M&A: The big land grab

BANK MERGERS ARE back in fashion. After a hiatus of more than two years, the consolidation of US financial institutions, which started in earnest when the state banking laws were changed in 1994, has now resumed.

There are two chief drivers. First, a core group of banks have their eyes on constructing as national a retail franchise as possible. Ken Lewis, Bank of America's chief executive, alluded to that when he dubbed his firm's acquisition of FleetBoston last October a land grab, one which takes the combined bank closest to a national branch network. The new bank will have 9.8% of all bank deposits.

It can't buy any more. One of the few remaining regulatory limits on retail banking in the US is that no one institution can have more than 10% of the country's deposits if it comes via an acquisition. Lewis's bank is now out of the retail bank merger business.

Those still in the game have a pretty short wish list of banks that are worth buying to get to that limit because, explains a financial institutions group (FIG) investment banker, there are only a handful of states with the right mix of deposits and growth potential: "To have a national franchise you ought to have a presence in five states: New York, Illinois, California, Texas and Florida. That gets you access to 60% of retail deposits."

Building a national franchise up to the 10% limit has been a goal for some time. What's making deals more palatable now is simple: bank earnings aren't looking too rosy.

If the debt and equity rallies continue, investment banks ought to have a good year, but it's a different matter for US retail and commercial banks. "While the consumer boom was in full swing and banks were raking in money from mortgages and credit cards there was little inclination to merge," says one senior FIG investment banker. "The root problem now facing bank executives is that there is very little top-line growth in financial services."

The retail boom in mortgages and other credit has slowed to a more normal pace and won't be helped by the onset of rising interest rates. And there's little or no growth in commercial lending. "Earnings growth is likely to get much tougher," suggests Ruchi Madan, financial services analyst for Smith Barney, in an examination of US banks' fourth-quarter earnings. "Fourth-quarter earnings growth of 8% annualized versus the third quarter was primarily driven by items we don't view as sustainable." These included improvements in credit costs, low expense growth and an increase in net interest margin, none of which Madan expects to work in banks' favour this year.

What's more, she continues, deposit growth has slowed, mainly due to lower corporate deposits, but also because retail customers have started putting cash back into the markets.

That doesn't leave banks with much room to manoeuvre. Almost all have done an excellent job from a shareholder perspective of cutting costs. And most banks' treasury departments have played the yield curve to help boost earnings.

That game appears to be over. A quick glance at the Fed's weekly h8 report, which monitors US banks' asset and liability movements, shows that their risk appetite in securities markets has diminished. The large banks have been much more cautious with pass-through mortgage-backed securities, a favourite way to play the curve: having bulked up by 37% to $327.5 billion in the year to June 2003, many were hurt when interest rates spiked, sold off a portion of their holdings and, as of January 15, had $281.3 billion. Unrealised securities gains are also down, at less than half of last year's peak.

Now some banks are concerned about the potential for a collapse in the ability of consumers to pay back the debts they have racked up in recent years. Even if that doesn't happen, it still leaves the problem of how to satisfy investor demand for growth. A merger that makes strategic sense or is well constructed enough to allow cost cuts looks like a good option.

Not every bank CEO is convinced that a new round of mergers has started. Dick Kovacevich, the chief executive of Wells Fargo, has long held that a large, transformational deal is not what his bank needs. He's not averse to deals: the current institution is the result of the 1998 takeover of Wells by his old bank Norwest, one of the few mergers of that decade that was well constructed. The bank is now often mentioned as a probable buyer in the next round of mergers.

With a market cap of just under $100 billion, Wells Fargo is the baby of the big four post-merger US banks, with Wachovia the fifth-largest bank, with a market cap of just over $63 billion.

But Kovacevich seems to be sticking to his line. "Dick's still saying no to a big deal," says one insider. "The standard test we use is that any combination leads to an acceleration in top-line growth. It's also got to be good for the customers."

Suntrust chief executive L Phillip Humann is the latest to talk down the chance of more large mergers. Speaking at a conference at the end of January, he stated: "I don't think we will have this huge wave. Banks are sold, not bought. Most are sold because their management and board thinks they have to do something." Humann knows his bank could be a target, so he may be sending a message to potential suitors that he won't be an easy catch.

It's a brave executive who will stick solidly to his no-merger guns, says Hamid Biglari, Citigroup's global head of financial institutions: "Standing still requires that executives must be extremely confident of their ability to compete and generate attractive revenue growth. Every CEO should be taking a very hard look at the options in the wake of these two deals," he says, referring to the BofA-Fleet and JPMorgan-Bank One mergers.