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Bank M&A: Forget Much Of What You Think You Know

Thanks to elevated interest rates, constrained balance sheets, reduced stock currency and regulatory uncertainties, M&A activity in the banking space was relatively subdued in 2023, during which fewer deals of $10+ billion in combined assets were done than during the worst of the pandemic in 2020 (Figure 1).

Figure 1: Bank Deals Greater Than $10 Billion

Due to several changing factors, M&A activity last year was even quieter than during the height of the pandemic.
Source: PCBB

But there’s a good chance that the pace of deals picks up this year. Many industry observers see the tide turning because of pent-up demand for expansion. In addition, rates are expected to come down modestly, stock prices are up, balance sheets are healthier and the economy has been resilient. Still, the banking landscape has changed considerably in the past several years, and whatever M&A playbook may have been operative in 2019 is now likely outdated.

Scale alone just doesn’t matter as much as it used to. Gone are the days when the integration of entities produced a reliable revenue stream from acquired customers inflating the top line and instant cost savings falling to the bottom line.

Today, three factors in particular have risen in significance and need to be central to any M&A evaluation: higher-for-longer interest rates, changing customer behaviors and intensifying scrutiny from regulators.

Deposit Rates Will Remain Stubbornly High

When interest rates were at rock bottom, much of a suitor’s due diligence focused on the asset side of the balance sheet — the ability of an acquired entity to sustain its lending volume, margins and delinquencies. Deposit performance counted for less because it was assumed to be predictably stable.

In a 2018 report, Curinos cautioned would-be buyers about underestimating future funding costs as rates rose. And as it happened, during this tightening cycle, an abrupt jump in funding costs through deposits has reduced the accretive value of many deals by as much as 20%. Deteriorating loan quality can be problematic, but deteriorating liquidity can be disastrous.

Today, we again offer a cautionary view to would-be acquirers. Some believe that, starting this year, rates will fall as fast as they rose in 2022 and 2023. Using past rate cycles as a guide, this will almost certainly not happen.

Curinos estimates that deposit rates will continue to remain elevated even after the Fed’s first three cuts, if and when they come. Institutions considering an acquisition will be ill-served if they’re overly optimistic about where rates might settle. The higher the rates, the higher the stakes for getting a transaction right.

And regardless of rate changes, how consumers react to those changes won’t be monolithic — rate dispersion is greater than it’s been in 15 years. The growing number of financial services providers will continue to create distinct differences in how various consumer segments chase rate. Those consumers most loyal to their institution may stay put no matter the offer, but what Curinos calls the “area of indifference” regarding rate continues to contract.

Customer Preferences Are Changing

In 2017, branches accounted for 69% of all new retail banking relationships while digital accounted for only 28%. Today, it’s just the opposite: Digital, which includes fintechs and direct banks, now accounts for 67% of new relationships while the branch’s share has shrunk to 28% (Figure 2). Customers now average 2.3 relationships with financial institutions, up from 1.7 six years ago. And today’s top driver of convenience — identified by close to half of respondents in Curinos’ latest U.S. Shopper Survey — is a “useful online banking capability, including a mobile app.” Meanwhile, branch-related drivers of convenience stand at only 24%. (See accompanying article in this issue of Curinos Review, “Mass Market vs. Mass Affluent: A Data-Driven Primer.”)

Figure 2: Initial Method Of Opening Primary Checking*

Branches have declined steadily as the source for opening new checking accounts to the same degree that digital has risen.
US Shopper Survey
Source: Curinos Customer Knowledge | U.S. Shopper Survey 2016-2023 | Q33: How did you open your current primary checking account? | Net Digital: ‘On my desktop or laptop’; ‘On a tablet’; ‘On my smartphone’ | *Excluding ‘On the phone with a representative’ & ‘At work or home with a representative’

The implications are consequential for any institution considering an acquisition. Customers have many more options than in the past, and many of those options are readily accessible, usually with a scroll and click. That means customer relationships and core deposits being acquired are far less stable than they were, and the risk of customer
attrition is amplified. Yet, all too often, we see acquiring institutions make broad assumptions (or no assumptions at all) about customer attrition after a deal. Institutional loyalty is waning as the ability to move money and accounts gets faster and easier.

Just as potentially damaging is overestimating how much and how fast an acquired institution’s production levels will grow after conversion. Acquirers will need to create treatment and retention plans for the front lines much earlier than in the past. And with the importance of branches in decline, the acquirer’s share of customers gained in a deal may already have approached its cap, reducing to marginal any benefits from an expanded physical network.

New Rules On Mergers Will Temper Deal Appeal

The Justice Department, in cooperation with the Fed, the OCC and the FDIC, is seeking public comments on whether and how to revise its 1995 Bank Merger Competitive Review guidelines.

Based on comments from several well-positioned officials, attention appears to be focusing on these three Cs: competition, consumer and community. Although guidance is still formative, in the coming months and years, any acquiring institution, especially those with assets above $100 billion, will likely need to produce what we would call a “full report card” addressing all three.

Competition. Michael Barr, the Fed’s vice chair for supervision, sees merged institutions as double-edged swords: On the plus side, he says, they can enhance competition in products and services, but at the same time they could create negative effects by raising prices, narrowing services or cutting back on loans in specific service areas. We can reasonably conclude that any merger or acquisition plan will need to ensure that at least the same degree of competition will be maintained in any given market. That will require submission of a “report card” with specific metrics for compliance. More than in recent years, increased institutional size is likely to raise the specter of shrinking choice and expanding prices. As a result, an acquirer’s burden of proof to the contrary will be all the heavier.

Consumer. The Justice Department plans to “carefully consider how a proposed merger may affect competition for different customer segments,” according to Jonathan Kanter, assistant attorney general for the Antitrust Division. Some consumers may seek personalized service that requires an FI to have “unique knowledge of their local communities, while others may rely on an extensive branch network or exclusively through their mobile device.” Recognizing that substitution across different types of banks may be limited. Kanter says antitrust enforcers must ensure that consumers have real choice in how they do their banking. Any acquisition plan will therefore need to consider the degree to which customer preferences will be maintained and how to measure it.

Community. Barr says the Fed will review “the potential effects on the convenience and needs of the communities to be served by the merged entity, particularly low-income communities.” The DOJ’s Kanter echoes the importance of “convenience and needs” and cites their significance as overriding even the potential “anticompetitive effects” of a proposed merger. With the revision of the 1995 bank merger guidelines, we expect to see a greater emphasis on the welfare of “community,” so acquiring institutions will need to address it both during due diligence and before integration. This is a different type of planning than regulations previously sought — today, acquirers will have a much smaller window to fit a successful deal through in terms of both execution and regulation.

What’s required today is a thorough analysis of customer-level relationships — one that goes beyond standard credit and deposit marks — to ensure that merger value is captured and regulator questions are addressed quickly. The only way an acquirer can realistically do this is by leveraging cross-bank data at the account level. Then, even more important will be to better understand exactly how the integration will take place given how tight the economics are on any deal.

Much has changed in M&A of late and today’s due diligence needs to acknowledge the changes and change with them because the stakes are growing while the margin of safety is shrinking. Only with an updated playbook to guide them can buyers and sellers hope to succeed in today’s challenging environment.

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