Stick to the Basics as Bank M&A Heats Up


Anyone paying close attention is seeing that the number of bank deals in the United States is increasing.

There was a 25 percent increase in bank deals in the U.S. in 2014, compared to 2013, and there is a good possibility that the number of deals in 2015 will exceed that of 2014.mergers-chart.PNG

While good news for the deal makers, investors and regulators are ratcheting up the pressure on buyers and sellers to get things right. But, if history has taught us anything in mergers and acquisitions (M&A), it is that they often are fickle undertakings, where many of them simply don’t work out as planned.

Costly and sometimes fatal mistakes are made in the planning, due diligence, and execution stages, just to name a few steps along the way. Those and other critical factors make it vital to issue a common reminder: Stick to the basics.

Fundamental Questions Can Help Form the Foundation
The top question management should ask themselves before the start of a M&A transaction is, “does this deal fit our current business model, both culturally and strategically?”

There must be a recognition that people sometimes get so wrapped up in trying to get the best deal possible that they lose sight of whether the deal makes sense on its merits.

A message we often deliver is that there will be times that participants might not get the best deal from a price perspective, but when deep considerations are made about the other matters that are involved—long-term strategic objectives, the people you will acquire, the level of technological sophistication, the seller’s culture of connecting with customers—the deal could be a very good one.

In short, it sometimes comes down to having to pay a bit of a premium on the price in order to get the best deal, given the circumstances and strategic plan.

We often counsel board members and top management—whether the buyer or the seller—to ask this question: Does the deal put me in a better place tomorrow than I am today? Beyond that baseline question, there always are considerations about fundamentals: Does this make sense as it relates to the strategy that is already laid out?

Four other key questions include:

  • What are the quality of earnings? Just a few years ago, many prospective buyers looking at the balance sheet of the target actually didn’t believe the financials. Now, in more than a few cases, we are seeing the main issue being some skepticism about earnings. Although we see fewer concerns about the balance sheet, it remains a prime area for deep review. When the issue of quality of earnings is raised, it is prudent to investigate whether there has been a flurry of reserve releases. Have costs been squeezed down so much that, from an operational perspective, there are some key processes that are untenable for a long-term period?  Has the bank gone too far out the rate curve in seeking yield on the bond portfolio so that when rates finally start going up, the bank is going to get whipsawed and take a bunch of mark-to-market hits on those bonds?
  • What is the current asset / liability management profile of the bank? It would be useful to discover whether the target bank has been focused too much on short-term products. Another question: After rates rise, will the customers who are happy to be in a transaction product today (because they are not making much on CDs or money markets) walk out the door if another bank has a better product?
  • Is the target bank up to date on their regulatory compliance efforts? Beyond the numbers, there should be ample evidence that the target’s regulatory profile is rock solid. Is there clear evidence that the bank has had professional assistance in determining any liability relating to anti-money-laundering or Bank Secrecy Act issues? If it has not engaged professional assistance, ask the bank board and senior management how it gained comfort that it has done the proper level of diligence regarding these critical challenges?
  • What are the data practices of the target bank? Where and how is data stored? What security protocols have been instituted and followed? How often are those protocols reviewed and updated? Does the board and top management believe the data it receives after it orders a report?

In a rapidly evolving M&A landscape, our message is simple: When the time comes to do a deal, rely on the basics.

Regulatory Scrutiny Focuses on Inadequate Strategic and Capital Planning


capital-planning-9-24-15.pngOnce again, regulators are zeroing in on inadequate strategic and capital planning processes at many community banks.

The Office of the Comptroller of the Currency (OCC) listed “strategic planning and execution” as its first supervisory priority for the second half of 2015 in its mid-cycle status report released in June. That echoes concerns from the latest OCC semiannual risk perspective, which found that strategic planning was “a challenge for many community banks.”

FDIC Chairman Martin J. Gruenberg said in May that regulators expect banks “to have a strategic planning process to guide the direction and decisions of management and the board. I want to stress the word ‘process’ because we don’t just mean a piece of paper.”

He said that effective strategic planning “should be a dynamic process that is driven by the bank’s core mission, vision and values. It should be based on a solid understanding of your current business model and risks and should involve proper due diligence and the allocation of sufficient resources before expanding into a new business line. Further, there should be frequent, objective follow-up on actual versus planned results.”

In writing about strategic risk, the Atlanta Federal Reserve’s supervision and regulation division said that “a sound strategic planning process is important for institutions of all sizes, although the nature of the process will vary by size and complexity.” The article noted that the process “should not result in a rigid, never-changing plan but should be nimble, regularly updated (at least annually) and capable of responding to risks and changing market conditions.”

Given economic changes and increased market competition, community banks must understand how to conduct effective strategic planning. This is more important now than ever, says Invictus Consulting Group Chairman Kamal Mustafa.

The smartest banks are using new analytics to develop their strategic plans— not because of regulatory pressure, but because it gives them an edge in the marketplace and a view of their banks they cannot otherwise see, Mustafa said.

Strategic planning is useless without incorporating capital planning. The most effective capital planning is built from the results of stress testing. These critical functions—strategic planning, capital planning and stress testing—must be integrated if a bank truly wants to understand its future,” he said.

He advises banks to use the same fundamental methodology for both capital planning and strategic planning, or else they will run the risk of getting misleading results. This strategy is also crucial in analyzing mergers and acquisitions.

OCC Deputy Comptroller for Supervision Risk Management Darrin Benhart also advises community banks to use stress testing to determine if the bank has enough capital. “Boards also need to make sure the institution has adequate capital relative to all of its risks, and stress testing can help,” he said in a February speech. “We also talk about the need to conduct stress testing to assess and inform those limits as bank management and the board make strategic decisions.”

Is Banking’s Business Model Broken?


5-28-13_Hovde.pngThe banking industry—by most measures—has improved markedly from the depths of the credit crisis. The industry’s return on average assets (ROAA) has increased through additional noninterest income and fewer charge-offs; credit quality is stronger; capital reserves are at all-time highs; and the number of banks on the Federal Deposit Insurance Corp.’s (FDIC) problem list has declined for the past seven quarters. Additionally, public bank stocks either have tracked or outperformed the S&P 500 in recent years.

Despite these positive trends, banking’s business model is significantly challenged in today’s interest rate environment. With deposit costs near zero and fierce competition for loans driving down yields, many banks are running on fumes.

As higher yielding loans mature, banks are replacing them with lower yielding assets, resulting in significant net interest margin (NIM) compression across the industry. Regardless of whether the Federal Reserve’s accommodative monetary policy has helped or hurt the economy, it is wreaking havoc on banks’ profit models. Indeed, it would be nearly impossible to start a de novo bank today and make money through traditional means.

According to the FDIC, the industry’s NIM in Q4 2012 was 3.32 percent—the 3rd lowest quarterly NIM since 1990. Since Q1 2010, net interest margins have declined each quarter except one, with no sign of near-term relief. To combat the NIM squeeze, some banks are taking more interest rate and credit risk. By venturing further out on the yield curve and underwriting riskier assets, banks can generate more revenue; however, the risks may not justify the returns. In the short-term, the strategy could increase profits. In the long-term, it could create less stable institutions and the conditions for another credit crisis.

Yet loan growth will be critical to maintaining earnings over the next several years if the Fed continues its low interest rate policy. Unfortunately, most regions of the country have not recovered sufficiently to support such growth. Since 2009, the banking industry’s net loans have grown at a compounded annual rate of 2.2 percent compared to 7.0 percent between 1990 and 2007, and during this time, many banks have experienced loan declines. Furthermore, competition for the few available high quality loans is intense and driving yields even lower.

Even if a bank were able to grow its loan portfolio, it would take exceptional growth just to maintain current net income levels if NIMs continue to deteriorate. Consider the following example: if net interest margins were to decline by 15 basis points per year, a bank with $500 million in assets and a current NIM of 4.0 percent would need to grow loans by $50 million each year just to maintain the same level of net income (assuming all other profitability measures remained static). Under these circumstances, the bank’s ROA would decline each year, and the present value of the franchise would decrease. Furthermore, there are very few, if any, banks that can achieve 10 percent year-over-year loan growth today.

In addition to the sobering interest rate environment, regulatory changes—including BASEL III, the Dodd-Frank Act, and the Consumer Financial Protection Bureau—are looming large over the decisions of bank management and boards. Compliance costs associated with the new regulations remain uncertain, but undoubtedly will increase.

The one-two punch of the interest rate environment and increased compliance costs could prove too painful for many banks—particularly smaller institutions with older management teams who may be frustrated and don’t want to slog out any more years of lackluster performance and regulatory scrutiny.

Industry observers have been awaiting a renewed wave of bank M&A activity, and growing frustration just might be the catalyst. With organic loan growth almost nonexistent, strategic M&A is the only other way to amass scale today. Banks hoping to enhance franchise value will need to grow through acquisition, and there could be a large supply of frustrated sellers coming to the market. Unfortunately, if this occurs there is likely to be a supply and demand imbalance between sellers and buyers, which will hurt smaller, community banks the most. Active buyers have moved upstream and are looking for acquisitions that “move the needle.” Many buyers simply won’t bother with sellers under a certain asset size. This attitude could prompt smaller banks to consider a “strategic merger” in which they join together in a stock exchange to increase scale and attractiveness to buyers down the road.

Other banks may be content to grind it out knowing earnings are likely to suffer in the near-term. If rates rise, those banks with deep core deposit franchises will once again become more valuable, but the wait could be painful.

Until then, banking’s operating model remains impaired, if not broken.