Expect a Spike in Bank M&A Soon

Industry observers expected M&A to be among the top themes for U.S. banking in 2012.

Softening industry fundamentals and increasing regulation were considered the main drivers of consolidation. Net interest margins would continue to compress in the low-rate environment; loan growth would mirror economic growth and remain sluggish; fierce price-based competition would persist; operating costs would rise – and fee income would continue to decline –from new regulatory requirements and limited expense reduction opportunities.

Given these trends, and the absence of a clear growth catalyst on the horizon, more and more banks would turn to acquisitions as a way to maintain earnings through cost savings, scale economies and balance sheet growth. Such was the common wisdom at that time.

While consolidation did occur in 2012 among small banks, there were few medium and large bank combinations. The often-discussed difference in price expectations between buyers and sellers is undoubtedly a factor weighing on deal volume. Other factors such as uncertainty about fiscal policy and new regulations are also contributing to the sluggish pace of M&A.

But perhaps the most significant reason for the dearth of M&A activity has been the ability of most midsize and large banks to maintain – or even grow – earnings in spite of mediocre core business. From my years spent as a sell-side and buy-side equity analyst, I know that consistent earnings growth tends to make boards feel good about their bank's current and future health. It tends to make regulators focus their attention on truly distressed, nonearning depositories. Consistent earnings growth also eliminates a sense of urgency to sell, and gives management teams confidence that they will make it through the tough operating environment without needing to throw in the towel.

Two key ways by which banks are maintaining or growing earnings include realizing securities gains and reducing provision expense. Both of these are low-quality, time-limited, noncore forms of earnings.

According to Federal Deposit Insurance Corp. data, realized securities gains were $7 billion for the first three quarters of 2012, up from $3.8 billion over the same period in 2011. Lower provisioning was an even stronger driver of earnings in 2012. At the industry level, improving credit trends and record recoveries on prior credit losses led banks to provision $21.2 billion less than actual chargeoffs in the first nine months of 2012, thereby releasing (i.e., lowering) reserves.  Provisioning below chargeoff levels provides a direct – albeit temporary – benefit to earnings.

This benefit is temporary because loan-loss reserves can't continue their decline much longer, especially in the current era of heightened regulatory scrutiny of bank financial strength and stability. Reserves will eventually reach a normalized (or steady-state) floor below which they cannot go. As banks approach this floor, the earnings benefit from lower provision expenses will abate, and earnings will be squeezed. With limited opportunities to counteract this squeeze through internal operating expense and/or funding cost reductions, M&A should emerge as an attractive strategy to maintain earnings and generate growth.

When might normalized reserves and the accompanying earnings squeeze occur? This obviously will vary from bank to bank and depend on current reserve levels, business mix and other factors. For the industry, we will probably arrive at normalized reserves by late-2013.  According to the most recent aggregates from the FDIC, industry reserves have declined for 10 consecutive quarters and stood at 2.2% of loans and leases in the third quarter of 2012, down from 2.7% a year earlier and from a peak of 3.5% in the first quarter of 2010. The average reserve level over the past 10 years was 1.9% (of gross loans and leases), so we're not far off from this hypothetical floor.

One could also reasonably expect that regulators will want the floor to be at levels higher than the historical rate due to concern about the current challenging operating environment and an emphasis on long-term safety and soundness. Comptroller of the Currency Thomas Curry recently gave credence to this view by noting in a speech that regulators are aware banks are reducing provisions to boost earnings. Consequently, the OCC is "watching reserves very closely" and won't "err on the side of allowing reserves to become too lean."

In addition, elevated recoveries, a key driver of credit cost improvement over the past three years, peaked in the first quarter of 2011 at an annualized rate of 28 basis points (of gross loans) and declined to 23 basis points in the third quarter of 2012. With the 10-year average of 18 basis points not too far off, declining recoveries should contribute to the arrival of normalized reserves.

An important mitigant to the earnings pressure from normalizing reserves and provisions would be a material pickup in loan demand and/or net interest margins from rising rates since both of these would contribute top-line revenue growth. Unfortunately, given the low growth and rate expectations reflected in both the yield curve and most economists' forecasts, it's difficult to see this offset materializing in the near future. As a result, the earnings squeeze and subsequent increase in M&A catalyzed by normalized reserves could arrive soon.

Dan Rosenbaum is head of corporate development and strategy at Bank of the West. He was previously a financial services equity researcher with Barclays Global Investors and Merrill Lynch and a strategy consultant with Accenture and McKinsey & Co.