The Growing Imperative of Scale

February 1st, 2016

bank-scale-2-1-16.pngWhy are there so many people attending Bank Director’s 2016 Acquire or Be Acquired Conference this year, which at over 900 people is the largest number of attendees in the 22 years that we have been holding this event? Clearly the participants are interested in learning about the mechanics of bank M&A and the trends that are driving the market. But something seems to be different. I sense that more boards and their management teams are seriously considering M&A as a growth plan than perhaps ever before.

The heightened level of interest could certainly be explained by the continued margin pressure that banks have been operating under for the last several years. The Federal Reserve increased interest rates in December by 25 basis points–the first rate hike since 2006. But Fed Chairman Janet Yellen has said that a tightening of monetary policy will occur gradually over a protracted period of time, so any significant rate relief for the industry will be a long time in coming.

Other factors that are frequently credited with driving M&A activity include the escalation in regulatory compliance costs – which have skyrocketed since the financial crisis – and management succession issues where older bank CEOs would like to retire but have no capable successor available. But these challenges have been present for years, and there’s no logical reason why they would be more pressing in 2016 than, say, 2013.

What I think is different is a growing consensus that size and scale are becoming material differentiators between those banks that can look forward to a profitable future as an independent entity and those that will struggle to survive in an industry that continues to consolidate at a very rapid rate.

In a presentation this morning, Tom Michaud, the president and CEO at Keefe, Bruyette & Woods, showed a table that neatly framed the challenge that small banks have today in terms of their financial performance. Michaud had broken the industry into seven asset categories from largest to smallest. Banks with $500 million in assets or less had the lowest ratio of pre-tax, pre-provision revenue as a percentage of risk weighted assets – at 1.41 percent – of any category. Not only that, but the profitability of the next four asset classes grew increasingly larger, culminating in banks $5 billion to $10 billion in size, which had a ratio of 2.27 percent. Profitably then declined for banks in the $10 billion to $50 billion and $50 billion plus categories. Banks in the $5 billion to $10 billion are often described as occupying a sweet spot where they are large enough to enjoy economies of scale but still small enough that they are not regulated directly by the Consumer Financial Protection Bureau or are subject to restrictions on their card interchange fees under the Durbin Amendment.

Size allows you to spread technology and compliance costs over a wider base, which can yield valuable efficiency gains. It makes it easier for banks to raise capital, which can be used to exploit growth opportunities in existing businesses or to invest in new business lines. And larger banks also have an easier time attracting talent, which is the raw material of any successful company.

There will always be exceptions to the rule, and some smaller banks will be able to outperform their peers thanks to the blessings of a strong market and highly capable management. But I believe that many banks under $1 billion is assets are beginning to see that only by growing larger will they be able to survive in an industry becoming increasingly more concentrated every year. And for banks in slow growth markets, that will require an acquisition.

jmilligan

Jack Milligan is editor-in-chief of Bank Director, an information resource for directors and officers of financial companies. You can connect with Jack on LinkedIn or follow @BankDirectorEd on Twitter.