merger-11-19-18.pngWe are in unprecedented times. The Fed is reversing both its zero-interest rate policy and quantitative easing (QE). Many banks have excessive loan-to-deposit (LTD) ratios, which are crimping growth and profitability. Rates on interest-bearing deposits are beginning to move upward, while deposits are starting to leave.

As banks grapple with their deposit issues, they must consider several hard truths, all of which suggest an unconventional strategy might be the best option.

M&A as a Solution?
While there is no panacea for the deposit challenge, affected banks must explore acquisitions. M&A is the one strategy that can significantly alter the balance sheet and the LTD ratio virtually overnight. M&A is an especially effective strategy in an environment in which organic growth is tough, if not impossible. However, while this strategy seems good in theory, there are three practical problems:

  1. Most banks with an LTD problem are in growth markets, yet growth markets have few banks with low LTD ratios.
  2. Those handful of banks with low LTD ratios are not for sale.
  3. Conventional valuation methods (EPS accretion, TBV dilution, etc.) won’t work, either because the acquiring bank doesn’t have strong enough currency, or the seller (if it exists) wants a valuation that appears excessive relative to recent comparable transactions.

An Unconventional Approach to M&A
Unprecedented times call for unconventional strategies. And that means community banks should consider out-of-market acquisitions, with a particular focus on lower-growth and rural markets.

This strategy can increase the number of viable targets and create significant financial value for the acquirer because of the potential deposit growth. There is also strategic value since a bank can increase its deposit portfolio, add loans in a new market, helping diversify the loan portfolio from a credit risk perspective. The bank can then deploy excess deposits into its legacy market where deposits are a scarce commodity, essentially optimizing its role as a financial intermediary.

While the acquiring bank might be concerned about its unfamiliarity with the target’s market, this is more than offset by, a more conservative lending culture, the lower “beta” of its market relative to the overall economy, and the opportunity to retain the target’s key leadership and employees, who understand the market and customers.

However, the need to retain more personnel and the absence of branch overlap also means less opportunity for cost reductions. In addition, many of these banks will demand valuations that might appear excessive if enticed to sell.

Banks lucky enough to have a fungible equity currency trading at an attractive multiple can solve this problem, but banks with out-of-balance LTD ratios are less likely to be in that situation. They must use more cash or a weaker equity currency to fund the transaction.

Conventional techniques such as EPS accretion and TBV dilution analysis cannot properly measure the impact of these transactions on shareholder value. One problem is banks often make rosy, unrealistic assumptions about loan growth, deposit growth, loan yields, and cost of funds. This sets the bar way too high, leading to lower EPS accretion, greater TBV dilution and a slower payback period.

Different analytics are required to properly value the balance sheet components of a prospective acquisition. The valuation of a target’s deposits must capture the ability to replicate such deposits with organic growth (which is just about impossible in this environment), the increase in capacity and impact on profitability to preserve or make loans with those deposits, and the downside protection the target’s deposits provide against a deposit drain caused by QE reversal.

Management teams must begin educating directors and shareholders on these challenges. Management will need to prepare their argument carefully because this strategy is counterintuitive. If the case is laid out properly, the vast majority of directors and shareholders will recognize how these types of acquisitions can ultimately maximize shareholder value.

Remember: This unconventional M&A strategy requires a first-mover advantage. A handful of banks in growth markets are already pursuing this kind of plan. In six to 12 months, expect more banks to follow suit, creating a mad rush to the proverbial rural door. By then it will be too late, as those low LTD ratio banks willing to sell will have already been picked off. Waiting until the “big fish” in your market announces an out-of-market acquisition to make it easier for you to pursue such a strategy is a mistake. This is where the CEO’s courage and leadership come in.

Many banks, especially banks in growth markets, are finding themselves at a crossroads. The urgency to grow deposits is increasing, yet the pie for deposits in the market is either not growing or shrinking. While out-of-market acquisitions might still be a long shot, they must be explored as a potential solution.


Adam Mustafa