Last week, ING of Netherlands, the world’s largest financial institution by revenue earlier this year, announced it would be breaking itself up into separate banking, insurance, asset management and U.S. internet banking companies.  Although prompted in large measure by regulatory pressure, the move has generally been praised for streamlining the business model to focus on respective financial services niches.

The divestiture also ends a Dutch made version of a too big to fail strategy begun in 1991 by the merger of two banks. Whether ING marks the beginning of a larger trend or is the exception rather than the rule remains to be seen. But since many analysts praised the move, it begs the question of whether too big to fail banks actually create value for shareholders?

First, a note about the meaning of the phrase. In the late 1980’s and early 1990’s, two papers published by the Federal Reserve of Atlanta and Minneapolis respectively argued that managers were pursuing a too big to fail acquisition policy to ensure that the deposit base became so large that the government would find it too costly to close the bank (with a nice side benefit of increased compensation for the C-level executives). As a loss mitigation strategy, the government would effectively provide a guarantee to the entire bank (here’s a rather chilling paper in 2000 supporting the assertion that the bond market thought a too big to fail acquisition strategy is a default risk decreasing event. It was the concept of moral hazard pursued to the max (leading to a strange possibility of the banks possibly bailing out FDIC).

For the shareholder, this strategy has proven to have mixed results based on historical studies. As I blogged in June 2007, the U.S. Federal Reserve itself found that financial institutions did not achieve any greater profitability or efficiency post-merger. If one assumes that acquisition costs (both cash in lieu of increased dividend/reinvestment in the business and dilution via share issuance) were approved by the shareholders on the premise of greater than pre-merger return on equity, it appears that this promise is largely unfulfilled.

However, newer studies analyzing post 2000 merger and acquisition activity in financial institutions (sorry, only free preview) indicates that too big to fail banks in America tend to yield some efficiency gains but there is no definitive evidence of increased shareholder wealth creation (the study is significant in that it was released after the credit crisis). Instead, shareholders of European financial institutions who have become too big to fail are at least benefiting from some increased value enhancement. What does appear apparent is that there is “robust” evidence that CEO’s were pursing too big to fail strategy to reap the associated benefits (power and money).

What does this all mean to you?

If you  believe the studies, it tends to pour cold water on the rhetoric that large financial institutions are needed to compete since there lacks any definitive evidence of efficiency gains or enhanced shareholder value.  For the bank shareholders, it should make one think if a bank wants to swallow up a troubled competitor now or to merger when times are better in the future (and whatever happened to organic growth?). It could be that in this situation, it may be optimal to cash out if you owned shares in the bank to be acquired.

For dividend investors, who almost cannot avoid purchasing a financial institution stock, it gives pause to simply buying the largest financial institution and raises the question of whether the emphasis should not be on size but on greatest return on equity year over year.

As a real life example, Citigroup, one of the largest too big to fail banks, failed both those investing for dividends and for share growth by slashing its dividend and being removed from the Dow Jones Industrial Average after become a de facto government agency. Predictability, it has also restructured itself for the possibility of spinning out its brokerage and asset management business to increase its value, an explicit recognition that the too big to fail strategy has not benefited the street or the shareholder.

Finally, for the lawmakers (read Congress), perhaps the focus should not be  requiring greater capital levels or other financial ratios but breaking up financial institutions into smaller, more manageable, and less economically risky parts. In other words, the regulatory solution may not lie in securities law but in anti-trust/competition laws.