Investors and industry experts predicted increased bank merger and acquisition activity in 2011, driven by foreign investors, reasonable target valuations and augmented regulatory requirements. However, lingering market volatility and investor inflation of potential target company stocks appear to be delaying market movement.

The foremost factor affecting the rate of merger and acquisition activity in 2011 is the interplay between the foreign market and the U.S. banking industry.

Various nations are using the financial crisis recovery period to reevaluate their needs. For instance, it appears that the current U.S. administration is reevaluating its stance on the ability of Chinese companies to acquire U.S. banks. While it had previously prohibited this type of activity, rejecting deals such as a bid by China's Minsheng Bank for UCBH in 2009, the U.S. is utilizing foreign interest in such acquisitions as an opportunity to negotiate foreign policy.

This is evidenced by the January 2011 Industrial and Commercial Bank of China acquisition of retail bank branches in the U.S., which marks the first U.S. acquisition by a Chinese bank. While final regulatory approval is still pending, this acquisition represents a move that could allow great expansion opportunities by Chinese financial institutions into U.S. markets. It also showcases the opportunity for the U.S. to gain concessions from China on issues such as export control, purchases of American-made goods and services, and rules on foreign investment.

The U.S. emergence from the financial crisis has been steady. This offers a strong advantage to the U.S. banking industry over countries in Europe, Asia and South America, which may have strong growth, but exhibit unstable political and legal environments, and cultural challenges.

The U.S. banking industry is also seen as having a better investment opportunity climate than Canada, which may be politically stable, but has questionable growth opportunity. This explains the recent level of merger and acquisition activity seen in the U.S. by Canadian banks at the end of 2010 and into 2011.

Natural disasters and social unrest around the world have stalled investing in the U.S. markets, which subsequently changes the stock prices of potential target companies. Recently, investors have seen the devastation in Japan and violence in Libya, both of which were reflected in the decline of the U.S. financial markets. With consumer confidence still rebounding, and investor activism on the rise, valuations of banks may not portray an accurate picture.

Bank valuation is one of many factors that will affect negotiations between target and acquiring companies in forthcoming deals. Attempts to value target companies will lead to lengthy negotiations, which is a change from the last two years in which the FDIC primarily arranged the merger and acquisition activity in the industry.

While sellers may be driven by low earnings and high growth pressure, investors are carefully following the industry news and, perhaps incorrectly, investing in the target company as a speculative play, as opposed to investing in the acquirer. These inflated target stock prices will add challenges to valuations and extend the time companies require to negotiate the deal.

The negotiation complications will be compounded as companies, their advisers and investors subjectively and objectively value the target company based on factors such as the quality of management, expected future earnings and value of assets. There will also be a change in the final deal terms.

The adoption of Dodd-Frank will also affect merger and acquisition negotiations. Dodd-Frank, enacted to increase regulation of the financial sector and protect consumers from mismanagement in the banking industry, will greatly increase the costs of compliance for banks with under a billion dollars in assets.

Banks that have continued to post losses over the last several quarters and have more than $300 million outstanding under the Troubled Asset Relief Program are likely potential targets, as Dodd-Frank will continue to place pressure on such companies that either will have to proceed with a dilutive sale of stock to increase their equity or sell the company.

Banks with strong earnings, looking to further their growth, will find many willing small and midsize target companies unable to survive the financial strain and investor pressure. The resulting acquisitions will likely be smaller than the multibillion-dollar bank mergers of the recent past, resulting in a gradual rise of merger and acquisition activity over the next several years.

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