Understanding the Attributes of Core Deposits


deposits-9-27-17.pngAs loan growth materializes, it is important to renew the focus on liquidity management, have an overall liquidity plan and a contingency funding plan. In order to create and implement such plans, it is important to understand the attributes of deposits. Even if a bank is not experiencing stronger loan growth, it is necessary to understand the elasticity of core deposits in order to make accurate modeling assumptions.

Anyone who experienced a higher interest rate environment remembers depository institutions having to compete with money market funds and other non-bank investment instruments that paid comparatively high rates. As the economy emerges from the bottom of a 10-year interest rate trough, depositors are starving for interest income. Institutions are finding that customers are willing to buy longer term CDs in exchange for yield. We simply do not know how long deposits will remain on books in a higher rate environment or how much we will have to pay to keep them.

The primary core deposit assumptions used for interest rate simulation models are beta and decay. Deposit beta is an indication of how rates correlate to the market. For example, if you use a beta of 0.25 on your savings rate, for every projected market rate move of 100 basis points, the savings account rate will move 25 basis points.

Decay is the measure of deposit attrition, or how long deposit accounts will likely remain open. If you decay a savings account over a 60-month period, you make the assumption that the savings account will have a 60-month maximum life. The normal range for decay is 24 months for sensitive deposits and 84 months for more static accounts.

Historically these numbers have been typically supplied by market averages, vendors, the Office of Thrift Supervision (which was merged with the Office of the Comptroller of the Currency in 2011) and management estimates. Various forms of deposit studies are gaining popularity but remain the least common means of obtaining core deposit assumptions. Meanwhile other modeling assumptions utilize prepayment rates, discount rates and spreads and are much more precise. The higher degree of precision for these non-deposit modeling assumptions helps reduce simulation risk. The irony here is that even though non–deposit assumptions are much more precise, they have a lesser impact on simulation results. This means that the greatest amount of simulation risk comes from assumptions with the least amount of basis!

In order to demonstrate the impact of these core deposit assumptions, we can take a typical Bank asset/liability management simulation and compare the results of the Economic Value of Equity (EVE shock/stress both with and without these beta and decay assumptions.) This serves as a stress test of the deposit assumptions. To stress the assumptions, we will simply set all betas to one and all maturities to one month. Then we can compare the results. To keep it simple, we will look at it graphically:

EVE-chart.png

Note how the EVE variance is between +7 percent and -14 percent when the betas and decays are utilized in the simulation. Once they are removed, this variance is between +10 percent and -30 percent, showing that it almost doubles in a rising rate scenario. In this case, removing the assumptions or making material changes to them can cause a financial institution to approach or exceed prudent risk limits. Additionally, this will also impact the net interest income shock as well, but a complete simulation will need to be performed to assess the impact.

The graph shows that core deposit assumptions are an important variable in the modelling results, especially if used as a management tool. As mentioned, this can be also used as a regulatory stress test. Stress tests are good but they do not serve the purpose of creating valid assumptions for management purposes. This can be accomplished by a core deposit study. A detailed core deposit study is a fairly involved and costly project but it will produce the most accurate assumptions. An abbreviated core deposit study can be used to understand the correlation of deposit line items to market rates and back into decay rates. There are a number of companies offering such services for institutions without in house expertise. It is worth exploring such options as the regulators are most likely to focus on core deposits as interest rates rise.

The Window of Opportunity to Sell Is Now


acquisition-5-22-17.pngDespite the recent pullback in bank stocks, valuations are still trading near a 10-year high (up 18.3 percent post-election). The drastic run up in both bank prices and trading multiples has had a direct impact on mergers and acquisitions (M&A) activity. The average price to tangible book value (P/TBV) for transactions is up 27 percent to 1.68 P/TBV since the presidential election. As multiples have expanded, buyers have a currency to pay higher values for targets in transactions. With bank valuations at a high level, both for publicly traded companies and their targets in an acquisition, management teams must evaluate two questions: Will the current optimism among bankers become reality? And, are we currently in a window of opportunity to sell?

To determine answers to these two questions we must first look into what is stoking investor optimism for bank stocks. There are three main drivers: rising interest rates and increased yields on loans, potential regulatory reform reducing associated noninterest expenses, and comprehensive tax reform reducing the overall tax burden on banks.

It would be overly optimistic to assume that all three of these factors would occur. Indeed, there are three main headwinds that should impede banks from increasing earnings to the most optimistic values: historical lessons, the current macroeconomic environment and government execution. These headwinds will not only have an impact on the trading of public bank stocks, but will have a direct impact on M&A pricing.

  1. Historical lessons from a rising rate environment: From 2004 to 2006, rates increased from 100 basis points to 525 basis points. The thought has been that a rising rate environment will allow banks to increase earnings through higher yields on loans. However, from 2004 to 2006, we saw the exact opposite. As rates increased, deposits migrated to higher yielding products, offsetting the benefit from the increased yield on loans, ultimately leading to a decrease in net interest margin. As banks felt the pinch, they began to expand their balance sheets by increasing loan to deposit ratios. The years to come proved challenging as nonperforming assets increased drastically.
    Interest-rate-chart.png
  2. Macroeconomic environment: Bull markets have historically lasted approximately seven years. We are more than eight years into the current bull-market run. How much longer can this bull-run last?
  3. Government execution: As the current trading multiples include regulatory and tax reforms that must be implemented by the government, we must ask ourselves if we can truly count on the government to deliver. Given the challenges the Republicans face passing healthcare reform, it is hard to believe that the Trump administration will be able to push through both comprehensive tax and regulatory reform without significant push back and concessions.

The headwinds facing the current optimism will have a direct impact on M&A pricing. If you are a potential seller and believe that the stars will align and all factors surrounding the current optimism will come to fruition, then enjoy the ride. If you are questioning any of these factors, it is likely that you have realized we are in a window of opportunity to sell.

Buying Bank Technology: If Not Now, When?


technology.png

FoMO, or the Fear of Missing Out, isn’t just a pop culture buzzword created to describe our obsession with social media. It’s an actual, scientifically proven phenomenon described in scientific literature as “the uneasy and sometimes all-consuming feeling that you’re missing out—that your peers are doing, in the know about, or in possession of more or something better than you.”

That feeling probably sounds very familiar to bankers these days. In the press, in blogs, on podcasts, and at every industry conference, bankers are hearing that the time is now to make big technology changes in their organizations. Everyone seems to be busy innovating, and many bankers are left wondering if they’re the ones being left behind.

In this case, the answer may be “Yes.”

We are facing a set of once-in-a-generation circumstances that will determine the winners and losers in banking for the coming decades. And this separation of the “haves” from the “didn’t act fast enough to be among the haves” is already in motion.

Here are the four big trends that have converged to create the opportunity—or threat—of a lifetime for banks.

1) Tech Spending Neglected
A great deal has been written about how antiquated much of the banking infrastructure has become. Some concerns about legacy systems are overblown, but there is undoubtedly a marked difference between the digital experience customers have with their banks and what they encounter in most other parts of their lives. Banks still handle debits and credits as well as ever, but when compared to the Amazon, Netflix or Gmail experience, the gap is widening. Banks cut all spending following the financial crisis, and have been slow to replace those vacated technology budgets in the face of new regulations and shrinking margins. The result is wide swaths of banking technology that haven’t been upgraded in 10-plus years.

2) Expected “windfalls” from regulatory and tax reform
In our interactions with banks, there has been a sudden change in mood. Bankers have shifted quickly from the glass being half empty to half full, in large part because of the outcome of the November elections. Banks now see the potential for big windfalls, in the form of tax relief and regulatory reform, with a recent Goldman Sachs piece suggesting that industry earnings in 2018 could increase by 28 percent over current estimates if the chips fall just right.

3) Interest rates (and margins) are rising
In addition to those windfalls, banks are also getting a long-awaited earnings boost from rising interest rates. The Federal Reserve has increased overnight rates by 0.75 percent, and long-term rates have followed suit, with 10-year Treasury yields up more than 1 percent from their 2016 lows. Deposits rates have been slow to follow along, resulting in margins that are finally improving after years of painful compression.

4) Game changing technology is plentiful and accessible
Finally, in the decade since most banks have been actively in the market, the number and quality of technology solutions has exploded. Computing power, high quality data sets and cheap storage are contributing to a renaissance in enterprise software, and banks now have multiple possible solutions for just about any conceivable business need. You are no longer beholden to your core provider to sell you everything, as the new generation of tools are better at integrating, easier to deploy and easier to use. On top of all that, most of them are also incredibly cheap for the value they are providing, making them accessible to banks of all sizes and shapes.

When you combine these four factors, you see why there is so much hoopla around innovation and fintech. Many bankers are viewing the next few years as their one big chance to completely revamp the critical pillars of their business. Due to the long gap in meaningful technology investment, they are starting with a blank slate, and because of the recent improvement in profitability trends, they have sufficient budgets to make substantial changes. They are approaching the market and finding plentiful options and are excited by the opportunity.

Some will choose wisely and win big. Others will choose poorly and will not fare as well. But FoMO is real: If you simply stand on the sidelines and do nothing, that is also a choice. Your competitors will leave you behind, and soon your customers might just do the same.

If you’re not willing to make some changes in this environment, when will you be?

Surging Stock Prices and Your Long-Term Incentive Strategy


incentive-3-6-17.pngWith the Trump administration, investors are anticipating an easing in banking regulations and modest increases in interest rates. Accordingly, the market response to Trump’s election sent bank stock prices surging. From election to year-end, the Keefe, Bruyette & Woods NASDAQ Banking Index, which is made up of money center banks, as well as regional banks and thrifts, was up 22 percent, alongside a very strong 7 percent increase in the S&P 500. Full year returns were even better, and they were better for many smaller banks as well. For example, banks with total assets between $1 billion and $10 billion saw returns of 20 percent to 65 percent.

In our experience, large swings in stock prices trigger important design considerations for long-term incentive grant strategies and grant policies.

Long-term Incentive Strategies—Target Value Versus Fixed Share
Long-term incentive strategies among banks typically incorporate the use of full-value awards, such as restricted stock or performance shares, or stock options.

There are two common approaches used to determine the number of shares granted under equity awards—a target value approach and a fixed share approach.

  • Target value approach: The bank targets a specific award “fair value.” Thus, as stock prices surge, the number of shares granted is reduced to deliver the same grant value. Conversely, when stock prices decline, more shares are granted. This is the most common method for determining the number of shares awarded.
  • Fixed share approach: The bank targets a specified number of shares. Thus, as stock prices surge, the fair value of the award also increases. The volatility in grant value is one of the reasons this approach is less common.

No matter the approach used, sudden surges in stock prices will result in significant changes in either the number of shares granted or the fair value of the award, assuming no adjustments are made to the grant strategies. For example, the increase in stock prices over the past year for banks with assets between $1 billion and $10 billion will likely result in a 16 to 40 percent decline in shares delivered through a target value approach or a 20 to 65 percent increase in fair values at banks utilizing a fixed share approach.

The advantages in delivering equity through a target value approach include providing tighter controls over the accounting expense of long-term incentive programs, a clearer understanding of the award value to the participant, greater consistency in disclosed compensation values for proxy-reported officers, and maintaining alignment with competitive market compensation levels. However, when stock prices surge, no matter the cause, the resulting reduction in shares under a target value approach may be perceived as a so-called performance penalty by participants. Your participants in the plan might wonder, “The stock price went up and you cut my shares?”

Alternatively, under the fixed share approach the increase in the fair value of the award may result in higher compensation expense, greater variability of disclosed compensation, and compensation levels that are positioned higher relative to the market than the bank’s stated compensation philosophy.

Considerations
In light of the potential variability in grant values or the number of shares issued, banks should thoroughly review the impact of recent stock price changes on their long-term incentive grant strategies to avoid unintended consequences.

Target value programs can be adjusted through an increase in the value delivered or revisions to the approach used to determine shares, or a combination of these two approaches. Generally, an increase in the value delivered would not correspond directly with the increase in stock price, for example award values would increase 20 to 30 percent of the gain in stock price. In adjusting the approach used to determine the number of shares issued, banks can use an average stock price (for example, 90 to 150 days) rather than the price on the date of grant.

Conversely, fixed share programs would be adjusted to reduce the grant value through a reduction in the number of shares issued. For example, shares granted would be reduced by 10 percent to 15 percent of the gain in share price.

In all cases, the impact of adjustments to long-term incentive strategies on total compensation should be evaluated against market compensation and share utilization levels as well as the bank’s stated compensation philosophy. Further, the rationale for adjusting long-term incentive strategies should be communicated clearly to program participants.

Why Every Basis Point Matters Now


derivatives-2-17-17.pngAfter eight years of waiting for interest rates to make a meaningful move higher, the fed funds rate is making a slow creep towards 2 percent. With a more volatile yield curve expected in the upcoming years and continued competition for loans, net interest margins (NIM) may continue to compress for many financial institutions. The key to achieve NIM expansion will involve strong loan pricing discipline and the full toolkit of financial products to harvest every available basis point.

Where to look on the balance sheet? Here are some suggestions.

Loan Portfolio
The loan portfolio is a great place to look for opportunities to improve the profitability. Being able to win loans and thus grow earning assets is critical to long-term success. A common problem, however, is the mismatch between market demand for long-term, fixed rate loans and the institution’s reluctance to offer the same.

Oftentimes, a financial institution’s interest rate risk position is not aligned to make long-term, fixed rate loans. A few alternatives are available to provide a win-win for the bank and the borrower:

  • Match funding long-term loans with wholesale funding sources
  • Offer long-term loans and hedge them with interest rate swaps
  • Offer a floating rate loan and an interest rate swap to the borrower and offset the interest rate swap with a swap dealer to recognize fee income upfront

With the ability to offer long-term fixed rate loans, the financial institution will open the door to greater loan volumes, improved NIM, and profitability.

How much does a financial institution leave on the table when prepayment penalties are waived? A common comment from lenders is that borrowers are rejecting prepayment language in the loan.

How much is this foregone prepayment language worth? As you can see from the table below, for a 5-year loan using a 20-year amortization, the value of not including prepayment language is 90 basis points per year.

Swap-chart.PNG

At a minimum, financial institutions should look to write into the loan at least a 1- to 2-year lock out on prepayment, which drops the value of that option from 90 basis points to 54 basis points for a 1-year lock out or 34 basis points for a 2-year lock out. That may be more workable while staying competitive.

Investment Portfolio
The investment portfolio typically makes up 20 percent to 25 percent of earning assets for many institutions. Given its importance to the financial institution’s earnings, bond trade execution efficiency may be a way to pick up a basis point or two in NIM.

A financial institution investing in new issue bonds should look at the prospectus and determine the underwriting fees and sales concessions for the issuance. There are many examples in which the underwriting fees and sales concessions are 50 to 100 basis points higher between two bonds from the same issuer with the same characteristics, with both issued at par. To put that in yield terms, on a 5-year bond, the yield difference can be anywhere between 10 and 20 basis points per year.

If you are purchasing agency debentures in the secondary market, you can access all the information you need from the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (TRACE) to determine the mark up of the bonds you purchased. Using Bloomberg’s trade history function (TDH), in many cases, it is easy to determine where you bought the bond and how much the broker marked up the bond. Similar to the new issue example above, a mark-up of 25 to 50 basis points more than you could have transacted would equate to 5 to 10 basis points in yield on a 5-year bond.

For a typical investment portfolio, executing the more efficient transactions would increase NIM by 1.5 to 5 basis points. For many institutions, simply executing bond transactions more efficiently equates to a 1 percent to 3 percent improvement in return on assets and return on equity.

Wholesale Funding
A financial institution can use short-term Federal Home Loan Bank (FHLB) advances combined with an interest rate swap to lock in the funding for the desired term. By entering into a swap coupled with borrowing short-term from the FHLB, an institution can save a significant amount of interest expense. Here is an example below:

borrowing-chart.PNG

Derivatives
As you can see from a few of the previous examples, derivatives can be useful tools. Getting established to use derivatives takes some time, but once in place, management will have a tool that can quickly be used to take advantage of inefficient market pricing or to change the interest rate risk profile of the institution.

Number of Community Banks Using Derivatives, by Year

derivatives-chart.png

Conclusion
In a low interest-rate environment and with increased volatility in rates across the yield curve, net interest margins are projected to continue to be under pressure. The above suggestions could be crucial to ensuring long-term success. Offering longer-term loans and instilling more efficient loan pricing is the start to improved financial performance.

Rising Stock Prices Could Impact Deal Market


stock-prices-1-19-17.pngThe year 2016 was filled with tumult and that had a negative impact on activity in the bank mergers and acquisitions (M&A) market, while higher bank stock prices are adding to the uncertainty. Will higher stock prices last? Will they lead to higher valuations in the months ahead? This article takes a look at M&A activity in 2016 with an eye toward how the environment could impact pricing and trends in 2017.

After posting 285 healthy bank acquisitions in 2014 and 279 deals in 2015, the market slipped back to 241 last year, according to data provided by S&P Global Market Intelligence. There are several reasons for this, but they can all be summed up in a single word—uncertainty. And bankers hate uncertainty like dirt hates a bar of soap.

In the first quarter of 2016, the sharp decline in the price of oil and economic softness in China and in Europe led to concerns about how that might impact the U.S. economy. There was even some talk that economic weakness abroad could result in a recession here in the United States by the end of 2016. “When oil fell off, combined with the China thing, it really took the bloom off of the rose,” says Dory Wiley, president and chief executive officer at Commerce Street Holdings, a Dallas-based investment bank. The Southwest, where Wiley works, saw a drop off in deal-making following the fall-off in oil prices. “It kind of froze all the buyers and a lot of deals, and of course sellers are always very reluctant to change their price expectations, so it slowed the amount of deals.”

The U.S. economy did not in fact slip into a recession in the second half of 2016, growing 2.9 percent in the third quarter, according to the U.S. Commerce Department. (Data for the fourth quarter was not available when this article was written.) But there was still plenty of uncertainty entering the second half of the year, which perhaps had an even more paralyzing effect on the M&A market. Once the presidential election campaign between Democrat Hillary Clinton and Republican Donald Trump had gone into full swing (both parties held their nominating conventions in July), it seems that some bank boards decided to hold off on a possible acquisition or sale in hopes that a Trump victory would create a better economic environment for banks, and have a positive impact on bank stocks.

Stocks, indeed, rose. The KBW Nasdaq Bank Index, a compilation of large U.S. national money center and regional bank stocks, expanded from 63.24 on January 19, 2016, to 75.42 on November 7, for an increase of 16 percent. However, immediately following the presidential election the index shot up from 75.42 on November 7 to 92.31 as of January 12 of this year, an increase of 22 percent. While Donald Trump’s election victory might have been received as good news by many bankers, it seems to have brought about a slowdown in M&A activity precisely because bank stock prices were going up. With valuations on the rise, some boards were reluctant to sell out if their franchise could fetch a higher price later on by waiting.

Johnathan Hightower, a partner at the law firm Bryan Cave LLP, supports this theory with data that shows a noticeable slowdown in deal flow in the fourth quarter of 2016. There were 88 announced deals in the fourth quarter of 2014 and 82 in the fourth quarter of 2015. In the final quarter of last year, the number of announced deals dropped off to 62. “I think a good bit of that can be attributed to uncertainty on the political scene,” says Hightower.

As we head into 2017, the biggest question might be how high bank stock prices will go, because continued increases may discourage M&A activity as buyers and sellers alike try to work out how deals should be valued, and what kind of structure should be used. “I think whenever you see a sharp change in valuation like we’ve seen over the past eight weeks or so, it does cause some complication in working out exchange math and exchange mechanics,” says Hightower. For example, does the seller want to lock in a fixed exchange ratio or opt for a structure that would allow the deal price to float higher if its stock price continues to rise? “The seller is doing that same sort of math on its end, so it can be hard to reach agreement, or at least require some creativity in structuring a deal,” he says.

How much higher can bank stock prices go? Jim McAlpin, who heads up the financial services practice at Bryan Cave, says he recently led a strategic planning session for the board of a Texas bank. “I was talking to the CEO about where the board was on a possible sale,” McAlpin recalls. “He said that given the recent changes [in the bank’s stock price], they’re now thinking that three times book value is possible. A year ago I would have laughed hard at that. I only chuckled this time because he said there was a bank across the street that went for 2.3 times book value. We just recently saw a bank in Georgia go for almost 2.7 [times book value] in part because of rising valuations.”

For an industry that has been dogged by low interest rates, margin pressures and economic sluggishness for several years now, the future suddenly seems very bright. But will it last? “The interesting question that no one can answer right now is, will we see a real shift in economic growth that would support an overall lift in those valuations?” asks Hightower. “Can we expect banks to have healthy, sustainable growth because we’ve got healthy, sustainable growth in the overall economy?”

Prices remained fairly steady from 2014 through 2016. According to S&P, average deal pricing was 1.42 times tangible book value in 2014, then went up slightly to 1.43 in 2015 before dipping back down to 1.35 in 2016, despite the steady run up in stock prices through the year. But we’ve now entered a period where, as the mutual fund industry likes to say, past performance may not be indicative of future results. “When you look at what the market has done in the last three to four months, with the election behind us … I don’t know that past pricing is going to be as relevant as it was,” says Wiley.

Other factors that impacted the M&A market last year include a kind of speed control that bank regulators exercise over the pace of deals. While the regulators are generally more receptive to acquisitions than they were in the years immediately after the financial crisis, and are approving deals much faster now, they still limit the frequency of deals for even experienced acquirers. “You’d be lucky to get somewhere between one and three [deals a year now],” according to Wiley. And that has added a layer of complexity to the M&A process, particularly for investment bankers. “So a guy calls you up and says, ‘Hey, run some comps, figure out what I’m worth.’ That’s not enough,” he says. “The investment banker running the deal has to know who’s in the market, who isn’t in the market and when they’re going to be in the market because it’s not an easy answer anymore.”

And because they are limited as to the pace they can string deals together, many acquirers have become more selective in what they are willing to buy. “Even with stock prices rallying like they have the last three or four months … it doesn’t mean that the acquirer can run around and just give his stock away because he’s got to be picky,” says Wiley. “He’s like, ‘Hey, I only get a couple shots at this because the regulators aren’t going to let me do anything.’’’

Does that mean it is now a buyer’s market? “I thought it was a buyer’s market for the last eight years,” says Wiley. “The only thing now is that the buyers are starting to realize it. They’ve got a big stock price now and they’re feeling good about themselves. Somebody told them they were pretty.”

New Factors Impacting Bank M&A


As the industry heads into 2017, new factors including commercial real estate concentrations and a potential rise in interest rates could affect the pace of mergers and acquisitions. In this video, Jim McAlpin and Jonathan Hightower, both partners at Bryan Cave LLP, detail the drivers of M&A.

  • What is driving M&A in today’s environment?
  • What could shift M&A expectations in 2017?
  • What was the best deal announced in 2016?
  • What makes a successful deal?

Bank M&A Update: Oil Prices and Low Interest Rates May Be Hurting Deals


The state of the bank merger and acquisition (M&A) market thus far in 2016 has been tepid compared to prior years. 2015 began the same way, but was helped by a tremendous fourth quarter in which the number of deals announced was more than 25 percent higher than the average of the first three quarters of the year. At the end of 2015, many bankers and industry experts hoped that the euphoria from the fourth quarter would carry over into 2016. Instead, the first quarter of 2016 saw M&A deals retreat to the moderate levels experienced in the first three quarters of 2015, with a modest increase in the second quarter giving way to a much lower third quarter. Year-to-date, announced deals are down a modest 5.6 percent compared to the same time period last year.

M&A Activity by Region

Quarter Mid Atlantic Midwest Northeast Southeast Southwest West Other* Total Deals
2015-Q1 7 26 2 12 10 8   65
2015-Q2 5 27 5 14 11 7   69
2015-Q3 9 24 3 9 12 6 1 64
2015-Q4 13 30 3 24 6 7   83
2016-Q1 4 38 1 10 5 5 1 63
2016-Q2 6 29 2 14 7 8   66
2016-Q3 4 25 1 14 6 7   57

*No geography listed
Source: SNL Financial, an offering of S&P Global Market Intelligence

The Midwest has been bolstering the modest numbers experienced year-to-date. This impact on the overall percent change in M&A activity for 2015 and the first three quarters of 2016 is apparent when compared to the other regions.

Indicators Affecting Bank M&A
Oil prices have had an impact on the number of deals in the Southwest. Credit quality does have an impact on deal volume, but between Jan. 1, 2015, and June 30, 2016, credit quality has been fairly good compared to the levels experienced in years 2008 to 2010.

The decline in longer-term interest rates could have an impact on buyers’ perceptions of banks’ future earnings prospects with already compressed net interest margins. The 10-year U.S. Treasury constant maturity rate has flattened in 2016, and this could be a contributing factor in the number of announced bank M&A deals.

As shown below, average deal pricing has declined, which also could be contributing to the decline in the number of M&A deals announced.

Pricing Over Time

Pricing ratios.PNG

Although not shown, a review of the trailing 12-month return on assets for the selling banks and also the level of tangible equity and tangible assets shows they are fairly consistent quarter to quarter, so these financial metrics are not responsible for the decline in either pricing ration.

An overrepresentation of the banks in the Midwest also has had an impact on why the median pricing ratios have declined. The sellers in this region tended to be smaller, and the size of the seller does affect the price realized:

Median Price/Tangible Book Value Jan. 1, 2015, through Sept. 30, 2016

Asset Size of Seller Mid Atlantic Midwest Northeast Southeast Southwest West Total
<$50 Million N/A 121.9% NA 96.9% 115.3% 50.1% 115.3%
$50M – $100M 129.1% 108.4% 146.7% 96.3% 132.7% 128.1% 114.4%
$100M – $500M 122.6% 126.2% 142.6% 136.2% 150.1% 133.5% 133.3%
$500M – $1B 161.5% 136.0% 125.7% 161.4% 165.8% 178.7% 157.7%
$1B – $5B 152.8% 179.3% 164.2% 194.9% 156.9% 222.1% 179.3%
$5B – $15B 219.4% 155.7% N/A 233.0% N/A N/A 219.4%
>$15B 159.8% 199.3% N/A 151.5% N/A 272.1% 171.4%

More than 80 percent of the transactions announced involve sellers with less than $500 million in assets, which explains the lower realized pricing ratios. The Midwest contains a significant number of bank charters with less than $500 million in assets and, as a result, if this region’s total deal volume is up and the rest of the regions are down or flat, the impact on the overall pricing still will trend down.

Looking Ahead
The big questions remaining are what will happen in the fourth quarter of 2016 and whether the industry’s experience this year will be a predictor for 2017.

None of the economic factors are expected to materially improve for the fourth quarter. The Federal Reserve is expected to increase interest rates modestly, but there are Fed governors who favor no interest rate increase this year. As a result, it appears unlikely that the compression of net interest margin will improve drastically over the next 15 months. What does seem likely to occur is consistent quarter-to-quarter deal totals, although a reduction in the number of deals in the Midwest region could lead to even lower M&A totals for 2017.

Busting the Logjam in Small Business Lending


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With reports touting the health of the economy and the officials at the Federal Reserve talking about raising interest rates again, the lending environment must be good for small business owners, right? Wrong.

According to Babson’s 2016 State of Small Business in America report, obtaining capital is a challenge that frustrated SMB owners continue to face. Even those receiving a loan from a traditional lender obtain less than half the amount they applied for. What’s standing in the way of entrepreneurs borrowing from a traditional bank?

Lingering fear from the Great Recession: From 2008 to 2013, small businesses benefited from loosened lending restrictions. But in the past couple of years, fears about SMB lending has shifted thinking and brought about a tightening of standards–leading banks to provide available loan opportunities only to bigger businesses, which they view as less risky.

Fallout from Dodd-Frank: Post-2008 recession, new regulations created paperwork headaches for large lenders and small community banks alike. But the annoyances aren’t just isolated to a potential borrower being required to fill out a couple of additional forms. Compliance increased the cost of originating loans, so much so that it’s no longer fiscally responsible for lenders to issue lots of small loans.

In fact, Oliver Wyman research (PDF) indicates underwriting these loans costs a marginal $1,600 to $3,200 per loan. Compare these costs to the annual revenue smaller loans generate—$700 to $3,500 on average—and they’re clearly unprofitable.

Fewer lending options: It has also become very expensive to raise capital to open new community banks due to heightened regulatory requirements since the financial crisis. These local financial institutions are a great lending option for small business owners when big banks tighten their lending requirements. But with fewer local banks, SMB owners are left with fewer borrowing options than ever.

The stimulus encouraged banks to stockpile reserves: Prior to 2008, the U.S. economic structure encouraged financial institutions with large amounts of cash to lend it to other banks in need of liquidity. The federal stimulus pact reduced this cash flow, and large banks began sitting on their significant reserves–reducing the amount of available capital to smaller lenders, which in turn would be passed on to small business owners in their form of much needed credit.

Despite these obstacles, traditional lenders can and should break the SMB lending logjam. According to Barlow Research’s 2016 Small Business Annual Report, SMB loan demand is trending down slightly in a year-over-year comparison—off 9 percent between 2010 and 2016. However, this downward trend applies only to the traditional-lender space. New digital marketplace lenders are helping SMB borrowers to get around this credit logjam–and capturing more and more SMB lending business that used to go to banks.

According to one report by Morgan Stanley, loan origination at alternative lenders has doubled every year since 2010, reaching $12 billion in 2014. While banks are still the dominate credit source for small businesses, last year SMBs sought 22 percent of their financing from alternative lenders. That’s hardly a trend that benefits small businesses. Marketplace lenders do offer SMB borrowers fast, convenient loans–but that speed and convenience comes at a steep price, with expensive and often opaque lending terms that have attracted increasing scrutiny from regulators.

How can traditional lenders reverse this trend and break the SMB lending logjam? Simply put, banks need to harness the power of financial technology, machine learning and big data to bring small business lending online. By streamlining the origination process, banks can reduce operational costs dramatically for these loans while offering the speed and convenience SMB borrowers demand–and get–from alternative lenders. Reducing loan origination costs improves their profitability and introduces a virtuous circle of increased lending that expands lending options for borrowers at more competitive pricing.

The innovations don’t stop there. New machine learning algorithms can supplement the traditional, narrowly defined credit score criteria with enhanced, real-time data like shipping trends, social media reviews and other information relevant to a small business’ financial health. Thus armed, banks can identify an expanded field of highly qualified borrowers without increasing risk. They can pilot risk-based pricing models based on a borrower’s creditworthiness, ending the all-or-nothing style of flat pricing for approved loans. The possibilities are exciting and enormous. But traditional lenders will need the right financial technology to break this lending logjam and unleash the SBM market’s full potential.

A version of this article originally appeared on the Mirador blog.

Election Results Could Mean Less Regulation for Banks


Regulation-11-10-16.pngIt’s an understatement to say Republican presidential nominee Donald Trump’s surprise victory shook up the world Tuesday. Trump got elected promising change in Washington and made statements that portrayed a confusing mix of anti-bank and anti-regulation rhetoric. But with the House and Senate now controlled by Republicans, many industry observers are optimistic that the election will mean the appointment of more bank-friendly regulators, while the Consumer Financial Protection Bureau (CFPB) could also be weakened.

Although many economists feel Trump’s policies would be bad for the national economy, bankers by and large felt Trump would actually be good for the economy, according to a Bank Director poll in September.

“We think the main result of Donald Trump’s election will be that Trump will be able to appoint regulators who are more industry friendly than regulators appointed by President Obama,’’ wrote Brian Gardner, an analyst with investment banking company Keefe, Bruyette & Woods, in a note to investors Wednesday. “The regulatory implications are more important than what might come out of Congress but are broadly positive for financials in our view.”

CFPB
As far as banking regulations, the biggest thing in jeopardy may be the CFPB. President Trump will be able to appoint someone to head the agency, and a Republican-led Congress may make a move to gut or end it. That’s not to say such a move would be easy to do, but if Congressional elections in 2018 remove even more Democrats from office, it’s a possibility. The existence and approach of the CFPB has been a thorn in the side of many.

The Dodd-Frank Act
It’s unlikely the Dodd-Frank Act will be gutted entirely even with a Republican-controlled Congress. Democrats still will have at least 47 seats in the Senate and be able to block legislation that they don’t support, as 60 votes are needed to pass legislation in the Senate, Gardner wrote.

Even some industry lobbyists will be advocating against that, as it would create even more uncertainty. “Our industry has spent billions implementing Dodd Frank and complying with the CFPB,’’ said Richard Hunt, the president and CEO of the Consumer Bankers Association, in an interview Wednesday. “The last thing the banking industry needs is a whipsaw effect of uncertainty.”

Instead, some lobbyists are advocating for measures that would ease regulation on community banks, especially. The Independent Community Bankers of America “believes the unified Republican control of the executive and legislative branches presents a unique opportunity for enacting significant community bank regulatory relief and fully intends to leverage this opportunity for the benefit of community banks, their customers, and the communities they serve,” the group wrote in a memo to members and published on its website.

Wall Street Reform
The Republican Party platform this year, which former Trump campaign manager Paul Manafort said was in fact Trump’s platform, supported the return of the Glass-Steagall Act, which forbid banks from having both commercial and investment banking businesses. It was a surprising move, as the other person supporting the return of Glass-Steagall was Massachusetts Democratic Senator Elizabeth Warren. But few expect Trump to actually push hard for this, let alone be successful.

Aite Group senior analyst Javier Paz, who covers assets managers, wrote in a note that there was talk of President Trump leaning hard on Wall Street, but “we believe this was a tactical shift to keep Hillary Clinton from outflanking him on the topic of Wall Street reform. Time will tell, but we highly doubt new pieces of legislation building on what Dodd-Frank started will be forthcoming under President Trump.”

Hunt says he counted about 35 seconds of anti-bank rhetoric during four presidential and vice presidential debates. “There is campaigning and then there’s governing,’’ he says. “This is where Speaker Ryan, McConnell and the president will get together and come up with a shared vision for what they want the first 100 days and first year to look like to show the American people that Washington can work.”

Federal Reserve
There is a lot of uncertainty about what impact a Trump presidency will have on the Federal Reserve. Trump has been critical of Fed Chairwoman Janet Yellen and the central bank’s policies. He has said the Fed has been artificially keeping rates too low but his views on the Fed have not been consistent. He will be able to appoint two members to the Federal Reserve after he takes office, and Yellen’s term ends in January 2018, according to Gardner. Although the Fed was widely expected to raise rates in December, some predict that won’t happen now, as uncertainty about the markets could lead the Fed to delay a rate hike.