Stressed Into Selling?

Last week, the largest U.S.-based banks passed the Federal Reserve’s stress tests. These results suggest each institution has sufficient capital to weather a significant financial shock. While the largest institutions in the U.S. remain, for the most part, on the sidelines when it comes to bank M&A, the test itself had me thinking about merger activity for the balance of the industry—roughly 6,600 organizations in total. Depending on the complexity of one’s business model, could modeling various economic conditions help a bank’s board to anticipate potential challenges and opportunities?

Banks above $10 billion in assets are required to conduct company-run capital stress tests, per the Dodd-Frank Act.  Banks below that are not. But what if they did anyway? I know for a fact that many of the banks below $10 billion do undergo the exercise not only for the sake of capital planning, but for other reasons as well. While stressing a smaller bank would certainly be expensive and time consuming, I see the exercise as valuable for many banks. With a bank’s capital tested, it strikes me that a follow-on to the results is a conversation about where the business might grow or expand and to shore up any vulnerabilities. For some, such a candid assessment of its strengths and weaknesses should lead to a discussion about a merger or acquisition, since M&A remains a principal growth strategy. So let’s play out a few scenarios.

Imagine a $2 billion asset bank with a significant commercial real estate exposure decides to shock its portfolio against various economic scenarios to make sure (1) it has sufficient capital and (2) it is generating sufficient return for the risk it takes on. While stress testing is primarily a risk management exercise, the results of the test might raise all kinds of questions, including whether or not the bank should remain independent, find a merger partner or consider staging an exit.  Admittedly, I have a hard time imagining that a bank would want to sell just because it can’t survive a worst case scenario. I do, however, think the results might reveal profitability weaknesses and make obvious potential problems with certain business lines that may not be fixed solely through “organic” means.

Alternatively, consider a similar-sized bank with a robust and diverse lending platform along with a proven credit culture. Testing its capital might reveal a credit engine running smoothly. Such a result could encourage the bank’s board to more actively pursue growth whether through organic means or mergers and acquisitions.

It strikes me that a number of factors are driving today’s bank consolidation: low valuations, lack of capital access, margin compression and slow loan growth. Given that the results of last week’s tests show the biggest players in our space are at least adequately capitalized and in a position to take on new risk, doesn’t it make sense for smaller banks to “plan for the worst and hope for the best” as they consider their future?