By Christopher D. Wolfe
With all the discussion surrounding the Federal Reserve’s recent interest rate lift-off, consolidation in the banking sector is also set to accelerate. Listening to earnings calls and analyst presentations, you can feel the bank M&A in the air as management teams are increasingly stating their desire to pursue attractive opportunities. To underscore this point, a few large deals were announced towards the end of 2015: Key Corp’s announced acquisition of First Niagara, and New York Community Bank’s announced acquisition of Astoria Financial. These came on the heels of regulatory approval for M&T’s long-delayed acquisition of Hudson City, signaling that bank M&A may start to take off.
While there has been a long-term secular trend towards consolidation in the banking sector—with 4,810 fewer banks now than in 1994—looking ahead, consolidation will be driven anew by the confluence of higher fixed regulatory costs, the low-growth and resulting low-interest-rate environment and rapidly changing technological and financial innovation. Taken together, these forces have contributed to structurally lower profitability for the industry as a whole versus pre-crisis levels. Moreover, some banks will struggle to consistently earn their cost of capital.
The U.S. is unique among large developed countries in terms of the sheer number of banks. By way of contrast, Canada gets by with just six major banks. Although in terms of assets, the U.S. banking industry is modestly concentrated, with approximately 50 percent of assets held by the 10 largest commercial banks, it remains highly fragmented with more than 5,410 commercial banks and 860 savings institutions as of late 2015. The fragmented nature of the industry reflects historical policy choices, such as the lack of interstate branching up to 1994.
In the aftermath of the financial crisis, aside from failed bank deals, meaningful M&A transactions were few and far between, as banks nursed their balance sheets and stock prices back to health. Now that this is mostly accomplished, many are positioned to pursue long-sought strategic opportunities. The urge to merge is often meant to address key product or footprint gaps. The promise of greater efficiencies from scale has not always met reality, as bank efficiency ratios for even some of the largest banks remain stubbornly high (around 65 percent for the largest banks).
Higher fixed regulatory costs. No matter how you slice it, banks will contend with higher fixed regulatory costs. This mainly reflects the expenses associated with implementing Basel III and Dodd-Frank Act requirements such as stress testing, along with building out compliance functions, notably around Bank Secrecy Act and anti-money laundering, as well as overall consumer compliance. Despite well-intentioned legislative efforts to shield smaller banks from the more onerous new laws and regulations, smaller banks have been contending with “trickle down” regulation, as they too are subject to heightened expectations meant for larger banks.
Low interest rates for longer. The pervasive and exceptionally low interest rate environment has put significant pressure on bank net interest margins. Bank margins fell to 3.02 percent in the first quarter of 2015, the lowest average net interest margin since 1984 according to the FDIC. While banks have laid out and executed on cost cutting plans in response to the low interest rate environment, pressure on earnings will intensify absent a meaningful rate rise by the Fed. Now that the Fed has followed through on its first rate rise in nearly a decade, future rate increases will likely be measured. Higher NIMs and profitability from a rate increase may thus continue to be pushed out into the future. Moreover, banks will need a steepening yield curve in order to genuinely benefit from rate rises. What is sometimes overlooked is that interest rates have been on a fairly steady long-run decline since the early 1980s, pocketed by a only a few up cycles over that time period. Looking at the last Fed tightening cycle from 2004-2006, bank NIMs failed to expand.
Technological and financial innovation. Against these other challenges, banks are confronted with rapidly changing technology and financial innovation. This is coming in many forms, such as digital wallets from deep-pocketed technology companies to competition from alternative nonbank lenders. Alongside this, banks need to continually invest in their own customer experience through better internet and mobile platforms in order to attract and retain new customers. This is especially important in the face of changing demographics, as younger customers are more accustomed to transacting online. All this technological change is happening against the backdrop of growing cybersecurity risks, which will also require ongoing investment to stay ahead of potential threats.
While new and greater use of technology offers tremendous opportunities to improve badly needed efficiencies, it requires significant upfront investment at a time when earnings are already pressured. Banks are countering some of this innovation by partnering with nonbank fintech lenders and participating in technology consortiums to stay on top of developments. Nonetheless, the cost associated with all this technological and financial change may also incentivize more M&A among banks in order to spread the costs across a larger expense base.
Weighed against further consolidation is the tougher regulatory approval process that deals face. Regulators expect that any acquisitions are fully regulatory compliant the day the transaction closes, which may put off potential acquirers. Nonetheless, bankers reading regulatory tea leaves are concluding that M&A can indeed proceed, provided the acquirer has performed solid due diligence and can present a clear integration road map to regulators.
Consolidation will likely be focused among non-systemically important banks as they seek scale to address all these associated costs and challenges. Large regional banks, defined as those over $50 billion in assets, could also be active in M&A as these entities have already met the hurdles of rigorous stress testing and other capital and liquidity requirements and could now leverage these capabilities.
While M&A is likely to pick up, not all transactions will ultimately be unqualified successes. In fact, M&A has been the undoing of some banks which have overpaid or failed to realize expected synergies. Moreover, regulators have taken a jaundiced view of “serial acquirers.” Having said that, further consolidation could make the industry stronger, as more regional banking organizations provide solid competition for the largest banks while retaining the competitive strengths typically associated with smaller institutions.
Christopher D. Wolfe is a managing director in Fitch Ratings’ financial institutions group. His responsibilities include overseeing the ratings and analysis on U.S. banking institutions. He is also a member of Fitch’s corporate finance criteria committee.
