4 Critical Success Factors for Bank M&A in 2023

After rebounding in 2021, bank merger and acquisition, or M&A, activity slowed again in 2022, a trend that is likely to continue.

In this economic environment, growth-oriented organizations need to make the most of the limited acquisition opportunities they find. To maximize the potential of sought-after deals in 2023, bank directors and executive teams should recognize the current critical factors that contribute to successful acquisitions.

Modest Growth Expectations
Bank M&A activity accelerated in 2021 from 2020’s pandemic-depressed levels, but the pace fell off again in 2022. By the end of the third quarter, only 123 deals had been announced, compared to 160 deals over the same period in 2021, according to S&P Global Market Intelligence.

The 2023 Bank Director M&A Survey suggests this situation will probably continue. Although 85% of survey respondents said their banks either plan to be active acquirers or were at least open to acquisitions, only 11% said they were very likely to acquire another bank in 2023, and 28% said they were somewhat likely.

Even fewer said they expect to acquire nondepository business lines, such as wealth management, fintechs or other technology companies. So although conventional acquisitions likely will remain the most common type of transaction during 2023, bank M&A activity overall could remain sluggish. 

4 Bank M&A Success Factors
With fewer opportunities available, the success of every deal becomes even more crucial. Bank boards and executive teams must take care to increase the likelihood that acquisitions produce expected results. Four critical success factors can greatly improve the chances, particularly in the bank-to-bank acquisitions that could make up most of 2023’s activity.

1. Detailed Analysis of the Loan Portfolio. Loan quality always matters, but with a potential industrywide increase in credit losses on the horizon, a buyer having a granular understanding of the seller’s loan portfolio is essential to determine if its allowance for losses is adequate.

Current economic expectations and likely rate changes during the interval between a deal’s announcement and completion mean it is important to analyze the portfolio as early as possible during due diligence. Advanced data analytics can help acquiring banks identify patterns — such as certain loan types, industries, geographic areas, and loan officers — that merit special attention.

Additionally, banks should prepare loan valuations as a part of due diligence. They should include expected rate increases in that analysis, as it is important to home in on the metrics that suggest the quality of the deal.

2. In-depth Understanding of the Deposit Customer Base. In addition to reviewing loan customers during credit due diligence, it’s important that prospective buyers also analyze the deposit customer base. Changing interest rates mean liquidity can become a concern if customers leave for higher returns or online competitors.

Pinpointing top customers, identifying the services they use, quantifying the revenue those relationships generate and developing customized communication plans to ease the transition are prudent initial steps. These plans should assign specific responsibility for communicating with customers; management should be ready to implement them immediately upon the transaction announcement, when such accounts become particularly vulnerable.

3. Proactive Talent Management. Although banks normally eliminate or consolidate positions in an acquisition, they still need to retain the best talent. Losing personnel with critical skills could jeopardize the investment thesis of the transaction; banks should identify these individuals before announcing the transaction. Consistent and open communication helps preempt rumors and minimizes employee uncertainty, while early retention bonuses and other tools can target essential team members who might be vulnerable to poaching while the transaction is pending.

Fair treatment for those who leave is also important. Outplacement services, severance packages, and other transition programs are worth their one-time costs for buyers, since they can help assuage negative community perceptions that could escalate quickly on social media.

4. Effective Technology Integration. Not every bank has adapted to digitization in the same way or at the same speed. Glitches in routine processes, such as online account access, direct deposits or electronic funds transfers, can alienate customers and employees, creating a bad first impression for the blended organization.

A gap analysis that identifies differences in virtual banking, remote workplace policies, fintech relationships and other technology issues is an important early step to successful M&A. This analysis should be followed quickly by a comprehensive technology integration plan that draws on the best ideas from each organization.

In view of the mixed bank M&A outlook for 2023, addressing these four broad issues can help bank directors and executives meet their fiduciary responsibility to recognize potential opportunities, while still managing the risk that is inherent in today’s banking environment.

Strengthening Stress Tests After Covid-19

Banks below $50 billion in assets aren’t required to conduct an annual stress test, following regulatory relief passed by Congress in May 2018. But most banks still conduct one or more annual tests, according to Bank Director’s 2021 Risk Survey.

A stress test determines whether a bank would have adequate capital or liquidity to survive an adverse event, based on historical or hypothetical scenarios. Financial institutions found value in the practice through the Covid-19 pandemic and related economic events, which created significant uncertainty around credit — particularly around commercial real estate loans and loans made to the hospitality sector, which includes hotels and restaurants.

“It gives you a peace of mind that we are prepared for some pretty big disasters,” says Craig Dwight, chair and CEO at $5.9 billion Horizon Bancorp, based in Michigan City, Indiana. Horizon disclosed its stress test results in third quarter 2020 to reassure its investors, as well as regulators, customers and its communities, about the safety and soundness of the bank. “We were well-capitalized, even under two-times the worst-case scenario,” he says. “[T]hat was an important message to deliver.”

Horizon Bancorp has been stress testing for years now. The two-times worst case scenario he mentions refers to loss history data from the Office of the Comptroller of the Currency; the bank examines the worst losses in that data, and then doubles those losses in a separate analysis. Horizon also looks at its own loan loss history.

The bank includes other data sets, as well. Dwight’s a big fan of the national and Midwest leading indicators provided by the Federal Reserve Bank of Chicago; each of those include roughly 18 indicators. “It takes into consideration unemployment, bankruptcy trends, the money supply and the velocity of money,” he says.

It’s a credit to the widespread adoption of stress testing in the years following the financial crisis of 2008-09. “All the infrastructure’s in place, so [bank management teams] can turn on their thinking fairly quickly, and [they] aren’t disconnected [from] what’s happening in the world,” says Steve Turner, managing director at Empyrean Solutions, a technology provider focused on financial risk management.

However, Covid-19 revealed the deficiencies of an exercise that relies on historical data and economic models that didn’t have the unexpected — like a global pandemic — in mind. In response, 60% of survey respondents whose bank conducts an annual stress test say they’ve expanded the quantity and/or depth of economic scenarios examined in this analysis.

“We have tested pandemics, but we really haven’t tested a shutdown of the economy,” says Dwight. “This pandemic was unforeseen by us.”

Getting Granular
The specific pain points felt by the pandemic — which injured some industries and left others thriving — had banks getting more granular about their loan portfolios. This should continue, says Craig Sanders, a partner at Moss Adams LLP. Moss Adams sponsored Bank Director’s 2021 Risk Survey.

Sanders and Turner offer several suggestions of how to strengthen stress testing in the wake of the pandemic. “[D]issect the portfolio … and understand where the risks are based on lending type or lending category,” says Sanders. “It’s going to require the banks to partner a little more closely with their clients and understand their business, and be an advisor to them and apply some data analytics to the client’s business model.” How will shifting behaviors affect the viability of the business? How does the business need to adjust in response?

He recommends an annual analysis of the entire portfolio, but then stratifying it based on the level of risk. High risk areas should be examined more frequently. “You’re focusing that time, energy and capital on the higher-risk areas of the bank,” says Sanders.

The survey finds two-thirds of respondents concerned about overconcentrations in their bank’s loan portfolio, and 43% of respondents worried specifically about commercial real estate loan concentrations. This represents a sharp — but expected — increase from the prior year, which found 78% expressing no concerns about portfolio concentrations.

We’re still not out of the woods yet. Many companies are now discussing what their workplace looks like in the new environment, which could have them reducing office spaces to accommodate remote workers. If a bank’s client has a loan on an office space, which they then rent to other businesses, will they be able to fill the building with new tenants?

If this leads to defaults in 2021-22, then banks need to understand the value of any loan collateral, says Sanders. “Is the collateral still worth what we think it was worth when we wrote the loan?”

It’s hard to predict the future, but Sanders says executives and boards need to evaluate and discuss other long-term effects of the pandemic on the loan portfolio. Today’s underlying issues may rise to the surface in the next couple of years.

Knowing What Will Break Your Bank
Stress testing doesn’t tend to focus on low-probability events — like the pandemic, which (we hope) will prove to be a once-in-a-lifetime occurrence. Turners says bank leaders need to bring a broader, more strategic focus to events that could “break” their bank. That could have been the pandemic, without the passage of government support like the CARES Act.

It’s a practice called reverse stress testing.

Reverse stress testing helps to explore so-called ‘break the bank’ situations, allowing a banking organization to set aside the issue of estimating the likelihood of severe events and to focus more on what kinds of events could threaten the viability of the banking organization,” according to guidance issued by the Federal Reserve, Federal Deposit Insurance Corp. and OCC in 2012. The practice “helps a banking organization evaluate the combined effect of several types of extreme events and circumstances that might threaten the survival of the banking organization, even if in isolation each of the effects might be manageable.”

Statistical models that rely on historical norms are less useful in an unforeseen event, says Turner. “[I]f someone told you in February of 2020 that you should be running a stress test where the entire economy shuts down, you’d say, ‘Nah!’” he says. “What are the events, what are the scenarios that could happen that will break me? And that way I don’t have to rely on my statistical models to explore that space.”

Testing for black swan events that are rare but can have devastating consequences adds another layer to a bank’s stress testing approach, says Turner. These discussions deal in hypotheticals, but they should be data driven. And they shouldn’t replace statistical modeling around the impact of more statistically normal events on the balance sheet. “It’s not, ‘what do we replace,’” says Turner, “but, ‘what do we add?’”

With stress testing, less isn’t more. “My advice is to run multiple scenarios, not just one stress test. For me, it’s gotta be the worst-case stress test,” says Dwight. And stress testing can’t simply check a box. “Can you sleep at night with that worst case scenario, or do you have a plan?”

Bank Director’s 2021 Risk Survey, sponsored by Moss Adams LLP, 188 independent directors, chief executive officers, chief risk officers and other senior executives of U.S. banks below $50 billion in assets. The survey was conducted in January 2021, and focuses on the key risks facing the industry today and how banks will emerge from the pandemic environment.

Bank Director has published several recent articles and videos about stress testing, including an Online Training Series unit on stress testing. You may also consider reading “Recalibrating Bank Stress Tests to a New Reality.”