Monday, April 1, 2013

Community Banks: Urge to Merge?

In speaking at the March 2013 ICBA National Convention, FDIC Chairman Martin Gruenberg said that the vast majority of community banks "came through the 2008 financial crisis in pretty good shape." As of 12/31/2012 there were 4216 commercial and savings banks with assets between $100 million and $1 billion. That’s down only about five percent (or 208 banks) since 12/31/2007.

Of the 470 bank failures that did occur between 2008 and 2012, the vast majority (87%) were community banks. The FDIC cited three common characteristics of failed institutions:

1) rapid growth
2) concentration of risky assets, namely CRE and construction
3) reliance on volatile brokered deposits for funding


Mr. Gruenberg noted that banks who focused on relationship lending, relied on stable core deposits, and managed the bank conservatively proved to be both resilient and successful.

With capital requirements tightening under Basel III, and low interest rates expected to continue at least until 2015, can this business model continue to be successful? Some analysts think not.  

New York-based Invictus Consulting Group stress-tested 7200 FDIC-insured banks and release the results in December 2012. Invictus' analysis  showed that almost 27% of banks have a toxic combination of low capital levels and poor returns. With limited opportunities for organic growth, the study finds that community banks will be forced into major consolidation. "More than half US banks should or must undertake M&A activity in order to preserve their shareholder value" the study argues.

However, predicting mass consolidation in the community banking industry is not new. Analysts warned of consolidation among community banks back in 2010. But according to data compiled by CB Resource and the FDIC, since then deals have averaged 168 per year. That's about half the activity we saw 2006-2008, and far fewer than the 500+ average that occurred throughout the 1990s.

While low interest rates and lackluster loan demand from a weak economic recovery will dampen prospects for organic growth, does that mean consolidation is inevitable? For one thing, it's not clear that the community banking industry has sufficient buyers and sellers to inspire massive merger activity in the near term.

First, who are the buyers? Banking analyst Bert Ely argues that banks with less than $500 million in assets will be the most likely deal makers, as smaller banks will seek economies of scale as a result of increased regulatory burden imposed by Dodd-Frank. Kip Weissman, partner with the law firm Luse Gorman Pomerenk & Schick, said in the Washington Post that banks with more than $50 billion in assets will stay out of the market.  “A lot of banks in the $40 billion area are going to be reluctant to pull the trigger on a deal that would get them above $50 billion, as they are trying to avoid being classified as systemically risky” said Mr. Weissman.

Invictus CEO Kamal Mustafa concurs. In an interview with BloombergTV, Mr. Mustafa said of small financial institutions -- "the big banks don't want to buy them.  They need to consolidate their little footprints with banks with similar footprints, so they can get economies of scale and better compete in the marketplace. "

So if the primary buyers are small, regional banks how many are eager to start shopping? With Bank of America's Countrywide merger and JP Morgan's Bear Sterns acquisition still causing problems "the regional and community banks see that, and it makes them uneasy" says Joseph Morford, an analyst with RBC Capital Markets in San Francisco, in a recent article in  Bank Director. Small banks are nervous about the portfolios they could be inheriting, and most don’t have the capital cushion of a mega bank to survive a mistake in the vetting process. Nor do they have the necessary resources to perform adequate due diligence.

Regarding the assertion that seeking economies of scale  will drive growth, the FDIC’s Community Banking Study (released in December 2012) found little data to support this claim. Firstly, most banks do not track compliance cost separate from other operating expenses, therefore quantifying compliance expense is difficult at best.

Furthermore, the FDIC study concludes that in general "most of the benefit from economies of scale is realized once community banks reached $100 million to $300 million in total assets, depending on the lending specialty. These results comport well with the experience of consolidation during the study period (1984-2011), during which the number of banks with assets less than $25 million declined by 96 percent, but the number of banks with assets between $100 million and $10 billion increased by 19 percent. This is where 65 percent of community banks operated in 2011."

While current market conditions will most likely make robust organic growth difficult for small banks in the near term, it’s unclear that community bankers--en masse--are lining up to take on the risks and expense of a merger.

Flannery O'Connor

You shall know the truth and the truth shall make you odd.