Buyer Beware: Why Today's Bank M&A Environment Raises Red Flags

Today's banking environment is nearly as dangerous – yet far more insidious – as it was in 2009 and 2010, when banks faced massive capital losses and hundreds of them failed. Regulatory agencies, which had traditionally focused on capital adequacy, were hard-pressed to manage the assets that fell under their control. This led to an increasing number of attractive FDIC-assisted transactions. Today we have a far different banking mergers and acquisitions environment:

• Many community banks survived the recession with depleted capital levels.
• Declining loan volumes created the illusion of improving capitalization, temporarily satisfying regulatory capital adequacy concerns.
• The weaker banks continued to face regulatory capital adequacy pressure, forcing additional deleveraging of assets.
• Regulatory response to the recession substantially increased compliance costs.
• Loan demand decreased dramatically.
• Competition increased, with large national and regional banks scrambling to grab a share of the declining loan market.
• Banks continued to operate in an artificially induced interest-rate environment, characterized by shrinking net interest margins, offset to some extent by present-day low cost of funds.
• Chasing higher net interest rate margins, many banks increased their dependence on fixed-rate loans, making them susceptible to the inevitable rising rate environment.

The present slow-but-inevitable hemorrhaging of bank earnings will give regulators the luxury of time to force undercapitalized banks to seek capital or sell. The number of assisted transactions will be limited, and possibly even non-existent.
The overall decline in loan demand, coupled with the reduced net interest margins, has left many banks with the unique combination of excess capital and low yielding assets (these are banks that need to acquire others) and many others with low capital and low yielding assets (these are banks that should sell). Weestimate that about 12% of the roughly 6,900 community banks are undercapitalized (below 3.5% post-stress leverage ratio) and have a severely reduced return on the regulatory capital required to support their present asset base. Even minimal increases in regulatory leverage ratios will dramatically increase the number of banks in trouble. 

These undercapitalized banks will continue to suffer, or decline even more, as quantitative easing is unwound. The recent decline in bank failures masks the weak earnings of many undercapitalized community banks and their increased dependence on low-cost funding. The morgue may be thinly populated now, but many banks will be headed there when the Federal Reserve's low-cost-of-funds life support machine is unplugged.

Presently, some of the more strongly capitalized banks continue to make acquisitions, often paying premiums that ignore the high regulatory capital burdens of their targets. Many of these acquisition targets are loaded with pre-recession loans that carry heavy regulatory capital loads in conjunction with their attractive higher net interest margins. Unfortunately, acquisitive banks have frequently used "the accretive to earnings" pabulum to sway their shareholders and justify these overpriced transactions. This has created an illusion of acquisition value that is detrimental to the whole market.

The traditional approach of "multiple-of-book" overlooks the impact of the heavy regulatory capital requirements of the targets. Bankers focused on closing transactions the old-fashioned way are successfully completing deals at inflated prices. Banks under regulatory capital constraints and pressures are reacting to these multiples, and are reluctant to accept acquirers with more practical analytical approaches.

The ongoing hemorrhaging of these weaker banks, coupled with their mistaken belief in higher book multiples, will only hurt the long and short-term interests of their shareholders. Over time, acquisition multiples will decline as the undercapitalized banks continue to weaken. As this process accelerates, the pendulum will swing toward very low multiples. A bank feeding frenzy could easily commence. The banks that did early, overpriced transactions will be silent regarding their overpayments, having already received the short-term benefits of the allegedly wonderful "accretive to earnings" acquisitions.

To avoid these problems, here is what should be considered:

• Banks that are eager for acquisitions need to be cautious. They must evaluate transactions in a rational manner, considering the regulatory capital requirements of their targets, the composition of their targets' loans and, most importantly, those loan vintages. Pre-recession loans have far worse stress characteristics than post-recession loans, but carry the allure of better net interest margins. The "half-life" of loan portfolios that are being acquired and their reaction to rising interest rates will have a considerable impact on the value of an acquisition.

• Banks need to do a proper analysis and be patient.  They must resist the temptation to rush into transactions in an unrealistically priced environment.

• On the other hand, under-capitalized banks with low returns must bite the bullet and contemplate earlier sales before time and rising interest rates drain their capital levels and shareholder value, with the pendulum swinging toward a buyer's market.

In conclusion: a caveat emptor to all investors when you hear "accretive to earnings" from your investment banker.

Kamal Mustafa is the chairman and CEO and Malcolm Clark is a managing partner at Invictus Consulting Group.