What a difference a year makes.

That's the view of Thomas Michaud, chief executive of Keefe, Bruyette & Woods, who points to March 20, 2014, as an inflection point of sorts for the banking industry. On that day, the KBW Regional Banking Index hit a modern-day peak on hopes of rising interest rates.

Bank stocks have struggled to return to last year's level as rates remain artificially low. Still, prices have been closing the gap since the Federal Reserve Board raised expectations for a near-term increase.

The peak in KBW's index, and its implications for earnings, capital raising and M&A, came up several times during a wide-ranging interview with Michaud earlier this month. He also reflected on his firm's first full year as part of Stifel Financial. The following is an edited transcript of the conversation.

We saw 14 IPOs last year, including 10 that involved KBW. Did that activity live up to your expectations?

It really did. I think that's a real positive for the industry, investors, bank managements. And it is going to continue because the share prices are attractive and the economy is getting better.

Texas has been a hotbed for bank IPOs. Given the uncertainty with oil prices, are they on hold there?

There's a big interest in continuing to tap the IPO market by Texas banks. The question is what the timing will be. The stocks have been so volatile over the last couple of months because of oil prices. I don't think it is going to stop, but I do think it is going to slow down until there's some more stability in the stock prices. Uncertainty and share price volatility usually slows down capital raising and bank mergers.

The CEO of Green Bancorp in Houston said recently that his company went public in August to do deals, but his stock price is making M&A difficult. You'd imagine others are following that case closely.

The story with Texas is that March 20 of last year was the peak in the KBW Regional Bank Index. At that time, regional bank stocks were trading at 16.9 times 2015 earnings. Over the last few decades, that price-to-earnings valuation only occurred 10% of the time. The stocks were priced for perfection and included in that perfection was higher interest rates. The outlook for rates changed and earnings estimates came down.

In Texas, you had another factor driving those stocks: energy. Now you have oil prices having declined like they have and so Texas has generally lost the valuation premium it had to the rest of the nation.

Texas is still a better-than-average market, but we need to get through a few quarters to have some evidence of whether some banks got a little too far out in their exposure to energy. We will get the answer to that, and then maybe the stocks will get a chance to revalue.

What are some of the current M&A drivers?

A lot of private equity money came into the industry right after the crisis. The private-equity investment window is typically five to seven years, and we're in that period, so you'd think those investors would be looking for a liquidity moment. That's going to be a continuing feature of bank M&A.

Another thing I've been following quite carefully is what percentage of the industry's banks are involved in a merger in any given year. Since the early '90s, on average, 3.5% of the industry merged. Last year, 5% merged. Most of those mergers were not on the front page of American Banker because they weren't big companies. [BB&T's agreement to buy Susquehanna Bancshares] was the first time a CCAR bank had bought a bank subject to the Dodd-Frank Act Stress Test. Over time, we could see the bigger banks get more involved. (KBW represented Susquehanna.)

Does private equity have a preferred liquidity method?

Go back to that March 20, 2014, date — the peak of bank stocks last year. The IPO valuation for a really high-performing community bank was probably a valuation that bank managers thought not that long ago they would get in a sale. The difference between the IPO market and expectations for a sale was very slim. The gap between the IPO valuation and a sale is starting to widen, so some candidates that were thinking IPO are likely shifting to a sale.

Let's revisit your statistic on the percentage of banks merging. That also reflects a shrinking denominator due to a lack of new banks. Do you think de novo activity will ever really resume?

It will. In some regard, it is going to require some regulatory support. I just don't see it picking up in earnest anytime soon. We will read in the paper one day that we need more community banks, but I just don't think we are going to read that anytime soon.

Are investors more willing to accept tangible book value dilution for accretive deals?

As the market shifts to being priced to earnings, it is going to put pressure on the tangible book value earn-back ratio, which is a new ratio since the crisis. We've never used that ratio before. There seems to be some unwritten rules — investors like earn-backs in two to three years, but are willing to accept five years for the right deal.

My view is that PE valuation matters most for a company that is healthy and growing. That is the main driver to stock prices. However, this tangible book value earn-back is becoming a little bit of a governor. If a bank takes a high earn-back period, they'll need to be ready to describe it to the market.

I'm a discounted cash flow model disciple. That's the religion I preach when it comes to securities analysis. I would be on the side that earnings per share accretion matters most. I would be somewhat respectful of the tangible book value earn-back ratio, knowing it is important to your communication to the market. But if I was pursuing an M&A strategy, I'd look to consistently build earnings per share.

What's your expectation for deals by the bigger banks?

It is coming, but I don't think it is going to come in giant waves. I think there's a limit of the number of acquisitions you can do in a year. We think right now the optimal ceiling for everyone is two because of the regulatory environment. BB&T has figured it out. RBC has figured it out. I believe M&T will get approval to buy Hudson City. It has taken a while, but I think they've gotten to the finish line. We weren't an adviser there, so I'm just a market observer.

The industry and the regulators are trying to find a balance. We're out of balance toward very heavy regulation. I'd like to believe that as we go through periods where 31 banks pass the Dodd-Frank Act Stress Test, the regulatory apparatus is going to be more comfortable with M&A.

How do you view the rise of challenges to mergers by community groups? They seem to have tapped into the backlash against banks after the financial crisis.

I understand the role of banks in the community and I understand the reasons for the Community Reinvestment Act. The bankers I talk to take it seriously, but I think the rise of these challenges has a lot more to do with how the banking industry has been on defense.

Something that I've been talking about that is important to me is how unfair it is that the whole industry is painted with the same brush. Our researchers calculated that $187 billion of fines have been paid since the crisis and they've been paid by something close to 50 financial firms, with 24 of those companies in the United States. There are 6,000 banks in the United States.

Most of the industry has been very responsible. I find it frustrating that banks are defensive because of what happened at the top end of the industry. I think the community challenges are somewhat opportunistic because of the sense that the industry is on defense. Most of our clients have a "satisfactory" CRA rating and "satisfactory" should mean something.

Activism seems to be on the rise. How much is that showing up in M&A discussions?

We've observed that activism is emerging as an asset class. Pension plans and investors can invest in activism funds for the sake of being activists. As that category gathers more assets, you're going to see more activity. The activity in banking, relative to everything else including the rest of financial services, has to be different because of regulation. You can't have an investor show up to a CCAR bank and say, "We want you to raise your dividend." But they can seek board representation, they can seek enhanced performance, they can encourage the company to sell.

In recent conferences, bankers and investors don't seem to be talking about loan growth much. Why is that?

Loan growth for the small and mid-cap banks is pretty good. If the economy is only growing at 2% and banks are able to grow loans at 9%, it is pretty darn good and suggests that the smaller banks are picking up market share. We think it is part of the bullish part of the story for the industry.

What does that mean for M&A, since deals had been largely driven by the hunt for loan growth?

The driver for M&A is earnings per share growth. Earnings per share growth is not matching loan growth because there continues to be margin degradation. To go back to March 20, the market was convinced we would see higher rates and that margins were going to inflect at some point in 2014. Here we are in 2015 and margins continue to decline. I think the big story here is what's going to happen to the margin when the Federal Reserve finally starts to move, and how much of that is going to come into banks' earnings statements.

How are rates affecting M&A, both today and in the future?

The industry needs interest rates to go higher to hit earnings estimates. We're baking in at least one 25-basis-point increase by the end of the year and several more next year. We need that and we need some steepening of the yield curve. If you don't get rate increases and you don't get a steepening of the yield curve, we'll be cutting estimates.

What's the sweet spot for banking?

The most profitable banks in the industry last year were the $5 billion- to $50 billion-asset banks. They're the most profitable and they are the most highly valued. So it is not the $700 million bank and it is not the big universal bank.

One of the big questions for the industry is going to be what happens to the big universal banks. Their capital constraints and regulatory restraints are enormous, and I think you're going to see more of what Citigroup is doing. They're buying back stock below book value and they're selling businesses and assets like crazy. That's an important question for the industry over the next few years.

Do you feel like the combined advantage of the Stifel-KBW acquisition showed up as much as you wanted in your first full year?

We think it was a terrific first year. We advised on six of the top ten mergers. We don't think our market share has ever been that high.

KBW was number one in terms of aggregate deal value last year, but Sandler O'Neill closed more deals. Sandler would likely question the perceived advantage of the Stifel-KBW merger since you're still close competitors by those measures. Did you think the gap between you and top competitors would be wider by now?

We advised on 66% of the top 15 mergers in the industry. I couldn't imagine our market share being higher. There are also other deals where maybe our client wasn't the winner. Maybe our advice in some cases is to not overpay or to sell at too low of a price, so our "mindshare" of all the largest deals is probably 90%. My feeling is that we're everywhere we need to be. Would I like to do all of the mergers? Of course, but I can only be an adviser to one bank at a time, and I can only be on one side of a transaction at a time. I think our market share was super high.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.