Chicago has long been viewed as a market ripe for consolidation, but it might be starting to rot on the vine.

In a particularly anemic year so far for bank mergers and acquisitions, the third-largest city in the country has been noticeably absent from the shortlist.

"I think we are all surprised by it. This is one of the most fractured markets," says Terry Keating, a managing director at Amherst Partners in Chicago. "We have so many banks chasing the middle markets, and the market just can't support it. You'd think more of these guys would join forces."

Illinois was one of the last states to allow branch banking, so it has nearly 600 discrete banks based in the state. The Chicago area is home to about 200 charters. Even after dozens of banks have failed there in recent years, it remains one of the least consolidated markets in the country.

For many industry observers, simple poor performance is one of the biggest factors behind the inactivity.

In the first quarter, earnings at the group of Chicago-area banks with more than $1 billion in assets fell 15% from a year earlier, according to data from Loan Workout Advisers LLC in Chicago. (The number of such banks held relatively steady from year to year.) By comparison, earnings rose 56% in the group of banks with more than $1 billion in assets nationwide.

"Chicago has just dragged behind the rest of the country," said Justin Barr, managing principal of Loan Workout Advisers. "This is a big problem."

The health of banks in the city with assets of more than $1 billion is particularly important to acquisition activity, because those financial institutions are often viewed as the most likely to buy.

"There aren't any real natural buyers in Chicago right now, and that has made it completely dry," says Christopher Zinski, a partner at Schiff Hardin LLP in Chicago. "The banks that would usually be the buyers are either still struggling themselves, still prefer to pursue failed banks or are too skeptical of credit quality to do anything."

Some banking companies are in a position to make moves, but have elected against doing so.

"You would think that a few of these banks would have some ambition to grow," Keating said.

Several analysts named the $8 billion-asset First Midwest Bancorp Inc. in Itasca, Ill., and the $14 billion-asset Wintrust Financial Corp. in Lake Forest, Ill., as the best positioned buyers in the city.

First Midwest declined to comment because of the proximity to the end of the second quarter, but Michael Scudder, its president and chief executive, told investors and analysts in its first-quarter conference call in April that it had been unable to find a seller with good enough credit quality.

"I think the bigger impediment to … what we call normal M&A still remains getting to a comfort level on the credit markets that are out there," Scudder said.

Meanwhile, Wintrust, which is a multibank holding company, has focused on acquiring smaller institutions in deals brokered by the Federal Deposit Insurance Corp., or acquisitions that enhance its ancillary businesses, such as its mortgage company.

To be sure, consolidation nationwide has been a dud. There have only been 65 whole bank sales announced as of June 10, down 18% from a year earlier, based on data from SNL Financial.

Smaller Chicago banks have also been passed over for overcapitalized deals, such as the $460 million investment led by Stephen H. Gordon that went into the $272 million-asset Bay Cities National Bank in Redondo Beach, Calif., last fall. Since that investment, Bay Cities has renamed itself Opus Bank and has announced a few acquisitions across the West Coast.

"Investors are still unsure about Chicago, and that is the most positive way I can put it," says Michael Iannaccone, the president of MDI Investments there. "They see it as a fragmented market that is marginal at best. If you follow the money, you see that the money is unsure about Chicago."

Iannaccone said that beyond credit quality, investors are skeptical about the long-term profitability of the market because of its fragmentation. The banking companies there have to compete so fiercely that it often results in thinner profit margins, he said. It is a point that he says he understands, but as an adviser who spends his days trying to help community banks find capital, it is a point he tries to fight.

"I argue with them vehemently," Iannaccone said. "We might be a fragmented market, but we aren't broken."

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