in an area of increasing returns to scale (IRS) or
decreasing returns to scale (DRS). Hence, in order to establish
whether scale inefficient DMUs exhibit IRS or DRS, the technical
efficiency problem (1) is solved under the assumption of non-
increasing returns to scale (NIRS) rather than variable returns to
scale (VRS) to provide
min?0 ?0




(2)


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