Navigating Four Common Post-Signing Requests for Additional Information

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Consolidation in the banking industry is heating up. Regulatory compliance costs, declining economies of scale, tiny net interest margins, shareholder liquidity demands, concerns about possible changes in tax laws and succession planning continue driving acquisitions for strategic growth.

Unlike many industries, where the signing and closing of an acquisition agreement may be nearly simultaneous, the execution of a definitive acquisition agreement in the bank space is really just the beginning of the acquisition process. Once the definitive agreement is executed, the parties begin compiling the information necessary to complete the regulatory applications that must be submitted to the appropriate state and federal bank regulatory agencies. Upon receipt and a quick review of a filed application, the agencies send an acknowledgement letter and likely a request for additional information. The comprehensive review begins under the relevant statutory factors and criteria found in the Bank Merger Act, Bank Holding Company Act or other relevant statutes or regulations. Formal review generally takes 30 to 60 days after an application is “complete.”

The process specifically considers, among other things: (1) competitive factors; (2) the financial and managerial resources and future prospects of the company or companies and the banks concerned; (3) the supervisory records of the financial institutions involved; (4) the convenience and needs of the communities to be served and the banks’ Community Reinvestment Act (CRA) records; (5) the effectiveness of the banks in combating money laundering activities; and (6) the extent to which a proposal would result in greater or more concentrated risks to the stability of the United States banking or financial system.

During this process, the applicant and regulator will exchange questions, answers, and clarifications back and forth in order to satisfy the applicable statutory factors or decision criteria towards final approval of the transaction. Each of the requests for additional information and clarifications are focused on making sure that the application record is complete. Just because information or documents are shared during the course of the supervisory process does not mean that the same information or documents will not be requested during the application process. The discussions and review of materials during the supervisory process is separate from the “application record,” so it helps bank management teams to be prepared to reproduce information already shared with the supervisory teams. A best practice for banks is to document what happens during the supervisory process so they have it handy in case something specific is re-requested as part of an application.

Recently, we consistently received a number of requests for additional information that include questions not otherwise included in the standard application forms. Below, we review four of the more common requests.

1. Impact of the Covid-19 Pandemic. Regulators are requesting additional information focused on the impact of the coronavirus pandemic. Both state and federal regulators are requesting a statement on the impact of the Covid-19 pandemic that discusses the impact on capital, asset quality, earnings, liquidity and the local economy. State and federal agencies are including a request to discuss trends in delinquency loan modifications and problem loans when reviewing the impact on asset quality, and an estimate for the volume of temporary surge deposits when reviewing the impact on liquidity.

2. Additional, Specific Financial Information. Beyond the traditional pro forma balance sheets and income statements that banks are accustomed to providing as part of the application process, we are receiving rather extensive requests for additional financial information and clarifications. Two specific requests are particular noteworthy. First, a request for financial information around potential stress scenarios, which we are receiving for acquirors and transactions of all sizes.

Second, and almost as a bolt-on to the stress scenario discussion, are the requests related to capital planning. These questions focus on the acquiror’s plan where financial targets are not met or the need to raise capital arises due to a stressed environment. While not actually asking for a capital plan, the agencies have not been disappointed to receive one in response to this line of inquiry.

3. List of Shareholders. Regardless of whether the banks indicate potential changes in the ownership structure of an acquiror or whether the consideration is entirely cash from the acquiror, agencies (most commonly the Federal Reserve), are requesting a pro forma shareholder listing for the acquiror. Specifically, this shareholder listing should break out those shareholders acting in concert that will own, control, or hold with power to vote 5% or more of an acquiring BHC. Consider this an opportunity for both the acquiror and the Federal Reserve to make sure control filings related to the acquiror are up to date.

4. Integration. Finally, requests for additional information from acquirors have consistently included a request for a discussion on integration of the target, beyond the traditional due diligence line of inquiry included in the application form. The questions focus on how the acquiror will effectively oversee the integration of the target, given the increase in assets size. Acquirors are expected to include a discussion of plan’s to bolster key risk management functions, internal controls, and policies and procedures. Again, we are receiving this request regardless of the size of the acquiror, target or transaction, even in cases where the target is less than 10% of the size of the acquiror.

These are four of the more common requests for additional information that we have encountered as deal activity heats up. As consolidation advances and more banks file applications, staff at the state and federal agencies may take longer to review and respond to applications matters. We see these common requests above as an opportunity to provide more material in the initial phase of the application process, in order to shorten the review timeframe and back and forth as much as possible. In any event, acquirors should be prepared to respond to these requests as part of navigating the regulatory process post-signing.

Industry Perspectives at Acquire or Be Acquired 2020

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People, Products & Performance – In this interview with Bank Director CEO Al Dominick, John Eggemeyer shares his thoughts on what drives performance.
Super-Connected Customers – Data, payments and other technology-related issues were top of mind for bankers at the 2020 Acquire or Be Acquired conference.
Who Gets the Dog? – On the heels of the CenterState Bank Corp./South State Corp. merger, Al Dominick evaluates a core cultural issue around these deals.
Spotlight on M&A – Drivers of M&A, balancing organic growth with acquisitions, and nonbank deals were key topics discussed from the stage at Acquire or Be Acquired.
Exploring Opportunities – Bank Director CEO Al Dominick shares three important takeaways from the first day of the 2020 Acquire or Be Acquired conference.
Technology’s Impact – Hear how banking industry leaders view today’s quickly evolving technology landscape.
Focus on Consolidation – Big mergers of equals and tech deals defined the banking market in 2019.

The Powerful Force Driving Bank Consolidation

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margins-8-16-19.pngA decades-old trend that has helped drive consolidation in the banking industry can be summarized in a single chart.

In 1995, the industry’s net interest margin, or NIM, was 4.25%, according to the Federal Reserve Bank of St. Louis. (NIM reflects the difference between a bank’s cost of funds and what it earns on its assets, primarily loans.) Twenty years later, the margin dropped to a historic low of 2.98%, before gradually recovering to 3.30% last year.

NIM-chart.png

The vast majority of banks in this county are spread lenders, making most of their money off the difference between what they pay for deposits and what they charge for loans. When this spread narrows, as it has since the mid-1990s, it pinches their profitability.

The decision by the Federal Reserve’s Federal Open Market Committee to reduce the target range for the federal funds rate by 25 basis points in August will likely exacerbate this by reducing the rates that banks can charge on loans.

“For most banks, net interest income [accounts for] the majority of their revenue,” says Allen Tischler, senior vice president at Moody’s Investor Service. “A reduction in [it] obviously undermines their ability to generate incremental earnings.”

There have been two recessions since the mid-1990s: a brief one in 2001 and the Great Recession in 2007 to 2009. The Federal Reserve cut interest rates in both instances. (Over time, lower rates depress margins, although banks may initially benefit if their deposit costs drop faster that their loan pricing.)

Inflation has also remained low since the mid-1990s — particularly since 2012, when it never rose above 2.4%. This is why the Fed has been able to keep rates so low.

Other factors contributing to the sustained decline in NIMs include intermittent periods of intense competition and rate cutting between banks, as well as the emergence of fintech lenders. Changes over time in a bank’s the mix of loans and securities, and among different loan categories, can impact NIMs, too.

The Dodd-Frank Act has exacerbated the downward trend in NIMs by requiring large banks to carry a higher share of low-yielding liquid assets on their balance sheets, which depresses their margins. This is why large banks have contributed disproportionally to the industry’s declining average margin – though, these institutions can more easily offset the compression because upwards of half their net revenue comes from fees.

Community banks haven’t experienced as much compression because they allocate a larger portion of their balance sheets to loans and do most of their lending in less-competitive markets. But smaller institutions are also less equipped to combat the compression, since fees make up only 11% of the net operating revenue at banks with less than $1 billion in assets, according to the Office of the Comptroller of the Currency.

The industry’s profitability has nevertheless held up, in part, because of improvements to operating efficiency, particularly at large banks. The corporate tax cut that went into effect in 2018 plays into this as well.

“If you recall how banking was done in 1995 versus today … there’s just [greater] efficiency across the board, when you think about what computer technology in particular has done in all service industries, not just banking,” says Norm Williams, deputy comptroller for economic and policy analysis at the OCC.

The Fed’s latest rate cut, combined with concerns about additional cuts if the escalating trade war with China weakens the U.S. economy, raises the specter that the industry’s margin could nosedive yet again.

Tischler at Moody’s believes that sustained margin pressure has been a factor in the industry’s consolidation since the mid-1990s. “That downward trend does undermine its profitability, and is part of the reason why the industry has consolidated as much as it has,” he says.

If the industry’s margin takes another plunge, it could drive further consolidation. “The industry has been consolidating for decades … and there’s no reason why that won’t continue,” says Tischler. “This just adds to the pressure.”

There were 11,971 U.S. banks and thrifts in 1995. Today there are 5,362. Given the direction of NIMs, it seems like we may still have too many.

Bank M&A in 2019: Is It a New World?

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Much like the countless dystopian novels and movies released over the years, the environment today in banking begs the question of whether we’ve entered a so-called new world in the industry’s M&A domain.

Deal volume in 2018 was roughly equal to 2017 levels, though many regions in the country saw a decline. And while it’s still early in 2019, the first two months of the year have been marked by a pair of large, transformative deals: Chemical Financial Corp.’s merger with TCF Financial Corp., and BB&T Corp.’s merger with SunTrust Banks. These deals have raised hopes that more large deals will soon follow, creating a new tier of banking entities that live just below the money-center banks.

Aside from these two large deals, however, M&A volume throughout the rest of the industry is down over the first two months of the year. As you can see in the chart below, this continues a slide in deal volume that began at the tail end of 2018.

Announced Bank Deals.png

Bank Director’s 2019 Bank M&A Survey highlights a number of the factors that might impact deal volume in 2019 and beyond.

Fifty-seven percent of survey respondents indicated that organic growth is their current priority, for instance, though respondents were open to M&A opportunities. This suggests that banks are more willing to focus on market opportunities for growth, likely because bank management can more easily influence market growth than M&A. The strength of the economy, enhanced earnings as a result of tax reform, easing regulatory oversight and industry optimism in general also are likely contributing to the focus on market growth.

The traditional chasm between banks that would like to be acquirers and banks that are willing to be sellers seems to be another factor influencing banks’ preference for organic market growth. In all the surveys Crowe has performed of bank directors, there always are more buyers than sellers.

The relationship between consolidation and new bank formation also weighs on the pace of acquisitions. If the pool of potential and active acquirers remains relatively stable, the determiner is the available pool of sellers. Each year since 2008, the number of acquisitions has exceeded the number of new bank formations. The result is an overall decrease in the number of deals. It stands to reason, in turn, that this will lead to fewer deals each year as consolidation continues.

Current prices for bank stocks also have an impact on deal volume. You can see this in the following chart, which illustrates the “tailwind” impact on deal volume for publicly traded banks. Tailwind is the percentage by which a buyer’s stock valuation exceeds the deal metrics. When the percentage is high, trading price/tangible book value (TBV) exceeds the deal price/TBV and deal volume is positively affected. The positive impact sometimes is felt in the same quarter, but there can be a three-month lag.

Deal Volume.png

In the beginning of 2019, bank stock prices recovered some of the declines they experienced in the latter half of last year, but they still are at a negative level overall. If bank stock prices continue to lag behind the broader market, as they have over the past year (see the chart below), deal volume likely will be affected for the remainder of the year.

Bank Stock Prices.png

It’s still too early to predict how 2019 will evolve for bank M&A. Undoubtedly there will be surprises, but it’s probably fair to assume a slightly lower level of deals for 2019 compared to 2018.

A Regulator’s Advice on Vetting Tech Companies

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regulator-12-13-18.pngAs a microcosm of the banking sector and the broader economy, North Carolina provides an interesting glimpse at some of the trends and issues impacting banks nationwide.

“North Carolina’s banks are strong and benefiting from a robust economy,” says Ray Grace, who has served as the North Carolina Commissioner of Banks since 2013. “A sign of the good times for banking here is the interest we’ve seen in this cycle from out-of-state banks buying their way into North Carolina markets.”

Out-of-state banks making recent acquisitions in North Carolina include Columbia, South Carolina-based South State Corp., Pittsburgh, Pennsylvania-based F.N.B. Corp., and two Tennessee banks: Pinnacle Financial Partners, in Nashville, and First Horizon National Corp., in Memphis.

As the state’s banks consolidate, there is interest in opening new banks—the first since the financial crisis.

North Carolina also boasts a burgeoning technology sector, including the bank operating system nCino, based in Wilmington, and payment solutions provider AvidXchange, digital banking provider Zenmonics and IT consulting firm Levvel—all based in Charlotte.

In this interview, which has been edited for length and clarity, Grace explains why he’s seeing more interest in opening de novo banks in the state, shares his advice for banks exploring fintech partnerships and weighs in on prospective challenges for the industry.

BD: North Carolina just chartered its first de novo bank in a decade, with American Bank & Trust in Monroe, North Carolina. The Charlotte Observer reported you believe there’s more interest in opening new banks in your state. What’s driving that interest, and do you expect more activity to result from that interest?

RG: During the so-called Great Recession, the traditional economic drivers for bank formations disappeared. The economic downturn increased credit risks from borrowers, monetary policy wrung the margins out of lending, and the predictable tightening of the regulatory screws increased both the cost and the complexity of banking. Normally, we would have seen a faster return of de novo activity, but this was of course no normal recession, and fittingly, it was no normal recovery. Rather than the “V-shaped” recovery we had seen following previous downturns, this was the dreaded “L-shaped” variety, prolonging the drought.

On the heels of an epic consolidation trend, many North Carolina markets, including some that had been historically very supportive of community banks, lost those banks. As with previous consolidation episodes, this has left voids in these markets, particularly in rural areas. At the same time, we have seen a strong, decisive uptick in the economy through much of the state, a gradual return to normalizing interest rates, and, mirabile dictu, the beginnings of a swing of the regulatory pendulum toward a somewhat less restrictive environment. All these factors have contributed to the return of industry profitability and made the banking model attractive once again.

BD: Banks have been increasingly working with fintech firms to better expand and improve their own products and services, but properly vetting younger tech companies can be tricky. Do you have any advice for banks exploring fintech partnerships?

RG: Banks will need to embrace new technologies if they are to remain viable. That said, they need to focus on being cutting edge, but not bleeding edge. There is a dizzying array of gee-whiz products being introduced now, and it’s important to be careful in what you choose to implement.

Like a lot of advice, mine is more easily given than followed, but start with the fundamentals. What [or] who are your markets? What are you offering those markets and customers in the way of products and services, and why? What is trending, and in what directions? How does all this fit in with your business plan? Does your business plan still make sense? If not, change it.

In light of the foregoing, is your management team and board adequate to your bank’s current and future needs? For example, do you have a chief technology officer? A tech-savvy director or two?

Know what is available, [and] study and carefully assess the alternatives that fit the needs of your business plan. Discard applications or products that do not enhance customer value and the quality of their experience—while not breaking the bank.

What existing bank systems must be accessed by the new application? What firewalls or other protections are provided for access, data and systems security?

What is the financial strength of the company you are contracting with? What is their capacity to support the application? Do they have a track record with other banks? What would be the consequences to your operations in the event of failure of the vendor? Who owns the code in that event, and who could take over support?

Not long ago, there were any number of fintech startups with interesting offerings but limited resources and infrastructure, which made them risky to engage with. The good news is that’s changing, and clearly it is better to deal with companies that have some legs, financially and organizationally.

BD: Is there anything else you think is important that boards be aware of heading into 2019?

RG: Change, or the failure to meet its challenges, is the single greatest existential risk to banking as we know it. However, boards cannot afford to lose focus on more traditional risks. There is an old banking axiom that the worst of loans are made in the best of times. These are some pretty good times, and we are beginning to see some troubling signs that memories are short. Among those I would cite are the rising prevalence of “covenant light” loans and other structural concessions on the commercial side, and 100 percent financing in both the commercial and mortgage lending spaces. Some in Washington are again talking about the need to increase access to affordable housing. Déjà vu all over again?

Interest rates are likely to continue to rise, albeit at a modest rate. I think this is a good thing for the industry and the economy, but it will require an increased emphasis on sound funds management policies and practices on both sides of the balance sheet.

Our banking industry has always faced challenges: the Great Depression, disintermediation and the thrift crisis of the 80s, the repeal of Regulation Q, the Great Recession and resultant Dodd Frank Act, and a host of others. Yet, the industry has survived and reinvented itself time and again. Unfortunately, banks have also been the target of damaging criticism from Washington, sometimes for good reason but too often for political motivation. Restoring the public trust tarnished by this criticism will play a critical role in ensuring the industry’s future. We need to be reminded that banks are special. That they are the only industry that “creates” money. And that they are the place where people have traditionally gone when they wanted to buy a home or a car, or start a business. In a very real sense, banks are where people go to make their dreams come true. That’s a powerful story. It’s up to banks to tell it and to make it so.

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.”

Small Bank Deals Dominate 2016 M&A Transactions

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merger-10-14-16.pngThere is a growing likelihood that the bank M&A market in 2016 will see declines in both deal volume and pricing compared to the previous two years, even as the industry’s underlying fundamentals remain relatively unchanged. “The operating environment is tough,” said Rory McKinney, the co-head of investment banking at D.A. Davidson Companies, during a presentation at S&P Global Market Intelligence’s 8th annual M&A Symposium in Washington, D.C., late last month. “We think there should be more activity. There’s a lot of pressure to build earnings per share and M&A is one of the ways you can do that.”

There were 181 announced healthy banks deals through September 30, which is well off the pace set in 2015 and 2014 when there were 278 and 282 deals, respectively, according to S&P. To match even the 2015 total, there would have to be 97 announced deals between now and the end of the year, which is probably unlikely. Pricing was also off through the first nine months of the year, with an average price-to-tangible-book-value ratio of 133 compared to 143 last year and 142 in 2014. Pricing was also lower on a price-to-earnings basis for four trailing quarters, coming in at 22 times earnings through September 30, compared to 25 last year and 26 in 2014.

So what gives? In a subsequent interview, McKinney reiterated his surprise that there hadn’t been more deal volume at the three-quarter post this year. “My personal opinion is that there should be more M&A just given the challenges from a financial perspective,” he says. “But banks are sold, not bought.” One factor might be that many potential sellers aren’t sure if this is the best time to sell if they want to maximize their bank’s value, he explains. If the economic expansion still has a few more years left before hitting the recessionary brick wall that most experts assume is out there, then perhaps the best thing to do is to wait for pricing to improve.

Of course, many of those potential sellers might have an unreasonably optimistic expectation for what their bank is worth in today’s market. “We get the question all the time—when can I sell my bank for two times book [value]?” says McKinney. There was a time in the early 2000s when banks did fetch that kind of valuation, but generally they don’t today. “We’ve only seen six deals this year at two times book,” he says.

Another factor is that after several decades of consolidation, the banking industry is much smaller than it used to be. “When you look at the number of deals this year compared to last year, keep in mind there’s also fewer banks as well,” he says. “We’ve got a shrinking universe.”

The decline in pricing might have less to do with the industry’s underlying fundamentals than the types of deals that are getting done in 2016. After all, the fundamentals are pretty similar. “If you look at where bank stock trading multiples are today—and that’s a pretty big driver of M&A pricing—they are pretty similar to where they were a year ago,” McKinney says. “I would say that most banks have the same currency [valuation today] they had a year ago from an earnings multiple or price-to-book [basis].”

However, what is different is the size of banks that dominated the deal volume through the first nine months of 2016. According to S&P, well over 60 percent of all deals this year have been for banks under $250 million in assets, where the average price-to-tangible-book-value ratio has been approximately 117, and the price-to-earnings-multiple has been about 17 times earnings. By contrast, the highest valuations have been for banks with $1 billion in assets and above, where price-to-tangible-book value ratios have ranged from 160 to 180 depending on the size of the bank. Generally, large banks sell for more than small banks, demonstrating a clear buyer preference for scale.

McKinney says that for small banks, it’s a buyer’s market. “The buyer is in the position to drive pricing [down] on those deals because they know they’re only one of maybe two or three [prospective] buyers for those franchises,” he says. “Where we see pricing stabilizing or maybe even slightly higher is [for banks with] good long-term demographics [in] metro areas, and also with $1 billion dollars and above in assets.”

Strategic Thinking: It Has Never Been More Critical

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5-19-14-wipfli.pngStrategic planning has never been more critical to the continued success of any financial institution. After all, the financial services environment continues to be extremely challenging, and these are no ordinary times. Many institutions are thinking about a rebirth in strategy as they get back to the basics and focus on their core business model. As you approach your forthcoming strategic planning initiatives, you will need to focus on several external and internal themes that demand attention and require ongoing, fluid strategic solutions.

Key External Themes to Keep in Mind

  1. A “wave of consolidation” is expected to accelerate. If your financial institution is going to be a survivor, how will you compete successfully? What does that portend for strategy?
  2. The core business model should be examined to decide what strategies will maximize shareholder value and ensure a return on investment. There is a limit to how far expense reduction and recapturing loan-loss provisions can boost industry earnings. At some point, profitability must come from the ability to grow revenue. Margin is not likely to come roaring back, efficiency ratios have remained relatively flat and the increasing regulatory burden and new delivery channels have added to expense. The supposed lower cost of electronic/mobile delivery has not hit the bottom line.
  3. The ultimate challenge is to identify the source of tomorrow’s profitable growth. What markets are growing? Which niches within those markets should the bank target? What are the habits of your customers? What role should technology play?
  4. Regulatory reform has changed the game. At the end of the day, it’s still about our ability to manage risk within a complicated, complex web of regulation.
  5. A distinctive competitive advantage needs to be ensured. Simply put: Why do customers choose your bank?
  6. The key to success is to focus and to prioritize. Reaffirm what your institution does really well and build the strategic direction on core foundational strengths and on the most significant opportunities. Motivated execution of strategic priorities equates to sustained bottom line performance. Implementation and execution of a well-developed strategic plan will significantly enhance earnings.

Key Internal Themes to Keep in Mind

  1. Strategic planning should result in sustained bottom line performance and should be the highest yielding annual investment a financial institution makes.
  2. The planning process has a defined purpose: To help an organization focus its energy on clearly aligned goals and to assess and adjust strategic direction as appropriate in a dynamic, rapidly changing environment.
  3. The process must be customized to meet the unique needs of each organization. A “cookie cutter” process or “glorified budgeting” meeting will not produce forward-looking strategies, nor will it maximize shareholder value.
  4. Strategic planning requires discipline and a focused, productive planning meeting where questions can be raised and assumptions tested. The leadership challenge is always about making choices. As we frequently say, “If you emerge from a planning session ‘exhausted…but invigorated,” you have likely had a successful session that propelled needed action and a renewed commitment to aligned results.
  5. Organizational structure needs review. Look forward, not backward. Pretend you are starting from scratch. Reaffirm what works and what does not work for your organization.
  6. Leadership does matter. In fact, it is all about the “M.” The quality of management is probably the single most important element in the successful operation of a financial institution. Proactively assess the talent within your organization. Develop a deeper culture of accountability that rewards implementation, execution and sustainable high performance.
  7. Board governance has never been more important. It has never been more challenging to find competent, qualified directors willing to assume the personal risk associated with being on a board.

The Outlook

All components of your strategic plan should align with the strategies the bank needs. Even if you have a well-crafted strategic plan, that is not enough. All critical issues must be addressed in an executable plan implemented within a well-led culture of accountability.

Difficult times can be an opportunity in disguise. On the other side of most challenges lie great opportunities. To survive and flourish, financial institutions must exploit the current opportunities—carefully, deliberately, and thoughtfully.

Has Consolidation Killed the Community Bank?

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4-21-14-jacks-blog.pngAn argument that I hear occasionally is that consolidation of the U.S. banking industry has put community banks on a path towards extinction. Two economists at the Federal Deposit Insurance Corp. (FDIC) have shot down this theory in a new research study whose findings are counterintuitive.

On the face of it, the industry’s consolidation over the past 30-plus years has been pretty dramatic. The FDIC says there were approximately 20,000 U.S. banks and thrifts in 1980, and this number had dropped to 6,812 by the end of 2013. A variety of factors have been at work. The biggest contributor, according to the study, was the voluntary closure of bank charters brought by deregulation, including the advent of interstate banking. A lot of the “shrinkage” that occurred between the mid-1980s and mid-1990s wasn’t so much the disappearance of whole banks as it was the rationalization of multiple charters by the same corporate owner to save money.

A couple of recessions—from 1990-1991, and again from 2007-2009—also played a role in the industry’s downsizing. The FDIC says that bank failures accounted for about 20 percent of all charter attrition between 1985 and 2013—a culling of the herd which is painful but ultimately healthy since it tends to eliminate the weaker management teams.

Interestingly, the study did not look at how many bank charters were eliminated through acquisition, although I think we can safely assume that this has played an important role, particularly among the larger banks. In 1990 the 10 largest U.S. banks controlled 19 percent of the industry’s assets; by the end of 2013 their share had climbed to 56 percent. That increase in financial concentration is almost all the result of acquisitions of large banks by even larger banks, much of which occurred in the 1990s.

While the big banks just got bigger, the really small banks mostly disappeared. In what I thought was the study’s most interesting finding, the number of banks with less than $100 million in assets dropped by a stunning 85 percent from 1985 to 2013. For banks under $25 million, the decline was 96 percent. Again, the FDIC doesn’t say why, although I think we can assume that acquisitions, charter rationalizations and failures all played a role.

A central point of the study is that there are still plenty of community banks around, especially if you define them not by an arbitrary asset size, but rather by what they do and how they do it. Community banks, according to the FDIC, “tend to focus on providing essential banking services in their local communities. They obtain most of their core deposits locally and make many of their loans to local businesses.” Most banks in the U.S. would meet this definition of “community,” including a great many that are well over $1 billion in assets.

How might consolidation affect community banks going forward? The FDIC study ends with the upbeat assessment that community banks will continue to be an important source of funding to local businesses, and I would agree in part because I am uncertain about how much more consolidation is likely to occur.

I pointed out in a February 4 blog that there were 225 healthy bank acquisitions in 2012 and 224 in 2013, according to SNL Financial. And I offered a prediction that there would be between 225 and 250 acquisitions this year and perhaps as many as 275 in 2015. That still sounds about right, and it would put the pace of consolidation back to where it was in 2007—or a year before the financial crisis. Many of those deals will likely involve community banks, and while that would lead to a decline in their overall population, it would also create “local” institutions that are larger in size. It certainly won’t decimate the ranks of community banks.

I don’t believe that community banks are facing extinction, but they are facing some very significant challenges in the years ahead—and not from consolidation. The sharply increased cost of regulatory compliance might lead some community banks—say, those under $100 million in assets —to sell out if they can find a buyer; others will respond by trying to get bigger through acquisitions so they can spread the costs over a wider base.

Gaining access to capital will also prove to be a huge challenge for many smaller banks. By “smaller” I am thinking of institutions with $1 billion in assets or less, although the cutoff point might be higher. The higher capital requirement that has been established under the Basel III agreement is a permanent minimum expectation. Traditionally, banks have had the freedom to manage their capital to fit the environment they found themselves in, preserving it when times were bad and leveraging it when times were good and they wanted to grow. Now, banks that want to grow might need to raise additional capital to support a larger balance sheet. But as the banking industry’s capital level has grown, its return on equity has declined (a function of simple math) and not all investors will be interested in a small bank offering limited returns. I believe there will be a great deal of competition between banking companies to attract capital, and there will be winners and losers.

A third challenge is the dependency that many community banks have on commercial real estate lending, a historically volatile asset class that resulted in hundreds of bank failures in the early 1990s, and again during the most recent financial crisis. The most enduring community banks could be those that are able to diversify into other loan categories so they are not at risk when the next commercial real estate crash occurs. But diversification will require the acquisition of talent and skill sets that most community banks do not possess, so it’s a strategy that must be pursued with purpose.

The challenges facing community banks today are real, but consolidation isn’t one of them.

This article originally appeared on The Bank Spot and was reprinted with permission.

Bank M&A Midyear Update: Consolidation Pace Remains Lower Than Expected

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Many people expected the pace of bank mergers and acquisitions in 2013 to pick up as a result of pressures from regulatory burdens, lack of growth in existing markets, and boards and management teams that had grown weary of banking.

However, deal activity for the first six months of 2013 indicates a consolidation pace consistent with 2012. The pace is ahead of 2011 and 2010 levels but still below levels seen before the credit crisis. Deal volume in 2012 was bolstered by a considerably vibrant third-quarter deal flow. Unless the same deal volume is experienced in the third quarter of 2013, the yearly deal count could slip below 2012 levels.

Number of Deals by Quarter
Year Q1 Q2 Q3 Q4 Totals
2008 45 38 36 24 143
2009 24 34 19 41 118
2010 27 52 49 50 178
2011 35 43 32 37 147
2012 55 51 73 56 235
2013 50 51 – – 101

Credit Quality Concerns Still Affecting Deal Volume

In a survey on merger and acquisition conditions jointly conducted by Bank Director and Crowe Horwath LLP in October 2012, one of the primary impediments to consolidation reported was the credit quality of potential sellers. While current-year levels of nonperforming assets by sellers are better than they were at the peak of the credit crisis, levels are still high compared with historical norms.

Average Nonperforming Assets/Total Assets of Sellers (%)
Year Q1 Q2 Q3 Q4 Totals
2008 1.69 1.15 0.81 2.14 1.40
2009 2.45 2.64 3.23 4.46 3.32
2010 4.07 4.21 4.52 4.13 4.25
2011 4.42 6.49 3.71 4.24 4.84
2012 2.95 4.25 3.78 3.29 3.57
2013 3.28 3.85 – – 3.57

* Totals are weighted averages.

History indicates that when credit problems are prevalent in the banking industry, both the number of deals and pricing are negatively affected.

Pricing for deals announced in the first half of 2013 are consistent with the overall pricing for 2012 and up slightly from the second half of 2012. Credit quality would appear to be dampening overall pricing.

Average Price/Tangible Book Value (%)
Year Q1 Q2 Q3 Q4 Totals
2009 101.48 123.27 125.62 107.24 113.73
2010 147.78 123.49 105.56 111.67 118.39
2011 112.11 105.93 108.88 107.15 108.48
2012 128.88 113.83 109.24 107.55 114.30
2013 115.97 112.53 – – 114.25

* Totals are weighted averages.

FDIC Deal Volume Drops 

Although the Federal Deposit Insurance Corporation (FDIC) continues to work with institutions, deal flow for assisted transactions has diminished from its peak in 2010. Asset discounts, the bid amount for an institution divided by the assets sold, have settled in at around 16 percent, likely the result of the FDIC offering deals without the benefit of a loss-sharing agreement. The average deposit size of the institutions sold has also decreased.

FDIC-Assisted Deals
Year # of Deals Average Deposits
Assumed ($000s)		 Average Asset
Discount %
2010 147 403,975 10.83
2011 90 319,549 15.70
2012 47 205,398 15.63
2013 YTD 16 107,881 15.94

Branch Deal Volume Slightly Lower Than Prior Years

Branch deal volume is on pace to be slightly lower in 2013. Deposit premiums dipped in 2012 but have rebounded back to 2010 and 2011 levels in the first six months of 2013. For many community banks, a small one- or two-branch network might be the only feasible acquisition opportunities. While deposit premiums are up in 2013, they still are at a reasonable level and in some regions are still well below the average. As larger and regional bank holding companies continue to evaluate their branch networks, there likely will continue to be acquisition opportunities available.

Branch Deal Volume
Year # of Deals Average Deposit
Premium %
2010 78 3.22
2011 81 3.33
2012 88 2.53
2013 YTD 27 3.40

Possible M&A Indicators for the Next 12 Months

While deal volume has been steady these past several years, it is still at a pace well below the predictions from various industry pundits. The past two Bank Director/Crowe Horwath merger and acquisition surveys highlighted concerns about credit quality, the economy, and regulatory issues as major causes of the slowdown.

While credit quality has been improving in the industry, the levels of nonperforming assets are still high compared to historical averages. Based on the correlation between deal volume and credit quality, the overall level of nonperforming assets will need to improve significantly before deal volume will increase. Economic indicators have been improving, but there are still unknowns both in the U.S. economy and worldwide, which suggests that uncertainty is still at levels that make it difficult to do deals.

The regulatory environment has stabilized some now that regulatory agencies have taken industry concerns into consideration and revised their Basel III rules, but the overall level of concern over regulatory issues is still high. Issues implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act and the new rules from Consumer Financial Protection Bureau are challenging banks as they try to comply with the onslaught of new rules.

As a result, it appears as though bank merger and acquisition levels will remain constant and more moderate than the levels predicted over the past several years.