M&A: US banks get acquisitive
Small banks face squeeze; IT and regulation need scale.
US bank M&A deals this year look set to top 2014’s volumes as small banks continue to sell.
There were several larger deals in the third quarter such as BB&T buying the $9.6 billion-asset National Penn Bancshares, but most of the M&A transactions taking place are for smaller banks.
According to Dealogic, 241 of the 250 deals done so far this year have been by banks with less than $500 million of assets. By late October, $26 billion worth of deals have been completed compared with $27 billion for all of 2014. In September, the Federal Reserve finally approved the merger of M&T with Hudson Bank after three years. That move will make M&T the 25th largest bank in the US with $132 billion in assets.
The Fed’s approval may boost M&A activity further, although for smaller banks additional motivation is hardly required.
Increased costs and lower margins from low interest rates are reason enough for small banks to sell out if they can.
Stephen Skaggs, president of the Bank Advisory Group in Austin, says: “Net interest income margins have been compressed, and non interest income has become strained. If you look at banks under $500 million, the service charges on deposit accounts were 20% lower in 2014 than in 2009. For banks with $2 billion to $10 billion, service charges income dropped 10% from 2009 to 2011, but has since recovered and is now down only some 5%.”
On the cost side, IT and regulation are the two forces pressuring smaller banks to look for scale or to get out of business, even though some of those costs are unnecessary.
Paul Schaus, president of CCG Catalyst Consulting Group, says: “Technology should be saving banks money but the issue is that they won’t part with outdated products. You have banks that are still maintaining and paying for voice response units when nearly all of their customers have smart phones. Bankers keep their old technology around far longer than they should.”
Skaggs agrees that in theory technology should not be costing small banks too much. “The cost of technology is not prohibitive – there are plenty of vendors out there that can offer improved platforms and services at a reasonable cost.”
Rather he says the problem is that the model of banking is no longer profitable without scale. Regulation cost, low interest rates and margin compression all make it difficult to achieve sufficient return on equity on a sustainable basis.
The golden number, says Schaus, is $1 billion. “A lot of banks below $1 billion in assets want to merge to get above that threshold.”
He says that banks are looking for like-minded partners in their mergers. “They need to focus more and pick a segment and run with it. The big banks can invest in every demographic, but the mid-tier banks need to pick a sweet spot, be it millennials, cash management, mobile solutions, or entrepreneurs or non-profits. It’s too overwhelming to do it all.”
That the model appears to be broken means that the US is in an unusual situation – very few new banks are being created other than online banks. “We used to have people selling banks and then starting another – essentially flipping banks. But that is no longer the case. There are no new banks starting up. We have a shrinking market with no one replacing those that are selling out,” says Schaus.
That is not leading to larger valuations however, because participants say there are still too many banks. “We’ve come down from the 20,000 banks we used to have to about 6,000, but now that customers rely less on their branch to do business, that needs to come down much more,” says Schaus. “While valuations have started to tick back up since the recession, no one expects the industry to have a big turn around, so we will never see prices like before the crisis.”
Skaggs has some data on the valuation comparisons between then and now. “If you were a bank with a $1 billion to $4 billion asset size with an RoA of 25 basis points to 1.5% and a tangible equity ratio of between 6% and 13% you would have sold for 2.2x tangible equity and 23.21% of assets on average. Fast forward to 2014 and 2015 and that is 1.85x tangible equity and 18% of assets on average. It’s far worse for smaller banks. Those with assets of between $50 million and $1 billion have seen their average price fall from 2.66x to 1.44x tangible equity, and from 23.57% of assets to just 14.45%.”
Of course, says Skaggs, hindsight is 20:20. “Perhaps they should have sold back in 2006 because we don’t foresee prices ever going back up to those levels. So banks have a difficult choice. Do they stay in the game, and pay money to upgrade their technology platforms and see how it goes?” That would require committing to another five years to see the fruits of their investment. Many banks are not positive enough about the future to make that commitment so are cutting their losses now, even though it may not be the perfect time to sell.
Those capable of hitting the magic $1 billion mark with a merger are going that route. “We are seeing more mergers of equals but that is difficult as there is always one dominant party,” says Skaggs. “It’s never combining the platforms that prevents a merger – it’s more about the soft issues – social issues such as executive leadership, bank name, board composition, corporate culture – that offer impediments to reaching a merger among equals.”