After several years of bank merger activity trending down, there are signs that the activity level may revive. As this subject may not have been a front burner topic for bankers in recent years, it is useful to consider how changes in the last few years have altered certain strategic priorities for considering mergers.

First, to put the activity level in perspective, bank mergers occurred at the rate of between 400 and 600 for the full decade of the 90s and began trending down roughly a decade ago. In 2011 there are likely to be fewer than 150 mergers consummated. While merger activity has dropped, bank failures rose sharply in 2009 and 2010.

There is, of course, a correlation between the increased numbers of failed banks and the decline in mergers; many banks were involved in acquiring failed banks through the FDIC resolution process and those combinations are not included in the merger figures. There will be less than half as many bank failures in 2011 as in the preceding year.

One reason for anticipating an increase in M&A activity is the improving financial position of the industry. Last month acting FDIC Chairman Martin Gruenberg indicated that bank liquidity and capital positions had hit four year highs. This improvement in financial position has put an increasing number of institutions in a strong enough position to explore merger opportunities.

Despite the overall improvement in bank performance, the number of problem institutions remains elevated and is only slightly lower than a year ago at this time. This fact suggests that there may be a number of banks looking for merger partners. Considering all of the above, it is reasonable to project an increase in M&A activity.

One condition that has changed little in recent years that bodes well for merger activity is that the capital markets are awash with liquidity and investors of all shapes and sizes are looking for equity opportunities. It is particularly noteworthy that private equity groups have increased their interest in bank investments. Many have established beachheads in the industry by acquiring either failed or troubled institutions and are now looking to expand their presence through additional acquisitions.

As bankers consider this new environment for mergers, what factors should be foremost in consideration? The first consideration is the strategic reason for the merger. There are many valid strategic justifications for mergers. Among the largest banks a dominant driver is enhanced shareholder value. The banking industry is a mature industry, meaning that it is not likely to experience significant growth in excess of the growth in the U. S. economy overall. As our economy is expected to grow in the 2% to 3% range over the next few years, that is likely to become the growth rate for the banking industry as a whole. Shareholders of major banks may be impatient with bank performance in that range, and many banks will look to improve earnings performance by acquisition. Acquisitions also provide opportunities for fundamental restructuring of the consolidated entity by eliminating duplications or using the merger as an opportunity to rethink lines of business.

Many large banks also view mergers as an opportunity to enhance an existing franchise by solidifying the presence in an existing market, expanding into adjacent markets or by acquiring banks or financial companies with complementary financial products. These acquisitions may or may not be immediately accretive to earnings. They may, however, improve the long term viability of the banking entity.

Community banks normally have less shareholder pressure to demonstrate earnings growth but mergers can provide many of the same opportunities for enhancing the value of the franchise. By expanding the marketplace footprint or increasing the penetration of an existing market, banks can improve earnings performance, afford to hire bankers with specialties not otherwise affordable for the smaller institution, and in the process make themselves potentially a more valuable acquisition target.

A second important consideration when thinking about a merger is price. Gone, but not forgotten, are the days when some banks sold for three or four times their book value. Bankers looking for buyers in that range today will be looking for a long time.  By historic standards today’s stock prices are unusually low. As of September 30, the listed stocks of bank holding companies in the $1 to $5 billion range traded at a median price of .82 to book value. Transactions of community banks completed in this past year generate only a slight premium at 1.05 times book.  A key factor in the elimination of large premiums to book is the elimination of all restrictions on the establishment of bank branches – including branching across state lines. The passage of Dodd-Frank eliminated the last barriers to interstate branching.

Two factors should be avoided when looking for merger partners: (1) venturing into fast-growing markets with minimal experience in that market; and (2) expecting that an in-market merger will eliminate a competitor. In the last economic crisis many of the most troubled banks were those that either started or relocated in major growth markets with minimal prior experience in those markets. They were victims of the classic adverse selection principle. The most marginal borrowers comprised most of their loan opportunities with predictable results. On the other end of the scale, banks that believe they improve their prospects by eliminating a competitor may find only short term benefit. The elimination of restrictions on branch banking ensures that any attractive but under-banked market will immediately attract new branching interest.

There are fewer banks in the U.S. today than a decade ago, but with still over 6,000 banks and an additional 1,000 thrifts remaining, many opportunities for bank consolidation still exist.

Mark W. Olson has served as a Federal Reserve Board governor, chairman of the PCAOB and chairman of the American Bankers Association. He currently serves as co-chairman of Treliant Risk Advisors LLC and can be reached at molson@treliant.com.