Banks Must Lower Expectations to Jump-Start M&A

Thanks to increasing interest margin pressure and steeper regulations inspired by the sins of the "too-big to fail" firms, industry analysts ambitiously predicted 20% to 30% of U.S. banks would consolidate following the financial crisis. This fate hasn't become reality. Since 2008, we've only witnessed a fraction of the expected bank closings and acquisitions previously anticipated.

Many leading experts believed 2013 would finally break this pattern and bring a surge of bank M&A activity. However, according to an analysis of data from SNL Financial, over the first four-and-a-half months of the year, only 97 transactions have either closed or reached definitive agreement. The stat is once again below the original predictions. At this rate, M&A transactions for the year will ring in somewhere around an underwhelming 270. 

To understand why we haven't seen the necessary consolidation that once seemed inevitable and even necessary, let's recap some of the factors that we feel played into those early projections.

The expanding gap between large and small institutions: At the end of the financial crisis, most banks were either suffering from a failure to adapt to the changing marketplace or were well-capitalized enough to thrive despite the economic environment. With minimal economic growth, the gap between both groups grew, leaving the door open for stronger institutions to increase their market share by merging with or acquiring those looking for a way out. 

At the beginning of 2013, over 200 banks still owed Troubled Asset Relief Program money. In turn, the U.S. Treasury divested the outstanding balances in these banks by auctioning the investment as well as converting the initial investments into bond-like instruments at premium rates of 9%. It seemed that institutions that hadn't raised enough capital for repayment would have to become an acquisition target or else carry growing debt.

Stricter regulations bring mounting costs: With more than 800 banking industry regulatory changes enacted since 2008, large institutions haven't been the only ones feeling the pressure.  Community banks have had to devote more time, money and manpower to comply, another trend likely to continue as new regulations emerge and reporting requirements become increasingly complex. Large institutions have the cushion to absorb the costs of stricter regulations, but banks with less than $100 million in assets could easily buckle under the burden of annual compliance expenses.

External growth is the only solution: In the banking industry, gaining market share is no minor feat. As the economy recovers and executives dig for new growth opportunities, many are finding that their go-to tactics to boost profits and attract customers no longer apply to today's evolved marketplace. With interest rates at an all-time low and compressed lending activity taking place, banks' income statements are strained while overall earnings are depressed. For institutions desperate to stay afloat, pursuing a merger or acquisition seemed the likeliest route to achieving continued growth and revenue diversification.

A new market valuation reality: In recent years, potential bank transactions have been limited by misaligned value perceptions between buyers and sellers. In hopes of earning a higher profit, community banks looking to sell have been holding out for 2 to 2.5 times book value. This price is in line with recent historical transactions, but unrealistic, given the current economic conditions.

A slight uptick in unassisted transactions (occurring at around 1.5 times book value), however, indicated a refocusing of the market valuation lens. Thanks to these deals, it appeared a new precedent would emerge, and banks would be more willing to venture into M&A territory.

So, given these ingredients for a seemingly unavoidable M&A storm, what happened?

If the first four-and-a-half months of 2013 are any indicator, all of the stars have yet to align. From a supply-and-demand perspective, a gap still exists. The price precedent between buyers and sellers that was supposed to establish itself hasn't, leaving troubled banks steadfast in their decision to hold out for a better deal. Additionally, the regulatory burden on banks is shifting executives' focus off of business growth (through acquisitions), and over to compliance.

In order to get banks to seriously consider a merger or acquisition, over-arching industry perspectives need to be modified. Institutions need to realize, given the relative health of their asset portfolios and the current economic and regulatory environments, valuations and deal prices will be below historical averages. The cost of compliance and thin interest margins will continue to erode shareholder value. In order to reverse this trend, many will have to look to exit strategies such as mergers and divestitures.

Given the limited market supply of available banks, buyers will need to rethink the value proposition of mergers and acquisitions, focusing more on the synergies of completing a deal and carefully deciding which characteristics warrant a premium price.   

Despite another round of unrealized predictions for banking M&A activity, a lesson has been learned. If M&A is the change needed to create a healthier industry, then banks need to warm up to a change in expectations.  

Neil Hartman is a director and leader of management and technology for consulting firm West Monroe Partners' Midwest banking practice. Ken Siegman is a director and leader of the firm's West Coast banking practice.