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.