Regulatory pressures to merge intensify at larger banks

Major regional bank buyers — and sellers — could help drive a merger-and-acquisition rebound in 2024 after the fallout from soaring interest rates bogged down consolidation activity this year.

Lenders with $100 billion of assets could be interested in gaining scale amid proposed costly regulations and capital requirements. Consolidation among large banks could ignite a broader pursuit of scale across the industry, galvanizing a new round of dealmaking among community lenders and propelling stronger M&A volume after a weak run in 2023, analysts and bankers said.

"Banks need to achieve significant scale to absorb more regulatory costs and to be competitive," Christopher McGratty, head of U.S. bank research at Keefe, Bruyette & Woods, said in an interview. "All of our work suggests more M&A is going to happen."

At issue: U.S. bank supervisors over the summer proposed rules that would further tighten regulations for large banks in an effort to incorporate elements of the international governance framework known as Basel III. Those rules were agreed upon after the 2008 financial crisis but have taken years to roll out. The failures of several regional banks in the U.S. earlier this year jump-started the process. The changes would broadly boost the level of capital that banks with at least $100 billion of assets must maintain to guard against possible losses.

The regulatory changes would ramp up costs at a time when banks already are dealing with elevated funding expenses — deposit costs spiked along with interest rates — and are investing heavily in technology to deliver rapidly evolving online financial services.

"It accelerates regulation for an already heavily regulated banking industry," McGratty said.

While the heightened requirements apply only to larger regionals — aligning them with the biggest banks — regulatory changes historically have trickled down to smaller players. As such, community lenders are bracing for compliance cost increases in coming years, too. This could spur more of them to merge and create heft to manage increased expenses.

"There is no question there will be an increased regulatory burden," Christopher Maher, chairman and CEO of the $13.5 billion-asset OceanFirst Financial in Red Bank, New Jersey, said in an interview. "The costs are going up…It's going to be tough."

Maher agreed with McGratty that banks near the $100 billion-asset level could be motivated to merge with other regional players to "leap" over the key regulatory threshold. A $150 billion-asset bank, for example, would have a much larger base over which to spread out new costs than a $101 billion-asset bank, he said.

Similar thinking applies to community banks, he said. Regulators often peg $10 billion of assets as a key cut-off for smaller banks. As regulatory costs wind down to the community lending sector, Maher said more banks near that $10 billion mark are bound to pursue M&A to rapidly build scale.

"I think you're going to see a wave" of deals, Maher said.

To be sure, an M&A surge in 2024 would represent a stark shift from the current landscape.

The 91 bank deals announced through Nov. 30 had an aggregate deal value of $3.95 billion, down from 144 deals valued at $8.24 billion over the same period in 2022, according to S&P Global Market Intelligence. There were about 160 deals announced over all of 2022. And last year was a relatively slow year, down from about 200 in 2021. 

The Federal Reserve's rate-hike campaign to curb inflation, dating to early 2022 and spanning 11 increases through July, raised the risk of recession. This, in turn, increased the potential for loan losses, making buyers nervous about would-be sellers' credit quality. The macroeconomic backdrop also put downward pressure on banks' stocks and hindered the ability for buyers to use their shares to pay for acquisitions. The regional bank failures of early 2023 — Silicon Valley Bank, Signature Bank and First Republic Bank — added further doubts.

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All of these factors linger and have kept M&A in check this year.

What's more, regulatory headwinds that emerged after the Biden administration in 2021 called for greater scrutiny of M&A caused deal approval delays and factored into multiple canceled bank mergers over the past year, including the planned combination of TD Bank Group and First Horizon earlier in 2023.

Still, while approvals are more difficult to secure, Robert Bolton, president of bank investor Iron Bay Capital, said acquisitive bankers are learning how to navigate the new regulatory gauntlet. Importantly, he added, regulators over the long haul of the past 15 years dating to the financial crisis, have largely embraced consolidation in the industry, viewing scale as necessary.

"Approvals have definitely been an issue," Bolton said in an interview. "But the message from regulators over time is that fewer — and bigger — banks is good. They'd rather see fewer strong banks than more distressed banks."

Bolton said the greatest volume of deals in coming years will involve community banks. But large regional banks "will also definitely have reasons to marry."

Daniel Goerlich, U.S. banking and capital markets deals leader at PwC, echoed Bolton in noting that the timing of an M&A revival remains hard to pinpoint. Banks want assurances that the Fed is indeed done hiking rates. They also want new clarity from regulators that larger deals won't face special roadblocks. But, whether it is 2024 or the following year, the need for greater size will prevail, and more banks are sure to merge to absorb rising costs and create larger budgets to invest in technology, business line diversity and geographic expansion.

At a time when banks are looking for new ways to bolster earnings, Goerlich said in an interview, M&A can be "one of the quickest ways to return value to shareholders, if done effectively."