Preparing for an Uncertain Future

“By failing to prepare, you are preparing to fail.” — Benjamin Franklin

Mergers and acquisitions may be sidelined for the foreseeable future because of considerable economic and market uncertainty related to the coronavirus pandemic, but PNC’s Financial Institutions Group anticipates activity will likely reignite when market volatility eases, and asset quality can be confidently assessed.

Savvy bankers and investors recognize that the best deals generally occur when bank valuations are low, but the credit downturn may just be starting, so the timetable for a pickup in deal activity remains unclear. Not to mention, there may be many coronavirus-related issues to still sort out, so the possibility of future government-assisted deals cannot be ruled out.

Recent history supports this post-crisis resumption. Deal activity slowed measurably at the start of the Great Recession, dropping from 285 deals in 2007 to 174 in 2008, according to S&P Global Market Intelligence. It picked up again once potential buyers gained more clarity regarding both their own balance sheets as well as those of potential sellers.

Credit Quality is Key
The uncertain environment underlines that nothing is more significant to a bank’s capital and earnings than its credit quality. It is anticipated that credit costs will continue to climb and remain elevated for quite some time following the sudden and shocking increase to unemployment and government-mandated business closures. So, looking at balance sheets — not income statements — will provide the necessary clues to differentiate banks in a downward credit cycle. But these issues will eventually get resolved.

The uncertainty could give way to wider pricing disparity among community banks. Bank earnings for the quarter ending on March 31 were inconclusive, and eclipsed by coronavirus-related economic developments and stock market volatility. The vast majority of companies did not provide guidance, but the overall lower direction appears clear, as credit will likely be a major concern for the next several quarters.

Investors and analysts appear to have a wide range of opinions; high levels of market angst seem likely to persist into the foreseeable future. There will, however, be winners and losers among banks across the nation. This emerging pricing gap could lead to increased M&A activity as more deals make financial sense.

Cash, Capital Rule
Bank boards should consider all liquidity and capital options under various economic scenarios to construct stronger balance sheets as credit conditions start to deteriorate. This preparation holds true for all banks: potential buyers, sellers and those committed to independence.

Along with more dynamic trading strategies, there will be a need to vigorously assess capital-raising options, cash dividend payments and stock repurchase programs. To start, companies should seriously consider emphasizing internal “burn down” tangible book value models. We believe that sensitivity models tailored to individual banks can best identify additional capital needs and, if so, what form of capital is best suited for current and longer-term strategic plans.

Equity offerings carry their own pros and cons. They can strengthen bank balance sheets but dilute earnings per share. Given current market conditions, these issuances may be difficult to achieve and limited to high-quality institutions that can issue equity on financially attractive terms (including tangible book value accretion).

The benefits from an equity capital raise include, but are not limited to: the ability to grow organically above the sustainable growth rate; stronger capital ratios and a bigger cushion to withstand the credit downturn; greater liquidity and visibility from institutional investors; and providing support for M&A opportunities, which may be abundant in the post-coronavirus landscape.

Some institutions may find issuing subordinated debt (“sub debt”) to be a better alternative than raising additional equity capital. Debt remains relatively inexpensive due to attractive interest rates and favorable tax treatment. The market for sub debt became more stable by early June, which has facilitated several issuances at favorable pricing levels.

The question for bank directors and management going forward is how to properly value capital raising and any M&A initiatives. They will need to take a hard look at financial models to determine required rates of return and sustainable growth rates along with regulatory needs. Efficient capital management that optimizes long-term shareholder value should always be the primary goal of directors in good markets, bad markets and those in-between.

The views expressed in this article are the views of PNC FIG Advisory, PNC’s investment banking practice for community and regional banks.

Can the Industry Handle the Truth on Credit Quality?

Maybe Jack Nicholson was right: “You can’t handle the truth!”

The actor’s famous line from the 1992 movie “A Few Good Men” echoes our concern on bank credit quality in fall 2019 and heading into early 2020.

Investors have been blessed with record lows in credit quality: The median ratio of nonperforming assets (NPA) is nearly 1%, accounting for nonperforming loans and foreclosed properties, a figure that modestly improved in the first half of 2019. Most credit indicators are rosy, with limited issues across both private and public financial institutions.

However, we are fairly certain this good news will not last and expect some normalization to occur. How should investors react when the pristine credit data reverts to a higher and more-normalized level?

The median NPA ratio between 2004 and 2019 peaked at 3.5% in 2011 and hit a record low of 60 basis points in 2004, according to credit data from the Federal Deposit Insurance Corp. on more than 1,500 institutions with more than $500 million in assets. It declined to near 1% in mid-2019. Median NPAs were 2.9% of loans over this 15-year timeframe. The reversion to the mean implies over 2.5 times worse credit quality than currently exists. Will investors be able to accept a headline that credit problems have increased 250%, even if it’s simply a return to normal NPA levels?

Common sense tells us that investors are already discounting this potential future outcome via lower stock prices and valuation multiples for banks. This is one of many reasons that public bank stocks have struggled since late August 2018 and frequently underperform their benchmarks.

It is impressive what banks have accomplished. Bank capital levels are 9.5%, 200 basis points higher than 2007 levels. Concentrations in construction and commercial real estate are vastly different, and few banks have more than 100% of total capital in any one loan category. Greater balance within loan portfolios is the standard today, often a mix of some commercial and industrial loans, modest consumer exposure, and lower CRE and construction loans.

Median C&I problem loans at banks that have at least 10% of total loans in the commercial category — more than 60% of all FDIC charters — showed similar trends to total NPAs. The median C&I problem loan levels peaked at 4% in late 2009 and again in 2010; it had retreated to 1.5%, as of fall 2019. The longer-term mean is greater due to the “hockey stick” growth of commercial nonaccrual loans during the crisis years spanning 2008 to 2011, as well as the sharp decline in C&I problem loans in 2014. Over time, we feel C&I NPAs will revert upward, to a new normal between 2% to 2.25%.

Public banks provide a plethora of risk-grade ratings on their portfolios in quarterly and annual filings, following strong encouragement from the Securities and Exchange Commission to provide better credit disclosures. The nine-point credit scale consists of “pass” (levels 1 to 4), “special mention/watch” (5), “substandard” (6), “nonperforming” (7), “doubtful” (8) and “loss” (9, the worst rating).

They define a financial institution’s criticized assets, which are loans not rated “pass,” indicating “special mention/watch” or worse, as well as classified assets, which are rated “substandard” or worse. The classified assets show the same pattern as total NPAs and C&I problem loans: low levels with very few signs of deterioration.

The median substandard/classified loan ratio at over 300 public banks was 1.14% through August 2019. That compared to 1.6% in fall 2016 and 3.4% in early 2013. We prefer looking at substandard credit data as a way to get a deeper cut at banks’ credit risk — and it too flashes positive signals at present.

The challenge we envision is that investors, bankers and reporters have been spoiled by good credit news. Reversions to the mean are a mathematical truth in statistics. We ultimately expect today’s good credit data to revert back to higher, but normalized, levels of NPAs and classified loans. A doubling of problem credit ratios would actually just be returning to the historical mean. Can investors accept that 2019’s credit quality is unsustainably low?

We believe higher credit problems will eventually emerge from an extremely low base. The key is handling the truth: An increase in NPAs and classified loans is healthy, and not a signal of pending danger and doom.

As the saying goes: “Keep Calm and Carry On.”

Preserving Franchise Value



The factors that help banks maximize value—including growth and profitability—are relatively timeless, though the importance of each value driver tend to change with the operating environment. But the way a bank pursues a sale impacts its valuation. In this video, Christopher Olsen of Olsen Palmer outlines the three ways a bank can pursue a sale. He also explains why discretion is key to preserving franchise value.

  • Factors Driving Today’s Valuations
  • The “Goldilocks” Process for Selling Banks
  • The Importance of Discretion

 

Your M&A Success Could Depend On This One Thing


merger-12-19-18.pngBenchmarking key performance indicators (KPIs) can help you more fully understand your bank’s financial condition and operating results, as well as the true value in a potential M&A market.

The success of your M&A strategy – whether buy, sell or stay – measurably increases with a sound grasp of the metrics that drive shareholder value.

KPIs as M&A drivers
KPIs can help you to identify important strengths in your target organization and your own institution. This can help determine the areas you could strengthen in an acquisition, or understand where your bank’s value lies within a merger. You can also learn about your organization’s, or your target institution’s, primary challenges and how this might impact the transaction.

These metrics can also help the organization evaluate the success of the transaction after completion. Have the key performance indicators drastically changed? Was that change different from the anticipated adjustment from the combination of the two entities? Understanding the metrics, and some of the forces impacting them, can be a strong foundation for successful M&A transactions.

Q3 2018 KPI observations
Community banks throughout the U.S. used the strong economy and relatively stable interest rate environment to maintain steady operations throughout the third quarter of 2018.

Baker Tilly’s banking industry key performance indicator (KPI) report reflected almost no change in comparison to the same benchmarks for the second quarter of 2018. Earnings, credit quality and capital adequacy benchmarks all remained essentially the same. This consistency appears to reflect a more stable economic environment, disciplined management of credit pricing and quality, notwithstanding a continued highly competitive environment, and the early stages of a move to higher interest rates.

M-A-chart.png

If there is anything to take away from the relatively unchanged KPIs over the first nine months of 2018, it is that community bankers have diligently pursued the opportunities emerging from the strong economy.

Loan growth, reflected in the comparison of the loan-to-deposits ratios each quarter, has been somewhat subdued. Potential drivers of this include increasing liquidity pressures arising from changes in interest rates, early stages of the potential for a downward credit cycle and the uncertainty of the November midterm elections. These factors kept many community bankers focused on internal matters such as compliance and technology during the second and third quarters of 2018.

Many banks continued to assess consolidation opportunities on both the buy and sell side. Until the recent series of market declines, bank equity currency remained quite strong, supporting a continued active consolidation of the industry, at price points that, on average, exceed 1.5 – 1.7 times book value.

We expect more of the same consistency in the KPIs as we have seen throughout 2018. It does not appear there will be any significant shifts in either direction arising from changes in economic policy. However, the pace of deregulation may subside due to the change in leadership in the U.S. House of Representatives.

If equity markets rebound following the midterms and the Federal Reserve pauses its increase of interest rates, we may see a re-acceleration of the consolidation of community banks, especially those with assets of $500 million or less. Other than an increased emphasis on securing and maintaining low cost deposits, we anticipate community banks to maintain a steady course into early 2019.

What’s The Same – And What’s Not – In Assessing Credit Quality


assessment-7-30-18.pngSince the 1970s, there has been an inevitable march toward a macro, quantitative assessment of credit quality. Technology and big data ensured its emergence to complement the more traditional, transactional counterpart of credit risk management.

Since the adoption of the 2006 allowance for loan and lease losses (ALLL) guidance, and the ferocity of loan losses during the great recession, we have seen the growing confluence among credit, accounting, regulatory and investor constituencies attempting to answer the same age-old questions: How much loss is embedded in the loan portfolio? How much is this portfolio worth?

While having comparable goals, each level of management has its priorities, biases and specialized methodologies for answering those questions. For directors, there may be a need to connect the dots to determine the objective of these measures.

Today’s ALLL
The current loss methodology was also used in 2006, prior to the massive, mainly real estate, credit losses from the great recession. The 2006 methodology included pool, formula-driven and specific impairment loss estimates. The incurred loss bias of the current methodology–often known as a “run-rate” approach–inflates the most recent credit quality performances. With no significant losses prior to the crisis, the industry was largely pushed into the abyss with low loss reserves–unable to raise reserves for forecasted losses. Given the relatively benign state of credit currently, it could be said that we are back to the future, having to defend ALLL levels, largely with qualitative justifications.

Tomorrow’s CECL
The soon-to-be implemented current expected credit loss (CECL) methodology is the inevitable reaction to the roller coaster nature of today’s ALLL. Some even consider it a fall back to the failed bid, about eight years ago, to impose mark-to-market valuations on the entirety of banks’ loan portfolios. Regardless of the pejorative “crystal ball” moniker often describing CECL–not to mention estimates of significant Day One implementation increases in reserves–its integration of historical losses, current conditions and reasonable forecasts is designed to be the more holistic, life-of-loan estimation of losses.

There is a high presumption in CECL that quantitative measures, such as discounted cash flows or probabilities of default (PDs)/loss given defaults (LGDs), overlaid by recovery lags, will be used to project future losses. In theory, it may be a more reliable estimate than the current guidance; however, its greatest hindrance is the perception that it is yet another de facto variant layer of capital buffer mandated by the Dodd-Frank Act, and Basel III.

Exit Price Notion
This accounting-based fair value measure disclosure (ASU 2016-01), often referred to as fair value/exit pricing, is new for 2018 and specifies the method by which public financial institutions calculate the fair value of their loan portfolios for purposes of disclosure. Fair value is the amount that would be received to sell an asset or paid to transfer a liability at the measure date. The estimate of fair value must be supported through specified protocols of valuation and calculation. Credit-based assessments, coupled with ties to loan review and risk grade migrations, will be key to justifying a reasonable, point-in-time fair value calculation.

Credit Mark in Mergers & Acquisitions (M&A)
Speaking of fair value, in M&A, it is truly in the eye of the beholder. How skeptical is the buyer? How much does the buyer want the deal? Determining a credit mark, or rational estimate (or range) of discounts to be applied to a prospective purchased loan portfolio, is very much a credit-based, symbiotic marriage between a traditional, more qualitative loan review and the more quantitative metrics of PDs, LGDs, risk grade migrations, yield marks, recovery lags and probabilistic modeling. Using one approach, without the informing nature of the other, is problematic and increases inaccuracies. What is sacrosanct in credit mark, is that an institution never wants to undershoot the estimates. Accounting plays a greater role when the deal-negotiated credit mark is refreshed at the deal’s completion, known as Day One accounting.

The credit discipline has often described as a qualitative decision stacked on an array of quantitative metrics. That remains an apt description for transactional credit–where it all begins. However, the new frontier in managing credit risk, even at smaller financial institutions, is in the ever-evolving, mostly mandated, macro, quantitative measures–some of which are described above. Each of these, not unlike a Venn diagram, has similarities and overlapping portions, but each has separate purposes, as well. Directors, like credit officers, need to understand and embrace these quantitative measures, which will, in turn, lead to better decision making for the bank.

CECL Will Result in a Sizable Capital Hit for U.S. Banks


CECL-6-8-18.pngWhile a new reserve methodology is far from popular among U.S. banks, it could prepare them for the next economic downturn.

The banking industry has bemoaned the new provision largely due to its complexity. The current expected credit loss model, or CECL, will require banks to set aside reserves for lifetime expected losses on the day of loan origination, resulting in a sizable hit to capital at adoption.

S&P Global Market Intelligence has developed a scenario estimating CECL’s capital impact to the banking industry in aggregate as well as community banks — institutions with less than $10 billion in assets. The upfront reserve build that will come with CECL adoption could allow banks to better withstand a downturn, which could begin when banks adopt the methodology in 2020.

But, we don’t expect banks to take the change in stride and believe institutions will respond with higher loan prices and slower balance sheet expansion.

CECL becomes effective for many institutions in 2020 and will mark a considerable shift in practice. Banks currently set aside reserves over time, whereas the new provision requires them to substantially increase their allowance for loan losses on the date of adoption.

Given the capital hit, S&P Global Market Intelligence believes the industry’s tangible equity-to-tangible assets ratio could fall to 8.25 percent in 2020, assuming uniform adoption of CECL by all banking subsidiaries at that time. That level is 127 basis points below the projected capital if banks continue operating under the existing incurred loss model.

We expect a much more manageable capital hit for community banks, which could see their tangible-equity-to-tangible assets ratio fall to 11.13 percent in 2020, 50 basis points below the projected capital level for those institutions if they maintained the existing incurred loss model.

We assume that CECL reserves would match charge-offs over the life of loans. For the banking industry, we assumed the loan portfolio had an average life of three and half years, while assuming an average life of four and half years for community banks, based on the current loan composition of both groups of institutions.

The expected level of charge-offs stems from our longer-term outlook for credit quality. While improving sentiment among consumers and businesses should support relatively strong asset quality in 2018, credit standards should begin to slip in 2019 as banks compete more aggressively to win new business. Competition should increase because economic growth is not expected to be quite strong enough to create sufficient opportunities for banks to lever the additional capital created by tax reform.

Changes in the competitive environment could coincide with regulatory relief efforts. The Trump administration and Republican-controlled Congress have pushed to soften many rules passed in the aftermath of the credit crisis and the rolling back of regulations could invite further easing of underwriting standards. This would occur as interest rates increase, leading to a more expensive debt service and pushing some borrowers to the brink.

Even with those headwinds, community banks should once again maintain stronger credit quality than their larger counterparts. Community banks have greater exposure to real estate and while valuations have risen considerably since the depths of the credit crisis, there are reasons to believe smaller institutions’ credit quality will hold up far better through the next downturn.

The lack of a housing bubble and massive overbuilding in the residential real estate sector as well as heightened regulatory scrutiny over elevated commercial real estate lending concentrations should help prevent history from repeating itself.

The impact of CECL should also encourage banks to raise rates on newly-originated loans, particularly longer-dated real estate credits that will require a larger reserve build under the provision. We think that loan growth will be slower than it would have otherwise been as banks with thinner capital ratios hoard cash and work to rebuild their capital bases.

If the credit cycle bottoms several years after CECL’s adoption, the new accounting provision might work as intended. Banks will have set aside considerable reserves well ahead of a downturn and pull forward losses, meaning their earnings will be stronger when credit quality reaches a low point.

However, if losses peak as the industry implements the new reserving methodology, the hit to capital could prove even more severe and leave banks on weaker ground to weather a downturn.

Is Your Bank’s Loan Review Good Enough?


lending-2-27-17.pngFor almost three decades, regulators have mandated independent loan review of commercial loans. So what could be needed to improve this time-tested concept? Well, for one, like all other aspects of banking, loan review must evolve and modernize to retain its effectiveness. This is more pertinent given that, statistically speaking, we may be in the fourth quarter of the credit cycle, which could be problematic as loan officers may pursue growth at the expense of loan quality. Also, there’s a growing dependence on loan review to facilitate accurate portfolio credit marks in mergers and acquisitions. Many loan reviews, whether in-house or externally contracted, remain too subjective, too random, are outdated technologically, lack collaborative processes, and, perhaps most importantly in the modern era, lack holistic linkage to the more quantitative and dynamic macro aspect of portfolio risk management.

So, for a board of directors, this may be a good time to assess your bank’s loan review processes. Here are some timely tips to push this evolution along:

  • Remember credit quality assessments—including those of regulators—typically are trailing, not leading indicators. There’s a perception that community banks have been beaten up enough over the past few years and that some of the regulatory credit dogs have been called off; thus, be vigilant to dated reports indicating stable credit quality. Additionally, historical loan performance indicates loans made at the end of credit cycles are sometimes made for the purpose of enhancing growth, and have proven to be more problematic.
  • Embrace updated—and secure—technologies to enable remote reviews and eliminate travel expenses. With the availability of imaged loan files, loan review can be done remotely; however, it must be done securely. Too many contract reviewers are putting banks at risk using their own porous laptops.
  • Ensure more file coverage and promote more collaboration within the bank’s risk management forces. Remember that loan review’s primary mission is to validate original underwriting, post-booking servicing, adherence to policies and ultimate agreement with risk grading—not to re-underwrite each sampled loan. An effective reviewer must always be willing to defend his or her work in a collaborative, non-defensive manner.
  • Be aware that industry-wide commercial real estate concentrations have recovered and now exceed pre-crisis levels. Given that highly correlated loan types exacerbated bank failures during the financial crisis, and that higher interest rates will likely put pressure on income properties, loan reviews should go well beyond the blunt concentration percentages by using smart sampling techniques. Peeling the onion on loan subset growth and performances will be critical in defending against and mitigating any significant concentrated exposures.
  • Explore hybrid loan review approaches. Even larger banks with internal loan review staffs are supplementing their work with external groups in order to effect efficiencies, broader coverages, and validations of their own findings. On the other hand, smaller banks relying exclusively on out-sourced loan review vendors should employ credit function policing arms to quick-strike areas of concern. Being totally dependent on a semi-annual loan review is akin to the fire department being open only a couple of weeks a year.
  • Understand the relationships among documentation exceptions, weaker risk grades and larger credit losses. Test technical documentation (capacity to borrow/collateral conveyance) proportionate to the weakness of the risk grade. After all, a lot of weakly documented loans go through the system unnoticed until a credit default occurs.
  • Go deeper than fee comparisons. While it’s understandable to consider fee structures when deciding on a loan review vendor, take the added steps of discussing loan review protocols and requiring examples of deliverables. All too many vendors provide only simplified spreadsheets and write-ups only of criticized-classified loans, in many cases, re-inventorying what the bank already knows. An effective loan review warns of problems about to happen; it doesn’t rehash those already acknowledged. Also, be mindful of the contractor: employee ratio as employee-based firms tend to offer more consistency and quality control.
  • Make loan review a viable bridge between the traditional, transactional analysis and aggregate, macro-portfolio risk management. While you can’t ignore the former, where it all begins, modern portfolio management requires a more quantitative and credible assessment of the latter, the sum of the parts. Thus, loan review emerges from an isolated, one-off engagement to a dynamic informer of all aspects of managing a bank’s credit quality.

Three Strategic Imperatives: What Your Bank Needs to Know


4-28-14-GT.pngDespite continued regulatory challenges and a sluggish economic environment, most financial institutions have seen their situations improve in recent months. How will banks keep the momentum going? We outline three areas to focus on.

Priority #1: Increasing Capital
Capital drives so much right now from the regulators’ perspective. Excluding statutory requirements, capital is the regulators’ be-all and end-all.

So how much is enough? In recent stress tests of the banking system, the results show that all but one of the top 30 banks—Salt Lake City, Utah-based Zions Bancorp.—would have ample capital to survive the exceptionally poor economic conditions and continue to lend. However, regulators failed four other banks based on qualitative concerns about their capital plans. The latest Comprehensive Capital Analysis and Review took some industry observers by surprise, as the Federal Reserve objected to five of the 30 participants’ capital plans, and approved another two banks only after they resubmitted.

The regulatory scrutiny clearly remains intense, and banks should not expect this level of oversight to ease anytime soon. To stay ahead of the curve, banks should examine their capital levels and ask a number of questions, including:

  • How will my capital ratios be impacted by changes in risk weights?
  • How will I respond to those changes?
  • Do I need to change my product mix or my underwriting? Should I even consider a strategy where the bank’s assets shrink in the short term?
  • Do I need to adjust my risk tolerance in lending?
  • Should I consider outsourcing certain functions or decrease operating expenses?

At a minimum, banks will need to integrate into their capital planning and strategic planning processes an analysis of where they stand relative to Basel III requirements. This will ensure they are well-positioned to address any capital needs.

Priority #2: Managing Credit Quality
The continued low-rate environment has compressed the net interest margin for most institutions. As a result, bank executives are turning to new, expanded or modified product offerings and service lines to improve performance.

As with any new opportunity, it’s critical to make sure that the risks are appropriately assessed and priced. New products and services may have a totally different risk profile than the bank’s traditional fare—and the bank may be ill-equipped to manage the risks of the new products and services. Banks may lack the necessary controls, risk-management processes, expertise and appropriate information systems needed to effectively monitor and manage these new products and services.

As banks look for new sources of income, it is imperative that they demonstrate the ability to manage the associated risks. Banks should not only be extremely diligent about following their underwriting standards, but also should be looking for new ways to shore them up.

A well-managed plan for expansion into new products, services or markets will include the following:

  1. Clearly communicate the growth strategy to regulators and the board.
  2. Develop risk plans that address risks particular to any new areas.
  3. Ensure sustained board and senior management oversight.
  4. Manage and monitor credit risk.
  5. Clearly document lending policies and procedures.
  6. Confirm that diversification/concentration management and controls align with established risk tolerances.
  7. Undertake stress testing and risk monitoring.
  8. Strengthen underwriting and documentation standards.
  9. Confirm that adequate loan review programs are separate from credit extending units/personnel.

Priority #3: Managing Interest Rate Risk
Interest rates remain low, compressing net interest margins and creating fierce competition among banks for higher yielding assets. Many banks are now turning to aggressive interest-rate strategies, such as extending asset or loan maturities or increasing holdings of riskier investments. However the OCC cautions that when interest rates increase, “banks that reached for yield could face significant earnings pressure, possibly to the point of capital erosion.”

While managing interest rate risk is highly complex, doing the following will help ensure a well-managed program:

  1. Be prepared to demonstrate to regulators your interest-rate-risk management plans and to support key assumptions used in modeling.
  2. Maintain documentation of how the bank considered the results of the models.
  3. Establish risk controls and limits.
  4. Monitor and report risk.
  5. Ensure adequacy of internal controls and audit.
  6. Consider whether to add certain expertise to your board or management team.
  7. Banks that are not already stress testing should begin to do so.
  8. For public banks, evaluate whether your interest rate risk disclosures appropriately tell your story.

This article is adapted from Grant Thornton’s 2014 Banking Report.

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


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.

The Consolidation Wave That Wasn’t


wave-crash.jpgThe past three years have seen bankers and industry pundits anxiously awaiting the so-called and highly anticipated wave of consolidation in the banking industry. There are many reasons why increased consolidation is expected, including sellers with less access to capital and, therefore, less opportunity to grow independent of a merger, a belief that banks must be larger to compete and absorb the cost of regulation, a lack of organic growth in existing markets, and compressed earnings.

Despite all of these reasons —some real and some perceived—the pace of consolidation has been modest, at least compared to the predictions of the past several years, begging the question: Where is all the M&A? According to the recently released Bank Director & Crowe Horwath LLP 2013 M&A survey, two of the primary barriers to buying other banks are concerns over credit quality and unrealistic pricing expectations of sellers, both of which we’ll examine in more detail.

Credit Quality Concerns

There is a direct correlation between the level of nonperforming loans and the number of deals that are realized. The following graph illustrates the pattern between nonperforming assets (NPAs)/loans and other real estate owned (OREO) and the number of deals announced in any given year. As the graph indicates, when the level of nonperforming assets is high, the number of announced deals is low.

crowe-exh-3.png

The period most similar to that of the past several years is the early 1990s, when the savings and loan crisis occurred and the government established the Resolution Trust Corporation to resolve a number of failed institutions. Today, the level of nonperforming assets is still too high for many acquirers to accept. While the level has improved from its high in 2010, it is still higher than historical norms. Until loan quality significantly improves, buyers will find it difficult to pay the prices sellers are requiring.

Unrealistic Pricing Concerns

Pricing concerns from sellers is another frequently mentioned reason for deals not occurring. While sellers are not expecting the high levels that occurred pre-crisis, they aren’t willing to sell for a low price. The following graph illustrates the distribution of price to tangible book value achieved by sellers for the period beginning in January 2011 and going through Dec. 7, 2012.

crowe-exh-4.png

While deal prices have improved and sellers in some regions have been able to achieve prices in excess of 200 percent price to tangible book value, the majority of the deals have closed at below 110 percent price to tangible book value, and almost 40 percent of the deals have been below 100 percent price to tangible book value. For many markets, a price to tangible book value of 140 to 150 percent would be the new “gold standard.” Until this pricing ratio average improves, though, it doesn’t seem likely that the number of deals will increase dramatically.

Looking Ahead

So where will the number of deals be in 2013? Any prediction is worth the ether it’s posted in, but all indications suggest that deal volume will continue to be steady but well below the significant levels of consolidation predicted. Through Dec. 2, 2012, the number of announced whole bank deals was at 209. During the pre-crisis years of the 2000s, the number of whole bank deals per year was approximately 225 to 250. So 2012 will finish with levels below the pre-crisis normative levels, but up from 2011. In the M&A survey, we asked respondents to provide us with their expectations as to where deal volume will be in 2013. The following chart shows that the majority of the respondents believe that deal volume will be less than 200 deals, with 80 percent estimating deal volume will be less than 225 deals in 2013.

Deal Volume Expectations for 2013

>225

20%

200-225

16%

175-200

35%

<175

29%

While the wave of consolidation might eventually occur, all indications, including banks’ own expectations, suggest consolidation levels likely will remain status quo for the time being.