More Bank Mergers? Don’t Bank On It

• Talk of increased bank M&A isn’t unfounded: There has been much speculation about increased bank M&A, including from Treasury Secretary Yellen last week, and there are good reasons—rising interest rates and compliance costs incentivize banks to seek relief through economies of scale.

• Bottlenecks and costs may be underappreciated, however: While drivers of M&A are well understood, key obstacles remain, and are arguably getting less attention than they deserve. The prospect of rising credit losses will dampen the ardor of both buyers and sellers, and the principal-agent problem looms as large as ever.

• Fed Funds futures, BTFP usage incrementally negative: Higher-Longer rate expectations are negatives for margins and credit quality, and the continued increase in BTFP usage implies ongoing deterioration in bank funding mixes.

Bank M&A Has Many Logical Drivers and Benefits

Fish gotta swim, birds gotta fly, banks gotta merge. There has been much speculation about increased bank M&A since the recent liquidity crisis, including from Treasury Secretary Yellen last week, and with good reason. With rates continuing to rise, deposit costs (and thus margins) are under increasing pressure. Bank mergers can reduce risk, including some that contributed to recent problems, by increasing diversification across geographies, customers, and lines of business. The secular trend of rising compliance costs, which is now poised to catch a cyclical tailwind, incentivizes banks to get larger in order to keep up with the burden.

Scalability and executive compensation incentivize M&A in all environments. The most fundamental reason for banks to merge is quite simple: Most of the banking business is scalable. A significant share of bank operating costs is fixed, so increasing volume while taking out redundant expenses yields lower unit costs and higher profitability, all else being equal. Another reason for banks to merge—perhaps not an excellent one, but a critical one—is executive compensation, which correlates much more strongly with size than with performance. As a rule, people do what they get paid to do, and running a mediocre large bank pays much better than running a high-performing community bank.

Customers can also benefit from consolidation. Benefits from customers of merged banks come in the form of broader product offerings, as the larger institution enjoys larger budgets to develop, say, mobile services. Customers also enjoy the convenience of wider geographic branch footprints (even after redundant branches are closed).

Acquirer’s communities often also benefit. Charlotte, North Carolina, is a major financial center, and the day may not be far off when it is the nation’s clear secondary capital, after New York. That is largely due to the many acquisitions of two empire-building CEOs during the 1980s and 1990s—Ed Crutchfield at First Union and Hugh McColl at NCNB/NationsBank—without whom the dominant local industry might still be stock-car racing. 

Most financial centers owe much of their status to geography. Consider America’s financial capital, New York, and regional capital in the west, San Francisco. In each case, the local geology, in the form of exceptional ports, made it especially likely that, when civilization came to them, they would evolve into cosmopolitan trading entrepôts, and thereby become centers for trade’s handmaiden, finance. North America has no shortage of good ports, but in the 19th century those two each got a big boost; New York from the Erie Canal, and San Francisco from the gold rush. Fast forward to the 20th century, with the general growth of the US economy relative to the world, and the federal government’s incubation of Silicon Valley, and the Wall Street and Sand Hill Road we know today begin to seem almost foreordained. 

Charlotte, however, is a creature of bank M&A. The geography of Mecklenburg County, North Carolina, isn’t what led it to become a financial hub. We have written previously about how Saudi Arabia’s decision to tank the oil market in 1985 took Texas out of the running as a potential secondary financial capital. But why Charlotte? Why not a larger city like Atlanta, or a city with a longer history as a regional financial hub, like Richmond, Virginia, or Birmingham, Alabama? Charlotte’s transformation into a financial center is down almost entirely to the sheer will of two men. Their shareholders often paid a stiff price, but the long-term benefits to Charlotte have been enormous. 

That’s why bank M&A is a constant. The FDIC insured 4,672 banks at the end of 1Q23; that’s a lot, but barely half of the 9,181 insured banks at the end of 2003. For the reasons enumerated above, consolidation has been a secular trend in the industry going back to the 1980s. One of the most remarkable things about this trend has been its consistency; as shown in Figure 2, the number of banks has declined by an average of 3.5% per year for the past 20 years, and the pace has stayed in a surprisingly narrow range; on average and over time, the number of banks declines by a bit less than 1% per quarter.

Large transactions have been scarce in recent years, however. One-third of the way through the 2020s, large bank transactions have been rare, with only two completed transactions worth more than $10 billion. Much has been said about regulators dragging their feet on approvals, and that is certainly a marginal factor (and a dispositive one with respect to Toronto Dominion - First Horizon). This explanation gives short shrift to other critical bottlenecks to, and underappreciated costs of, bank M&A.

A telling detail: The largest recent deals have involved foreign sellers. Excluding Toronto-Dominion’s cancelled acquisition of First Horizon, the three largest transactions (and all transactions over $10 billion in value) have involved the sale of US subsidiaries by foreign bank parents. This is noteworthy because such transactions do not face the primary bottleneck to banking consolidation: the principal-agent problem, about which more shortly.

Bank M&A Bottlenecks and Costs Are Underappreciated

Credit deterioration is a cyclical bottleneck. Credit quality is beginning to fray, most notably in commercial real estate, but credit risk is rising across a range of areas. It varies by type of exposure and by geography, but it is also happening on the consumer side, in credit card and auto for example (auto finance is in a very interesting place right now as COVID-driven trends normalize, but not interesting in a good way; this month’s announcement by Citizens Financial that it is exiting indirect auto is only the most recent indicator of trouble brewing there). Worsening credit quality is a significant disincentive to bank mergers, as it makes both buyers and sellers more skittish about prospective partners.

The cautionary tales of Bank of New England and SouthTrust. One of the largest bank failures in U.S. history, that of Bank of New England three decades ago, serves as a cautionary tale. Just a few years prior, the bank scored a seeming coup with the acquisition of Conifer Group, which had been driven to sell by an unsolicited offer from Fleet Financial. Conifer’s bad loans went a long way in sealing the fate of Bank of New England. That’s the buyer’s problem, and they at least get to do due diligence. The seller is placing something close to blind faith in the management of the buyer whose stock they are accepting. The acquisition of SouthTrust by Wachovia in 2004 is a useful example of the risk here. SouthTrust shareholders scored a 20% premium to their stock price, in a 100% stock transaction. Two years later Wachovia acquired Golden West Financial, an S&L loaded with risky mortgages that would lead to Wachovia being acquired at a single-digit stock price in 2008, leaving SouthTrust shareholders far worse off than if the bank had remained independent.

The principal-agent problem remains the primary bottleneck. Bank CEOs, like CEOs generally, tend to have worked very hard and made many sacrifices over many years in order to win the top job. Having at last earned the job, they tend not to be in any great rush to give it up. Sometimes, performance has been weak enough for long enough that they can’t turn down a sufficient offer, but most of the time, a one-time pop in the stock price is an insufficient incentive. Typically, a transaction requires that the CEO of a prospective target be personally ready and willing to do something else with their days. Prior to the 2008 crisis, one such alternative was to found a new bank, bring on other displaced executives from the acquired bank, and essentially execute the old playbook, only with larger equity stakes. As Figure 4 shows, however, new bank formation has ever really come back post-crisis, which only reinforces this bottleneck.

Don’t take our word for it; listen to former FDIC Chairman Bill Isaac: “You know what we need if we’re to get consolidation in this business? What we need is for a certain number of bank CEOs to get up in the morning, look out the window at the rose garden and say, ‘I’m tired of having a limousine pick me up every morning and take me to work. I’m tired of spending the day in a big office on the 50th floor, having all these people come in and bow and scrape. I’m tired of the gourmet lunches with filet or swordfish and fancy wines. I’m tired of being on the phone with Congressmen and telling them what bills to pass. And I’m tired of making all that money—I don’t know what to do with it all.’ If you get enough bank chairmen saying things like that, then you’ll have a lot of mergers of big banks. Until then, forget it.”

Extreme consolidation presents systemic risks. This is not an immediate risk in the US, but the recent experience of Switzerland highlights the need for some bounds to banking consolidation. A quarter century ago, UBS was in a weakened position and merged with Swiss Bank, leaving Switzerland with two outsized banks, and one obvious option should either of them need rescuing. This year, Credit Suisse needed rescuing, and the obvious option came to pass: The merger to create a single enormous Swiss Bank—with total combined assets of more than twice Switzerland’s GDP. Switzerland now has a tiger by the tail, with no easy domestic options should a crisis befall their new national champion.

Economies of scale don’t always find their way to shareholders (or customers). Inevitably some of the economies of scale promised by mergers get appropriated by other interests—by management to some extent (even if only in the form of higher executive comp raising the cost of that input), but in the case of banks, by regulators as well. One can’t draw blood from a stone, but regulators know they can demand more, and get a result from, a $100 billion bank than from a $100 million dollar one.

Diseconomies of scale also exist. Diseconomies of scale can be difficult to quantify, and there are fewer incentives (and more explicit disincentives) to even trying, but they are no less real for it.

Human capital is where the diseconomies of scale get especially severe though. The economies of scale in the C-suite—the combined company only needs one CEO, one CFO, etc.—carry the cost of fewer opportunities for the next generation of leaders to emerge, and that attendant creativity and ingenuity is lost. That all sounds a bit hippy-dippy, we freely concede, but the proof is in the pudding. The shareholders of Standard Oil and AT&T prospered as never before once they were broken up. Conversely, most of America’s largest banks are the product of transactions that condemned acquirers’ shareholders to years of underperformance. 

The original LBO boom offered further evidence. The firms we now refer to as alternative asset managers were known in the 1970s and 1980s more derisively as LBO firms (and by certain rather less flattering colloquialisms which, this being a family-friendly publication, we refrain from enumerating here). In that era, their stock-in-trade was buying and dismantling the sprawling conglomerates that had been built during the mid-20th century, and unleashing entrepreneurial energy was typically a primary justification. Mandy Rice-Davies applied, of course; the claims were entirely self-serving. But they weren’t wrong. 

As banks grow, they tend to become more opaque. Investors get far less detailed information about one oligopolist than they would from its constituent parts. Go ahead and compare the volume of data one gets from a G-SIB, voluminous though it is, from the aggregate data one got say, 25 years ago, from the core bank, its main bank acquisitions, and key line of business acquisitions in areas like mortgage or credit card or auto or payments. Now compare the level of insight afforded by one 60-minute call per quarter for the combined entity versus one each for all of the pieces.

Sellers’ communities also bear costs. The First National Bank of <your hometown> may be too small to offer a leading edge mobile app with the latest bells and whistles, and may be too small to finance your hometown’s aerospace industry. But how big is your hometown’s aerospace industry? What it does offer, though, is a financial institution that is keenly interested in the well-being of your hometown, because its fortunes are inextricably bound up in it. The marginal character loan gets made. The marginal loan that has positive externalities for downtown gets made. The local little league team and the float in the Independence Day parade get sponsored, because your hometown is the bank CEO's hometown too. The acquirer’s CEO, in its distant headquarters, likely bears your hometown no ill will, but couldn’t find it on a map in 10 tries, and the question he asks most frequently about your hometown is not “what more can I do to enable this community to thrive?” but “how much deposit runoff would we expect if we shutter the main street branch?” In a nutshell, mergers often represent a monetization of social capital accumulated over generations, and only replaceable over generations. The consolidator’s expanded product set is valuable, but it isn’t free. 

Bottom line: An awful lot of stars must align for bank mergers to happen. It just isn’t as simple as getting two bank CEOs in a room to hash out the details. There are a lot of interests, from the personal and financial for executives and shareholders, to a range of public interests overseen by policymakers, that must align for any transaction to be finalized. We don’t argue that there will or will not be an M&A boom, only that those who are charged with such forecasts should account for a much wider range of considerations than are commonly discussed.

Weekly Federal Reserve Balances

June 21 Federal Reserve balances show continued rise in BTFP usage. BTFP usage rose 0.8% last week to another new high of $102.7 billion, suggesting the persistence of liquidity and funding mix/cost challenges. PacWest’s June 26 sale of a $3.5 billion loan portfolio to Ares Management illustrates banks’ efforts to mitigate this by deleveraging (and also highlights the opportunities this trend creates for alternative asset managers).

Interest Rates

Higher-Longer expectations bode ill for margins and credit quality. As Figures 8-10 show, the yield curve remains inverted, and Fed Funds futures imply an additional rate hike in July, with no easing expected until 2024. We note that the effects of “higher/longer” are likely to be asymmetrical, with proportionally worse effects on both margins and credit quality.

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