Nine Steps for Getting Your Contracts Aligned with Your Acquisition Strategy

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acquisition-8-2-17.pngAs banks contemplate future mergers and acquisitions, we are hearing a common question in our vendor contracts practice: “What should I do in my contracts to prepare for an acquisition opportunity?”

The truth is that whether buying or selling, there are many steps bankers can take to prepare for an acquisition, but they need to be taken well in advance. Here are some secrets from behind the curtain.

For banks that are serial acquirers:

1. Perform serious due diligence on the target’s technology contracts and your own.
Review the large technology agreements of the target bank using the 80/20 rule–80 percent of your spending is going to be in a handful of agreements. When you’re done reviewing the target’s contracts, review your own. This will provide a high-level view of your entire vendor relationship. Reviewing the target’s contracts will show your costs to exit their agreements. Looking at the target’s contracts in relation to your own will show opportunities for consolidating vendors and services at reduced rates.

2. Look for opportunities where you can take advantage of your vendor relationships.
If you use one vendor for core processing and you are buying a bank that uses another vendor, your onetime costs for the technology conversion and ongoing expenses will be entirely different than if you are both using the same vendor. Understand your leverage in these situations. If your target is using different systems than you are, an acquisition takes a competitor out of business. If your target is using the same systems as you are, then you are going to be paying for processing the same accounts twice for a period if you don’t negotiate differently.

3. Have pricing established that takes advantage of acquisition volume growth.
As the acquirer, you need to establish pricing that decreases on a per-customer basis as you grow. Negotiating tiers for your major pricing components is a basic requirement. Your goal should be to negotiate tiers that are market priced and are commensurate with the volume that will be loaded on during a five-year term. This could be substantial if you are in an aggressive growth mode.

4. Establish a firm understanding with your vendor about staffing conversions.
Moving quickly during acquisitions is par for the course. Your vendor’s ability to convert your target’s accounts to your system in a timely manner is vital. Best practice would be to negotiate with your vendor in advance for professional services to support your acquisition plan. This could include negotiating for a fixed number of conversions per year along with expectations for how long a conversion will take.

5. Manage your termination costs for acquired technology.
Smart buyers know that a vendor is due a fair share of its committed revenue and reasonable termination costs and no more. Negotiate with your current vendor for language that recognizes when you acquire a bank using their technology, you should only have to pay for any given account once. This can materially reduce your liquidated damages and termination penalties when you buy a bank using your vendor’s technology.

For banks that wish to be acquired:

6. Keep your contract terms to two or three years at most.
It’s never good to have long terms for your technology contracts if you are looking for a buyer. Even suitors using technology that is similar to yours will not want to pay for your commitments.

7. Keep your terms aligned.
I’ve seen a target bank’s contracts with a mix of long and short durations. This can look bad to a potential suitor.

8. Use standard technologies.
Buying a one-off solution or technology to get a competitive edge or save a few dollars is a non-starter if you are looking to sell. Software, services or equipment that can’t be reused or interfaced with the new bank’s core will run up your acquirer’s costs.

9. Negotiate decent pricing and known exit costs.
Keeping your costs in line is very important. Even if your contracts will be superseded by your buyer’s contracts, the liquidated damages to shut down your contracts are directly related to your pricing. If your pricing is three times market pricing, your buyer’s costs to get out of your agreement are going to be three times market. Your costs to de-convert from the system should be plainly laid out along with a clear and fair definition of what your liquidated damages will be.

Growth that comes to your vendors through acquisition increases their market share without the usual upfront costs associated with bringing on business. They want to see you succeed, so work closely with them to make it happen.

M&A Readiness: Making Sure Your Bank Can Do Acquisitions

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acquisitions-5-10-17.pngWith many financial institutions benefiting from increased stock values and renewed optimism following the November election, merger activity for community banks is on the uptick. Successful acquirers must remain in a state of readiness to take advantage of opportunities as they present themselves.

Whether a prolonged courtship or a pitch book from an investment banker, deals hardly, if ever, show up when it is most convenient for a buyer to execute on them. As a result, buyers need to develop a plan as to what they want, where they want it and what they are willing to pay for it, long before the “it” becomes available. M&A readiness equates to the board of directors working with management to have a well-defined M&A process that includes the internal and external resources ready to jump in to conduct due diligence, structure a transaction and map out integration. Also, M&A readiness requires that buyers have their house in order, meaning that their technology is scalable, they have no compliance issues and the capital is on hand or readily available to support an acquisition.

Technology. In assessing the scalability of an institution’s technology for acquisitions, a buyer should review its existing technology contracts to see if it has the ability to mitigate or even eliminate termination fees for targets that utilize the same core provider. Without this feature, some deals cannot happen due to the costs of terminating the target’s data processing contracts. Cybersecurity is another key element of readiness. As an institution grows, its cybersecurity needs to advance in accordance with its size. Buyers need to understand targets’ cybersecurity procedures and providers in order to ensure that their own systems overlap and don’t create gaps of coverage, increasing risk. Additionally, buyers should understand existing cybersecurity insurance coverage and the impact of a transaction on such policies.

Compliance. Compliance readiness, or lack thereof, are the rocks against which even the best acquisition plans can crash and sink. Ensure that your Bank Secrecy Act/anti-money laundering programs are above reproach and operating effectively, and that your fair lending and Community Reinvestment Act policies, procedures and practices are effective. Running into compliance issues will cause missed opportunities as the regulators prohibit any expansion activities until any issues are resolved.

Conducting a thorough review of compliance programs of a target is critical to an efficient regulatory and integration process. A challenge to overcome is the regulators’ prohibition on buyers reviewing confidential supervisory information (CSI), including exam reports as part of due diligence. While the sharing of this information has always been prohibited, the regulatory agencies have become more diligent on enforcement of this prohibition. Although it is possible to request permission from the applicable regulatory agency to review CSI, the presumption is that the regulators will reject the request or it will not be answered until the request is stale. As such, buyers should enhance their discussions with target’s management to elicit the same type of information without causing the target to disclose CSI. A simple starting point is for the buyer to ask how many pages were in the last exam report.

While stress testing may officially apply to banks with $10 billion or more in assets, regulators are expecting smaller banks to prevent concentrations of risk from building up in their portfolios. The expectation is for banks to conduct annual stress tests, particularly among their commercial real estate (CRE) loans. Because of these expectations, buyers need to know the interagency guidance governing CRE concentrations and how they will be viewed on a combined basis. Reviewing different stress-test approaches can help banks better understand the alternatives that are available to meet their unique requirements.

Capital. An effective capital plan includes triggers to notify the institution’s board when additional capital will be needed and contemplates how it will obtain that capital. Ideally, the buyer’s capital plan works in tandem with its strategic plan as it relates to growth through acquisitions. Recently the public capital markets have become much more receptive to sales of community bank stock, but this has not always been the case. In evaluating an acquisition, the regulators will expect to see significant capital to absorb the target as well as continue to implement the buyer’s strategic plan.

The increase in financial institution stock prices has increased acquisition opportunities and M&A activity since the election. Opportunistic financial institutions have plans in place and solid understandings of their own technology needs and agreements, regulatory compliance issues and capital sources. Although it sounds simple, a developed acquisition strategy will aid buyers in taking advantage of opportunities and minimizing risk in the current environment.

How Future Consolidation Will Change the Value of a Branch

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consolidation-3-3-17.pngTwo long-term trends that have helped shape the banking industry as we know it today are consolidation and the shift from physical distribution built around branches to digital channels, including mobile. Although we tend to think of consolidation and the shift toward digital as separate but parallel evolutionary forces, they are beginning to interact in ways that could impact the bank mergers and acquisitions (M&A) market going forward.

The number of bank branches has been steadily declining since 2009, when they peaked at 89,775, according to Federal Deposit Insurance Corp. data. There was a glut of de novo branches from 2004 to 2007 when, according to veteran bank analyst Tom Brown, founder and CEO of the New York-based hedge fund Second Curve Capital, the popular deposit gathering strategy of many banks was to flood their markets with lots of new brick and mortar in order to sell free checking programs. “Before long, the landscape was littered with redundant, expensive, new bank branches,” writes Brown in his February 17 weekly newsletter. “All this at a time, remember, when consumer behavior was starting to move away from branch banking and toward online banking.”

The seminal event in 2008 was, of course, the collapse of the U.S. housing market and the advent of the sharpest economic downturn since the Great Depression. Since 2009, the number of U.S. bank branches has declined to 83,768 at the end of the third quarter of 2016, or by 6.7 percent. Brown has argued for years that the industry needs to reduce the size of its brick-and-mortar distribution system at a much faster pace. “[As] I’ve said many times, that’s still way too many branches,” Brown writes in his newsletter. “Consumer behavior toward online, non-branch banking isn’t growing at a slow, linear pace, but rather exponentially. A mere 7 percent reduction this decade after the reckless expansion the prior decade isn’t nearly enough.”

And this is where these separate trend lines of consolidation and distribution could begin to merge. For one thing, the quickening pace of the industry’s shift toward digital distribution—most banks have been seeing declines in branch traffic for several years now, which is the primary reason they’ve been closing branches in the first place—could have an impact on a seller’s valuations. If branches are a fixed asset of declining importance (and therefore declining value), how much will an acquirer be willing to pay for them? In an interview, Brown says this impact has already begun to occur. “In the ‘80s and ‘90s, when you did your due diligence on a target, you wanted to see that their branches were owned,” he says. “Today when you evaluate a target, the last thing you want to see is branches with long-term leases.”

It could also be that consolidation will hasten the reduction of branches because they offer a plum cost-takeout target in an acquisition. If a bank’s branch system is one of the most significant components of its cost structure, and if branches are of declining value as the industry continues its shift toward digital distribution, then one of the best ways that a buyer can reduce costs in the combined bank is by closing branches. Cost-takeout deals aren’t new in banking. They were very popular back in the ‘80s when they were the principal merger model. But branches were a much more valuable asset back then, and therefore did not bear the brunt of post-merger cost cutting. It’s a different game today. “It’s not going to be about PNC Financial moving out to the West Coast and buying Western Alliance,” says Brown. “It’s going to be a $20 billion bank buying a $5 billion bank and closing all sorts of branches.”

Minimizing the Risk of Protests During M&A

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merger-2-24-17.pngBankers are in the business of managing risk, which is critical, not only in an institution’s day-to-day oversight, but also in its evaluation of strategic acquisitions. While obvious acquisition-related risks, such as credit or operational risks, may be appropriately addressed through careful due diligence, banks often overlook the more indeterminate risk that its acquisition application will draw adverse public comments.

The application review process for each of the federal bank regulatory agencies involves a notice and comment procedure through which the agencies may receive adverse comments or “protests” to an application from individuals or interested community groups. These comments are typically based upon the applicant’s Community Reinvestment Act (CRA) or fair lending records, and regardless of their merit, are increasingly employed with an apparent intent to gain leverage over the applicant.

Although the percentage of protested applications is small, the cost of a single public comment can be significant. For example, during the first half of 2016, the average Federal Reserve processing time for an application that received adverse public comments was 213 days, versus 54 days for an application not receiving comments. Even though nearly all protested applications are ultimately approved, the extended review process creates a significant amount of deal uncertainty; enhances the risk of employee and customer loss, which may diminish the value of the target; and generally results in higher professional fees. A history of protested applications may also affect the attractiveness of an acquirer’s offer to a potential target.

Fortunately, the risk of adverse application comments is not completely unmanageable. Although a bank cannot eliminate the risk of a protest, it may employ certain best practices to reduce that likelihood and minimize any related processing delays. As part of its regular CRA program, an acquisitive institution should proactively work to establish and preserve productive, two-way relationships with activist community groups, with a particular focus on groups with a history or growing reputation for application protests. Community participants who feel that an institution is listening and responsive to their needs are less likely to damage that growing goodwill through a formal application protest. These relationships should have the added benefit of enhancing the long-term effectiveness of the institution’s CRA program.

An acquisitive institution should also project a consistent, positive image in its community and be mindful about how all of the information that it provides to the public may be used. For example, a bank touting that it is “ranked first in deposit market share” should ensure that it also maintains a similar rank for meeting credit needs in its assessment area with products such as mortgages and small business loans. An acquisitive bank should also emphasize its CRA and other community service initiatives as a part of its marketing strategy.

In summary, bankers cannot avoid the risk or effects of adverse public comments in the context of regulatory applications. However, proactive and engaging institutions with strong, well documented CRA and compliance management systems are much less likely to attract public protests and will be better positioned to address those received.

Navigating Today’s M&A Market

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Bank deal activity in 2017 is likely to be on par with 2016, as the bank executives and board members responding to Bank Director’s 2017 Bank M&A Survey reflect lower levels of optimism for the bank M&A environment. In this video, Rick Childs, a partner at survey sponsor Crowe Horwath LLP, provides his perspective on the survey results and explains why, despite a lower number of sellers, it really is a buyer’s market today.

  • Expected Deal Activity for 2017
  • What Successful Buyers Look For in a Target
  • Factors That Sink a Deal

In accordance with applicable professional standards, some firm services may not be available to attest clients. This material is for informational purposes only and should not be construed as financial or legal advice. Please seek guidance specific to your organization from qualified advisers in your jurisdiction. © 2016 Crowe Horwath LLP, an independent member of Crowe Horwath International. crowehorwath.com/disclosure

M&A Alert for Banks: Preparing to Be a Buyer

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strategy-1-27-17.pngBefore a board and management of a bank pursue an acquisition, they should realistically assess their bank, the characteristics of the board and the shareholders, and the alternatives available.

The board and senior management should develop a strategic plan for the bank. The Federal Deposit Insurance Corporation has cited an increasing number of banks for lack of strategic planning in matters requiring board attention. The Office of the Comptroller of the Currency also has focused on strategic planning in the last few years. 

All board members must share a commitment to the strategic plan. Divisiveness in the boardroom often jeopardizes a bank’s ability to achieve its objectives.

The board has a fiduciary duty to make fully informed business decisions as to what is in the best interests of the hypothetical shareholder who is not seeking current liquidity. Management must assume the responsibility of educating the board (or bringing in consultants to do so) regarding the bank’s strengths and weaknesses, its inherent value, and the market(s) for targets. The board and senior management should meet regularly to discuss the bank’s strategic direction.

Debate in the planning process is healthy, but once the board agrees on a course of action, the board and management should speak with a united voice.

The board and management should communicate the bank’s strategic direction to shareholders. If key shareholders disagree with the direction, the board and management should arrange for such shareholders to be bought out or be comfortable that the bank need not do so. It is difficult to achieve strategic objectives if the board and key shareholders are working at cross purposes.

Evaluate Alternatives
The prospective buyer has a number of alternatives for enhancing shareholder value or multiple paths to be pursued at the same time. The board should evaluate such alternatives to identify the most attractive transaction.

Evaluate Your Prospects for Success
In embarking on bank M&A in the current environment, sellers will demand assurances that buyers can close. Here are some of the factors purchasers should consider:

  • Community Reinvestment Act and compliance ratings: Purchasers need to understand the “hot button” issues driving regulatory reviews and stay up to date. Yesterday’s focus on asset quality, anti-money laundering and Bank Secrecy Act compliance and third-party relationships have been joined by redlining, incentive compensation, concentration risk and cybersecurity, among others.
  • Capital levels: Determine whether the bank’s capital is sufficient to support an acquisition. If not, where will your bank obtain the needed funding?
  • Management: Does the purchasing bank have sufficient senior management capacity to staff the acquired bank or will target management be needed to implement the acquisition?
  • Systems and facilities: The purchasing bank’s board should evaluate whether the bank has compliance management systems and an enterprise risk management program that can scale for the acquisition.

Coming up with a good strategic plan while considering the bank’s alternatives is important for the board to discuss before embarking on an acquisition.

Negotiating the Transaction
There still may be a problem: What if there are very few targets that the bank has identified as “fits,” and none of them are in the market to sell?

Increasingly would-be buyers are willing to consider offering stock as part or all of the merger consideration. There are several drivers of this newfound willingness. First, buyers must meet increasingly challenging capital requirements. The exchange ratio in the merger may offer more attractive pricing to the buyer than issuing common equity to the market. Second, sellers have become more willing to accept private or illiquid stock as merger consideration. This may be a function of sellers’ understanding that economies of scale offer potential for greater returns on investment while enabling sellers to refrain from taking their “chips off the table” as would be the case in a cash sale. The recent run up in the stock market indexes has not yet translated into a general increase in M&A pricing. Third, a transaction that provides for a significant stock component allows for more one-on-one negotiations. Lastly, a strategic combination allows for mutuality of negotiation.

Just offering the selling shareholders stock may not be enough to convince a reluctant seller to consider a transaction. Would-be community bank buyers must recognize that there are social issues in any transaction (even when the merger consideration is cash). Accordingly, the buyer must evaluate in advance the roles of senior management of the seller, retention arrangements to proffer, severance to provide as well as bigger picture social issues such as board representation, combined institution name and headquarters.

A focus on the social issues and a willingness to put stock on the table may allow community bank buyers to continue to compete for acquisitions despite the rebounding stock market. Other competitors may be able to offer nominally more attractive pricing, but such an offer may not have better intrinsic value.

When Things Go Sideways: Managing Deal Crises

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A deal may be great on paper, but not all deals are a success. At Bank Director’s 2016 Acquire or Be Acquired Conference, Scott Anderson and Joe Berry of Keefe, Bruyette & Woods moderate a panel discussion with three successful and experienced acquirers: Scott Custer, CEO of Yadkin Financial Corp., James Ryan, EVP and director of corporate strategy at Old National Bancorp and Kirk Wycoff, founder and managing partner of Patriot Financial Partners. Even the best-laid plans don’t always work out, and these seasoned M&A veterans share the lessons they’ve learned.

Highlights from this video:

  • Getting the Opportunity
  • Negotiating the Deal & Managing Expectations
  • Announcement Pitfalls
  • Avoiding Execution Gaffs

Preparing Your Bank for Sale

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bank-sale-2-18-16.pngIf your board is considering a sale of the institution, you’re not ready to sell if you’re not prepared to sell. There are a variety of issues that your board will need to consider if it wants to maximize the value of the bank’s franchise in a sale. Many, although not all of these considerations, involve the bank’s balance sheet. Other important issues include cutting overhead costs and dealing with regulatory compliance issues. Sal Inserra, an Atlanta-based partner for the accounting and consulting firm Crowe Horwath LLP, offered the following advice to Bank Director Editor in Chief Jack Milligan.

Take a hard look at impaired loans on your balance sheet.
When bank executives consider a sale and analyze the loan portfolio, they are not always looking at it from the perspective of a potential buyer. If there’s a problem customer, they have a sense of the potential collection on that impaired loan. When buyers come in cold, they don’t have that history. They are doing an antiseptic review. It is numbers on a page that lead to a conclusion. They’re not going to accept the backstory as a reason why they should pay more for the loan than they think they should. If you have another appraisal in hand that shows the value higher, they may give credence to that, but not as it relates to the sob story. From the buyer’s perspective, if a loan is leveraged with 100 percent loan-to-value with a five-year life, the prospective buyer will require accretion yield of 9 percent to be attractive given the risk. If the coupon on that loan is only 5 percent, the buyer is only going to pay 75 cents on the dollar to achieve their yield. You have to get past the subjective analysis and get more objective detail about that impaired loan. You need to get the most current financial information possible about that impaired loan and the borrower.

Avoid bad leverage transactions as much as possible.
A bad leverage transaction sometimes occurs when the bank has excess deposits and invests in securities of different durations in an attempt to leverage the capital in the financial institution. Depending on how far out into the future the bank is leveraged, it could end up in a bad position where the assets are at a fixed rate, and the liabilities are at a variable rate. And because the bank is maximizing yield, as liabilities start creeping up, net interest margin can erode rather quickly. In the current market, unless the bank wants to go out four or five years or more on a bond and take some credit risk in something other than a U.S. Treasury security, the bank is going to have a pretty narrow net interest margin. Rather than buy low-earning securities, you might benefit your bank’s value by waiting for a buyer with a high loan-to-deposit ratio that needs additional funding. If the seller has excess funding that hasn’t been tied up, that could be a very lucrative purchase to a bank that needs the funding. But once the seller has tied that funding up in something with a narrow net interest margin, the buyer will have to unwind that in order to get value. And if the buyer has to take a hit to unwind that investment, it’s going to impact the seller’s value.

Manage excess capital on the balance sheet.
This is really about how you spin the story of selling the bank. Let’s say you have $50 million in capital. So if you sell for two times book value, you would get $100 million. But of that $50 million, let’s say that $10 million has not been deployed, so you’re not going to get two times $50 million. You’re going to get 1.60 times $50 million, which is $80 million. However, if the bank gets rid of that $10 million in excess capital by paying it out in dividends, it will receive $70 million, but because it is now working off a $40 million base, the bank reports a higher premium. Net cash is still $80 million when you consider the dividend.

Another approach would be to try to leverage up that excess capital. Where you may have turned down a loan before because the pricing wasn’t good, but it was still going to create a good margin and a decent return on investment, the bank may want to invest in the loan because at least it becomes an earning asset. This strategy will depend on what is available in the market.

Shed costly assets or debt before attempting to sell the bank.
Since the value of the bank is based on future earnings, if the bank is carrying some high cost debt, it’s going to impact future margins. Or if the bank has low yielding assets, that’s going to affect future margins. When buyers come in to price those assets and liabilities, they’re going to knock down the value of the bank. Most high cost debt has a prepayment penalty associated with it, so there’s a net cost to get out of that debt. But when it comes to low yielding assets, the bank can maximize net interest margin by getting rid of assets that are going to cause issues for future earnings.

Focus on cost control prior to a sale.
When it comes to cost control, the first thing to look at is the branch network. It’s no secret that branch activity continues to decrease as folks get more and more comfortable with digital banking. I love [author Brett King’s motto], “Banking is no longer somewhere you go, it’s something you do.” And the value of a seller’s branch network may be going down because the cost of maintaining those branches is still significant, not only from a hard cost standpoint but also with training staff, marketing and all the other costs of operating a branch. So take a hard look at those branches that buyers are going to consider exiting. If the bank can start narrowing those costs by closing some of those marginal branches, so that the buyer can see what the run rate is going forward, that will help improve value because the value is going to be driven on the multiple of future earnings.

The other thing I would focus on is staffing. A lot of banks have made big strides in technology, but they haven’t reevaluated their head counts. And they need to do a review of what is necessary to operate and deliver service. A phrase I hear a lot is, “We’re not going to change our head count, we’re going to grow into it.” And that doesn’t necessarily work because as you grow, it doesn’t mean the resources are going to be able to continue to help you get to the next level. So doing a critical analysis of head count is key. Those are the two major variables—branches and people—that when addressed can help you improve your efficiency.

Avoid entering into long-term contracts if you’re considering a sale.
The thing that just makes me scratch my head is when a board is thinking about selling the bank and a year before it pulls the trigger, it enters into a four- or five-year core processing contract. The cost associated with exiting a core processing contract, unless it happens to be the same company that they buyer uses, is incredible. I’ve seen millions of dollars spent to exit a core processing contract.

Factor regulatory compliance issues in a potential sale.
If the bank knows its potential acquirers, it knows its potential new regulators. The key issue is making sure that regulator knows the seller has its compliance house in order. The seller can put together an in-house review or use external resources to address the issues of that potential regulator. If I’m a $2 billion asset bank and it’s likely that I’m going to become part of an institution that’s over $10 billion in assets, I need to be focused on issues that the Consumer Financial Protection Bureau is focused on, because I know that my portfolio is going to be subject to a CFPB review. If I’m a $200 million asset bank and I’m going to merge into bank that’s in the $2 billion to $3 billion range, that may present a higher level of scrutiny. So knowing my potential acquirer allows for adequate preparation.

The Growing Imperative of Scale

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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.