Does size matter in banking? Many senior bank executives and directors plainly think that it does, based on the results of Bank Director’s 2016 Bank M&A Survey. Sixty-seven percent of the survey respondents said they believe their banks need to grow significantly larger to stay competitive in today’s more highly concentrated marketplace, and about a third of them say their institutions need to get to at least $1 billion in assets.
I struggle with this logic because there is nothing that is necessarily magical about size per se—and particularly a specific number like $1 billion—that makes it more likely that a bank will be able to attain an acceptable level of profitability. The argument you frequently hear is that scale helps you spread your compliance costs—which have gone up precipitously in recent years—over a larger base. It also makes it easier to afford the kind of technological investments that are necessary to stay competitive in a marketplace where consumers and small businesses are using digital and mobile channels in increasing numbers. Both rationales have some basis in fact, but I wonder how many boards of directors have actually put their banks up for sale solely because they couldn’t afford the costs of regulatory compliance and/or technology upgrades. I think not very many.
One of banking’s most persistent problems in recent years has been a low interest rate environment that has compressed net interest margins across the industry and made it difficult to grow both top line revenue and bottom line profits. And herein, I believe, lays the rationale for many of the acquisitions that we have seen in recent years. Perhaps by getting bigger, many CEOs and their boards think they can become more profitable—but that doesn’t just happen ipso facto. Almost always, there’s vital post-acquisition work that needs to be done, such as cutting duplicate administrative costs, rationalizing overlapping branch networks, or deploying one of the merger partners’ expertise in a particular area to the other partners’ untapped market.
Gaining scale can increase a bank’s profits in an absolute sense, but not necessarily its profitability. Profit is the actual amount of earnings that a bank makes for a particular reporting period, while its profitability is what it makes relative to its asset base (return on assets) or market capitalization (return on equity). I believe that profitability is the better yardstick with which to judge the effectiveness of a management team and board of directors because it measures how well they did with what they had to work with. And behind every successful acquisition is, I believe, a strategy for how to increase the combined bank’s profitability rather than its absolute profits.
I really don’t consider doing an acquisition to be a “strategy” per se. An M&A transaction is exactly that—a transaction. This might seem like an overly nuanced point, but “strategy” is what the acquirer intends to do with its prize after the deal closes. How does the acquirer use its new, larger platform to increase its profitability? In fact, I would go so far as to say that if the acquirer’s ROA and (if it is a public company) ROE don’t improve materially within 18 months of the deal’s closing date, than the acquisition has probably failed to live up to its potential even if the bank’s net income is higher.
Strategy is so important, in fact, that many highly successful banks avoid the M&A game altogether and focus all of their efforts on organic growth, which is rarely achieved and sustained without a well-conceived plan for how to make it happen. I don’t discount the fact that regulatory compliance and technology costs have gone up significantly in recent years, but growth through acquisition needs to be done with a larger purpose behind it than just getting bigger.