Why bank M&A may be in for a slow stretch

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The stock market slump has created uncertainty over bank consolidation in 2019.

Industry observers are divided as to whether activity will keep pace with the 258 deals, and nearly $30 billion in volume, of last year. The thought is that it will likely take time for buyers and sellers to adjust pricing to account for swooning stock prices. The KBW Nasdaq bank index fell by 21% last year.

At the same time, the underlying reasons for bank M&A remain the same, including a need for cheap deposits, operating leverage and scale, industry observers said.

“Unless there's a change in the economy, low-cost deposits will remain very valuable,” said Bob Wray, managing director at the investment bank Capital Corp. “Low-cost, stable deposits are the strongest driver for community banks.”

American Banker recently discussed M&A with Wray; Blaine Jackson, CEO of NewDominion Bank, a division of Park National; Brendan Duffey, president and CEO of Uwharrie Bank; Jonathan Hightower, a lawyer at Bryan Cave Leighton Paisner; and Cheryl Pate, an analyst at Angel Oak Capital Advisors.

The following is an edited transcript of their responses.

What are your expectations for bank M&A this year?

CHERYL PATE: We believe M&A will continue to accelerate. There's a need for scale. Regulatory costs are still high and we expect the pace of earnings growth to slow as the benefit of the corporate tax cut fades and cost of funds continues to rise. The lifting of regulatory asset thresholds should be an added boost to deals at the smaller end of the spectrum.

JONATHAN HIGHTOWER: I expect a modest slowdown. The market sell-off currently taking place may get us off to a slow start, and the trend is certainly that there are fewer and fewer desirable targets each year.

BLAINE JACKSON: The increased volume of bank M&A over the past few years inherently means there are fewer opportunities in the future. However, for those opportunities that remain, I think bank M&A will continue to be a theme.

BRENDAN DUFFEY: Nationally, we expect M&A activity to be in line with 2017 and 2018. Expect activity to be strategic acquisitions centered on high-growth markets where acquiring banks seek to enter a market or to garner greater market share and scale in a current markets. Deal size could be larger than those in 2017 since lawmakers raised the asset threshold for becoming a systemically important financial institution. Small rural banks will be potential targets for urban banks that need low-cost core deposits and especially those adjacent to major markets, but there’s not as many to choose from as there were even a couple of years ago.

What does the slump in stock prices mean for M&A?

JACKSON: I think the impact, while mostly psychological, will still be material. The banking industry is very strong right now. When you look at the specific financial health of a particular bank there generally are no indicators that would tell you why the stock price has declined. It’s all based on future expectations related to interest rates and the overall health of the economy. Fear of the unknown is driving prices down. Some will see it as a significant buying opportunity, while others will be spooked. As for how lower stock prices will affect M&A, I don’t expect it to cause many banks to walk away from the table, but I think we might see a different mix of stock versus cash.

PATE: M&A was robust in the fourth quarter even with the volatility. A lot of volatility has stemmed from global concerns, such as Brexit and tariffs. The fundamentals of the banking sector, asset quality in particular, remain strong. Interestingly, when we have seen downturns in bank stocks over the past 30 years, they have been followed by sharp rebounds in price. While we may have some banks on the margin pause due to market conditions, we believe this is likely temporary. Additionally, we believe subordinated debt remains a valuable tool, particularly on the smaller-bank side of the spectrum.

WRAY: We believe it will have a negative impact, at least temporarily. Ultimately, buyers’ and sellers’ expectations will align. In the past 45 days we have seen some public buyers back down on their pricing a little bit because of the drop in their stock price. To be clear, we have not seen a buyer try to change an agreed-to contracted price, but in discussions regarding value for a target as the stock prices have dropped the value they are offering has dropped.

How important is low-cost funding to future deals?

PATE: This is probably the most important factor in considering M&A candidates in the community bank universe. Typically, the banks we're investing in are higher growing, from an asset perspective, but attractive low-cost deposits require a lengthier process to build out.

HIGHTOWER: These low-cost deposit franchises are incredibly important in an academic sense, but the fact is that many of them are largely situated in lower-growth rural markets. Many publicly traded acquirers are not able to sell a story of buying a bank in a low-growth area to analysts. Many of the best deposit franchises are held in small pieces and their size makes them irrational partners for larger acquirers. While everyone desires low-cost deposits, the majority of buyers are not willing to take on the banks that have them.

JACKSON: Low-cost deposits are extremely important, especially in the current environment where deposit rates are generally rising faster than loan rates. For banks experiencing margin compression in 2019, acquiring a bank with a low cost of funds will allow them to continue to be competitive on loan pricing without compromising the overall margin.

What role will fintech play in consolidation?

JACKSON: Fintech is obviously gaining some serious momentum, but I don’t expect it to be a huge driver of M&A in 2019, especially among community banks. Beyond 2019, I think we’ll possibly start to see a pickup. I generally expect core providers to be the most active in acquisitions of fintech companies rather than the banks. Essentially, the core provider would acquire the fintech company and then offer those products and services to their banking clients.

PATE: Fintech can certainly be viewed as a disruptor ... and we believe it has incentivized banks to increase investments in technology to improve processes, offer capabilities and speed up processing. However, we believe fintech companies are more likely to partner with banks rather than be acquired by banks, at least in the community bank/regional bank space. As we tour the country and evaluate a wide swath of community banks, we're always impressed with their willingness to embrace niche products or new models to better serve their customers.

DUFFEY: If you’re asking if fintechs will be an acquirer, no. Select fintech business models will continue to be attractive to larger banks. At least one major M&A firm that works with banks on acquisitions is working to put fintechs together with bank acquirers, so that’s a new potential niche for them to exploit. We can expect to see more [acquisitions] of fintechs by banks, but expect the acquirers to be the largest banks and perhaps even some of the largest regionals.

What regions will get the most interest this year?

PATE: We believe consolidation will likely remain pronounced in the more overbanked and competitive markets, as well as markets with more attractive demographics, including the Midwest and the Southeast. We would not be surprised to see a pickup in activity on the West Coast.

HIGHTOWER: There are still incredible numbers of banks in the Midwest, and that will lead to another year of Big Ten Country having the strongest numbers in terms of numbers of deals.

JACKSON: I expect the metropolitan markets will continue to see strong activity. Loan demand remains strong in metro markets and borrowing needs continue to increase in size. Clients in metro markets are beginning to outgrow their local community bank. This is one of the reasons NewDominion agreed to merge with Park National. Since the merger closed on July 1, we have made $46.5 million in loans that would have previously surpassed our pre-merger limit [of $4 million]. In our specific situation, we're able to look, think and feel like a local community bank but with the firepower of a much larger bank behind us.

Do you expect more credit union/bank deals?

WRAY: Yes. Credit unions, similar to banks, are looking for size and scale. Now that credit unions have a proven legal and regulatory path, we expect them to become more active.

HIGHTOWER: I certainly do. Credit unions have no pressure to meet pricing metrics or be in certain prized markets. While most banks would never set out to merge with a credit union, many will find that a credit union is the most, or only, interested party.

JACKSON: Credit unions, in general, have gotten out of hand, in my opinion. It used to be that you had to be a member of the military, a teacher, or an employee of a specific large corporation to be a member of a credit union. Somewhere along the way that changed and almost anyone can now do their banking with a credit union. Because they are now a viable competitor and threat to traditional banks, I think there’s a chance you’ll potentially see banks consider acquiring a credit union simply to remove a competitor from the market.

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