Growth Through Digital Banking, Not M&A

Since becoming a banker in 1985, Andy Cecere has climbed the ranks of the banking industry to become the chairman and chief executive officer of U.S. Bancorp. He’s amassed an impressive resume along the way. He was at the table when what is now the fifth-largest commercial bank in the country was created through a megamerger almost two decades ago. He helped navigate U.S. Bancorp through the financial crisis, which the bank emerged from with the highest debt rating in the industry. And by the time the now 58-year-old bank executive moved into the corner office in 2017, the $465 billion asset bank based in Minneapolis, Minnesota, had been the most profitable big bank in the U.S. for seven consecutive years.

But don’t let this experience fool you. While Cecere certainly has a sophisticated philosophy on banking, as you would expect given his professional pedigree, a conversation with him settles immediately on technology and innovation. Indeed, among his cohort of contemporaries, Cecere has emerged as one of the most articulate evangelists of the future of banking.

“I think we’re in a new era,” says Cecere. As he sees it, the first era in banking during his career was the era of consolidation, when the population of commercial banks in the U.S. fell by half over 20 years, from 1985 to 2005. “Every morning you’d wake up and read The Wall Street Journal, and you’d read about a bank acquisition,” he says. The second era was the era of the financial crisis, lasting a decade, from 2006 to 2015. “In that period of time, the industry was on defense,” he says. “Everything was about capital, liquidity, increased regulation, huge failures.” Since then, the industry has entered a third era-the era of digital innovation and technology. “Now when you wake up on Monday morning, what do you read about? Amazon. Google. Fintech. Banks opening up digital branches. New technologies,” says Cecere. “It’s really changing.”

Claims like this have been made before. There was a time in the 1950s when banking by mail looked like it would render branch banking obsolete. By 1954, nearly half of the deposits at Union Bank & Trust were mailed to the bank as opposed to made in person at its location in downtown San Francisco. Yet, the 1950s marked the beginning of large-scale branch banking, not its end. The number of branches has since grown from less than 20,000 in 1954 to more than 80,000 today. It was the same story with phone banking, the ATM and the internet. This point isn’t lost on Cecere. “When I started in banking in 1985, I was told that checks, cash, branches and ATMs were going to go away,” he says. “And they didn’t.”

But the changes taking place now are different. Seventy-seven percent of deposit transactions at Bank of America Corp., the nation’s second biggest bank by assets, are done using digital devices. Nearly three-quarters of mortgage applications at U.S. Bancorp are completed and tracked by customers on its mobile application. More than half of customers at PNC Financial Services Group say they don’t need a branch or only visit one infrequently. And when Karen Garrett, a partner in the banking practice at the law firm Stinson Leonard Street LLP in Kansas City, Missouri, went to lunch recently with colleagues, just one reimbursed her with cash. The rest used person-to-person payment services like Venmo.

Trends like these raise lots of questions about the future of banking. Is there a role for branches? Can community banks compete against the billion-dollar technology budgets of megabanks? Will younger, digitally-savvy consumers usher in the death of banking as we know it? None of these questions are new. They’ve been discussed and dissected ad nauseam. But one question bankers have just begun to grapple with revolves around what the digital banking era means for the decades-long bank consolidation cycle. Can the two coexist? Or are they mutually exclusive? If a bank like U.S. Bancorp can expand into new markets using digital distribution channels, why would it go through the hassle of buying another bank? And if a bank like U.S. Bancorp does do another deal, will it pay the same premium it would have in the past?

“The calculus around acquiring a bank has changed dramatically,” says Cecere. “Twenty years ago, if I wanted to expand into [a new market] there was really only one way to do that, which was to buy a bank. Otherwise, it would be hard. You needed a physical presence. You needed a density of branches, because people used branches for transactions.” This is no longer true. Today, U.S. Bancorp can use its digital banking products, combined with its millions of existing out-of-footprint customers, as an alternative way to expand into new geographies. “If I went into a new market and tried to acquire new customers who didn’t know U.S. Bank, I’d either get negative selection, or I’d have to pay really high interest rates. Otherwise, why would they come to me?” says Cecere. “But if I go into a market where I already have customers or employees … and extend that relationship with a few select branches and digital capabilities that are really good, I have a better chance.”

Cecere points to Dallas as an example. “In Dallas, we have hundreds of thousands of customers. What if I went into certain markets in Dallas with a handful of branches, or a dozen branches, strategically placed, perhaps close to where we already have a mortgage operation. Then we add wealth management and acquire more of their business, targeting very specifically on customers that are already U.S. Bank customers, then expand with digital capabilities. That’s better than acquiring 100 branches, closing 50 of them, losing 40 percent of the customers and paying a big premium for the deposits.”

This isn’t to say that U.S. Bancorp will never buy another bank, because it might, but “the numbers would [have to] change,” says Cecere. “I wouldn’t pay the same premium as I would have 20 years ago, because I have an alternative acquisition model. That’s why I say the calculus has changed.”

Executives at Fifth Third Bancorp see things the same way, though for a different reason. “I agree with the thesis that one of the impacts of digital on the banking sector is that the acquisition premiums for acquiring super community banks will go down,” says Tim Spence, head of consumer banking, payments and strategy at the $142 billion asset bank based in Cincinnati, Ohio. “But I don’t actually think it’s because it’s easy to enter new markets with digital-only products.”

The bigger issue, as Spence sees it, is that digital banking is chipping away at the franchise value of community banks. “The hidden driver here is that the prolonged low interest-rate environment disguised a fundamental shift of deposits originating from primary banking relationships from the small banks to, call it, the top 25 banks in the U.S.,” says Spence. “It masked the shift, because small banks were able to use money-market accounts and other core funding products to raise deposits at low rates. But the primary transaction accounts, which are the basis of the client relationship, are shifting pretty dramatically from the community banks to the big guys, owing to advancements in digital capabilities and marketing at the superregional and national level.”

Industry data reflects this shift. Since 2010, the country’s six biggest commercial banks have captured 79 percent of the growth in domestic demand deposits, increasing their market share in the category from 66 percent to 74 percent, according to data from the Federal Deposit Insurance Corp. In 2017 alone, nearly half of new checking accounts were opened at just three large national banks, even though they operate only a quarter of the industry’s branches, noted Steven Hovde, chairman and CEO of Hovde Group, in a presentation at Bank Director’s Bank Compensation and Talent Conference in early November 2018.

In short, given that large banks are already organically gaining deposit share with their digital offerings, why would they need to buy it, much less pay a premium for it? “We’re both getting a huge share of the younger folks [choosing a bank for the first time] and when existing customers switch banks, they’re disproportionately choosing the big guys,” says Spence. “The problem with that as it relates to M&A premiums is that … what you’re paying for when you’re paying well above book value is the franchise-the belief that their primary client relationships will, on an ongoing basis, be a source of incremental revenue and growth,” he adds. “But that’s just not the case.”

Spence points to what’s going on in Fifth Third’s markets. “If you look at our rate of growth in terms of consumer checking households, it’s a multiple of the growth of the population overall in our footprint,” says Spence. The bank’s chief financial officer, Tayfun Tuzun, has made the same point. The number of new household customers Fifth Third has gained from direct marketing campaigns has tripled over the past two years, Tuzun noted in a recent conference presentation. Over the same period, average deposit balances traceable to direct mail campaigns quadrupled. And household growth in the bank’s Southeast markets was up 8 percent in the third quarter 2018, compared to the same period the previous year.

And it’s not just among big banks that the upward migration of demand deposits and primary banking relationships is exerting an influence. Smaller banks are responding to it, too, though they’re doing so in the opposite way, says Bob Monroe, a partner in the banking practice at Stinson Leonard Street. Speaking specifically about banks with less than $1 billion in assets, Monroe says: “Buyers today are looking for deposits. The seller today is one with a big deposit-to-loan ratio. Buyers don’t need the loans so much as they need the deposits. There’s not a technological bent to it-it’s more driven by liquidity.”

Acting as an accelerant on these trends is what Ron Shevlin, director of research at Cornerstone Advisors, refers to as “deposit displacement.” That is, instead of keeping money in a depository account at a bank, consumers are stashing cash elsewhere. “There are lots of examples of this,” says Shevlin. “Venmo is one example. Health savings accounts are another. You can have money sitting in your Starbucks account. Now every vendor wants to have an app where users can store money to make payments. Robo advisor tools are another example. It’s estimated that by 2020, there will be $2 trillion in robo advisor accounts, and they expect half of that to come from money sitting in checking accounts.”

This represents a more fundamental shift that only further loosens community banking’s grip on primary checking accounts. “What the banks have been doing for the past couple years is rolling out digital banking capabilities to make it easier and more convenient for customers to keep their money with them,” says Shevlin. “It’s enabling them to not have to pick up the phone or go to the branch. But it hasn’t really changed the behavior-how people manage their money. What the fintech companies are doing is changing consumers’ behaviors-how they manage their money, how they manage their relationships. That’s what is causing a fundamental change in the industry, not simply being able to check your account balance or transfer funds digitally.”

PNC is a third superregional bank that seems to have cooled to the idea of growth through acquisition. Instead, the $380 billion asset bank based in Pittsburgh, is using a de novo branch strategy, paired with aggressive marketing and digital offerings, to move into new markets. It did so recently in Kansas City, Missouri, opening its first branch there in 2018. It’s also pursuing this strategy in Dallas. “Our branch strategy pivots from the traditional stand-alone branch destination, leveraging high-end retail locations to put flagship offices where people typically spend a lot of time anyway,” said Kevin McCann, PNC’s national retail digital strategy executive, at a recent industry conference. “These are the types of places we’ll see a lot of foot traffic anyway. So, it’s not just a branch for us. It also serves as a billboard to introduce ourselves in new markets.”

Core to PNC’s strategy are surveys it has completed showing that, while only 7 percent of its customers are ready to go without branches entirely, 45 percent say they’re “thin-branch ready,” meaning they won’t visit a branch often-maybe once or twice a quarter-but still want access to a physical location when they need advice or have to resolve a more complex problem. “When you think about the ultrathin branch network, it’s not just about brick and mortar,” said McCann. “You can think about the branch as a hub. These retail locations, while offering a lot of self-service and digital options, will also be focused primarily on outbound sales. Essentially, we treat these branches as distribution centers for all the things PNC does well.”

A fourth superregional bank that has weighed in on this is BB&T Corp., a $223 billion asset bank based in Winston-Salem, North Carolina. “I don’t really expect to see a lot of … big bank mergers,” said Chairman and CEO Kelly King on the bank’s third quarter 2018 earnings call. “At one time I did … but I don’t expect to see that today.” King’s comments are notable, given that BB&T has been one of the most active acquirers in the banking industry over the past 30 years. Since its current leadership team took over in 1989, it has acquired nearly 70 banks and thrifts, averaging more than two a year. Its latest deal, in which it paid $1.8 billion for National Penn Bancshares in Allentown, Pennsylvania, closed in 2016.

But King comes at it from his own unique angle. The reason he doesn’t expect to see as many acquisitions by large regional banks is because he doesn’t think scale is as important as it used to be. In the past, “you had to get your scale to get your cost per unit down, because you had to build all these systems all by yourself,” said King on the earnings call. “We’re now looking at some systems improvements where we’re not going to have to build it ourselves. There’s a real movement inside our industry and [among] outside providers to use a shared utility concept, where it’s possible for organizations to plug into a shared utility and not have to have … the scale necessary to get the cost per unit down.”

Neither PNC nor BB&T responded to interview requests.

Now, even among these banks, there are exceptions to this rule-the most obvious being Fifth Third’s latest acquisition, which will likely go down as the biggest bank deal announced in 2018. “We looked at Chicago,” says Spence. “We like the market. We operate nearly 150 branches there, which sounds like a lot, but spread across nine million people does not put us top in the market. And we were operating in the consumer business with a No. 6 or 7 market share. In a competitive market, that’s not a sustainable strategic position. So when we were looking at Chicago, the question was: Do we win the battle on marketing, do we build more branches, or do we make an acquisition?”

Fifth Third chose the acquisition route. It announced in May 2018 that it would pay $4.7 billion, or 2.7 times tangible book value, for MB Financial, a $20 billion asset bank based in Chicago. The decision was based on MB’s “clear, demonstrated ability to compete for primary banking relationships,” says Spence. “They had succeeded where many others had failed.” As such, Spence and his colleagues at Fifth Third believed the deal offered a compelling opportunity to combine Fifth Third’s digital capabilities with MB’s branch locations in a market where it’s hard to secure top-tier real estate. “By putting the two companies together, we were able to achieve a No. 2 market position in both the consumer and middle-market businesses,” says Spence. “That’s why we were willing to pay a premium.”

There’s also reason to believe that community banks, instead of avoiding mergers and acquisitions because of digital banking, will more aggressively pursue deals in order to gain scale. “I don’t know for sure, but I think there’s going to be more consolidation of small and mid-size banks because of technology,” says Cecere. “I can spend $1.2 billion a year on technology and another $1.2 billion on operations. So that’s basically $2.5 billion a year on technology. A $50 billion [asset] bank can’t do that. And a $5 billion [asset] bank certainly can’t do that. We’ve already said that large banks are taking share from small banks. So if you’re a small bank, what do you do? I think small banks will come together.”

Shevlin echoes this point. “It’s important to appreciate that the logic and rationale [when it comes to doing deals] is different if you’re smaller than a superregional or national bank,” says Shevlin. “If you’re a U.S. Bank or even a BB&T, and are thus orders of magnitude larger than the typical mid-size or community bank, they’re not necessarily doing the deal for scale. They already have scale. They’re doing it for geographic expansion, product expansion and so forth. But at the mid-size level, the issue is more about scale. Given the expansion of digital channels, you need volume to make it economical. So, for the mid-size and smaller banks that think, ‘Look, we’re just not competing well. We need to join forces with somebody our size or larger,’ scale becomes much more of a factor.”

The moral of the story is that the impact of digital banking on the industry’s appetite for mergers and acquisitions seems to be a function of size. Bigger banks with the resources to pursue digital banking can stay on the sidelines, organically usurping deposit share, until a compelling opportunity presents itself. Smaller banks, on the other hand, don’t have the same luxury. Size and scale still matter to them-maybe more than ever.