Banks' New Merger Strategy: Becoming TBTF

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Many bankers are wary of being slapped with the too-big-to-fail label, given the increased compliance, risk management and stress test requirements that accompany such a designation. But there are benefits that come with being TBTF. Surprisingly enough, it can be an effective merger strategy for regional banks.

I find it useful to divide domestic banks into four asset-size categories based on the differing regulatory treatment that each receives. The first category includes traditional community banks with less than $10 billion in assets. In the second category are the 60-plus regional banks in the $10-billion to $50-billion asset range. Next are the TBTF-Lite banks: the 30 or so super-regional institutions with between $50 billion and $500 billion in assets. And in the last segment are the eight global, strategically important, super-sized financial institutions with assets exceeding $500 billion.

Banks that are TBTF benefit from access to an implicit government funding subsidy. This subsidy can motivate banks to offer a premium purchase price for acquisitions that would put them over the TBTF threshold, as illustrated by a 2013 study published in the Journal of Financial Services Research. The key question for regional banks evaluating a potential acquisition that would push them over into TBTF territory is whether the benefits of the implicit subsidy exceed the increased regulatory burden.

Regional banks need to be big enough to succeed-a goal that has become more complicated because of regulatory requirements added in the aftermath of the Great Recession. Given the limited economies of scale for banks beyond a relatively small size, it is critical for these banks to obtain funding subsidies in order to improve their shareholder value. In practice, most large M&A decisions are driven by the lure of taxpayer subsidies to TBTF institutions.

To be clear, this strategy works only for regional banks that would become TBTF-Lite. The super-sized category carries a host of incremental rules, including higher capital ratios and living will requirements. In addition, the largest banks may suffer from being too big to manage, due to diseconomies of scale reflected in their heightened legal expenses. And it is also unlikely that regulators would even approve a merger creating another megabank.

Going forward, expect to see increased M&A activity among regional banks as they recognize the benefits of becoming TBTF-Lite. The decision should be part of the bank's overall strategy and supported by investments in risk management and compliance infrastructure that will ensure the merger receives regulatory approval. (Such investments would probably be required anyway, as TBTF regulations tend to trickle down to smaller regional banks over time.)

The appeal of sizing up was illustrated by two deals this summer that enjoyed positive market reaction. The first was CIT Group's acquisition of OneWest Bank, the successor to failed-bank IndyMac. The acquisition propels the $47 billion CIT, which entered bankruptcy during the crisis before it obtained a bank charter, to over $70 billion in assets. The company's chief executive, John Thain, has said that CIT had been making the necessary regulatory investments in preparation for growing past the TBTF threshold.

The second noteworthy deal was the North Carolina-based First Citizens BancShares' acquisition of the $8 billion-asset First Citizens Bancorp. in Columbia, S.C. The combined $30 billion entity is well-poised to do additional deals on its way to becoming TBTF-Lite.

The positive initial market reactions to the CIT and First Citizens deals will encourage more regional banks to breach the TBTF barrier. If they fail to act, they risk losing out to competitors who will preempt them. The threat of growing regulatory scrutiny over such deals may also compel banks to act quickly.

Regulation is a two-sided coin. Regional banks will do their best to exploit the benefits it offers.

J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.

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