Four hurdles for bank buyers to clear

April 21, 2024 9:00 PM

Bank merger-and-acquisition activity is poised to bounce back in 2024 — or is it?

After a two-year lull, during which deal volumes slowed to a crawl amid pervasive economic doubts, bankers and analysts entered 2024 with high expectations for a resurgence. They pointed to the ever-mounting need for scale and diversity in an era of fierce competition and escalating technology costs. They also noted the U.S. employment market's enduring strength — it posted six-figure job gains every month last year and again in January and February — and said it had effectively countered the adverse impacts of a surge in interest rates.

Fears of credit quality deterioration had eased, and bank stocks, often the currency used to pay for acquisitions, had begun to recover from a rough 2023.

Conditions, the bullish M&A argument went, were ripe for the unleashing of pent-up demand.

"Everyone was worried about the economy, but it's hard to see a big slowdown anywhere on the horizon right now, given the job growth," said Mike Matousek, head trader at U.S. Global Investors. "I'm not saying there are no concerns, but nothing seems to be derailing this economy, and that does not bode well for more dealmaking."

It would mark a stark reversal from the doldrums of the past two years.

Banks announced only 99 deals in 2023, according to data from S&P Global Market Intelligence. That was far below the 157 in 2022, which was hardly a banner year for M&A. It fell far short of the 202 transactions inked in 2021, when activity rebounded from the temporary pause imposed by the pandemic. The 112 total in 2020, when COVID-19 paralyzed vast swaths of the economy, was still higher than last year.

In the same span, the S&P data showed, the aggregate disclosed deal value plunged to $4.2 billion last year from nearly $9 billion in 2022 and $77 billion in 2021, when several large deals were announced.

Through the first two months of 2024, meanwhile, acquisitive banks announced 20 deals, putting the industry on pace for 120 transactions this year — more than last year yet hardly strong momentum.

Total U.S. M&A deal value across all sectors totaled $1.3 trillion in 2023, down nearly 50% from 2022 and the lowest level since 2010, according to KPMG. Carole Streicher, head of deal advisory and strategy for the firm, said 2023 "was a very weak year for M&A." Deal talks were on the rise early in 2024, but ultimately, much depends on the interest rate environment, she added.

While the economy and the banking industry as a whole weathered a storm of interest expense spikes between 2022 and last year as the Federal Reserve sought to combat inflation, policymakers continue to delay a shift to lower rates.

They cited an inflation rate that, while far from its 2022 peak of 9.1%, continues to hover above 3%. That is more than a percentage point above the level that Fed officials say is healthy.

"We are waiting to become more confident that inflation is moving sustainably down to 2%," Fed Chair Jerome Powell said before the Senate Banking Committee in March. "When we do get that confidence, and we're not far from it, it will be appropriate to begin to dial back the level of restriction so that we don't drive the economy into recession."

Powell's statement spurred fresh futures market bets on initial rate cuts in June or July. But Matousek noted that investors have awaited reductions for about a year. Powell's outlook, he said, hardly cements a move to lower rates this summer.

"Predicting the Fed's next step is a fool's game," Matousek said. "I don't think there's any assurance of rate cuts this summer, and if we do see that, the process could be long, slow and gradual. "Uncertainty tends to accompany that kind of process, and that can have side effects for things like M&A. So there are bullish and bearish factors at play for deals," he added.

Against that mixed backdrop, here are four impediments that may prevent an M&A rebound.

Rates and unrealized losses

The fivefold jump in interest rates over the past two years bruised banks' bond portfolios and made deal math more difficult for buyers to assess.

"The single biggest roadblock to more M&A is the hit to bond portfolios and the level of unrealized losses on many targets' balance sheets," said Jacob Thompson, a managing director of investment banking at Samco Capital Markets.

A bond's worth is tied to the value of the income it produces via interest payments. When rates climb rapidly, the existing bonds that banks hold lose value because they generate less income than new bonds hitting the market at higher rates.

This can adversely impact the value of a bond portfolio in the near term, causing unrealized losses. In turn, it becomes increasingly challenging for bank buyers to assess the true worth of acquisition targets. Rather than get caught in a quagmire of guessing, buyers tend to pass, Thompson said.

He and others in the M&A business had hoped that rates would start to decline in the first half of 2024 and the bond portfolio wrinkle would smooth out enough for more deals to happen.

"Obviously, there are still a lot of expectations for cuts, but I think based on recent history, we have to be prepared for no rate cuts this year, or at least not until late in the year," Thompson said. "The Fed gives lots of hints, but at the end of the day, they want to see inflation at their target level or very close to it before they move."

Given that uncertainty, many growth-minded banks with an abundance of capital and the wherewithal to make acquisitions would rather focus on organic expansion this year. Tulsa, Oklahoma-based BOK Financial is among them. The $50 billion-asset bank's president and CEO, Stacy Kymes, said in an interview that, for now, hiring bankers or new investments in technology make more sense than grappling with whole-bank M&A unknowns.

"Right now, we're more interested in incremental gains — product acquisitions, new talent," Kymes said.

He also noted that intense regulatory reviews of deals loom large.

Thompson agreed. He said headwinds that emerged after the Biden administration in 2021 called for greater scrutiny of M&A delayed several large deals over the past two years — and nixed a few of them. This included most notably the planned merger of TD Bank Group and First Horizon. These regulatory-related developments also deterred other buyers, who dreaded drawn-out and costly approval processes.

A spate of regional bank failures early last year — Silicon Valley Bank, Signature Bank and First Republic Bank all folded — added to downbeat sentiment that kept some buyers on the sidelines then and continues to foment caution.

"The overall environment just isn't cooperating yet," Thompson said.

Regulators and New York Community

New York Community Bancorp's struggles crossing $100 billion of assets — a threshold at which lenders face more rules and examinations — amplified worries about regulatory pressure tied to acquisitions.

The $116 billion-asset company surged in size after its acquisition of Michigan-based Flagstar Bancorp in 2022 and parts of the failed Signature Bank last year. The deals sent the Long Island-based New York Community into the orbit of stiffer regulation, and shortly thereafter, during the fourth quarter, it set aside a whopping $552 million provision to cover potential losses in its commercial real estate-heavy loan portfolio.

While the bank in March attracted a $1 billion capital infusion to shore up its finances, its stock, earnings power and customer base are vulnerable, analysts said. Any further negative news could "test customer loyalty and deposit stickiness" after "the fallout from a disappointing" fourth quarter, said analyst John Mackerey of Morningstar DBRS.

New York Community's tribulations put other large regional banks on notice that jumping over the $100 billion-asset line via deals could present serious growing pains.

The "result and reaction" of New York Community's hardship "are reminders of risks that remain in the regional banking space," Jefferies analyst Ken Usdin said.

He and other analysts said, in time, banks nearing the threshold of more regulatory heat may choose to sell, driving M&A. Analysts at Keefe, Bruyette & Woods said in a report that "emerging $100 billion banks, with less scale and less margin to their respective cost of capital," could be "potential sources of scale for larger peers."

But in the near term, buyers big enough to make such acquisitions are likely to remain cautious and, as PNC Financial Services in Pittsburgh announced during the first quarter, may instead invest in building new branches and adding staff in key markets, said analyst Terry McEvoy of Stephens. "Targeted organic growth is probably a safer bet," he said.

The $562 billion-asset PNC said it would invest about $1 billion to renovate more than 1,200 existing offices and open more than 100 new ones in a bid to expand in high-growth cities, including Dallas, Houston, San Antonio, Miami and Denver.

PNC said the new branches would be built between this year and 2028. PNC Chairman and CEO William Demchak said in an interview that "the need for scale has never been greater" and he is open to possible bank acquisitions. "But we aren't going to force it," he said. "That's not something we need to do."

Cracks in credit quality?

While the overall economy proved resilient, New York Community is hardly an island when it comes to CRE vulnerability.

Several banks with exposure to urban office towers and the neighboring multifamily and retail buildings that were built for residents living near their workplaces reported increased loan losses in recent quarters. More lenders also boosted reserves for potential future loan losses and cautioned that office properties — hampered by enduring remote work trends — and CRE broadly could face more problems this year.

Bankers also are watching closely for signs of trouble among consumers and small businesses, monitoring those customers' ability to absorb both higher expenses imposed by lingering inflation and increased borrowing costs following the Fed's rate-hike campaign.

These potential pitfalls pushed some bank buyers to the sidelines in 2023. Some may stay there this year, said Michael Jamesson, a principal at the bank consulting firm Jamesson Associates.

"There's no question CRE is a challenge," he said. "It is definitely another hurdle for M&A. Is it a killer? I don't think we know the answer; 2024 will probably let us now."

Credit quality concerns also continue to weigh on bank stocks and, by extension, buyers' ability to use their shares as currency to pay for acquisitions. Sellers are often loath to accept depressed stocks.

The KBW Nasdaq Bank Index, while up year to date through mid-April, was still down from the levels reached in early 2023 prior to the run of regional bank failures.

The potential for higher credit expenses is particularly concerning at a time when banks are also wrestling with high deposit costs. Banks paid up to hold on to deposits throughout 2023, reflecting the inevitable pressure caused by the high-rate environment. At the same time, loan growth slowed last year.

This combination squeezed net interest margins — a key measure of profitability that reflects the difference between the interest banks pay on deposits and earn on loans. Banks' fourth-quarter cost of funds grew 21 basis points from the prior quarter to 2.48%, according to data from S&P Global.

"I think it's obvious to see that it is not a particularly easy time to be running a bank," Jamesson said. "Over the long run, the secular trend is going to be for more consolidation in the industry, and we could see a modest pickup this year, but with challenges and uncertainties right now, bank stocks are having a hard time finding a stride and M&A momentum might take more time to develop as a result."

President Biden Campaigns In Pennsylvania

Hannah Beier/Bloomberg

Election uncertainty

A looming presidential election — on top of global geopolitical tumult — adds another dose of unpredictability that may deter some bank buyers from pulling the trigger on deals.

President Biden, if reelected, could double down on stiffer regulatory reviews of M&A. Former President Trump, the presumptive Republican nominee, championed deregulation during his term in the White House. The head-to-head campaign is just getting underway, but analysts say the unknowns presented in an election cycle are bound to put some bankers in wait-and-see mode.

Mitch Berlin, Ernst & Young's Americas vice chair of strategy and transactions, said in a report that M&A activity across all industries is expected to rise 12% this year after falling by 9% in 2023. However, the forecast is clouded by global unrest, including the Israel-Hamas and Russia-Ukraine wars, continued high interest rates and the potential for domestic political changes following the election.

"Our perma-crisis of geopolitical volatility, slower consumer spending and the impact of disinflation could all pull the punchbowl from the party — to say nothing of what promises to be a fiercely contested U.S. election," Berlin said.

For all the potential hindrances, Berlin echoed Jamesson in noting that M&A is bound to rebound once there is more clarity, including in the banking sector.

Bank sellers, struggling to keep pace with the expensive technology spending of larger banks and the increased competitive pressure those investments present, are looking to join larger banks and create more cost-efficient digital offerings and loan products for customers.

Larger community and regional banks, meanwhile, are eager to broaden their loan portfolios, giving them greater options to both grow interest income through loan volume and diversify to help safeguard credit quality should the economy slow and defaults on certain types of loans rise.

If one or two loan categories generate losses but several others in a diverse portfolio persevere, a bank can profitably weather a recession, analysts say. Geographic diversity can prove similarly positive.

Bankers amplified that thinking during recent earnings calls.

For example, executives at the $15.6 billion-asset Community Bank System in DeWitt, New York, said a "more constructive" M&A environment likely is on the horizon once interest rates decline and buyers can get better reads on sellers' loan portfolios and securities books.

"It's been a couple of years of headwinds, I would say, from an M&A perspective in terms of figuring out the values, the rates, the marks," Community Bank System President and CEO Dimitar Karaivanov said.

"So we're hopeful that this year there's going to be a little bit more clarity and stability in the market, which would allow folks to kind of really understand what's on the balance sheet," he added.

Christopher Holmes, president and CEO of the Nashville-based FB Financial, offered a similar view. The $12.6 billion-asset bank is among prospective buyers that could drive more activity.

"We believe that we're due for some consolidation based on the lack of activity over" 2022 and last year, "as well as how much more burdensome and expensive it's becoming to run a community bank," Holmes said.