Bank mergers in the US often require one thing above all others: patience. In recent years, such deals have been conspicuous by their absence and those that have taken place can move at a glacial pace: M&T Bank’s $3.7 billion acquisition of Hudson City Bank took three years to eventually complete in 2015.
It is surprising, therefore, that when the Economic Growth, Regulatory Relief and Consumer Protection Act was signed into US federal law by president Donald Trump on May 24 this year many predicted an immediate wave of mergers between the country’s mid-tier regional and community banks. The reasoning behind this was the change to the threshold for capital planning and stress testing requirements, which previously applied to banks with $50 billion or more in assets. Now these systemically important financial institution (Sifi) requirements will only apply to banks with $250 billion or more in assets (banks with assets of over $100 billion are subject to an 18-month transitional period).
This is a huge change. Smaller banks are now free to merge without running the risk of breaching the $50 billion threshold and therefore subject to the onerous and costly regulation that comes with being classified as a Sifi.
“There is a massive difference between a $50 billion Sifi threshold and a $250 billion threshold,” says Stephen Greer, senior analyst in the banking team at Oliver Wyman subsidiary Celent in New York. “At $100 billion-plus, banks are still at a certain scale where they can invest in proprietary assets and onboard talent.” But now they do not have to meet Sifi regulation requirements.
The important change here is that while a $49 billion bank probably will not have been conducting a lot of the processes that Sifi regulation requires, a bank that is $249 billion in assets most definitely will, so any move to Sifi status will be relatively straightforward.
“Regulatory relief helps at the margin,” says H Rodgin Cohen, senior chairman at law firm Sullivan & Cromwell, who is regarded as the leading bank M&A lawyer on Wall Street. “People were concerned not only that a bank would have higher compliance costs over $50 billion but also the market was sceptical that banks of this size could meet the demands of Sifi regulation,” he tells Euromoney. Cohen has acted on eight of the 10 largest bank mergers in the US since 2010, including ING and Capital One, Royal Bank of Canada and City National, KeyCorp and First Niagara, BMO and Marshall Ilsley, Hudson City and M&T, Huntington and FirstMerit, CIT and OneWest and, most recently, EverBank and TIAA.
On the consumer side regional banks are investing in incubators, fintech, alternative payments. They are trying to grab consumers before they move out of the banking system altogether- Jeffrey Levine, Houlihan Lokey
According to S&P Global Market Intelligence, there were 259 bank mergers among regional banks and thrifts in the US in the year to June 15, 2018. The lion’s share had been in the mid-west (102) and the southeast (67). Just 27 of these deals had a transaction value greater than $100 million, while 18 were between $50 million and $100 million. Forty-one deals were valued at less than $50 million. And it is smaller banks that are selling: 69 of these deals involved a seller with assets of less than $250 million. None of the deals in the past 12 months involved a seller with assets greater than $10 billion.
The real question, therefore, is what impact the new rules will have on the potential for M&A between mid-sized US lenders. Here the likelihood of heightened merger activity is rather harder to establish. “We have had consolidation in financial services over the last 10 years but there are still 6,000 depositaries in the US,” points out Bruce Van Saun, chairman and chief executive of Rhode Island-based Citizens Financial Group, which has assets of $155 billion.
Bruce Van Saun (centre), chairman and CEO of Citizens Financial Group
Van Saun joined the bank in October 2013 from RBS where he was group finance director and an executive director on the RBS Board from 2009 to 2013. He ran Citizens during its IPO in September 2014 and to full independence from RBS in October 2015. “There is certainly room for additional consolidation,” he tells Euromoney. “Sifi limits did have a constraining effect at the smaller end, which caused smaller institutions not to merge. Lifting the threshold at the smaller end should facilitate a higher level of consolidation. But at the regional and super regional level – there the picture is much more mixed.”
Euromoney meets Van Saun at the opening of the bank’s new campus, built on a previously undeveloped parcel of land on the west side of Interstate 295 in the bank’s home state. It will house 3,500 employees in 424,000 square feet of office and meeting space, and feels more like Silicon Valley than Wall Street. As we arrive the facility is buzzing with activity as people clad in Citizens Bank green T-shirts rush around the building and its sports fields, tennis and basketball courts, trails and integrated wildlife paths for habitat circulation. Nearly 50% of the 123-acre site is trees and wetlands. That is not normal at most of the bank offices that Euromoney has visited over the years.
It is also not accidental and is indicative of Van Saun’s firm belief that regional US banks should be concentrating on meeting the customer expectations established by their tech counterparts rather than rushing to make major acquisitions. “We are at an inflexion point. Banking models are pivoting to digital,” he explains.
“Convenience, seamless integration and the use of data and tech is a differentiator. Banks would be wise to focus their efforts on getting that right. They need to move to embracing this new business model. A large acquisition will distract you,” he warns.
“Migrating to a new business model and meeting customer expectations is both the biggest challenge and the biggest opportunity that we face. Customers have a great customer experience when dealing with Amazon and Google and they expect the same from their bank. We have to run hard to get caught up. It is not a moon shot to figure it all out. We can get there, but we need a very open thought process.”
That process could involve acquisitions, but the target might be a non-bank fintech or consumer finance company rather than another bank. In April this year, for example, Citizens Bank partnered with Finastra and Infosys to digitize its trade finance offering.
“On the consumer side regional banks are investing in incubators, fintech, alternative payments. They are trying to grab consumers before they move out of the banking system altogether,” says Jeffrey Levine, managing director and co-head of the financial institutions group mid-market specialist investment bank Houlihan Lokey.
“We do many more bolt-ons of specialty finance companies, insurance companies, payments companies onto banks than bank mergers,” he reveals. “You still can’t run a bank on as levered a basis as you could pre-crisis so you need a profitable bolt-on business.”
Levine’s co-head at Houlihan Lokey, Reinhard Koester agrees. “Banks are trying to get niche businesses that are defensive and regulatory easing makes that more possible,” he says. But this is not necessarily straightforward. “The easiest deal for a bank to do is to buy the 50 branches next door, but when you buy a consumer finance company you are getting into something entirely different,” he warns.
It makes sense, therefore, for banks to choose the path of least resistance. “I don’t know if moving the Sifi threshold to $250 billion will be a catalyst for consolidation,” points out one observer. “When you hit the $10 billion asset threshold you are already hitting new regulation and that hasn’t stopped those institutions consolidating. If you are a bank that wants to grow deposits, then buying deposits is the way to do it. Consolidation has been happening down market for a long time.”
It is now starting to happen in the mid-market too. In May, Fifth Third Bancorp ($142 billion in assets) agreed to buy Chicago-based MB Financial (assets of $20 billion) in a $4.7 billion deal, and BB&T ($221 billion in assets) has revealed that it is also looking for an acquisition in the $20 to $30 billion range. Such a deal may push BB&T over the new, $250 billion threshold, something that does not really seem to be an issue.
“At the small end the regulations were a deal breaker. At top end they aren’t. If you go across $250 billion today there will be more work, but you are doing all these things anyway. You just have to factor in dis-synergy,” says Van Saun. “A segment of mid-sized and super regionals will look at acquisitions if the price is right and it makes sense. Valuations are a concern. You have to be very disciplined to make sure that the maths work,” he warns.
Scale provides certain advantages, but there are some diseconomies too. You don’t have the same grip on the operations of the company- Bruce Van Saun, Citizens Financial Group
The maths includes two important sums: the amount of tax you need to pay and what the impact on your earnings per share (EPS) will be. “Our business is very quantitative,” says Koester. “We look at where you are buying the franchise at and what is the pro forma impact on your EPS. Banks will do the deal that boosts their EPS the most,” he says.
Recent tax reform in the US has certainly helped that calculation. “Nobody has benefited more from the change in the tax law than the banks,” says Cohen. “Banks were always very inefficient taxpayers and if you are paying 33% tax, then that number being cut to 20% is a big deal. Bank mergers are very synergistically driven and if they now come at a lower tax rate, that will be a driver of consolidation.” It should be remembered, however, that sellers’ net operating losses will also be taxed at the new lower rate as well, which mitigates the benefit somewhat.
Rules versus tech
Activity in the second quarter of 2018 saw some sizeable trades coming through, with State Bank Financial Corp being sold to Cadence Bancorp for $1.37 billion and Guaranty Bancorp’s $1.04 billion pending sale to Independent Bank Group Inc. People’s United Financial also agreed to buy First Connecticut Bancorp for $543 million. The focus of merger activity will, however, be at the smaller end of the market.
“There is no unique data point you can point to to spur consolidation,” says Koester. “We have all heard about banks not buying because of concern over their Sifi status, but the quantum of mergers will be among the 4,800 smaller banks,” he says. “The backdrop for FIG M&A is that the economies of scale are so great. In the US there are 5,600 regional banks and 4,800 of them have assets of less than $1 billion. The fundamentals for bank mergers are very strong. It is hard to tell which is the greater driver for this, new Sifi rules or tech.”
The importance of the latter cannot be overstated. “Regardless of their size, banks continue to struggle with diminishing brand value and reputation among certain customer segments, including attracting and serving younger demographics in a manner they desire,” state Jason Langan and Paul Legere, partners and principals in the M&A transaction services division at Deloitte. “Embracing the rapid adoption of cutting-edge financial technology, therefore, is not just a short-term means to boost revenues or eliminate cost inefficiencies; it’s a way for banks to repair and enhance their brand and value perception.”
This gets to the quandary that smaller US banks now face: it is vitally important to focus on improving customer experience or you risk your business disappearing before your very eyes. “The banking environment itself may be disintermediated,” shrugs one banker. “If you know that Venmo will disintermediate you, then you want to at least have an app.”
It is as axiomatic as the difference between country music and jazz – there won’t be a fusion between community banks and larger banks, because they serve different purposes- Don Andrews, Reed Smith
And banks don’t necessarily have to be big to do this themselves. “On the mobile side we see the large banks release something and it then cascades down the bank tiers,” explains Greer. “This has been fairly consistent. Some larger banks are white labelling tech for smaller banks,” he says.
This somewhat undermines the argument that banks need to consolidate in order to be big enough to compete on tech. Why not just buy it off the shelf from one of the big banks? Banks including Goldman Sachs, JPMorgan and Morgan Stanley have long made tech a profit centre and have sold a range of products covering data security, mobile applications, fraud management and systems integration to smaller rivals. By buying from larger competitors even the smallest banks can offer state of the art technology.
“The larger banks have become a vendor provider of tech for smaller banks. They have made tech a profit centre,” says Greer. But there is no such thing as a free lunch. “This opens the question for the smaller banks of why would you eat from the hand that is trying to take your business? You are shooting yourself in the foot.”
|US Regional Banks|
|>$100bn to <$250 bn|
|Citizens Financial Group||151|
|Fifth Third Bancorp||142|
|>$50bn to <$100bn|
Are the larger banks trying to take their business? Is there are real desire by the big banks to take over retail banking across the country? Because in an age where everyone conducts day-to-day transactions on line, does it matter where your mobile banking app provider’s head office is?
“Big global banks want to invest in commercial and retail businesses as they want to diversify their revenue streams” states Julien Courbe, partner and head of PwC’s US financial services advisory practice in New York. “This is a fundamentally different environment for many of them. They have significant engineering talent and want to digitize distribution channels to retail and commercial consumers. Many regional banks will have to transform their businesses in order to compete effectively and not lose customers to larger banks’ digital offerings, including looking to develop stronger specialty offerings or focus on community banking,” he tells Euromoney.
If you are up against the likes of Bank of America or Citi in terms of reach, it seems obvious that regional banks need to get as big as possible, as soon as possible. Van Saun at Citizens strongly disagrees with this thesis, however. “Regional banks are in the middle of the river. Local banks have community involvement and big banks have scale,” he says. “The middle has proved a great place to be.”
Certainly, looking out of the window of his office in the bank’s new campus beyond the rows of state-of-the-art work stations to the onsite fitness and wellness centre, scenic walking trails and sports fields it is hard to disagree. This is not a bank that seems too worried about its place in the wider industry.
“You are big enough to afford tech and regulations, but you are not in the crosshairs of the regulators like the big banks are. Scale provides certain advantages, but there are some diseconomies too. You don’t have the same grip on the operations of the company. It makes the bank harder to manage and for management to achieve full efficiency,” says Van Saun.
He certainly does not seem to be in any rush to take Citizens into super-regional territory. “We have assets of $155 billion so we have a lot of runway before we hit the Sifi threshold. Our organic growth rate is 5% to 6% so that is $8 billion to $9 billion a year of organic growth. You can go a long time at that rate before you get to $250 billion,” he says.
The bank is, nevertheless, busy with more targeted acquisitions. In May it bought mortgage servicing and origination firm Franklin America Mortgage Corp for $511 million in cash, taking its off-balance sheet mortgage servicing portfolio from $20.2 billion to $61.6 billion.
Down the food chain
What about the banks that are not in the middle of the river? Those that are further down the food chain know that the writing is on the wall. “There is increasing recognition that scale is advantageous in a different way than it used to be,” says Cohen. “It used to be back office, but it now includes marketing, product services suites and many more. It is the ability to provide many different entry points.”
H Rodgin Cohen,
This did not escape the notice of the 259 bank acquirers in the year to June 15. In that month People’s United Bank, with $44 billion in assets, announced the acquisition of New England-based First Connecticut Bancorp for $544 million. This is exactly the type of deal that many in the market expect to see.
“I don’t see any reason why consolidation won’t happen,” says Chris Cole, senior regulatory counsel for the Independent Community Bankers of America (ICBA) in Washington DC. “Banks with assets of under $100 billion are very interested in acquiring community banks and prices are edging up. The tax reduction bill and healthy economic climate are helping, along with the loosening of bank regulations,” he says. “Buyers are trying to get core deposits because interest rates are going up and deposits are therefore becoming more valuable. Many banks at around the $40 billion mark are looking to boost core deposits and market share.”
Koester at Houlihan Lokey raises an interesting question over whether rising rates necessarily mean that deposits are more valuable in today’s banking environment.
“One of the most interesting things to watch in deposit valuations in the next few years is that interest rates are rising,” he says.
“Deposits are supposed to be sticky, but if people have become savvier because of technology then they can move their deposits more easily. Will deposits be as sticky as they have been in this new environment? We have only seen decreasing interest rates so far with this new technology. What happens when rates rise?” he asks.
Regardless of how sticky they might now be, all banks nevertheless still want more deposits. And the quickest way to achieve that is to buy someone else’s. This prospect of larger regional players now gobbling up America’s community banks is one that certainly seems to touch a nerve.
“Over half of the small business loans made in the US are made by community banks,” says Don Andrews, global practice leader of the risk and compliance group at law firm Reed Smith in New York. “They are a vital part of the US landscape and there is zero chance that they will go away. It is notable that the few bipartisan actions taken by Congress this year were actions designed to protect community banks. Community banks are required to serve their community and any buyer has to fulfill requirements under the CRA [Community Reinvestment Act],” he says.
“Different types of banks have different roles. It is as axiomatic as the difference between country music and jazz – there won’t be a fusion between community banks and larger banks, because they serve different purposes. Culturally it would be difficult to replace what they do.”
Cohen at Sullivan and Cromwell also warns of the need to prevent the wholesale takeover of the country’s smallest banks. “All the predictions in the late 1990s and early 2000s that any bank below a certain size would disappear because of technology have not come to pass. I don’t see this like Google ending encyclopaedias. The change may be more gradual,” he emphasizes.
“I definitely believe that it is important to have community banks. The regulators need to think long and hard as to where they go from here and whether there is a need for regulation to help the community banks. I am hopeful that starting at the smaller end of the scale that the regulators will do all that they can to support community banks.”
This call for regulatory support only underscores the threat that digitization poses to smaller banks. This is a threat that some see as insurmountable.
“Traditionally in the community banking space the value proposition has been knowing the customer: they hype locality. But with different technology investment there has been significant erosion of that value proposition for smaller institutions,” says Greer at Celent.
“The removal of barriers to interstate banking means that they are at a fundamental disadvantage – an irreparable disadvantage. Banking is a scale game. Some smaller institutions are in denial. Some say that they don’t need tech. Private banks offering specific services such as trusts will be OK, but on the retail side margins are so thin that I don’t see smaller banks being able to compete. They won’t survive unless they choose to be niche and specialized.”
There is a firm belief that, even for younger customers, there is still value to a branch, even if this now means a marketing kiosk in a mall rather than a traditional full-service facility. “Millennials will still go to a branch for advice and complex transactions,” says Van Saun. “They will connect with someone at a branch, so you have to have a good strategy about how the channels are integrated,” he warns.
For more day-to-day transactions, however, the rationale for branches, and therefore locality, is increasingly hard to see. “To see how tech is affecting this sector you need to bifurcate between the asset and liability side of the balance sheet,” explains Levine at Houlihan Lokey. “On the asset side, for example with mortgages, there is still a touch for important transactions that will always have the advantage. On the deposit side the jury is out – there is generational change where younger customers feel that they don’t need to go to branches.”
Cole at the ICBA believes that consumers still see value in the smaller bank proposition. Indeed, he points to the number of new startups in the sector. “We are starting to see the number of de novo banks picking up,” he reveals. “The second de novo bank in DC was announced in July and we expect 15 to 20 countrywide this year. Between 2010 and 2016, we averaged no more than one or two a year.” This shows how far the industry has come since the crisis.
“We haven’t got to a point where people are leaving smaller banks because of their digital offerings,” Cole claims. “Many community banks are not far behind and are still able to compete with the larger guys. They may not have an SME turnaround system, but they are not hurting,” he insists.
He does, however, concede that conditions in the retail space are tough. “If I am a community bank CEO and I want to increase market share then I should be promoting small business lending and CRE [commercial real estate] lending as much as I can. Consumer lending is not as profitable for community banks,” he agrees.
Regulatory change and technological pressure mean that something has to give at the smaller end of US banking. This does not, however, mean that smaller community banks will necessarily be subsumed in a wave of digital disruption.
“A lot of community banks are very small and in some geographies they will always exist,” says Levine. “And for a lot of regional banks, tech has actually levelled the playing field – if you want to do international wire transfers, electronic bill payments, they can do it. Technological developments are enabling them to build on relationships. Three quarters of tech in banking is nothing new,” he declares. “It is just an interface behind which is 30-year old technology.”
Consolidation in US banking will definitely still be a very slow process. “In five years, there will still be 4,000, even low 5,000 banks left in the US,” predicts Cohen at Sullivan & Cromwell. There is no doubt, however, that many feel that the time is now right for potential buyers and sellers to test the waters.
“Valuations are up and sellers have been waiting 10 years since the financial crisis to sell,” says Koester. “A lot of CEOs are in their 50s or 60s and spent the five years after the crisis saving their bank. Now they have shareholders that have been invested in the bank for 10 to 15 years and want to sell. This makes it that much harder to go to investors and propose not doing anything.”
The rise in valuations, particularly among the smaller banks, is one dampening factor for all-stock deals, as sellers may demand even higher multiples to protect shareholders from potential post-deal downside value risk. Indeed, the recent mergers of First Niagara with KeyCorp and of FirstMerit with Huntington drew criticism over tangible book value per share dilution and related earn-back periods.
Most believe, however, that because the environment for mergers is now more attractive than it has been for a very long time, deals will get done. Regulatory change may have spurred talk of consolidation, but it is technology that is the key dynamic for change across the industry. It is not simply a case of getting bigger, banks also need to raise their digital game in tandem. This is a challenge but not an insurmountable one.
“We have all the weapons we need to compete with the disruptors,” says Van Saun, confidently.