US banks will need to look beyond mergers for growth. Better earnings will have to be won from improved value propositions and productivity.KEVIN P. COYNE, LENNY T. MENDONCA, AND GREGORY WILSONThe McKinsey Quarterly, 2004 Number 1The primary rationale behind the wave of mergers in the 1990s梩o achieve substantial economies of scale by exploitingtechnology and deregulation梚s naturally weakening. For most large banks, furtherexpansion won抰 necessarily yield dramatic scale-based savings in systems and product-development costs. So although mergers will continue to take place, opportunities to create substantial value have diminished and relatively fewer deals will pack the punch of the 1990s. Executives of large banks must look for new ways to increase earnings.Until recently, the solution was falling interest rates, which fueled unprecedented profits from mortgages and credit cards.1 But with rates beginning to rise, banks will have to look elsewhere. More compelling value propositions are required if banks are to compete with the nonbanks and specialists that have flourished in many markets. Like the best retailers, banks must differentiate themselves by understanding the needs of their customers and giving those customers a distinctive experience. Banks should also boost their performance the old-fashioned way, by improving productivity梥omething that will become vital as their payments businesses, representing a substantial share of industry profits and operating expenses, shrink with the falling use of checks.To succeed in these tasks, banks must innovate in their formats, their customer targeting, their approach to lending and asset management, their operations, and their use of electronic payments. This agenda is challenging, and it calls for skills beyond those梥uch as identifying and valuing acquisitiontargets and driving integration梩hat served executives so well in the recent past. Significant changes lie ahead for managers working toward a new set of performance priorities.THE OLD GAME WINDS DOWNAlthough the banking industry抯 structure and regulatory framework will permit more mergers in the future, the reduced potential for synergies means that CEOs who make deals their primary strategic focus could be disappointed by the results. Some obvious pairings will realize worthwhile cost savings, especially among second- and third-tier banks, but for most large institutions the opportunities for consolidation are not what they were a few years ago.During the 1990s, the economic rationale for mergers was indisputable. Enormous efficiency gaps between the acquirer and the acquired often created cost and revenue synergies ranging from 30 to 100 percent of a seller抯 net income.2 New technology made many of these efficiency gains possible by facilitating the consolidation of branches. In addition, the Riegle朜eal Act of 1994, which allowed bank holdingcompanies to acquire banks in any state, opened the door to pairings梥uch asthose between Bank of America and NationsBank, and Norwest and Wells Fargo梩hat previously would have been difficult or impossible.So successful was this wave of mergers that the industry progressed toward a natural endgame in which a handful of nationwide banks began to emerge. Although curbed by a regulation limiting an individual bank抯 share of US deposits to 10 percent of the total (which, with antitrust safeguards, ensured that thousands of community banks continued to thrive), the top ten institutions increased their share of US deposits from 27 percent in 1994 to 44 percent in 2002 (Exhibit 1).But the larger banks have picked most of the opportunities from consolidation. Today抯 possible combinations among the larger institutions present fewer geographic overlaps. While scale economies are always helpful, most leading banks are already big enough to support the systems, branding, and product-development costs of the next few years. To be sure, bank mergers are not a thing of the past. Under the 10 percent deposit ceiling, there is still room for the top 20 or 25 players to make substantial acquisitions and for two or three moves that would create the handful of truly national banks anticipated with the Riegle朜eal Act抯 passage. Moreover, many middle-tier regional banks have survived and prospered and will probably consolidate further. The rationale supporting big-bank mergers during the 1990s thus still applies, particularly given the geographic concentration of many regional banks: at least eight middle-tier banks do business in Alabama, Georgia, and Tennessee, for example.Yet the economics mean that many big deals will be more likely to exploit reduced valuations, opportunities for transferring skills, or the possibility of expanding into new businesses or geographies than the cost synergies that often justified significant premiums during the 1990s. Both managerial capabilities and economies of scope will be drivers of well-received deals. So M&A, while still a log