Question

How has JPMorgan performed in the new environment? Would you consider it a winner or a loser? Why?

Answer 1

Banking mega-mergers keep on coming. On Jan. 14, 2004 , J.P. Morgan Chase announced a $59 billion merger with Bank One, just three months after Bank of America and Fleet Boston said they would tie the knot. But there’s a difference: This time, Wall Street is wildly enthusiastic, while reaction to the earlier deal was lukewarm at best. Does that mean J.P. Morgan Chase-Bank One is destined to succeed?

Not necessarily, according to several Wharton professors and industry representatives. When it comes to big corporate mergers, success is devilishly difficult to predict. Even several years after the transaction has been completed, it’s often hard to tell whether two companies are better together than they would have been apart.

“It looks as though we are in an era of continuing consolidation in the financial [sector], which is leading to the emergence of these enormous companies,” says George J. Vojta, chairman of the Financial Institutions Center at Wharton and director of the Financial Services Forum in New York City . “It’s what happens when you deregulate an industry … Of course, a lot of [the mergers] do not return real value to shareholders. But you can’t say that about this one, because nobody knows yet.”

Big mergers often succeed in reducing costs as the companies eliminate overlap, but it’s much harder to achieve revenue growth, Vojta notes, adding that mega-mergers often produce companies that are very cumbersome to manage. He is “cautious,” he says, about predicting success for J.P. Morgan Chase-Bank One. “I’m not overjoyed. But I see it as inevitable” because of banking industry deregulation that occurred during the last decade.

Thumbs Up from Wall Street

The deal would combine J.P. Morgan Chase, the country’s second largest bank, based in Manhattan , with Chicago ’s Bank One. The new company will have an estimated $1.1 trillion in assets, making it a rival to the country’s largest bank, Citigroup, with $1.2 trillion. J.P. Morgan’s strength is in investment and commercial banking, Bank One’s in consumer banking. Though both have branch banks, there is little overlap outside of Texas . Together, they will have 2,300 branches in 17 states.

The goal: Save $2.2 billion over three years by eliminating about 10,000 jobs. J.P Morgan CEO William B. Harrison says his company has been too heavily reliant on volatile corporate banking. By grafting on Bank One’s larger branch operation, performance should become more stable, he suggests, adding that the deal gives Bank One broader retail scope and the investment banking clout it had lacked.

Although the deal is structured like a takeover, with Bank One shareholders getting 1.32 J.P. Morgan shares for each of their own shares, each company will get half the seats on the new board. Harrison will run the combined company for two years, then turn it over to Bank One CEO Jamie Dimon.

A soap opera aspect of the story involves Dimon’s return to Wall Street after a six-year exile. Dimon will thus go toe-to-toe with his long-time mentor, Citigroup chairman Sanford Weill, who fired Dimon as president of Citigroup in 1998. Dimon has long been a Wall Street darling, and he led Bank One to a dramatic turnaround.

Wall Street analysts generally praised the merger, and investors climbed on board. Typically, the shares of the acquirer fall, reflecting the cost of the acquisition. In this case, investors are signaling they believe the combined company will make up for that cost by holding the shares in the $39-$40 range, about where they were before the deal was announced. J.P. Morgan has been on a roll, with its shares up about 74% in the past 12 months. Bank One shares jumped about 15% when the deal was announced, matching the premium J.P. Morgan will pay. Such a move is typical in an acquisition.

By comparison, investors were unenthusiastic about the $48 billion Bank of America-FleetBoston deal. A major concern was the 40% premium offered by B of A. That lifted FleetBoston shares dramatically, but drove B of A shares down 10% the day of the announcement. J.P. Morgan is paying a premium of only 14% for Bank One shares – so little that some analysts asked whether Bank One had left money on the table. Dimon says no, that shareholders will benefit far more down the road if the combined company is not burdened by an excessive payment for Bank One.

Gazelles Out of Dinosaurs

Big mergers are generally touted as ways to grow fast, combine complementary operations and cut costs. But in many cases it’s difficult to determine whether a deal was a winner or loser, because there’s no way to know for sure how each company would have done had it remained separate, according to Loretta J. Mester, senior vice president and director of research at the Federal Reserve Bank of Philadelphia. “Success is hard to measure,” says Mester, who also teaches at Wharton. “One of the problems is that when you look at these things you look at what happened to the stock price. That’s very short-term looking.”

A common approach is to compare the newly-merged company with its peers. That will mean seeing how it does against Citigroup and Bank of America-FleetBoston.

Though there appear to be few of them, critics of the merger argue that internal, or organic, growth is a healthier way to get bigger. “Put simply, you don’t get a gazelle by breeding dinosaurs,” says Gary Hamel, chairman of Strategos and director of the Woodside Institute, two management consulting firms. Writing on the editorial page of The Wall Street Journal, he notes: “Peer beating growth, when achieved organically and free of accounting trickery, is an undeniable testament to the quality of a company’s underlying strategy and the competence of its management. Think of Southwest Airlines, Best Buy, Dell computer or Wal-Mart. Aggregation via acquisition carries with it no such implicit warranty. A company that expands via acquisition grows not because it’s good (although it may be), but because its investment bankers are good.”

Depression-era regulations had long kept banks small. But recent changes permitting interstate banking opened the door to the wave of consolidation, leading to the question: Just because banks are allowed to consolidate doesn’t mean they have to. So why do they?

While the partners generally say they’ll be bigger, better, more efficient and more profitable, the real reasons may be different. In their 2002 paper, Eat or Be Eaten: A theory of Mergers and Merger Waves, Wharton banking and finance professor Gary B.Gorton and his colleagues examine various conditions that can spur mergers within an industry. The co-authors are Matthias Kahl of the Anderson School at UCLA and Richard Rosen of the KelleySchool at Indiana University .

Often, they find, a wave of mergers is set off by some change in the industry – such as bank deregulation. The result is “defensive mergers” designed to make companies too big for hostile takeovers. Whether the result is good for shareholders or bad depends largely on managers’ motives – typically, how important they feel it is to keep their jobs and the other benefits of control.

“If managers do not care very much about private benefits of control, only profitable acquisitions occur …,” the authors write. “However, if managers care very much about private benefits of control, they may engage in unprofitable defensive acquisitions that preempt some profitable acquisitions.”

Good Business or Ego Gratification?

Mester’s research has reached similar conclusions. “There are economies of scale in getting larger,” she says. But benefits to shareholders are less likely at companies with entrenched management. “The question is, are you building an empire or are you doing something that will add to the value of the firm? What we have shown is that in firms where there’s evidence that maybe the management is entrenched, they work on their own behalf rather than shareholders.’”

Though Harrison and Dimon each have large personal investments in their companies, neither has the financial dominance often found in companies run by their founders or the founders’ descendants. Still, both men have personal reasons for pulling off a big deal. For Harrison , the merger offers redemption after a number of missteps, including the troubled previous merger between J.P. Morgan and Chase. And Dimon will get a chance to run a mega-bank after all, after being stripped of the opportunity by Weill. Harrison and Dimon have insisted the merger is merely good business, not ego gratification.

Some mergers benefit bank customers, others do not. It depends very much on how well the two companies can blend their systems – whether there are errors in statements or unwelcome changes in account features or service. Except in Texas , J.P. Morgan Chase and Bank One have little overlap in branches. Hence, the two companies’ customers will continue to have as many banking alternatives after the merger as before. Most analysts believe customers should notice little change, which bodes well.

Since the increase in phone and Internet banking makes it less important to have a branch nearby, customers actually have more banks to choose from now than they did before the wave of mergers. Because of that, most experts think the merger will have no problem receiving regulatory approval, although smaller banks, represented by Independent Community Bankers of America, warn that mega-mergers create a “systemic risk” to the economy should one fail.

Mester says consolidation has not gone far enough for that to happen. Nor will it, given continuing competition and regulation. Banks are prohibited, for example, from using acquisitions to gain control of more than 10% of the nation’s total bank deposits, though they can exceed that through internal growth.

A few years ago, according to Mester, many banks expected that electronic banking would allow them to cut back on branches, but they have found many customers still want branches. Banks also have found that ordinary customers provide steady revenues that can offset the volatility of fancy corporate services such as investment banking. As a result, small customers are seen as a valuable asset that needs to be treated well, Mester adds.

Though the early reviews of J.P. Morgan-Bank One have been favorable, there’s no evidence early reviews are a good predictor of ultimate success, she notes. Many mergers that look good on paper falter through poor execution and culture clashes. After all, not many experts can predict the future for companies that are not involved in mergers.

With this deal, there will be three mega-banks – Citigroup, J.P. Morgan-Bank One and Bank of America -FleetBoston – followed by a slew of smaller ones. “This seems to be a logical joining of franchises,” says Andrew Metrick, professor of finance at Wharton. “It’s not clear where the synergies are – who’s going to get fired or what else is going to happen.”

Conceivably, many smaller banks could aggregate into another colossus, or they might be absorbed into the big three, he suggests, adding there will always be a market for some small banks. “But it seems like, for better or worse, the optimal scale of banking has changed. So you’ve got to get bigger.”