Informational Externalities of Bank Initial Public Offerings - Evidence From Banking Industry

5/27/2018 Informational Externalities of Bank Initial Public Offerings - Evidence From Banking Industry

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Applied Financial Economics, 2009, 19, 19872007

The choice of IPO versus M&A:

evidence from banking industry

Bill Francisa, Iftekhar Hasana,b and Dona Siregarc,*

aLally School of Management and Technology, Rensselaer Polytechnic

Institute, Troy, NY 12180, USAbBank of Finland, Helsinki, FinlandcDepartment of Economics, Finance, and Accounting, State University of

New York at Oneonta, USA

This study investigates factors influencing private banks exit strategy

between going public (Initial Public Offering (IPO)) and being a target in

Merger and Acquisitions (M&A). Evidence indicates that a bank with high

liquidity, operating in a geographical deregulatory environment is more

likely to go for the M&A option. Larger and older institutions, improved

economic environment, increased recent trend of choosing IPOs and

smaller difference in premiums paid between the alternative choices are

likely to encourage banks to opt for IPO as an exit strategy. We observe

the existence of self-selection in making the exit choice and find that the

average transaction value of bank IPOs (M&As) would have been higher

(lower) had the banks chosen to engage in M&A (IPOs).

I. Introduction

Going public can be viewed as a choice faced by a

private firm. At some point, a private firm may opt to

go public for economic and financial reasons, or for

the interest of the owners or managers. Under this

argument, theoretical studies on the decision between

going public and staying private have been widely

developed. Zingales (1995) offers an explanation on

the role of initial public offering in maximizing the

proceeds obtained by the owner of a firm. Subsequent

studies include Mello and Parsons (1998), Pagano

et al. (1998), Pagano and Roell (1998), Chemmanurand Fulghieri (1999), Maksimovic and Pichler (2001)

and Boot et al. (2006). Rosen et al. (2005) study the

choice of going public or remaining private for a

sample of banking institutions.

A more recent approach by Brau et al. (2003) and

Poulsen and Stegemoller (2008), yet not much

explored, suggests that besides going public, there

exists another appealing exit route for a private firm,that is, takeover. Going public and takeover can be

seen as two comparable paths as both represent an

access to capital funds, a liquidity method to the

owners, and a way to shift ownership and control.

Although they are comparable, they are different in

ways to achieve each purpose. Going public allows

private firms to access capital funds through capital

markets, while takeover enables firms to access

funds through the acquirers. Going public provides

a liquidity method to the owners through holding

the issued stock, whereas takeover is through cash or

acquirers stock. Finally, Initial Public Offering (IPO)enables owners to maintain control and ownership,

while takeover results in relinquished or substantial

diminished control and ownership.

Given the major similarities and differences

between going public and takeover, the choice can

be influenced by several factors. Using cross industry

data as the subject of analysis, Brau et al. (2003)

*Corresponding author. E-mail: [email protected]

Applied Financial Economics ISSN 09603107 print/ISSN 14664305 online 2009 Taylor & Francis 1987

http://www.informaworld.com

DOI: 10.1080/09603100903251262


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report that the choice is driven by factors of industry

characteristics, market timing, demand for funds

and deal-specific factors, such as firm size, insider

ownership and liquidity. Poulsen and Stegemoller

(2008) analyse differences in growth, capital con-

straints and asymmetric information between

industrial firms that go public and sell out to public

firms. They found that going public firms tend tohave greater growth opportunities and face more

capital constraints.

Our work offers a better understanding on factors

that are unique to banking institutions ignored by

previous research (Brau et al., 2003; Poulsen and

Stegemoller, 2008). We focus on the empirical

question of the decision between IPO and takeover

in the banking industry. We are motivated by the

observation that while many private banks chose for

takeover, still a number of privately held banks

decided to go public. We inquire why some private

banks decided to be taken over while some others

preferred to go public in the midst of the industry

transformation. Building on the previous study by

Brau et al. (2003), we put emphasis on regulatory

and market competitive factors as the determinants of

the choice. We also consider the impact of the

individual bank financial characteristics on the

choice.

Our goal is to test factors that may affect private

banks choice between going public and takeover.

We hypothesize that regulatory, market competitive

environments and bank financial characteristics have

influence on private banks to choose between IPO

and takeover. Since the IPO and takeover havefundamental consequences that lead to changes in

banks future decision on investment, financing,

as well as ownership of the owners and managers,

it is important to discover the factors that may

influence private banks to choose one path from

the other.

Results show that unrestricted branching and

banking activities increase the likelihood that banks

will merge. Age and size are positively related to the

probability that the banks will conduct IPOs. Private

banks with high liquid asset are more likely to involve

in Mergers and Acquisitions (M&A).

Furthermore, analysis of self-selectivity in choosingIPO and M&A based on Transaction Value (TV)

is performed. It is found that the mean of observed

TV of bank IPOs is lower than that of bank M&A.

The TV of Bank IPOs would have been higher

had the banks chosen to engage in M&A, while

the TV of Bank M&A would have been lower had the

banks chosen to go public.

The article is organized as follows. Section II lays

out similarities and differences between IPO or M&A

and closely related papers. Section III presents factors

and hypotheses for the two alternative choices.

Section IV describes the research design including

data and methodology. Section V presents results,

and the summary appears in Section VI.

II. IPO Versus M&A

IPO and M&A provide many similar benefits to the

owners and managers of private banks. They are

comparable paths as both represent an access to

capital funds, a liquidity method to the owners and

a way to shift ownership and control. Access to

capital funds can be achieved directly from a public

market when private firms choose to go public, and

indirectly through their acquirers when they opt for

takeover. A varying level of liquidity needs of the

owners can be obtained through a design of transac-

tion through either an IPO or takeover. An IPO

allows the founders to convert some of their paper

wealth into cash at a future date, while a takeover can

provide such a design through cash proportion in the

transaction.

The other comparable aspect is that the level of

ownership and control can be shifted after either

IPO or takeover. The owners of private firms can

establish a level of controlling ownership after IPO by

retaining a proportion of primary to secondary shares

(Brennan and Franks, 1997), or by tailoring owner-

ship slowly in the years after IPO if going public is

considered as the first stage of gradual sell outstrategy (Zingales, 1995; Mello and Parson, 1998;

Paganoet al. 1998). In a takeover, change of control

and ownership can be determined by the methods

of payment. Typically, cash payment implies that the

owners of the target must relinquish the control to

the acquirer at the time of transaction. At the other

extreme case, fully stock payment may consequently

offer a control power to the targets owners.

Brau et al. (2003) explore factors that influence

firms to choose between going public and takeover.

They find that firms in more concentrated industries

are more likely to go public. Going public is also

more likely when IPO market is hotter than thetakeover market, and when the cost of debt is high.

IPO is also more likely for firms that have lower

market-to-book ratios, lower debt level and are larger

in size. The study is drawn from samples of firms

across industries. However, this study lacks data at

individual firm level, including for banks.

Poulsen and Stegemoller (2008) investigate the

choice of private companies between going public

and takeover using industrial firms as their sample

1988 B. Franciset al.


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of study. Focusing on firm-specific factors to identify

difference in growth, capital constraints and asym-

metric information between the two alternatives,

they find that firms that eventually go public have

greater opportunities and face more capital

constraints.

Studies have investigated motivations of bank

mergers and analysed features of target banks incomparison to their comparable banks that stay

independent.1 Studies on going public banks are very

limited. Houge and Loughran (1999) analysed the

long-run performance of banks following IPO and

changes in operating performance of banks around

the time of new equity issues. They find that returns

over a 5-year post-offering holding period are

significantly below benchmarks. The banks exhibit

significant low levels of loan loss prior to IPO, but

increase loan loss allowance up to the industry

average in the subsequent years following IPO.

They suggest that the provision of loan losses

increases as banks adopt marginally riskier loan

investments. Rosenet al. (2005) use banks to examine

the decision to go public in comparison to similar

banks that stay private. Matching samples by asset

size, they find that going public banks are riskier,

more likely to be acquired and also more likely to

become acquirers than those that remain private.

Following IPO, banks show deteriorating perfor-

mance measured by return on equity or return

on assets, or ratio of charge offs to total loans.

In addition, banks are found to go public in a period

of high stock market returns.

III. Factors Affecting IPO Versus M&AChoice in Banking Industry

Regulation-related factors

Restrictions on geographic entry may affect the

choice between going public and selling out. Banks

were subjected to severe entry barriers in the form

of intrastate branching and interstate banking restric-

tions. Prior to the federal regulation of McFadden

Act 1927, The National Banking Act of 1864 was

interpreted to ban national banks from branchingin the states where state banks were allowed to

branch. The inequality restriction between the banks

was ceased by the passage of McFadden Act of 1927

and GlassSteagall Act of 1933. The amendment gave

national banks the same power of the state-chartered

banks to establish branches.

Regardless of the passage of the McFadden and

GlassSteagall Acts, however, many states continued

implementing restrictions on bank branching. Prior

to the 1970s most states had laws restricting within-

state branching. Restrictions of intrastate branchingvaried from state to state, but typically state

authorities formulated the regulations on the basis

of minimum size of population, administrative region

boundaries, the presence or adequacy of a bank in the

allowed boundaries, the distance of a new branch

from existing bank or branch and the size of a branch

(Amel, 1993).2 By 1970, 39 states restricted branch-

ing, including those that completely banned branch-

ing and others that put limits on branching. Only

11 states allowed statewide branching. Most states

with restrictions on intrastate branching only allowed

banks to expand by acquiring a bank, which eventu-

ally was converted into a subsidiary or branch.

In states with limited branching, banks made mul-

tiple acquisitions to expand their network. In states

with statewide branching, a bank could expand by

acquiring any bank located in the same state

(Amel, 1993; Carrow and Heron, 1998; Kroszner

and Strahan, 1999; Johnson and Rice, 2007).

Bank Holding Company (BHC) structure was

used as a way to circumvent branching restrictions.

A Multi-Bank Holding Company (MBHC) owns

multiple banks and places them under the same

ownership. However, technically, they cannot operate

as a single network. Each bank has to operateindependently and meet all regulatory requirements,

and the bank subsidiary is treated as if it runs as

a stand-alone bank. Although the creation of MBHC

was allowable, some states also placed restrictions

on the BHC expansion within the states. These

restrictions include the ban on BHC to own more

than one bank and limitation on BHCs expansion by

setting the percentage of state bank deposits that

could be controlled (Amel and Liang, 1992; Savage,

1993; Johnson and Rice, 2007)

In addition to intrastate branching, banks are

historically restricted to expand across state borders.

The Douglas amendment to the BHC Act of 1956prohibited bank holding companies from buy out-

of-state banks, unless the states in which the target

banks located specifically permitted such acquisitions.

1 See, for example, Hunter and Wall (1989), Hawawini and Swary (1990), OKeefe (1996), Berger et al. (1999) and Wheelockand Wilson (2004).2 For example, Florida and New Hampshire still strictly ban branching. Alabama restricted branches in countries with lowerthan a specified population level. Minnesota prohibited branching, but permitted facilities within 1000 feet of the main office.Other states used a combined measure consisting of bank size, population served and distance from main office as a branchingdetermination (Amel, 1993).

The choice of IPO versus M&A 1989


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This Act prohibited interstate banking, except for

19 small multistate BHCs that were given grand-

fathered rights that allow them to continue to operate

in multistates. Since no state allowed such acquisitions

defined in the Act, interstate banking was effectively

prohibited until 1980s.3

Both federal and state laws historically prohibited

banks from establishing branches across state lines.As mentioned previously, the McFadden Act of 1927

established in-state branching laws for national banks

and for state-chartered banks that are members of the

Federal Reserve System. However, the Act prohibited

these banks from branching outside their home state.

The passage of the BHC Act of 1956 provided states

with controls to rule interstate banking activities by

BHC; however, it does not provide powers for states

to regulate these banks on interstate branching.

Interstate branching restrictions continued on these

banks until the RiegleNeal Interstate Banking

and Branching Efficiency Act (IBBEA) was passed

in 1994. Prior to this Act, only eight states permitted

some degree of interstate branching, but it only

applies to state nonmember banks (Savage, 1993).4

Since 1970s, more states started relaxing bank

branching, and in 1980s, more states allowed inter-

state banking laws for MBHC. Throughout the rest

of the century, individual states set up their own

banking legislation. The level of deregulation and

the time it was introduced varied from one state to

another. As of 1994, five states had laws that limited

intrastate branching, seven states had statewide

branching with restrictions and the remainder

allowed full statewide branching. All states butHawaii had allowed regional interstate banking by

BHC by the year 1994 (Amel, 1993; Carrow and

Heron, 1998; Kroszner and Strahan, 1999).

The RiegleNeal IBBEA of 1994 is a culmination

of deregulation on interstate banking and branching.

It replaces the existing state-level legislation on

interstate banking and branching. The Act allows

BHC to acquire banks in any state and permits

nationwide interstate branch banking. The interstate

branch provision permits banks to consolidate inter-

state banking subsidiaries into a single bank.5

The long-standing geographic restrictions have

contributed to the fragmented structure of the US

banking industry and to the geographic restrictions

on competition. Geographic restrictions limit entries

into local bank markets and impair the market for

corporate control. Existing studies provide some

insights on how intrastate and interstate geographic

restrictions may affect the likelihood of banks to go

public or engage in takeover.

Geographic restrictions are found to prevent entry

to local markets (Beattyet al., 1985; Amel and Liang,1992). Such restrictions on entry may allow many

inefficient banks to survive during the geographic

restriction era. Barrier to entry helps the existence

of limited competition in local deposit and loan

markets. Lack of competition allows some banks to

acquire market power that in turn, to some extent,

may distort the efficiency of banks. For example,

banks may operate inefficiently because management

does not screen loan based on competitive rates,

or banks accept negative Net Present Value (NPV)

loans because the market power allows banks to seek

economic rent (Berger et al., 1995).6

The intrastate and interstate geographic barriers

limited the set of banking organizations that are

eligible to acquire banks. For example, many states

restricted acquisition to acquiring banks in the same

location. Even if branching by merger is permitted,

branching restrictions based on the percentage of

deposits controlled within the state may also insulate

banks from a takeover threat. This lack of corporate

control market to discipline management would

result in inefficiency, due to misalignment of share-

holders and management objectives (Schranz, 1993;

Hubbard and Palia, 1995). Reduced activity in the

corporate control market may contribute to increasedcosts and reduced profitability for banks that operate

in the states with geographic restrictions. Schranz

(1993) finds that banks located in states with strict

restrictions on take over are less profitable than

banks in states without such restrictions. Jayaratne

and Strahan (1998) find that operating costs and loan

losses decrease after statewide intrastate branching

and interstate banking deregulation. They suggest

that branching restrictions limit the growth of banks

and reduced the efficiency of banks on average.

As the intrastate and interstate banking regulations

are lifted, the potential acquirers increase and the

market for corporate control becomes more active.

Banks can obtain benefits from takeover, including

3 Maine started allowing out-of-state BHC to buy banks residing in Maine with reciprocity laws since 1978. However, becauseno other states established out-of-state acquisition rules, Maines laws remained inactive until 1980s, when New York andMassachusetts passed interstate banking laws.4 The states that allowed the interstate branching by 1994 are Alaska, Massachusetts, Nevada, New York, North Carolina,Oregon, Rhode Island and Utah.5 See Carrow and Heron (1998) and Johnson and Rice (2007) for further discussions on the authorities of individual statespost the IBBEA Act.6 For evidence on market power, see e.g. Berger and Hannan (1998).



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better disciplines of the management of banks

(Schranz, 1993; Hubbard and Palia, 1995).7

Jayaratne and Strahan (1998) reported that banks

loan losses and operating costs fell sharply following

the removal of interstate branching. They suggest

that low-cost, high profit banks grow at the expense

of their less efficient rival banks. Other studies also

indicate increased scale of economies, increasedmarket power (Amel and Liang, 1992), diversification

(Demsetz and Strahan, 1997) and incentives of

managers and directors of potential targets

(Hadlocket al., 1999).8

The reduction in geographic restrictions may also

promote IPO activity. Banks now face much less

restrictions to expand their business across borders or

within the state. In response to the expansion

opportunity, banks can go public to raise funds and

use them to support their business expansion. Going

public would also provide a bank with stocks that can

be used for acquisition in the future (Pagano et al.,1998). Rosen et al. (2005) find evidence that going

public banks are more likely to become acquirers

than their counterparts who remain private after

controlling for size, age and profitability of the bank.

This finding indicates that becoming acquirers is an

important motivation that drives banks to go public.

However, although by going public is hypothetically

possible for banks to become acquirers, it involves

a sequence of transitions and entails different sets

of regulatory requirements. As a result, going public

becomes a costlier choice for the banks for this

particular objective, and this is especially difficult

for banks that had been operating less efficiently inrestricted geographic era.

Therefore, the lessening of intrastate and interstate

restrictions is expected to have a positive impact on

M&A activities. It is predicted that the relaxation

of geographic restrictions affects privately held

banks to more likely engage in acquisitions. As the

deregulation is left to an individual state, each state

introduced the deregulation in different years. The

years when interstate and intrastate legislations

became effective for each state follow those reported

by Amel (1993) and Kroszner and Strahan (1999).

Hypothesis 1: The lower the regulatory restrictionsrelated to intrastate or interstate banking activities

in the states where banks operated, the less (more)

likely the banks will go public (M&A).

Branching and acquisition barriers were signifi-

cantly reduced by the RiegelNeal IBBEA in 1994.

The act replaces existing state level legislations on

interstate activities by allowing bank holding compa-

nies to acquire banks in any state, effective from

30 September 1995. The interstate branching provi-

sion allows banks to consolidate their interstate

banking subsidiaries into a single bank, effectivefrom 1 June 1997.

The nationwide interstate banking and branching

replaces the previous regional interstate banking that

had been introduced prior to the passage of the Act.

Many individual state laws already permitted inter-

state banking, but only eight states allowed some

forms of interstate branching.9 Six states allowed

interstate branching under reciprocal laws, Nevada

allowed interstate branching in counties with a

population of less than 100 000 with nonreciprocal

laws and Utah permitted nonreciprocal interstate

branching.10

Methods of out-of-state branching are extended

by the passage of the IBBEA. Branching across state

lines prior to IBBEA can be carried out only by

two ways. First, a bank can charter a new subsidiary

or de novo bank in a state other than the state where

the banks headquarters are located. Second, a bank

can acquire an out-of-state bank and then convert it

to a subsidiary of the parent bank. Following the

IBBEA, BHC can merge subsidiary or branch in four

ways (Johnson and Rice, 2007). First, the BHC can

separately acquire chartered institutions. Second, it

allows interstate agency operations that permit a

bank subsidiary of a BHC to act as an agent of anaffiliate of the BHC without being legally considered

as a branch of that affiliate. Third, the Act allows

banks to consolidate acquired banks or individual

branches into branches of the acquiring bank, and the

last is branching by establishment of a new branch

office of a banking company across state borders as

long as the states statute expressly allows opening of a

new branch by out-of-state banks.

Many believe that the interstate branching provi-

sion of the IBBEA will have greater influence on the

activity of corporate control. As the cost of entry

decreases, bank holding companies can increase their

opportunities nationwide, and at the same time theIBBEA enables them to convert their subsidiaries

into branching networks that many argue will reduce

the costs of running bank holding companies.

7 Evidence by Hubbard and Palia (1995) shows that turnover and the sensitivity of pay to performance for senior executivesincrease after states allow interstate banking, indicating an increased alignment between management and shareholders.8 Hadlocket al. (1999) show that bank managers with a large ownership stake might push for being acquired in the hope ofreceiving an attractive takeover premium.9 For further explanation and examples on interstate banking prior to the IBBEA, see Savage (1993).10 For further explanation and examples on interstate branching pre- and post-IBBEA, see Johnson and Rice (2007).



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Grabowskiet al. (1993) show that branch banking is

a more efficient organizational form than the BHC

when performance is measured by nonparametric

frontiers. Carrow and Heron (1998) find that

investors anticipated that BHCs gain benefits from

the relaxation of interstate branching restrictions.

Due to the perceived increased benefits coming from

the interstate branching, we expect that the corporatecontrol activities will increase as the interstate

branching comes into effect. A study by Johnson

and Rice (2007) also finds that the M&A increases

following the interstate branching. The number of

banks decreases over time and the number of out-of-

state branches increases.

The effect of the nationwide deregulation will be

tested to examine its impact on the decision of going

public or M&A. The hypothesis is that banks tend to

choose to go M&A instead of IPO, since engaging

in M&A can increase the potential of scale of scope

and scale of economy more aggressively after the

passage of the Act, while the cost of organizational

form reduces.

Hypothesis 2:Banks are less (more) likely to go public

(M&A) in the period when geographical unrestricted

banking activities are permitted.

Certain types of depository institutions may expe-

rience changes in the environment of the banking

industry that lead them to favour going public than

sellout. A large number of banks and thrifts have

issued an initial public offering of stock. The issue of

stock is a response of savings and loans to increased

growth opportunities that are caused by changes intechnology, increased competition in the savings and

loan competition, risk bearing and potential scale and

scope economies (Masulis, 1987; Carhill and Hasan,

1997; Esty, 1997). Opportunities to grow opened up

as electronic funds transfer technology allowed

depository institutions to achieve greater economy

of scale and scope. The types of services savings and

loans could offer also expanded as dictated by the

Depository Institution Deregulation and Monetary

Control Act of 1980 and the Depository Institutions

Act of 1982. However, a higher volatility in interest

rate and interest rate level increased variability of

earnings and leverage ratios. Going public providedcapital to savings and loans to anticipate increased

growth opportunities and to prevent insolvency from

losses and uncertainty in earnings. In the new

environment, stock type improves thrifts access to

capital, and allows thrifts to grow steadily in the

increasingly competitive environment.

Studies show that a certain type of depository

institutions prefers to go public because changes

in their circumstances give them substantial forces

to favour the benefits from going public. Based on

previous evidence, this study will test the hypothesis

that savings institutions are more likely to choose

IPO than the other type of institution.

Hypothesis 3: Depository intermediaries chartered as

savings institutions are more (less) likely to go public

(M&A).

Market competitive environment

Local market environment where banks operate may

influence the decision to go public or takeover. In less

concentrated local loans and deposits markets, banks

may be able to increase market concentration, up to

an extent, by merger. Being in less competitive

markets bring benefits to banks. These banks can

raise their expected profits and reduce risk. Rhoades

and Ruts (1982) show that banks that can increase

market concentration experience higher profits and

less variability in net income. Another benefit is thatregulators are likely to accept proposed banking

mergers in less concentrated local markets.

However, in competitive local markets, profitabil-

ity is more uncertain and pressures for investment in

new products and services are more intense (Rhoades

and Ruts, 1982; Masulis, 1987; Esty, 1997). Going

public can provide capital that can be used to invest

in new services, raise the level of liabilities, and to

provide cushion against losses and lower probability

of insolvency. As in competitive local markets vari-

ability in earnings is higher, going public can provide

banks more benefits to offset the negative effects

from high uncertainty of earnings.Given these two competing arguments, the effect

of market competitive environment on the decision

of banks to go public or sellout will be left to the

outcome of the empirical testing.

Hypothesis 4:The more competitive the local market,

the more likely that banks will go public (M&A).

Bank fundamental factors

Banks, like other business, have a growth cycle

in terms of financing and investing. As banks grow,

their financial needs and investments change. Youngbanks may heavily depend on internal financing or

acquisition of deposits. As banks become mature,

banks are more likely to go public to meet their need

for growth, especially in response to encouraging

conditions, such as good economic environment

(Ritter and Welch, 2002; Brau et al., 2003; Pastor

and Veronesi, 2005), or deregulation (Esty, 1997).

A model by Chemmanur and Fulghieri (1999) also

predicts that older firms are more likely to go public



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because the evaluation costs on going public firms

depend on the amount of information already avail-

able in the public domain about the firm and its

management, which is positively related to the years

of establishment of the firm.11

Younger banks may be at a disadvantage due to

lack of information available to investors. These

banks may find that acquisition provides a betterdeal on specific aspects that fit the acquirers purposes

given their stage of growth, and receives better eval-

uation for the particular features. Therefore, every-

thing else being the same, older banks are expected to

be more likely to go public. The age of a bank is

measured from the time when the bank is found to the

time when it goes public or engages in M&A.

Hypothesis 5:Older banks are more (less) likely to go

public (M&A).

Bank size represents the resources and capability

of the bank to successfully compete as a publicly

traded entity. Even before accessing the public

market, a bank should consider its resources for the

direct and indirect costs involved in issuing new

securities. Pagano and Roell (1998) point that IPOs

involve high explicit fixed costs. Ritter (1987) has

estimated that the fixed cost of going public can reach

$2 50 000 and the variable costs are about 7% of the

gross proceed of the IPO. As the costs are not linear

to size, smaller banks will face the costs at a larger

proportion than banks with bigger size.

In addition to the direct costs of going public,

smaller banks may experience larger asymmetric

information between issuers and investors. They aretypically followed by fewer analysts, and this asym-

metric information adversely determines the magni-

tude of IPO pricing. On the other hand, small banks

may find sellout as a better option than going public.

They may not be adversely affected by the cost of

going public that can hinder them even from the

beginning stage of going public, or the costs of higher

underpricing because the small banks possess high

asymmetric information.

Thus, for the size factor, it is predicted that bigger

banks prefer to go public. The variable that will be

used to measure the size is total assets. Total asset

is widely used as a proxy of size for banks. The higher

the asset of a bank, the more likely that the bank

chooses to go public.

Hypothesis 6:The bigger (smaller) the size, the higher

the probability that banks go public (M&A).

Banks manage the amount of capital to reduce the

chance of bank failure, to meet capital adequacy set

by regulatory authorities, and to lessen moral hazard

by reducing the incentive of bank owners to take risk.

Banks with substantial growth in the past would

eventually opt to raise capital, as capital ratio holding

becomes shrinking due to growth in their asset

size prior to going public. Findings by Houge andLoughran (1999) and Rosen et al. (2005) show IPO

banks in general grow significantly faster in their

assets prior to the stock issuance. Poulsen and

Stegemoller (2008) also find that going public firms

tend to grow significantly in total assets and capital

expenditures prior to the public offering. These banks

may find it necessary to increase their capital holding

to meet the requirement and to provide a cushion

against unpredicted losses. Houge and Loughran

(1999) suggest that some banks went public to take

advantage of growth opportunities, and invested the

capital raised from the offering in marginally riskierloans that eventually made these banks relatively

experience larger loan write-off than the average

banking industry. We expect that banks that ulti-

mately go public exhibit low capital-to-asset ratio.

The target banks are expected to have relatively

higher capital-to-asset ratio than going public banks.

The target banks are also found to have a high

growth in total assets (Hunter and Wall, 1989;

OKeefe, 1996). With other things constant, banks

that experience the same growth as others but hold

higher capital ratio may find takeover a better option.

Acquirers may place higher values to banks with

excess capital. At the same time, acquirers may find

them attractive since excess capital can be used as a

means to help them grow once acquisitions complete.

In addition, return on equity of target banks would

rise following the reduction of capital holding of the

targets.

To test the effect of capital ratio to the likelihood

of going public or takeover, capital ratio is measured

by standardizing it to total assets. Banks with

relatively lower capital ratio are predicted to go

public.

Hypothesis 7: The lower (higher) the capital, the

higher the probability that banks go public (M&A).

Core deposits may also be a factor in determining

the choice between going public and acquisition. Core

deposits are the base of demand and savings accounts

that banks can expect to maintain for an extended

11 In spite of this common prediction, Rosen et al. (2005) find that younger banks are more likely to go public than stayprivate using a size-matching sample.



8/22

period of time. They include deposits that are

acquired from noninterest bearing deposit demand

account, NOWs and savings accounts.

Core deposits are seen as an essential and stable

source of funds for lending. They are influential

because the accounts generally carry lower interest

rates than other funds obtained from the open

market, making them valuable low-cost funds forbanks. Using low-cost core deposits as source of

funds allows banks to generate high margin products

because interest rates differential between typical

loans and core deposit funds can be significant.

In addition, these accounts experience less interest

rate sensitivity than other short-term accounts, and

may insulate borrowers against exogenous changes

in aggregate credit risk (Berlin and Mester, 1999).

Perhaps the most important feature of core deposits

is that customers usually open these accounts and

remain with the banks for quite a long time. They

usually stay with the banks and emphasize on

relationship with the banks. This makes core deposits

a stable source of funds for lending.

Core deposits can be attractive for both going

public and bank acquisition. The volume of core

deposits would give an edge to banks that are about

to go public. Having a strong deposit base along with

the possibility of expanding products offered to the

customers of these accounts could lead to potential

earnings in the future. For a bank acquisition, the

buyer receives a built-in base of stable customer

relationships through accounts associated with core

deposits. These deposits benefit the buyer by provid-

ing low-cost funds, and helping to boost profits whileat the same time reducing the interest rate risk. In

addition, for acquisition, deposit relationships may

provide even more value addition through the cross-

selling opportunities to these customers.

However, everything else being the same, banks

with a higher level of core deposits can be especially

valuable in the view of acquirer due to tax benefit of

these accounts. Core deposits can be viewed as

intangible assets to banks; they become worthless or

meaningless when they are separated from the

business. In the valuation of acquisition, intangible

assets can be amortized for federal income tax

purposes. As a result, significant tax savings may berealized from acquiring banks with a higher volume

of core deposits. We predict that banks with relatively

higher core deposits will tend to be acquired.

In addition, evidence in the bank merger literature

suggests that core deposit is one of strategic

profiles of target banks (Hunter and Wall, 1989).

Wheelock and Wilson (2004) also find that higher the

core deposit ratio is positively related to merger

probability.

Hypothesis 8: The lower (higher) the banks core

deposit, the more likely that the bank goes

public (M&A).

Any banking organization must ensure that

adequate liquidity is maintained in order to meet

customer withdrawal requirements, satisfy contrac-

tual liabilities, fund operations and for loans. Sourcesof liquidity include assets readily convertible to cash,

including investments and other securities with matu-

rity in 1 year or less, interest bearing balances at

other banks and short-term debt that is money

market related.

In the financial market, an excess liquidity signals

inept management who may not be efficient in asset

management. On the other hand, high liquidity may

signal a higher value to potential acquirers as more

liquidity means less risky and also more unused assets

that can be used for new capital budgeting decisions

to the acquirers. OKeefe (1996) find that compared

to banks that stay independent, the probability ofengaging in merger increases with bank liquidity.

Therefore, it is expected that banks with low liquidity

are more likely to go public.

Hypothesis 9: The lower (higher) the liquidity, the

more likely that banks go public (M&A).

IV. Data and Methodology

Data

The sample used for the analysis consists of bank IPO

and bank takeover samples. The bank IPO sample

is obtained from the Securities Data Company (SDC)

Global New Issues database for US banks that went

public in the period 1985 to 1999. The initial sample

of IPO consists of 361 banks. Then the FDIC

certificate number and Fed ID number for each

bank are matched. We found 337 banks with the

ID numbers. Each bank is also required to have

sufficient data available for the hypothesis tests. As

some of the banks did not have data available

from the FDIC database, the final IPO sample

consists of 272 banks.In the same way, the bank takeover sample is

initially drawn from the SDC M&A database for

US bank M&As that occurred between 1985 and

1999. We utilized all US banks that are privately held

targets and completed the M&A deals with US bank

acquirers. The initial number was 4393. The list was

matched with the merger list provided by Federal

Reserve Bank of Chicago, and selected only the

M&As that are not involved in government assistance.



9/22

This gave 790 banks. Finally, due to data availability,

the target banks sample has 440 banks.

The FDIC database provides most of the data

needed for the hypothesis tests. The FDIC database

provides financial data and history of all entities

filing the Report of Condition and Income (Call

Report) and some savings institutions filing the OTS

Thrift Financial Report (TFR). The entities includecommercial banks, savings banks and savings and

loans. Other databases employed in this study include

Center for Research in Security Prices (CRSP)

(for the stock market returns). The years when state

allowed intra or interstate banking activities are

provided by Kroszner and Strahan (1999). The

years are used to define whether a state already

allowed intrastate branching or interstate banking

when a bank went public or are acquired. This is to

reflect intrastate and interstate banking activity

restrictions.

Methodology

The aim of the analysis is to test factors that may

affect privately held banks to choose between IPO

and M&A. A binomial choice model is developed

with the regulatory, market competitive environment

and firm fundamental factors as the influencing

aspects contributing to the decision taken by private

banks. This problem is suitable for examination

and testing using a logistic regression methodology.

The binomial choice variable is one for banks that

choose to go public, and zero for banks that decided

to go M&A, with the influencing factors as indepen-

dent variables in the logistic regression method.

The maximum likelihood estimation method is

performed for the following model:

ln Pi

1Pi

0

X3j1

jXji 4X4i

X9j5

jXjiX13

j10

jXjiui

where

i i-th observation,

j 1,2, 3 regulatory environment factors(STATEREG, DEREG, SVINST),

j 4 market competitive environment

factors (MSA),

j 5, . . . , 9 firm fundamental factors (AGE,

LASSET, CAPITAL, CORE,

LIQUIDITY),

j 10, . . . , 13 control variables.

The logistic model defines Pi eXi=1eXi as

the probability that i-th bank will offer IPO. Xiis the

vector of factors that are used to distinguish banks

that went public from M&A, and is the vector of

estimated coefficients.Pi=1Piis the odds indicat-

ing how often IPO happens relative to how often

it does not occur. The logit, i.e. natural log of the

odds, is linearly related to the explanatory variables.

Variables

Variables used for the logistic regression estima-

tions are as follows. The regulatory environment

factors consist of three variables: state regulation

(STATEREG), bank deregulation at national level

(DEREG) and type of banks (SVINST). A dummy

variable is used for each of these variables.

STATEREG equals one if the states in which banks

went public or merged allowed full intrastate

branching or interstate banking activities. DEREG

depicts the geographical deregulation on banking

industry at the national level. Effective from 1997,

geographical restriction is eliminated as a result of

RiegelNeal Act. A dummy variable of one is

assigned if banks went public or M&A in the post-

deregulation era, the year of 1997, else a dummy

variable of zero is assigned. Type of bank institution

is represented by SVINST, which equals one for

savings banks and zero for commercial banks. We

define savings banks as savings institutions and

savings and loans associations.

The market competitive factor is represented by

Metropolitan Statistical Area (MSA).12

Antitrustanalysis has relied on the definition of a banking

market at the MSA level (Dick, 2008). MSA is to

indicate whether a bank is in MSA area or not. The

dummy variable is utilized for this purpose, with

MSA equal to one for banks operated in MSA areas.

Urban banking markets are considerably less con-

centrated than rural areas as the number of banks

competing in urban areas is larger than that in rural

markets.

Firm fundamental factors have five variables: AGE,

LASSET, CAPITAL, CORE and LIQUIDITY.

AGE is measured as years from when a bank is

established to the year when the bank went public orinvolved in M&A. LASSET is the log of total assets.

CAPITAL is the level of equity of a bank divided

by total assets, CORE is the level of core deposit

over total assets and LIQUIDITY is the ratio of the

sum of securities and cash to total assets.

Control variables include economic environment

factor measured by Standard and Poor (S&P) returns

12 Many recent papers define local banking market by MSA, see Dick (2008) for a recent example.



10/22

at the day when the banks go public or when the

M&A deal is completed. The market practice factors

comprise LPREMIUM and TIMING variables.

LPREMIUM is measured by taking the natural

logarithm of the difference between the premium paid

for public bank targets and that for private bank

targets. TIMING is a lagged relative volume that

measures the volume of IPOs over the volume ofM&A in the previous year when a bank conducted

IPO or M&A. These factors are used to control

economics and market practices, which are found

to be influential (Brau et al., 2003).

V. Empirical Results and Discussion

Figure 1 presents the distribution of IPO and M&A

samples over the period January 1985 to December1999. The bars represent the number of bank IPOs

and bank takeovers in each year. As shown in the

graph, a larger number of banks went public in

the years between 1985 and 1988. The trend reverses

in early 1989, with a larger number of banks chose to

be acquired.

Table 1 reports descriptive statistics of variables

for the whole sample of bank IPOs, and for savings

institution and commercial bank sub-samples. As

shown in Table 1, more than 90% banks went public

during the time when states in which they located

have allowed full intrastate or interstate banking.

About half of the sample is savings institutions orsavings and loans associations.

The MSA variable is a proxy used to identify

whether a bank operates in a high competition

market. Overall, more than half of the banks going

public operate in highly competitive local markets.

Around 79% of the bank IPOs are located in MSA

areas, almost 90% for savings institution IPOs and

around 67% for commercial bank IPOs.

Looking at the descriptive statistics of firm funda-mental factors, the average age of the bank that

chooses IPO is 64.5 years, with the savings institutions

that do so older than the commercial banks (84 years

versus 40 years). The rest of the firm fundamental

factors are also interesting to look at. The average size,

measured by the log of total assets, is 12.0696 ($174

million) for the full sample. The savings institutions

($305 million) are much larger than the commercial

banks ($89 million). For capital ratio, the full sample

has an average of 0.0739. Savings institutions are

found to have a much lower capital ratio than

commercial banks do (0.0539 versus 0.0984).Similarly, the liquidity ratio of savings institutions

(0.2400) is lower than that of commercial banks

(0.2666). However, the core deposit ratio is shown to

be higher in the savings institutions (0.8188 compared

to 0.7521), although the magnitude may not be

considerably larger. In summary, savings institutions

that choose IPO are more mature and larger than

commercial banks that choose IPO, and their funda-

mental structures are quite different. Savings institu-

tions seem to rely on core deposits, while commercial

banks hold more capital and liquidity.

Table 2 shows descriptive statistics for the full

sample of bank M&As, savings institutions and

commercial bank sub-samples.

Fig. 1. Number of bank IPOs and M&As in the sample by yearNote: The sample consists of 272 bank IPOs and 440 bank M&As from January 1985 to December 1999.



11/22

Table1.

DescriptivestatisticsforthesampleofbankIPOs

PanelA.F

ullsample

PanelB.Savingsinstitutions

PanelC.Commercialbanks

Variable

Mean

SD

Minimum

Maximum

Mean

SD

Minimum

Maximum

Mean

SD

M

inimum

Maximum

Regulatoryfactors

STATEREG*

0.9302

0.2554

0

1

0.5000

0.5017

0

1

0.9508

0.2171

0

1

DEREG

0.1324

0.3395

0

1

0.0200

0.1405

0

1

0.2705

0.4461

0

1

SVINST

0.5515

0.4983

0

1

NA

NA

NA

NA

NA

NA

N

A

NA

Marketcompetitiveness

MSA

0.7868

0.4104

0

1

0.8800

0.3261

0

1

0.6721

0.4714

0

1

Firmfundamentalfactors

AGE

64.5368

44.8384

0

165

83.9533

40.1481

1

165

40.6639

38.4185

0

137

LASSET

12.0696

1.4000

9.1089

16.3690

12.6301

1.3114

9.1089

16.3690

11.3842

1.1870

9.2281

16.1000

CAPITAL

0.0739

0.0740

0.0662

0.7435

0.0539

0.0344

0.0662

0.2242

0.0984

0.0983

0.0435

0.7435

CORE

0.7892

0.1355

0.1562

1.0148

0.8188

0.1287

0.3639

1.0148

0.7521

0.1351

0.1562

0.9235

LIQUIDITY

0.4048

0.2554

0.0072

1.3155

0.3661

0.2400

0.0348

1.3155

0.4534

0.2666

0.0072

1.2827

Economicfactor

MRET(%)

0.1587

0.8039

4.3510

2.2040

0.2591

0.7587

4.3510

1.8730

0.0352

0.8430

4.3510

2.2040

Industrypracticefactors

LPREMIUM

4.8044

0.6513

2.8326

6.2454

4.7463

0.4867

1

6.2454

4.8760

0.8057

2.8326

6.2454

TIMING

8.1764

15.5053

0.4000

85.3333

4.0517

12.2276

0.4

85.3333

13.2477

17.5304

0.4000

85.3333

Notes:Thefullsampleconsis

tsof272USbankIPOsfromJanuary

1985toDecember1999.STATEREG

isadummyvariableequaltooneifthestatewhereanIPOis

locatedpermittedfullintrastateorinterstatebanking.SVINSTisadummyvariableequaltooneiftheIPO

isasavingsinstitution(savingsbanksorsavingsandloans).

DEREGisadummyvariablewithavalueofoneiftheIPOgoespubliconoraftertheyearoftheRiegelNealAct(1997).

*indicatesthatthevariableis

INTRA,insteadofSTATEREG,forS

avingsInstitutionssub-sample.INTRA

isadummyvariableequaltooneifth

estatewhereanIPOis

locatedallowedfullintrastate

branching.MSAisadummyvariablew

ithavalueofoneiftheIPOislocatedinaMetropolitanStatisticalArea.AGE

isthenumberofyears

anIPOhasbeenestablishedt

otheyearofitsgoingpublic.LASSET

isthelogoftotalassets.CAPITAListotalcapitaldividedbytotalassets.COR

Eistotalcoredeposits

dividedbytotalassets.LIQUIDITYisthesumofcashandsecurities

dividedbytotalassets.NAisnotapplie

d.MRET(%)ismarketreturns.LPRE

MIUM

isthelogofthe

premiumdifferencebetweenp

ublicandprivatetargets.TIMINGisamarkettimingvariablemeasuredbycalc

ulatingthenumberofM&Ainthepreviousyeardividedbythe

numberofIPOsoverthesam

etimeperiod.



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Table2.

DescriptivestatisticsforthesampleofbankM&As

PanelA.Fullsample

PanelB.Savingsinstitutions

PanelC.Commercialbanks

Variable

Mean

SD

Minimum

Maximum

Mean

SD

Minimum

Maximum

Mean

SD

M

inimum

Maximum

Regulatoryfactors

STATEREG

0.9955

0.0673

0

1

0.8280

0.3795

0

1

0.9942

0.0760

0

1

DEREG

0.3182

0.4663

0

1

0.2473

0.4338

0

1

0.3362

0.4731

0

1

SVINST

0.2114

0.4087

0

1

NA

NA

NA

NA

NA

NA

N

A

NA

Marketcompetitiveness

MSA

0.7205

0.4493

0

1

0.6774

0.4700

0

1

0.7304

0.4444

0

1

Firmfundamentalfactors

AGE

42.9705

37.4379

1

193

53.5914

37.6893

1

174

40.1971

36.9834

2

193

LASSET

11.3200

0.9254

8.9121

14.9431

11.4608

1.1084

8.9121

14.9431

11.2740

0.8610

9.3846

13.9357

CAPITAL

0.0899

0.0322

0.0043

0.2357

0.0837

0.0441

0.0097

0.2357

0.0916

0.0281

0.0043

0.2087

CORE

0.7824

0.0784

0.4526

0.9842

0.7778

0.0936

0.4526

0.9842

0.7841

0.0727

0.4797

0.9220

LIQUIDITY

0.5090

0.2951

0.0032

1.6807

0.4130

0.3045

0.0032

1.3612

0.5364

0.2875

0.0219

1.6807

Economicfactor

MRET

0.0712

0.8492

3.0827

3.8609

0.0540

0.7971

3.0827

1.4492

0.1040

0.8630

3.0108

3.8609

Industrypracticefactors

LPREMIUM

4.7530

0.8820

2.8326

6.2454

4.5966

0.8655

2.8326

6.2454

4.7937

0.8803

2.8326

6.2454

TIMING

18.6295

17.4818

0.4000

85.3333

20.2345

15.3705

2.6364

53.6667

18.2603

18.0358

0.4000

85.3333

Notes:Thefullsampleconsistsof440USbankM&AsfromJanuary1985toDecember1999.STATEREGis

adummyvariableequaltooneifthest

atewhereatargetbank

islocatedpermitsfullintrasta

teorinterstatebanking.SVINSTisad

ummyvariableequaltooneifthetargetisasavingsinstitution(savingsbanksorsavingsandloans).

DEREGisadummyvariablewithavalueofoneifthebankengage

sinM&AonoraftertheyearoftheR

iegelNealAct(1997).MSAisadumm

yvariablewithavalue

ofoneifthetargetbankislo

catedinaMetropolitanStatisticalArea.AGEisthenumberofyearsabankhasbeenestablishedtotheyearofitsm

ergers.LASSETisthe

logoftotalassets.CAPITAL

istotalcapitaldividedbytotalassets.COREistotalcoredepositsdividedbytotalassets.LIQUIDITYisthesumofcas

handsecuritiesdivided

bytotalassets.NAmeansno

tapplied.MRET(%)ismarketreturn

s.LPREMIUM

isthelogofthepremiumdifferencebetweenpublicandprivatetargets.TIMINGis

amarkettimingvariablemea

suredbycalculatingthenumberofM&Ainthepreviousyeardividedbythe

numberofIPOsoverthesametimepe

riod.



13/22

The findings in regulatory factors indicate that

around 21% of the bank M&A sample is depository

intermediaries chartered as savings institutions. Of

the full sample, around one-third of the banks are

taken over in the period when banking activities

are geographically unrestricted. Only around 25% of

savings institutions, and about one-third of commer-

cial banks are acquired in that period of time. Thus,on average, less than half of private bank takeovers

occur during the geographical deregulation era.

For the market competitive environment factor,

it shows that around two-thirds of target banks are

located in urban areas. About 73% of commercial

banks are located in competitive local market

compared to a small percentage (68%) of savings

institutions. On average, over half of the target banks

operate in high competition market.

Description of age, size, capital ratio, core ratio

and liquidity ratio of bank that choose M&A are

shown under firm fundamental factors. The average

age of the bank M&A sample is 43 years. The length

of establishment is longer (around 54 years) for

savings institutions than for commercial banks

(40 years). The size of bank that chose M&A is

11.32, or $82 million on average, with savings

institutions ($95 million) larger than the commercial

banks ($79 million). The capital ratio of the bank

M&A sample is around 0.09. This ratio level is quite

similar between savings institutions (0.0837) and

commercial banks (0.0916). The core deposit ratio

is also quite similar between savings institutions

(0.7778) and commercial banks (0.7841). The average

core deposit ratio is 0.7824 for the full sample. Thelast variable, liquidity, is found to be lower for

savings institutions (0.413) than for commercial

banks (0.5364). In brief, savings institutions that

choose merger are older and larger than commercial

banks that do so, and the commercial banks have a

higher liquidity ratio than the savings institutions do.

The average market return is 0.0712% for bank

takeovers. In particular, the average market return is

0.054% for savings institution targets, and 0.104%

for commercial bank targets. This shows that, on

average, commercial banks are acquired during the

time when the economic environment is better.

Turning to descriptive statistics of market practicefactors, the log of the difference in premium paid

between public bank targets and private bank targets

is around 4.753 or $116 million. The average

premium difference is 4.5966 ($98 million) for savings

institution M&A, and 4.79 ($121.5 million) for

commercial bank M&A. The TIMING (volume

of mergers divided by volume of IPO) suggests that

banks are more likely to agree to takeover during

heavy periods of M&A deals. This is especially

obvious for savings institutions (20) compared to

commercial banks (18). Thus, timing may encourage

savings institutions to undertake merger deals.

These sections present descriptive statistics of the

bank IPO and bank M&A samples for each variable.

They summarize the data used in the analysis for

each sample. The next section gives an idea how the

two samples differ in terms of their central tendencies.

Difference test between bank IPO andbank M&A samples

Tests of the mean differences between IPO and M&A

samples for all factors are presented in this section.

t-tests are conducted to test whether the mean

between bank IPOs and bank targets for each

variable are equal. Thus, the null hypothesis is that

the mean difference is zero. The alternative hypoth-

esis is that the difference is not equal to zero. The

associated p-value less than 0.01 rejects the null

hypothesis at a 1% level of confidence (two sided)and leads to the conclusion that the means of IPO

and M&A samples are different.

Table 3 reports the results of the tests. Overall, the

means of regulatory factors, market competitiveness,

most of the firm fundamental factors and market

timing are significantly different between the IPO and

M&A samples, with corresponding p-values less

than 0.01.

Interesting results on firm fundamental factors

show related financial characteristic of banks that

may affect the choice between IPO and M&A.

On average, the age of banks chosen IPO is 64.5years compared to 43 years for banks that are the

target of M&A. Banks conducting IPOs are found to

be larger than target banks, with an average size of

$175 million for bank IPOs and $82 million for target

banks. A t-test confirms these differences in means

for age and size. The capital ratio of bank IPOs is

shown to be lower (0.0739) than that of target banks

(0.0899). The liquidity ratio is also lower for bank

IPOs (0.4048 compared to 0.509). These two variables

are also found to be significantly different at a 1%

level of confidence. Thus, it can be concluded that

fundamental characteristics of banks may contribute

to the decision of banks to go public rather thanengage in M&A.

Tests on the economic factor show that means

of bank IPO and bank M&A stock market returns

are considerably different. Banks apparently conduct

IPOs when stock market returns are relatively high

(0.1587%) on average, while bank takeovers occur

when stock market returns are relatively low

(0.0712%). Although the t-test for this factor is not

significant at the 1% level, the result supports



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Table3.

DifferencesinmeansbetweenbankIPOsandbankM&Asusingfullsamples

PanelA.IPOsample(N272)

PanelB.M&Asample(N440)

Variable

Description

Median

Mean

SD

Median

Mean

SD

t-value

p-value

Regulatoryfactors

STATEREG

Stateallowin

traorinterstatebankingdummy

1.0000

0.9302

0.2554

1.0000

0.9955

0.0673

5.09

Informational Externalities of Bank Initial Public Offerings - Evidence From Banking Industry

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