With Sector Primed to Consolidate Further, Large Mergers Magnify Opportunity, Risk

The highly competitive and regulated US banking industry has grown increasingly concentrated over the past few decades, and continued ultralow interest rates will spur increased consolidation over at least the next two years, particularly among small and midsized banks that rely heavily on net interest income. Mergers and acquisitions (M&A) offer these banks opportunity to achieve greater scale, efficiency and profitability, a credit positive, but also introduce execution and integration risks that can erode these benefits.

Low interest rates are not the sole driver of consolidation but they increase the likelihood of a jump in M&A activity. The pace of sector consolidation slowed in 2020 as the coronavirus pandemic subdued business activity. But small and mid-sized banks retain a particular motivation to pursue M&A because their earnings potential rests more heavily on net interest income, which is hobbled in the current low interest rate environment. Other motivations for M&A include opportunities to cut expenses and the need to obtain and invest in emerging technologies.

In-market transactions present the greatest cost-saving opportunities. Acquisition targets that present the opportunity for efficiency gains have greater relative value. They are also easier for management teams to assess and evaluate, particularly because loan growth and business activity remain hard to forecast in the present economic environment. Branch reductions are a primary means of reducing expenses.

Banks have warmed up to larger deals and so-called ‘mergers of equals.’ The attractiveness of these transactions has grown in the past couple of years, partly because of favorable equity market response. However, execution risk grows with the size of a transaction because issues such as cultural fit become more prominent, with the potential to erode the credit benefits of the combination.

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