Feeling the squeeze: looking for lemons in the market for used banks

Abstract

This study examines adverse selection and geographic information asymmetry costs stemming from branch network expansion on bank performance. Using a comprehensive dataset covering the period from 1994 to 2022 from the FDIC, this paper investigates how geographic expansion and resulting merger and acquisition (M&A) activity impact bank performance, as measured by Return on Assets (ROA), Return on Equity (ROE), and Non-Performing Loans. The findings reveal that while increasing bank size generally (as measured by total assets) yields benefits, likely due to operational efficiencies, these are accompanied by offsetting costs due to both local information losses resulting from increased geographic branch network size and adverse selection ("lemons") effects stemming from the M&A process. These costs are particularly acute during economic downturns, as evidenced by the interaction effects observed during the Great Recession. The results suggest that information asymmetries, resulting from geographic distance and a lemons effect, are significant in determining bank performance outcomes. This study contributes to the existing literature by reconciling previously mixed findings regarding the net benefits of bank branch network expansion, highlighting the importance of considering both the benefits and costs associated with these strategies.