More Mergers on the Horizon?

As the banking industry continues its recovery, everything points to an increase in merger & acquisition (M&A) activity. Still, questions remain as to its proper form and timing. The uncertainty is exacerbated by the lack of transparency behind government regulations and still-stagnant economic conditions. The recent announcement by the agencies of a delay in Basel III implementation and the lack of guidance from the Dodd Frank law help generate continuing uncertainty.

Traditionally, bank M&A activity has consisted of healthy and performing banks acquiring smaller healthy and performing banks so that the acquiring bank can grow through scale and improved efficiency. However, in recent years, much of the deal-making has involved the regulators.

Loss Share

One important type of transaction has been the “loss-share agreement,” introduced by the FDIC in 1991. Under loss-share, the FDIC tries to maximize asset recoveries and minimize FDIC losses by absorbing a portion of the loss on a specified pool of the assets of a failed bank as part of an agreement to sell that bank to another.

While loss-share assistance stimulated M&A activity in some markets, it left other undercapitalized banks with very few options for attracting potential suitors or capital. Between 2000 and 2008, only 52 banks were closed by the FDIC. That number rose to 140 in 2009. With a bank closing nearly every week at that time, healthy banks were active participants in the bidding process. And the process was competitive, as over 350 bids were submitted for FDIC approval in 2009.

Today, M&A activity driven loss-share assistance deals has dramatically decreased from its 2009 high. At the current pace, the number of failed institutions in 2012 will finish at nearly 35% of the 2009 total. Also, there has been a drastic reduction in the number of bids for the banks closed year-to-date. The reasons: the loss-share process can be a cumbersome form of acquisition due to the regulatory requirements and “claw-back” provisions associated with such activity.

Since the FDIC insures banks against the potential loss of an asset, it is critical that the bank show proper credit management that minimizes the potential loss. If the bank fails to provide proper management and accounting, the guarantee may be jeopardized, leading the bank to underestimate the impact of the loss on its balance sheet. The FDIC has increased the number of audits and is sensitive to the loss still being incurred to the deposit insurance fund. Many acquiring banks faced challenges and costs that reduced the financial rewards they had anticipated. The management of loss share assets in order to comply with FDIC requirements was much more costly than anticipated and the requirements to hold assets in order to maximize asset value was exacerbated by the continuing decline of real estate values.

Banks with extremely low capital levels and questionable loan portfolios failed to produce the yields required by acquiring banks, thus creating a deal environment where the discount expected was too large for the target bank’s shareholders to absorb. This dynamic has led to slower M&A activity, even though there seems to be plenty of interested buyers and sellers. The data from 2009-2011 indicates that that many banks were prepared to help troubled banks but were unable to receive a discount relative to the protection behind loss share.

Investor Anxiety

Today, banks see many of their problem loans finding resolution. As the loan portfolio is improved, shareholders feel that the value in the bank has improved. However, proposed increased regulation, particularly the capital banks are required to maintain, has only heightened investor anxiety, as investors are unsure as to how new regulations will impact earnings. Both Basel III and Dodd Frank propose substantial increases in capital, as well as a methodology that increases the weight placed on assets in the calculation of capital. Without understanding the required capital, investors are not able to determine the leverage they will have in generating a return. Furthermore, the economic uncertainty behind the “fiscal cliff” and continued high unemployment has created extremely weak loan demand. With such uncertainty as to when this loan demand will return, investors find it difficult to identify an opportunity to produce a return on assets that meets their yield expectation.

Both Dodd Frank and Basel III are cumbersome and will force banks to realize a significant increase on their balance sheets. Many smaller banks do not have the efficiency or scale in order to achieve a positive return for their shareholders in this environment. Conversely, a well capitalized and healthy bank may be facing an expectation of growth. In light of increased regulatory expenses and continued weak loan demand, an acquisition of an institution would increase revenue within the loan portfolio while also reducing expenses through increased scale and efficiency.

Smaller banks that are looking to be acquired and maximize shareholder value must provide extremely clear transparency behind the loan portfolio. With the heavy amount of risk being placed on the investment, it is critical that the acquiring bank clearly understand where the opportunities and risk exists within the acquired bank. A lack of clear transparency within the loan portfolio will only lead to a low tangible book value being assigned from the acquiring bank that will fail to meet the acquired bank’s shareholder expectations.

It seems probable that more consolidation is coming. Over time, banks looking to sell will improve balance sheets and loan portfolios and implement the tools necessary to provide transparency to potential suitors. As economic conditions and regulatory guidelines become clearer, acquiring banks will be more inclined to provide a premium on deposits while also taking increased risk on credits. The combination of these factors will help close the gap that is currently preventing a pickup in traditional M&A.

Mr. Dittrich is a director for the Financial Institutions Group at Raleigh, N.C.-based Sageworks Inc., a financial information company that provides risk management solutions to financial institutions. He can be reached at [email protected].