Finance

Every week brings news of another financial services acquisition in the United States. Such events act as a reminder, if one were needed, that this massive and diverse industry is undergoing unprecedented consolidation. Consider these facts:

* In 1980, the 25 biggest banks generated a third of the industry's net income. Today, they generate more than half.

* In 1990, the top 25 mortgage originators did 26 percent of the business. Today, they do 45 percent.

* A decade ago, the top 10 credit card companies held 45 percent of all outstandings. Today, they hold 57 percent.

* The top 10 mutual fund companies currently control 47 percent of all assets.

* The top 15 home and auto insurers write roughly two-thirds of all policies.

And so it goes for every sector of the financial services industry.

Sweeping though the consolidation has been, this is only the beginning. In fact, enough excess capital remains in banking alone to fund up to $1 trillion in future deals. If a company's stock (or acquisition currency) is highly valued, it is often cheaper for it to acquire another company to gain access to valuable customers, a choice distribution network, and market-tested skills, rather than build these things from scratch. So the deals will keep coming.

There are three key points to bear in mind as the financial services industry consolidates. First, the national endgame is closer than it may seem. Second, the constant need for revenue growth, productivity improvements, and cost efficiencies is the force that is driving consolidation and transforming industry economics. Finally, any serious player must adopt an explicit growth strategy that incorporates expertise in both mergers and acquisitions and options-based valuation.

THE ENDGAME APPROACHES

The pace of consolidation is accelerating. The next five years will make the past five look tame, as players jockey for position while the new industry structure locks into place. The most effective way to stake out territory in the new landscape will be by means of M&A, which puts this issue squarely at the top of the strategic agenda. Senior management should ask tough questions about where their company is going in the next five years; and seek brutally honest answers:

* What is our view of the future? What role should we play in the new industry structure?

* Do we have the management talent, the market strength, and the world-class productivity to be a buyer in the consolidation game?

* If so, what kind of companies should we buy, and how should we go about valuing them?

* Do we need to sell part of our current business, and refocus?

* Perhaps most difficult of all: should we take advantage of generous valuations and sell our company to the highest bidder?

Five years from now, financial services will be virtually unrecognizable (Exhibit 1). Although there will still be thousands of small community banks, the industry, like airlines and aerospace before it, will be dominated by a handful of national and global giants that will dwarf even the biggest players we know today.1 They will have achieved their might by buying complementary or weaker players and transferring superior management skills to create value. As in airlines and aerospace, these behemoths will be tightly run; highly productive, innovative, and skilled at M&A; and intensely competitive with one another.

In banking, for example, the removal of the remaining geographic barriers to acquisition in 1997 has set the stage for a truly national marketplace. To see what this might mean, consider California, Florida, and North Carolina, where internal barriers were dismantled a long time ago. In these states, the top three banks already control more than 50 percent of all deposits. In the developed world as a whole, that share is 58 percent. By contrast, the top three US banks command only 13 percent of the national market.

Such a low share suggests that there is plenty of room for the best banks to expand nationally into less consolidated markets. The mergers between NationsBank and Barnett, and First Bank System and US Bancorp, point the way. In theory, current antitrust and nationwide deposit-gathering rules would allow the top 50 US banks to be amalgamated into just six mega-banks commanding roughly 60 percent of industry assets and 66 percent of revenues.2 The next 50 banks could be merged into a seventh bank of similar size (Exhibit 2).

Most of these mega-banks would be twice as big as today's largest bank, Chase Manhattan. Given the state of deregulation and the variety of banking licences and corporate structures available, these six or seven mega-banks could evolve over time into full-line financial service providers; the US equivalent of universal banks.

As companies hunt for new products and channels in a consolidating environment, M&A activity will increasingly cut across artificially defined industry lines. Financial service firms of all types are discovering the need to provide investment management services to cater for the savings and retirement funding needs of baby boomers, for instance. Traditional banks have had to cross conventional industry borders to secure new revenue streams to meet these needs. The recent round of bank acquisitions of retail brokerage firms, such as Fleet Financial's acquisition of Quick & Reilly, were driven by the need to gain new fee income by cross-selling products.

The same trend is also apparent in the wholesale arena. The acquisitions by NationsBank of Montgomery Securities and by Canadian Imperial Bank of Commerce (CIBC) of Oppenheimer epitomize revenue-driven acquisitions across separate but related industry lines.

Travelers Group is a prime example of an institution built on cross-industry deals (Exhibit 3). Its recent acquisition of Salomon Brothers continues the trend, and is also likely to spark similar deals by national competitors.

From the acquisition of Shearson in 1993 to that of BankAmerica's consumer finance division