A Challenging Deal Environment In 2023

The year ahead is likely to present a challenging environment for M&A. According to Dory Wiley, president and CEO of Commerce Street Holdings, the rising interest rate environment, possible deposit runoff and economic uncertainty are likely to tamp down deal activity in 2023. Nonbank deals could be more attractive to some buyers, in part because they draw less regulatory scrutiny. And banks focused primarily on organic growth need to shore up capital at the holding company level to make sure they have options, too.

Topics include:

  • Interest Rates’ Impact on Valuations
  • Appeal of Nonbank M&A
  • Emphasis on Capital

Earnings Are High but Bank Stock Prices Are Low

Banks are doing very well, if you look at credit quality and profitability. But tell that to investors.

Last week, the Federal Open Market Committee raised the target federal funds rate by 75 basis points, the third hike of that magnitude in a row, to combat inflation.

The market has punished equities lately in response, but even more so, bank stocks, probably in anticipation of a recession that may have arrived. The S&P 500 fell 21.61% in 2022 as of Friday, Sept. 23, but the S&P U.S. large cap bank index was down 25.19% in that same time frame, according to Mercer Capital using S&P Global Market Intelligence data. By asset size, large banks have seen the biggest declines so far this year.

Going back further in time, the cumulative return for U.S. bank stocks in general, as measured by the S&P U.S. BMI Banks index, was down 5.30% as of Sept. 22 from the start of 2020, compared to a gain of 21.55% for the S&P 500.

Investors’ dim view of bank stocks belies the underlying strengths of many of these banks. Bank net income of $64.4 billion in the second quarter was higher than it had been in the same quarter of 2018 and 2019, according to the Federal Deposit Insurance Corp. Since 2019, in fact, bank profitability has been going gangbusters. Rising interest rates improved net interest margins, a key profitability statistic for many banks. Plus, loan growth has been good.

And credit quality remains high, as measured by the noncurrent loan and quarterly net charge-off rates at banks, important bank metrics tracked by the FDIC. Despite weaknesses in mortgage and wealth management, this combination of variables has made many banks more profitable than they were in 2018 or 2019.

“Earnings are excellent right now, and they’re going to be even better in the third and fourth quarter as these margins expand,” says Jeff Davis, managing director of Mercer Capital’s financial institutions group.

Investors don’t seem to care. “It’s been a real frustration and a real incongruity between stock prices and what’s going on with fundamentals,” says R. Scott Siefers, managing director and senior research analyst at Piper Sandler & Co. “You’ve had a year of really great revenue growth, and really great profitability, and at least for the time being, that should continue. So that’s the good news. The bad news is, of course, that investors aren’t really as concerned with what’s going on today.”

Worries about a possible recession are sending investors away from bank stocks, even as analysts join Davis in his prediction of a pretty good third and fourth quarter for earnings this year. The reason is that investors view banks as sensitive to the broader economy, Siefers says, and think asset quality will deteriorate and the costs of deposits will rise eventually.

The place to see this play out is in two ratios: price to earnings and price to tangible book value. Interestingly, price to tangible book value ratios have remained strong — probably a function of deteriorating bond values in bank securities’ portfolios, which is bringing down tangible book values in line with falling stock prices. As a result, the average price to tangible book value as of Sept. 23 was 1.86x for large regional bank stocks and 1.7x for banks in the $10 billion to $50 billion asset range, according to Mercer Capital.

Meanwhile, price to earnings ratios are falling. The average price to earnings ratio for the last four quarters was 10.3x for large regional banks, and 11.4x for mid-sized bank stocks. (By way of comparison, the 10-year average for large cap bank stocks was 13.4x and 14.6x for mid cap bank stocks, respectively.)

For bank management teams and the boards that oversee them, the industry is entering a difficult time when decisions about capital management will be crucial. Banks still are seeing loan growth, and for the most part, higher earnings are generating a fair amount of capital, says Rick Childs, a partner at the tax and consulting firm Crowe LLP. But what to do with that capital?

This might be the perfect time to buy back stock, when prices are low, but that depletes capital that might be needed in a recession and such action might be viewed poorly by markets, Childs says. Davis agrees. A lot of companies can’t or won’t buy back their own stock when it’s gotten cheap, he says. “If we don’t have a nasty recession next year, a lot of these stocks are probably pretty good or very good purchases,” he says. “If we have a nasty recession, you’ll wish you had the capital.”

It’s tricky to raise dividends for the same reason. Most banks shy away from cutting dividends, because that would hurt investors, and try to manage to keep the dividend rate consistent, Childs says.

And in terms of lending, banks most certainly will want to continue lending to borrowers with good credit, but may exercise caution when it comes to riskier categories, Davis says. Capital management going forward won’t be easy. “If next year’s nasty, there’s nothing they can do because they’re stuck with what’s on the balance sheet,” he says. The next year or two may prove which bank management teams made the right decisions.

Key Considerations with the Community Bank Leverage Ratio

Banking regulators have adopted a final rule offering community banks the ability to opt in to a new, simplified community bank leverage ratio. The CBLR is intended to eliminate the burden associated with risk-based capital ratios, and became effective on Jan. 1, 2020.

Congress amended provisions of the Dodd-Frank Act to provide community banks with regulatory relief from the complexities and burdens of the risk-based capital rules. Agencies including the Office of the Comptroller of the Currency, Federal Reserve and Federal Deposit Insurance Corp. were directed to promulgate rules providing for a CBLR between 8% and 10% for qualifying community banking organizations (QCBO). These banks may opt-in to the framework by completing a CBLR reporting schedule in their call reports or Form FR Y-9Cs.

In response to public comments, the final rule includes a few important changes from the proposed one, including:

  • The adoption of Tier 1 capital, instead of tangible equity, as the leverage ratio numerator.
  • A provision allowing a bank that elects the CBLR framework to continue to be considered “well capitalized” for prompt corrective action (PCA) purposes during a two-quarter grace period, if its leverage ratio is 9% or less but greater than 8%. At the end of the grace period, the bank must return to compliance with the QCBO criteria to qualify for the CBLR framework; otherwise, it must comply with and report under the generally applicable capital rules.

To be eligible, a QCBO cannot have elected to be treated as an advanced approaches banking organization. It must have: (1) a leverage ratio (equal to Tier 1 capital divided by average total consolidated assets) greater than 9%; (2) total consolidated assets of less than $10 billion; (3) total off-balance sheet exposures of 25% or less of total consolidated assets; and (4) a sum of total trading assets and trading liabilities 5% or less of total consolidated assets.

If a QCBO maintains a leverage ratio of greater than 9%, it will be considered to have satisfied the generally applicable risk-based and leverage capital requirements, the “well capitalized” ratio requirements for purposes of the PCA rules and any other capital or leverage requirements applicable to the institution.

QCBOs may subsequently opt-out of the CBLR framework by completing their call report or Form FR Y-9C and reporting the capital ratios required under the generally applicable capital rules. A QCBO that has opted out of the leverage ratio framework can opt back in by meeting the discussed qualifying criteria discussed above.

The leverage ratio provides significant regulatory relief to QCBOs that would otherwise report under the risk-based capital rules. Opting-in to the CBLR allows a qualifying bank to be considered “well capitalized” under the PCA rules through one simple calculation (assuming the organization is not also subject to any written agreement, order, capital directive or PCA directive). Additionally, calculating the community bank leverage ratio involves a measure already used by banks for calculating leverage: Tier 1 capital.

The cost of adoption is low as well. If qualified, a bank simply has to adopt the new leverage ratio in its call reports or Form FR Y-9C. And the two-quarter grace period offers further flexibility. For instance, if a QCBO engages in a major transaction or has an unexpected event that impacts the 9% leverage ratio, the bank will be able to reestablish compliance with the CBLR without having to revert to the generally applicable risk-based capital rules. Since the CBLR is voluntary, it is within each qualifying bank’s discretion whether the benefits are sufficient enough to adopt the new rule.

Qualifying banks should be aware that opting in to the community bank leverage ratio essentially raises its well-capitalized leverage ratio requirements under the PCA rules from 5% to 9%. These banks must ensure their leverage ratios are above 9% or find themselves attempting to comply with both the CBLR and the risk-based capital rules.

It has been suggested that the CBLR may create a de facto expectation from the agencies that a properly capitalized qualifying bank should have a leverage ratio greater than 9%. Though the agencies emphasized that the CBLR is voluntary, community banks eligible to adopt the rule should be thoughtful in their decision to use it. While qualifying banks can opt in and out of the new leverage ratio, the agencies noted that they expect such changes to be rare and typically driven by significant changes, such as an acquisition or divestiture of a business. The agencies further indicated that a bank electing to opt out of the CBLR framework may need to provide a rationale for opting out, if requested.

While the community bank leverage ratio will be useful in reducing regulatory burdens for qualifying community banking organizations, its adoption does not come without risk. 

The M&A Limitations of Privately-Held Banks

More than half of bank executives and directors responding the Bank Director’s 2018 Bank M&A Survey see an environment that’s more favorable to deal activity, but those at privately-held institutions—which comprise 52 percent of survey respondents—are slightly more likely to see a less favorable environment for deals, and significantly more likely to expect limitations in their ability to attract an acquisition partner and complete the transaction.

In the survey, 30 percent of respondents from private banks say their bank has acquired or merged with another institution within the past three years, compared to 53 percent of respondents from publicly traded institutions. Respondents from private banks—which, it should be noted, also tend to be smaller institutions—are also less likely to believe that their bank will acquire another institution in 2018, with 47 percent of private bank respondents saying their institutions are somewhat or very likely to acquire another bank within the next year, compared to 61 percent of public bank respondents.

Rising bank valuations are largely to blame for dampened enthusiasm on the part of private banks that would like to consider acquisitions as a growth strategy, but feel excluded from the M&A market. Higher valuations mean two things. Potential sellers have higher price expectations, according to 84 percent of survey respondents. And public buyers—whose currency now holds more value in a favorable market—could have an edge in making a deal. Half of private bank respondents say that rising bank valuations have made it more difficult for the institution to compete for or attract acquisition targets, compared to 36 percent of respondents from public banks looking to acquire.


For the most part, private buyers “have to do an all-cash deal,” says Rick Childs, a partner at Crowe Horwath LLP, which sponsored the 2018 Bank M&A Survey. Banks under $1 billion in assets have some flexibility in leveraging their holding company to lessen the impact on the bank’s capital ratios in such a transaction, as a small bank holding company can use debt to fund up to 75 percent of the purchase price. “I can borrow fairly easily in today’s environment at the holding company, then fuse it down into the bank and make the capital ratios acceptable, and be able to use those cash funds,” says Childs. “But it does mean that there’s an upper limit on how much [the bank] can pay because of the goodwill impact, and that I think is having a detrimental impact on [privately-held] institutions.”

Thirty-five percent of private bank respondents say they would favor an all-cash transaction if their bank were to make an acquisition, compared to 5 percent of public respondents. More than half of private bank respondents would want to structure a transaction as a combination of cash and stock—despite these banks’ stocks being thinly traded at best and relatively illiquid. Equity in the transaction “potentially adds to the pool of available shareholders who might want to buy stock back and produce a more liquid market,” says Childs. While some sellers may prefer to take stock in a deal to defer taxes until the stock can be sold, shareholders still want to know that they will be able to take that stock and cash out if desired. Private buyers that want to issue stock in the transaction should have a plan for that stock to become more liquid within a relatively short period of time, says Childs. Remember, boards have a fiduciary duty to represent their owners’ best interests. If another bank is willing to offer a deal that provides more liquidity, that’s going to be of more interest to most sellers.


For a private bank, offering a cash deal has its benefits, despite limiting the size of the target the bank can acquire. Just 39 percent of private bank directors and executives responding to the survey say they would agree to an all-stock or majority-stock transaction if the board and management team sold the bank, compared to 63 percent of public bank respondents. “For some sellers, that’s actually easier to understand, because it gives you ultimate liquidity and takes some of the decision-making anxiety out of the seller’s hands” in terms of how long the seller should hold onto the stock and how it fits within that person’s portfolio, says Childs. The tax repercussions are immediate, but the seller is also paying today’s tax rates, versus an unknown future rate that could be higher.

That’s not to say that private banks won’t make deals in 2018. Some will, of course, buy other banks. But other types of transactions could pique the interest of private institutions and be particularly advantageous. Branch deals allow banks to cherry-pick the markets they want to enter and pick up deposits at a better price, says Childs. Thirty-nine percent of respondents from privately-held banks say their institution is likely to buy a branch in 2018, compared to 30 percent of public bank respondents.


Private banks are also more inclined to acquire nondepository lines of business, as indicated by 30 percent of survey respondents from private banks, compared to 20 percent from publicly traded institutions. Acquiring wealth management firms and specialty lending shops are of particular interest to private banks, according to Childs. Both allow the institution to expand its services to customers and generate fee income without going too far afield of the bank’s primary strategic focus.

Both branch and nondepository business line acquisitions carry fewer due diligence and integration burdens as well.

Potential regulatory reform on the horizon could make the deal environment even more competitive, says Childs. Bank boards and management teams that worried about the impact of the regulatory burden on the sustainability of their bank may feel that the viability of their institution as an independent entity is suddenly more certain. “That likely lowers the pool of institutions that feel like they have to sell,” says Childs. And most bank executives and directors indicate that they want to remain independent—in this year’s survey, just 18 percent of respondents say they’re open to selling, with another 4 percent indicating their institution is considering a sale or in an agreement with another bank, and 1 percent actively seeking an acquirer.

The 2018 Bank M&A Survey gathered responses from 189 directors and executives of U.S. banks to examine the M&A landscape, M&A strategies and the economic, regulatory and legislative climate. The survey was conducted in September and October of 2017, and was sponsored by Crowe Horwath LLP. Click here to view the full results of the survey.

How Community Banks Can Fund M&A

bank-manda-6-13-16.pngAs bank mergers and acquisitions (M&A) have increased over the past several years, many banks are considering how to participate as buyers and take advantage of growth opportunities. One critical impediment for banks hoping to participate in M&A is funding the purchase. Many community banks lack a publicly traded stock to use as consideration, so they have to offer all cash in a transaction. When common stock is not used in a transaction, no additional capital is created and it becomes difficult to complete the transaction while maintaining adequate capital. Some banks use their holding company as a source of cash through a loan from a correspondent bank or other lender.

The Federal Reserve has a long-standing Small Bank Holding Company Policy Statement indicating that it does not look at capital ratios on a consolidated basis for institutions with consolidated assets under a certain threshold. Initially this threshold was $150 million in consolidated assets, but it increased to $500 million in February 2006. In April 2015, the consolidated assets threshold was increased again to $1 billion. This change is significant because as of March 31, there were more than 3,700 holding companies with less than $1 billion in consolidated assets, according to S&P Global Market Intelligence, formerly SNL Financial. As a result, the overwhelming majority of bank holding companies can take advantage of the Fed’s policy to engage in bank M&A and use leverage to fund acquisitions.

Between Jan. 1, 2015, and May 6, 2016, 183 acquisitions were announced in which the selling bank had less than $250 million in assets. Almost 69 percent of those transactions were not common-stock based. More than two-thirds were deals in which a small bank holding company (by the Federal Reserve’s definition) could have been competitive because consideration did not require common stock for the selling institution to accept the deal.

Funding M&A With Holding Company Debt
As a bank considers its long-term growth plans, acquisitions are a viable option when the size of the seller lends itself well to the type of consideration a bank can use: cash. As banks consider using holding company debt, it would be helpful to be aware of what qualifies a bank holding company to use holding company debt to fund acquisitions under the Fed’s policy statement:

This policy statement applies only to bank holding companies with pro forma consolidated assets of less than $1 billion that (i) are not engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (ii) do not conduct significant off-balance sheet activities (including securitization and asset management or administration) either directly or through a nonbank subsidiary; and (iii) do not have a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the Securities and Exchange Commission.

For most holding companies, these qualifiers won’t have an impact on their ability to rely on the policy statement. When applying the policy for using bank holding company debt in an acquisition, the Fed also includes the following parameters:

  • Acquisition debt should not exceed 75 percent of the purchase price, meaning a minimum 25 percent down payment should be provided by the acquirer.
  • All acquisition debt must be paid off within 25 years.
  • The debt-to-equity ratio at the holding company should be less than 30 percent within 12 years.
  • No dividends are expected to be paid out of the holding company until the debt-to-equity ratio is less than 1:1.

The simplicity of the small bank holding company acquisition debt policy is that it allows holding companies with less than $1 billion in assets to use the cheapest form of capital for corporate level transactions. Subordinated debt, which counts as Tier 2 capital (with limits), is a good source of available capital. However, it should be used to fund an acquisition purchase only if a holding company’s pro forma assets will exceed $1 billion, because the costs and limitations on the debt make it a more expensive and more restrictive type of debt than a simple bank holding company loan.

Additionally, even if acquisitions are not a part of a holding company’s long-term strategic plan, the bank still should consider holding company debt under the small bank holding company policy to:

  • Fund stock repurchases at the holding company to provide liquidity for shareholders.
  • Provide capital for organic bank growth (the repayment can come from future bank earnings).
  • Retire more expensive forms of holding company capital or debt that no longer is needed as a result of the increase in consolidated asset limits.

Industry observers often are critical of regulatory policy. However, this recent change to the small bank holding company policy should be viewed as positive for the industry and the future of community banks.

New Rules Benefit Small Bank Holding Companies

holding-companies-12-25-15.pngConfirming an important regulatory concession Congress previously granted to community banks, the Federal Reserve Board recently amended its regulation and related Policy Statement governing “small bank holding companies” (SBHCs) to include companies up to $1 billion in total assets, up from $500 million. The Policy Statement now applies to about 90 percent of all U.S. bank holding companies.

Significance of the Change
This is good news for community banks because the regulation was designed to cut smaller banks and bank owners some slack when it comes to using internal leverage as a source of capital funding. Effectively, Congress has given community banks an “ownership” advantage to help balance against the marketplace advantages enjoyed by larger banks.

Key Benefit of SBHCs
The regulation basically exempts qualifying SBHCs (but not their bank subsidiaries) from the higher consolidated capital generally required for larger banks. Stated differently, the SBHC is deconsolidated from its bank subsidiary, such that only the subsidiary bank is subject to minimum capital ratios. This enables SBHCs to offset the investment inefficiency of maintaining excess capital at the bank level by incurring debt at the holding company level.

Investment Advantage
For shareholders, the principal advantage of the SBHC structure is that it allows the shareholder’s investment to be internally leveraged with holding company debt, which simultaneously reduces the amount of common equity required from shareholders to support the bank’s capital while increasing the shareholders’ return on the capital invested. Moreover, the cost to the issuer of debt capital is typically about half that of equity capital, partly because interest on the debt would be tax deductible whereas dividends on preferred stock would not. In addition, leverage provides a non-dilutive source of bank-level capital to support growth, as compared to common stock. Accordingly, taking advantage of the opportunities afforded to SBHCs can have a material and lasting impact on shareholder value.

Operational Flexibility
An even more important attribute is operational flexibility, because management can readily tap holding company debt to meet common strategic challenges and opportunities, such as:

  • Providing growth capital for a bank subsidiary,
  • Buying another bank or branch, and
  • Repurchasing stock to support shareholder liquidity.

These situations often demand more rapid and decisive action than might be possible if funding must wait for a successful equity stock offering, especially one undertaken in a small community. In fact, having ready access to capital funding through holding company debt could be the key resource that enables some community banks to preserve their independence. The 1,500 community banks without a bank holding company should consider this advantage as well.

Benefit for Subchapter S Banks
The SBHC advantage will be especially helpful for growing Subchapter S banks because it enables these banks to raise capital without affecting the constraints on numbers and types of shareholders permitted for S corporations.

Regulatory Leverage Limits and Conditions
Holding companies are not required normally to obtain regulatory approval to incur debt up to 100 percent of the holding company’s net equity (typically 50 percent of bank equity). The Policy Statement sets out various conditions and requirements that become applicable when debt exceeds that level or when the company has previously been instructed not to incur debt.

In practice, most SBHCs needing capital for any reasonable purpose (except perhaps to cover loan losses) will be eligible under the rule to borrow more money than their directors would have imagined possible or considered desirable. The limiting factor is more likely to be the marketplace’s appetite for the holding company’s debt rather than regulation. 

Sources of Funding
The best resource for senior debt financing will often be an up-stream correspondent or bankers’ bank. These lenders normally expect borrowers to amortize principal over 5 to 10 years, maintain acceptable ratios throughout the financing period and pledge the bank stock owned by the holding company as collateral for the loan. Because of the latter requirement, these loans are often referred to as “bank stock” loans.

Longer term, less restrictive and unsecured or subordinated debt financing could also be sought from major shareholders or other local investors as well as from institutional investors. These instruments tend to provide more flexibility in terms (fixed vs. floating) and can be structured to include conversion features. Moreover, bank holding companies have the ability to issue subordinated debt without the onerous covenants and events of default typically inherent in senior debt instruments.

The Takeaway
Well-managed community banks of tomorrow will wish to use every tool possible to deliver value for shareholders. The SBHC could prove to be the most important tool in the box for many smaller banks.