Bank Valuations: What You Can and Can’t Control

The Federal Reserve’s decision to pause interest rate increases in June 2023 gave markets hope that the period of rapidly rising rates had ended. “The fact that they paused likely indicates we are near the top,” says Patrick Vernon, senior manager, advisory services at the consulting firm Crowe LLP. But he notes that no one knows for sure whether more rate increases could come.

For financial institutions, this moment has provided a breath of fresh air. Rising rates have cut into bank valuations as bond portfolios went underwater, and investors grew more concerned about an uncertain economy. High-profile regional bank failures, including Silicon Valley Bank and First Republic Bank, further fueled concerns. 

But, for bank directors evaluating their own organization’s valuation, a chaotic environment highlights a simple fact: Many of the external factors that impact a bank’s valuation can be out of leadership’s control. Instead, it requires understanding what the business can plan for and protect against to improve valuation figures. With that awareness, leaders can determine the best way to respond when the unexpected occurs. (To understand more about the metrics that drive a bank’s valuation, click here.)

“What’s driving the decline in multiples — uncertainty of the future or the probability of a recession?” asks Scott Gabehart, chief valuation officer at BizEquity, a technology platform for business valuations. “What’s the impact on the bank’s profitability? As GDP growth goes, so does bank profitability and therefore, value.”

The interest rate environment provides a great example of this balance between what you should expect management to control and what it cannot. 

According to Bank Director’s 2023 Risk Survey, conducted in January, 91% of executives and board members cited interest rate risk as an area of heightened concern, up markedly from 2022. No surprise there, since the federal funds rate increased by roughly 500 basis points since March 2022. For many banks, the bond portfolio has taken a significant hit. Fixed rate assets declined in value as interest rates increased; newer bonds pay a higher rate. Most banks can hold onto the lower yielding bonds until they mature, but a bank that has to sell the bond would record a loss. Acquirers would want to pay less for targets with these assets on their books.

If a bank doesn’t have to sell, then it won’t lose money on the bond’s face value — or the amount the bond would return at the end of its term. For most banks, “it’s paper losses not actual losses,” says Vernon.

A bank may see its valuation shift based on its bond portfolio. But if it has done an effective job of managing assets, then it will likely play a smaller role in the valuation. Asking management for an understanding of the resources available to cover different liquidity concerns within the business will provide an indication of how well it can manage its responsibilities.  

Another area that’s primarily out of the hands of bank management, particularly for an organization looking to be acquired: deflated M&A pricing. This impacts the amount another bank would pay for the business. 

Valuation has a direct connection to what the bank would earn if an acquirer bought it. If another institution will only pay a certain price, it can have an impact on the bank’s value in the market, perceived or otherwise. “Bank stocks trade at lower multiples, and the public market sets the tone for M&A pricing,” says Jeff Davis, managing director of the financial institutions group at Mercer Capital.

The number of bank acquisitions dropped in 2022, according to S&P Global Market Intelligence, and only 32 such deals had occurred through May 2023. Deal value also dropped from 154.3% deal value to tangible common equity in 2022 to 130.6% as of May.

Lower multiples for public stocks and lower valuations for would-be sellers are driving the M&A decline in the bank sector, says Davis. These valuations have suffered due to long-duration bonds and loans made during the lower rate environment. Banks don’t want to sell at depressed prices, preferring to “wait to see if rates fall and public market valuations increase,” says Davis. 

For boards discussing their M&A prospects, directors should know the value of the bank to ensure they do not sell at a time when acquisition prices are depressed — or so they don’t pay too much for a target if they’re the acquirer. The current environment does allow for banks open to buying distressed targets to look for a deal on an acquisition. In doing so, the bank can possibly expand through acquisitions — and at a discounted sales price. 

One of the best ways that banks can control their valuation is to have a plan as the economy moves forward. Whether markets struggle or surge, having a strategy to grow assets, loans and profitability will improve the valuation.

“What are the bank’s plans for maintaining the asset base and/or expanding it?” asks Gabehart. “The focus should be on the future. What can be done to improve the metrics of the bank and profitability?”

Expecting management to have a plan for such scenarios can ensure the organization has a way to respond, no matter what outside forces bring. 

Tactics like diversification can ease the impact of stress in other areas of the business. For instance, mortgage demand has suffered due to rising interest rates. Questioning how the bank can improve its product and service offerings could add new avenues for growth and improve the bank’s valuation.

Or, if the organization has a robust fintech arm, then the bank’s valuation could remain stronger in the current market, since there’s less threat from interest rates on the fintech space, says Vernon.

Asking management how the bank will seek areas of strength can give directors insight into how executives view the future. 

Board members cannot escape the outside forces that affect the bank. But protecting the balance sheet ensures that business doesn’t halt when rates rise or other economic forces batter the bank — improving its long-term value. 

For more information about the metrics behind bank valuations and why it matters, read the first part of this series, “What Drives a Bank’s Valuation?” 

The cover story in the second quarter 2023 issue of Bank Director magazine, “Banking’s New Funding Challenge,” focuses on the rising interest rate environment and its impact on deposits. The Online Training Series library also contains information about understanding and managing interest rate risk. 

Bank Director’s 2023 Risk Survey, sponsored by Moss Adams LLP, surveyed 212 independent directors, CEOs, chief risk officers and other senior executives of U.S. banks below $100 billion in assets to gauge their concerns and explore several key risk areas, including interest rate risk, credit and cybersecurity. Members of the Bank Services Program have exclusive access to the complete results of the survey, which was conducted in January 2023.

A Regulator Questions Long-Standing M&A Practice

There seems to be broad consensus that the way bank mergers are assessed should be updated. The question facing bank regulators and the industry is how. The Office of the Comptroller of the Currency recently grappled with the question in a Bank Merger Symposium it hosted on Feb. 10. 

“There is a robust ongoing debate about the effects of bank mergers on competition, on U.S. communities, and on financial stability,” said Ben McDonough, senior deputy comptroller and chief counsel at the OCC, at the symposium’s opening, delivering remarks prepared for Acting Comptroller Michael Hsu. “At the same time, many experts have raised questions about the ongoing suitability of the current bank merger standards at a time of intense technological and societal change.”

I wrote about how community banks and regulators think about mergers and acquisitions from a competitive perspective for the first quarter 2023 issue of Bank Director magazine. The competitive analysis conducted by regulators is arguably antiquated and overly focused on geography and on bank deposits, which has become less relevant in the face of digital innovation. 

“Regulators are beginning to revise M&A rules, but it’s unclear what impact that will have,” I wrote. “Everyone wants the market to remain competitive — the question is what vision of competition prevails.”

Regulators assess a deal application for the competitive effects of the proposed merger, and the convenience and needs of the communities to be served. The framework they use was last updated in 1995 and has its roots in a 1960s Supreme Court case and the Herfindahl-Hirschman index, or HHI, which was developed in the mid-1940s and early 1950s.

The measurement is calculated by squaring the market share of each firm in the market and then calculating the sum of the resulting numbers; four firms with shares of 30, 30, 20 and 20 have an HHI of 2,600, according to the U.S. Department of Justice. The HHI ranges from zero, which is a perfectly competitive market, to 10,000, or a perfect monopoly. Deals that increase a market’s HHI by more than 200, or where the HHI exceeds 1,800 post-merger, can trigger a review. The bank HHI calculation uses bank deposits as a proxy for bank activity within geographic markets that the Federal Reserve has drawn and maintained.

Hsu highlighted HHI in his opening comments at the symposium as a “transparent, empirically proven, efficient, and easily understood measure of concentration,” but said the decades-old metric may have become “less relevant” since the 1995 update. 

He pointed out how the “growth in online and mobile banking and rise of nonbank competitors” has made HHI, which uses bank deposits as the basis for its calculation, “a less effective predictor of competition.” 

M&A activity in rural banking markets is especially impacted by the HHI calculation. More than 60% of defined geographic banking markets in 2022 were already above the 1,800 threshold, according to a speech from Federal Reserve Governor Michelle Bowman in the same year — meaning any bank deal that would impact those markets could merit further scrutiny.

Some of themes around potential changes to the bank merger application process included “updated and clearly defined concentration, competition and systemic risk analysis,” along with new requirements around “increase[ing] transparency and tools to enforce community benefits commitments,” wrote Ed Mills, managing director of Washington policy for investment bank Raymond James & Associates, in a Feb. 13 note. 

Mills wrote that proposed updates to bank merger guidance “are likely coming soon,” but expects the more extensive changes that seek to “build a better mouse trap” to be a much longer process. His firm believes that current pending mergers are likely to be approved, and that slower approvals don’t necessarily indicate a moratorium. His report occurred in the same week that Memphis, Tennessee-based First Horizon Corp. extended its agreement to sell to Toronto-based TD Bank Corp., which will create a $614 billion institution, from Feb. 27 to May 27, 2023. That would make the sale occur more than a year after announcement. 

It’s still not clear where the agencies will land, and how their changes will impact community bank deal approvals, if at all. But for now, there seems to be consensus that geographic markets and bank deposits may not be the truest measures of competition, before or after a deal.

The Equipment Leasing M&A Outlook for 2023

Fear, uncertainty and doubt are never harbingers of a good M&A environment. However, in my opinion, that is not the case as it relates to the equipment leasing and finance market.

In my 30-plus years of experience in the equipment finance sector, it’s always a good time for a bank buyer to purchase a solid equipment leasing and finance company as a way to enter the space. Generally, community banks’ commercial and industrial assets tend to be concentrated in real estate. Many community banks are also sitting on a lot of cash they are having trouble deploying into loans, especially non-commercial real estate C&I. By comparison, equipment finance companies are fantastic generators of C&I assets.

We’ve been involved in some recent transactions and projects during these less-than-ideal economic times. In early 2021, Marietta, Ohio-based Peoples Bancorp acquired North Star Leasing out of Vermont. In mid-2021, Indiana, Pennsylvania-based First Commonwealth Financial Corp. did a lift out of a team to start their foray into equipment finance. In mid-2022, Trustmark Corp. out of Jackson, Mississippi, launched a bank leasing business by hiring a well-known bank-owned equipment finance leader. Lastly, in the third quarter of 2022, New Orleans-based Gulf Coast Bank and Trust Co. acquired KLC Financial out of Minnetonka, Minnesota.

Each of these banks has a relatively small geographical footprint and acquired national leasing companies or platforms nowhere near their core markets. All were sitting on a great deal of cash and found equipment finance as one solution to effectively deploy those funds.

What does this mean for the future M&A market of equipment finance companies? The obvious headwinds for the space will be the continuation of the Federal Reserve’s tightened monetary policy, abnormal supply chain issues, elevated asset values and increasing interest rates to fight inflation. Fed governors are on record saying that the risk of recession is worth the price for reining in inflation.

Since equipment finance transactions have a short amortization period and each new transaction is reviewed based upon its own merits at the time of application, equipment leasing and finance companies adjust to conditions reasonably fast. Granted, some bank-owned competitors sometimes hold off raising rates longer than necessary; for them, it is a balancing act between needing C&I assets, their intrinsic cost of funds and their cash levels. Another thing that occurs during any period of uncertainty is that banks tend to pull in the reins on credit quality and lending in general, especially to small businesses.

The equipment leasing and finance business has all the attributes that make it appealing to potential bank buyers: The equipment finance industry does well in good times and very well in counter-cyclical times.

And generally speaking, it is always a good time for a bank to purchase a solid equipment finance company. There are roughly less than 700 independent leasing companies; there are roughly 4,800 banks in the U.S. of all sizes.

One of the key attributes of a “solid” leasing company is that it has a platform that is scalable. After all, the only reason for a bank to buy a leasing company is to scale it so it can put more of its assets to work generating larger spreads and stronger returns in this asset class, lifting the bank’s total spreads and return on assets. In every case, independent lessors are constrained by capital and the cost of capital that it can obtain. It is the exception for a bank acquisition of an equipment leasing company not to pan out as planned. Generally speaking, the actual results turn out well beyond what buyers expected going into the acquisition.

There are not many potential equipment leasing targets that are bank-ready at any moment in time; the same goes for banks that are prepared to purchase and succeed in a deal for an equipment leasing and finance company. We refer to those institutions that are ready as “equipment finance industry ready:” the prospective bank acquirer has done enough research and modeling of the equipment finance industry to understand what kind, size and equipment-type focus of equipment finance company would work best for them. That is, in fact, why banks engage advisors who have deep expertise in the whole equipment leasing and finance industry.