Banks looking to expand continue to consider mergers and acquisitions as the surest growth vehicle, but a vital first step to making an M&A deal work is not to grow — but to shrink.

Before completing a deal, the most successful acquirers focus on engineering their balance sheet with an eye toward efficiency and effectively managed capital. Likewise, when pursuing target institutions, acquirers should not be looking for the fastest-growing institutions, but rather for the leanest.

Over the last eight years, any growth has seemed like good growth. But this has left banks holding a lot of assets with suboptimal returns. Banks that undergo a correction — shrinking by disposing assets with the lowest marginal returns — are in the best position to free up capital that can be reallocated to a profitable acquisition.

The first place to look is at bloated investment portfolios and any excessive liquidity stored at the Federal Reserve. Both require capital that, if freed up, could be better used for an acquisition.

The next place for shrinkage is in the bank’s loan portfolios. Obviously, loans with the highest spreads and risk-adjusted returns should be retained. But what is the cutoff for loans considered profitable enough to keep, versus those that the bank should try to trim?

All loans need a minimum of 1.50% spread, after loan loss reserves and expenses, in order to achieve a 10% return on equity. In the short run, if you have some loans below that threshold, then adjust pricing in order to increase the return on the loans you do maintain while freeing up capital for an acquisition on those loans you lose.

Like having a yard sale before moving into a bigger house, banks should find ways to dispose of unprofitable assets before completing a merger deal. Adobe Stock

In addition, analyze whether some loans can be easily securitized — such as residential mortgages — or can be participated to other banks — such as commercial real estate loans. Then move these loans off balance sheet without losing the customer relationship. The ultimate goal is to consume less capital while maintaining profitability.

But right-sizing the balance sheet is not a one-time, short-term endeavor to pursue as part of a pending merger. The work needs to start well in advance of a potential deal, as many of the pricing and runoff strategies take time to have a material effect.

Yet such corrective measures are linked with M&A. The steps a bank takes to make its balance sheet more efficient ultimately determine how much capital it can devote to an acquisition, thereby maximizing the size of potential target banks.

Likewise, target banks with efficient balance sheets — rather than fast-growing institutions that might overheat — often make the best merger candidates for acquirers to pursue. Alternatively, the early days of a closed merger should involve an acquirer rightsizing its new holding.

Quite often, the target bank has even a greater percentage of uneconomic, low-return assets and liabilities. You are not entering into an acquisition to obtain a highly leveraged investment portfolio (you can do that on your own). Similarly, you probably do not want those narrow-spread loans.

By thoughtfully pruning an acquired bank’s assets, without slicing off any of the core franchise, you may be able to fund much of the acquisition through the acquired bank’s excess capital.

Like having a yard sale before moving into a new, bigger house, completing a successful M&A deal often means getting your financial house in order, before focusing on your growth targets.

David S. Fisher

David S. Fisher

David S. Fisher most recently served as chief operating officer of the Federal Home Loan Bank of Topeka.

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