Monday, December 17, 2012

 Community Bank M&A Tipping Point?

The latest FDIC quarterly banking profile shows that the banking industry continues to get back on its feet.  More than half of all institutions showed improvements in their quarterly net income from a year ago, driven largely by improving credit quality.  Headwinds are becoming tailwinds and the downward spiral in credit quality seems to have stabilized.

One gets the sense, from the industry dialogue, that merger and acquisition (M&A) activity at the mid-size and community bank level is poised to increase significantly in 2013.   With recent news stories indicating that the mega-banks have been sidelined by the Fed with regard to M&A activity, the M&A focus moves to the mid-size and community bank segments of the industry.

Three reasons contribute to this hunch.  The first is the program of financial repression created through the Federal Reserve zero interest rate policy and its efforts to push down long-term rates.  A community bank, in particular, has to have a reasonably wide positive carry (net interest margin) to cover its overhead.   Fee income helps, but with what looks like a public jihad against banking fees (think overdraft and interchange fees), there are limits to flexibility on that front.

With loan demand lethargic, options to offset financial repression are few.  Many community bankers are seeing the present Fed zero interest rate policy remaining for years to come.  This is pushing some to pursue classic “down and out” banking - moving down the scale of credit quality and out along the yield curve to squeeze out a few more basis points of yield.  But those practicing “down and out” banking know, in the back of their minds, that a reasonable buyout offer tomorrow would be preferable to the risky, and potentially mortal, balance sheet positions they are building out of necessity and desperation today.

The second is the escalation in the average community bank cost structure. Community bank cost structures are creeping up faster than technology can lower them.   Technology is a great way to lower unit costs of production, but diminishing returns appear to be kicking in.  The cost reduction curve is being slowed by increased expenditures for cyber-security and privacy protection.

Then add in to the community bank cost structure increases in personnel expenses associated with the implementation of the Affordable Care Act, compliance costs associated with the ongoing implementation of the Dodd-Frank Act, Consumer Financial Protection Board regulations in the pipeline, and the increased regulatory agency fondness for “guidelines” (which appear to be recommendations, but are enforced as obligatory through the examination process).

Not helping the cost structure situation either, is the emotional attachment to lightly-trafficked brick-and-mortar branches as monuments to territorial conquest and icons to the exercise of superior generalship in days gone by.  Cede turf to a competitor? Never!

Third, battle fatigue is showing up in more and more community bank CEOs and boards of directors.  Not only is this economic recovery so frustratingly long and slow, but many of the true joys of community banking are being overshadowed by the aforementioned frustrations and obstacles.  The familiar five stages of adaptation are at work: denial, anger, bargaining, depression and acceptance.   This process tends to soften opposition to market value buyout offers.   Stock swaps may also become more popular, as many shareholders may think that buying a ticket on a winning horse may be preferable to being passengers on a foundering vessel.

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