The state of bank consolidation turned an important corner during the second half of 2015.

Since the financial crisis, bigger financial institutions had been largely reluctant to make bank acquisitions, while a number of deals, including M&T Bank's agreement to buy Hudson City Bancorp, were languishing in regulatory limbo.

Things changed quickly over the summer.

BB&T in Winston-Salem, N.C., received approval in July to buy Susquehanna Bancshares and then agreed to acquire National Penn Bancshares. The Federal Reserve Board finally approved M&T's deal, then KeyCorp and New York Community Bancorp joined the list of large acquirers.

While such momentum should continue, most deals will likely involve community banks as those institutions continue to face stiff competition for loans and struggle to add revenue.

American Banker recently asked three investment bankers — Bob Wray, president and chief executive of the Capital Corporation; Paula Johannsen, managing director at Monroe Financial Partners; and Aaron Packles, head of depository institutions investment banking at Bank of America Merrill Lynch — to discuss their outlook for bank M&A in 2016. Here is an edited transcript of their responses.

What will be the biggest drivers of bank M&A in 2016?

BOB WRAY: We will see continued consolidation [in the Midwest], especially in the small community bank market — under $1 billion [in assets]. Our activity has picked up in the past 12 months and we don't see it slowing down. We're going into 2016 with several deals in due diligence, and several banks have already engaged us to assist them in the sales process. 

The primary driver in our market for M&A is the need to grow to remain economically viable. Most Midwest markets have very limited growth opportunities, so growth by acquisition is a driving factor. On the sell side, [motivation comes from a] lack of capital to make acquisitions or age of the ownership group with no ownership succession. Management succession is an additional factor, but not a primary driver.

AARON PACKLES: There's a thawing occurring in the bank M&A market. As new regulations have been introduced, it is natural for institutions to take their time getting comfortable with the rules of the road. As always, some react faster than others, but we expect senior management teams and boards to sharpen their focus on M&A in 2016. Activity [in 2015] clearly showed this theme, and we expect bank CEO confidence to continue its gradual rise in 2016.

Drivers of M&A will be multifaceted and will result from the increased cost of regulation; the need for acquirers to strengthen deposit funding in a rising rate environment; the easing of regulatory M&A concerns, as banks have been successfully closing their deals over the past few years; and the need for synergies and scale to drive shareholder value in a lower growth environment.

PAULA JOHANNSEN: We're seeing smaller banks struggle with lower net interest margins, higher costs and lower profitability. That's the new world order. If these banks can justify their valuations with low margins and higher costs, they will probably stay independent, but a lot look at that and say, "We aren't doing shareholders any favors if we can't grow earnings better than this." Buyers want to grow their franchises and enter new markets. Sellers are looking to make money for shareholders. Those motivations never change. I tend to deal with banks with $500 million of assets and less. Everyone is engaged in a conversation either with their investment banker or their board.

What metrics will be most closely watched? What will pricing look like?

WRAY: In 2015, we started to see significant pricing differences based on markets and loan-to-deposit ratios. Banks in markets with growth prospects or high loan-to-deposit ratios received higher-than-average pricing, while banks in markets with limited growth prospects or low loan-to-deposit ratios received average or below-average pricing. Interestingly, while high loan-to-deposit ratio banks tend to have stronger earnings, which would explain higher pricing, even banks with below-average earnings that were in a strong market or [had good] earning assets [could commend strong] pricing. 

In 2016, we expect bank pricing to remain strong, at least in comparison to the last six to eight years, for most sellers, but we expect the pricing difference to continue to expand. People will pay up for certain banks, and other banks will see limited pricing or no buyers at all.

PACKLES: Deal metrics have not changed over the last few years, but clearly investors have been reacting differently to various acquirers' interpretations of acceptable levels of these metrics. Accretion to tangible book value and earnings remain in the forefront. If the number of years to earn standalone tangible book value back is too great, investors have shown that they will move share prices down to reflect their views.

We expect pricing to remain bound by the relative values of the acquirer and the target stock prices in order to maintain acceptable tangible book value and earnings accretion. What a bank pays can continue to increase as long as the value of the acquirer's stock maintains its relative strength in value to the target prior to, and through, closing. Bank M&A is mostly a stock-for-stock endeavor, hence relative value is the name of the game.

We've seen some acquirers' stock drop significantly after announcing a deal. How will investors react to deals in 2016?

PACKLES: We continue to expect investors to critically evaluate each transaction on its own merits. The strategic logic of a deal needs to be sound with very compelling financial implications and low regulatory risks. The management teams that can artfully bring these deals to their shareholders will be rewarded given the challenges of this lower growth operating environment.

JOHANNSEN: There are some banks that got beat up after an acquisition and have yet to recover their value and I think there are a variety of reasons for that. I think investors look at the buyers they know have been active and have [pursued acquisitions] with a disciplined approach and a good integration history.

We've seen Bank Secrecy Act and anti-money-laundering issues hold up deals. Are there other areas acquirers must tend to before filing for deals? Should we expect regulatory delays? 

WRAY: Our experience is that the regulators are scrutinizing all deals more than they have in the past couple of years, and I don't see it changing. We have a couple of deals that have been delayed because of the seller's compliance issues, and we have seen a few buyers on the sidelines because of pending regulatory issues.

I think we'll continue to see the regulators use the approval process to force buyers into compliance. We have been encouraging our prospective buyers to talk to the regulators about a potential acquisition before moving forward on due diligence or contract negotiations. Our most common regulatory issue is market concentration so we work with the regulators before filing an application, and often even before a final definitive agreement, to eliminate as much approval risk as we can. We believe it is in a buyer's and a seller's best interest to identify any regulatory issues very early in an effort to avoid a delay or the need to withdraw an application. We've been fortunate that all of our deals that make it to application have been approved quickly, but believe that the regulators will continue in increase the scrutiny.

PACKLES: BSA and AML compliance issues have clearly made a lot of the headlines recently, but to overemphasize one area versus another would be a mistake. Good acquirers maintain a strong discipline over their entire regulatory profile. With that as background, we would encourage institutions to stay vigilant around their [Community Reinvestment Act] programs. This area will stay in focus in the coming year. But assuming regulatory matters are handled appropriately, deals should continue to close as they have in 2015. 

JOHANNSEN: There's a renewed interest in BSA. I've seen BSA consent orders with banks in markets that you wouldn't expect. Regulators are trying to send a strong message that they are looking at this no matter what a bank's size is. Still, the regulatory piece is always sort of the mystery in an acquisition. Five years ago, we didn't know what would pass muster. We're working with buyers and sellers to make sure of any issues before we put in an application.

What are the up-and-coming markets or business lines for deal activity? 

WRAY: We're seeing strong interest in banks with fee income and specialized lines of business. Many of our larger buyers are trying to diversify their revenue and buy expertise in areas where they have limited or no current line of business. Additionally, we're seeing more buyers seeking low cost, core deposit bases.

PACKLES: The U.S. bank M&A market should maintain its focus on the traditional "meat and potatoes" type of transactions. Investors tend to ask fewer questions when an institution is buying another that does "more of the same." Outside of these principles, we're seeing banks show increased interest in specialty finance and wealth management transactions, which need to be evaluated with care given the potential for increased credit risks and accounting goodwill.

JOHANNSEN: I think the large banks have a more diversified revenue base. If they see opportunities to add to lines such as wealth management, which is always a focus, they will. Some banks are interested in insurance firms. In our case, the focus is always on markets with good demographics and a growing population. You want to go where the people are.

What banks will likely be acquirers? Why?

WRAY: We have very few publicly traded companies headquartered in our market, so our buyers will be primarily be banks with access to capital. We have a very large group of banks that believe they are, or should be, a buyer, but not all of them have access to capital to support an acquisition strategy. Banks with access to capital will be, or at least attempt to be, a buyer because most banks in our market are trying to grow asset size and enter new markets by acquisition.

PACKLES: In our view, the 2016 acquirer will continue to be the well-regarded larger bank looking to take advantage of the lack of buyer competition, in addition to the small to midsize bank needing to combine to fight for survival or greater shareholder returns. U.S. banking is a business that benefits from size and scale in profitable markets. The management teams that can successfully navigate the M&A market will be best positioned, given the significant fragmentation that still exists in America versus many other bank markets around the world.

JOHANNSEN: There are several fairly active buyers out there and maybe a few starting to emerge. You'll see the same ones taking advantage of opportunities. As long as their stock value is good, and the market is approving of what they're doing, those are the ones we will continue to see acquire.

We've seen a few [banks] on the larger side announce deals. The same thing drives the small side and the big side. They see earnings headwinds and they recognize opportunities with partners they've maybe talked to for a while — and the timing is right. I would fully expect a few bigger bank deals. It's all about generating value for your shareholders. If you can't do it on your own, and you aren't providing dividends, then you need to look for other outlets to generate that value.

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.