The Scale Imperative: Banks Can Acquire Credit Unions

The traditional financial industry is facing a quiet, steady drain of its lifeblood. While the "unbanked" population is shrinking, the "loyalty" of the modern consumer is fragmenting. Millennials and Gen Z—the oldest of whom are now 45—are systematically moving their balances away from traditional institutions toward "cool" digital tools and high-yield platforms like Rocket or SoFi. Even loyal Gen X customers are increasingly treating their primary bank accounts as "paycheck motels", a term coined by Ron Shevlin, quickly routing funds to wherever they earn the most.

To survive this shift, banks don't just need better apps; they need scale.

The Untapped Reservoir of Retail Funding

Many banks have pivoted toward business banking to find higher balances and margins, but the foundation of a community bank’s funding remains retail deposits. Interestingly, the most robust retail deposit bases are currently locked inside credit unions—institutions that are struggling with their own scale issues and merging at a similar clip to banks.

While credit unions buying banks have dominated the headlines and trade group lobbying, it is time for the industry to flip the script. Banks can—and should—buy credit unions.

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Industry Interest

I recently sat on an ABA panel at the recent ABA Washington Summit about this very issue. Joining me were industry experts on such transactions from law firm Luse Gorman and the ABA, moderated by Dave Daraio of Maspeth Federal Savings and Loan Association in Queens. The message: let’s pivot from lobbying against CU-bank deals to executing our own. It can be done.

Debunking the Myths of the "Impossible" Deal

The industry has long viewed bank-on-CU acquisitions as a regulatory and accounting nightmare. And recent history is no help. But the landscape has shifted:

• The Legal Path Exists: Federal law (12 U.S.C. §1785) and NCUA regulations (12 CFR Part 708a, Subpart C) explicitly provide the roadmap for a bank to acquire the net assets of a credit union.
• Regulatory Winds are Changing: The NCUA is currently rewriting its rules to make charter conversions to mutual banks easier, and is potentially "defanging" the poison pills of the past that they have wielded to thwart bank-CU deals.
• The Efficiency Edge: Despite their tax-exempt status, credit unions are often less efficient than banks. For similarly sized institutions, banks have historically delivered better financial performance, even after paying taxes.

Overcoming the Capital Hurdle

The primary challenge is accounting. These deals are structured as asset purchases where the credit union’s value must be distributed to its members. While this can strain a buyer’s capital, it creates a unique opportunity for:

• Stock Banks: Their ability to raise fresh capital gives them an advantage in absorbing these assets.
• Larger Banks Buying Smaller CUs: When a larger bank acquires a smaller credit union, the capital contingencies become negligible, making the deal "cleaner" and faster to execute.
• Member-to-Mutual Deals: The NCUA would likely be friendlier toward deals where credit union members gain depositor rights in a mutual bank.

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Call to Action: Who Will Step Up?

We are currently in a favorable regulatory environment for deal-making. And I will confess that my firm would welcome the opportunity to be at the forefront of this deal-making. More important to readers, we cannot continue to ignore the fact that our retail funding base needs a massive infusion of scale to compete with non-traditional providers while doing so profitably.

Credit unions have the deposits banks need, and many are looking for an exit due to scale or succession issues or a way to provide more flexibility to their members.

The tools are in the manual. The law is on the books. The market demand is clear.

It is time for bank leadership to stop complaining about credit union expansion and start executing their own. Who is going to step up and lead the first major "reverse" merger of this new era?

~ Jeff

Debunked! Are Bank Merger Approvals Taking Longer?

I enjoy my Twitter community because I get diverse views on banking, sports, politics and entertainment. One of my Tweeps, Rick Childs, a Crowe partner, recently tweeted about the amount of time it is taking merger deals to get regulatory approval. His numbers are raw, and buck the conventional wisdom that regulators are dragging their feet on approvals. A conventional wisdom that our clients are asking us about, so it is tremendously beneficial to have actual data, instead of my standard answer: "we haven't noticed it at smaller bank deals." Data rules.

Conventional wisdom must result in actual wisdom, right?

Average Months From Announcement to Closing

Average Months From Announcement to Closing (Terminated Deals Separate)

Average Months From Announcement to Closing by Asset Size

Average Months From Announcement to Closing by NPA/Assets

Average Months From Announcement to Closing by Tang. Eq./Assets

Average Months From Announcement to Closing by ROA

Average Months From Announcement to Closing In-State vs. Out-of-State Acquirors

Average Months From Announcement to Closing for Merger of Equals

There you have it. Merger deals are taking no longer from announcement to closing this year versus recent history. Terminated deals intuitively take longer because the regulatory approach is not to reject the merger, but to inflict pain on the parties until they withdraw their application and subsequently terminate, a process that obviously would take longer.

Larger deals are taking longer, as has been the case in recent history. I should note there is likely a smaller universe to calculate averages, that likely skew the numbers for >$50B bank deals. Also intuitive is bank deals where targets have lower capital levels and profitability (ROA) took longer.

Not intuitive is that there doesn't seem to be a correlation between the seller's asset quality and time to complete a deal. And rounding out Rick's deep dive into the merger completion timeline rabbit hole, MOE's and out-of-state transactions take longer for approval.

There you have it. Now bankers don't have to rely on investment banker opinion as to the length of time it takes deals to get done. 

Thank you to Rick Childs and the Crowe researchers for keeping us steeped in facts!

~ Jeff

Fintech Buys Bank. Keeps Stratospheric Valuation.

Imagine a fintech, with off-the-chart valuations such as 2.6x book value and 51x EBITDA, buying a bank. For 1.85x book. 

In today's M&A valuations, 1.85x is pretty lofty. Especially for a community bank. But you don't have to imagine it. Because that was what LendingClub paid for Radius Bank. Since the deal closed, LendingClub has kept its valuations. In fact, since February 17, 2020, one day prior to the Radius Bank deal announcement, LC's share price has risen 58% versus the S&P BMI Software & Services Index increase of 20% (see chart). 

LendingClub bought a bank and didn't trade down to traditional bank valuations. Their valuation grew loftier. Making for even better currency to buy even more banks. And putting them at a strategic advantage over other would-be financial institution buyers mired in the lowly yet more rational bank stock valuations. Truth be told, LC paid mostly cash in the deal. What's cash worth these days? And there are plenty of examples of investors throwing barrelfuls of cash to technology firms.

This is a clear threat to financial institutions. How can we overcome such a hurdle? I wrote that one primary reason banks need scale is to enjoy greater trading multiples. It was one of my most read posts and is a chapter in my upcoming book, Squared Away (soon to be available in your favorite bookstore). 

But we can't pay 2x book for a target when our stock is trading at 1.2x book. Even if we enjoy higher bank-like trading multiples because of scale we may get to 1.5x. Green Dot Corporation is currently trading at 2.6x book and over 6x tangible book. They can easily afford 2x book with that valuation. With more experience acquiring banks in the rearview mirror, fintech's who might have once been worried about bank valuations weighing them down, will be more confident to bid on for-sale banks, to be aggressive, to get deals done. 

Having said that, net interest income is a very small part of  LendingClub's revenue mix, at 22% for 2020, which was prior to the close of the Radius Bank transaction. And they're in the business of lending! Green Dot Corporation showed less than 2% revenue attributed to net interest income. So the continued lofty valuation might be relating to the relative size of the bank within the fintech. 

We were worried that credit unions would be buying banks. Using their ample cash positions, which aren't earning much in the investment portfolio or at other financial institutions, and turning taxable earnings from target banks into non-taxable earnings at credit unions.

What about fintechs that may not be too concerned about profit? I reviewed LendingClub's last five years and see nothing but red ink. Radius Bank had net income of $6.7 million in 2020. On a consolidated basis with the currently bleeding LendingClub, that might revert to tax-free money. Just what we feared with credit unions. 

Should we be worried about more fintechs stepping up to buy banks? (Ref: SoFi and Golden Pacific Bancorp) 

Will these precedents be part of a trend?

~ Jeff

Twitter Reacts to M&T / Peoples United Bank Deal

The headlines for subject deal, which dealmakers hope beyond all hope starts a robust bank M&A frenzy, were like the following:

(you can click on articles and tweets to enlarge)

Conversely, here are what some Twitter users thought of the deal, which starts with a factual tweet from yours truly. Keep in mind most tweets were from investors, not other stakeholders.

Any other reactions?

~ Jeff

Is Your Contemplated Bank Merger Anti-Competitive?

Yesterday at the ABA's virtual Conference for Community Bankers (CCB), Federal Reserve Governor Michelle Bowman gave a speech, My Perspective on Bank Regulation and Supervision. In that speech, she briefly commented on the FRB's review of merger applications from an anti-trust standpoint. She said:

"Technological developments and financial market evolution are quickly escalating competition in the banking industry, and our approach to analyzing the competitive effects of mergers and acquisitions needs to keep pace. The Board's framework for banking antitrust analysis hasn't changed substantially over the past couple of decades. I believe we should consider revisions to that framework that would better reflect the competition that smaller banks face in an industry quickly being transformed by technology and non-bank financial companies. As part of this effort, we have engaged in conversations and received feedback from community banks about the Board's competitive analysis framework and its impact on their business strategies and long-term growth plans. We are in the process of reviewing our approach, and we are specifically considering the unique market dynamics faced by small community banks in rural and underserved areas." 

The Fed's FAQs on their approach in analyzing the competitive effects of a merger say the following:

On the initial evaluation of the competitive effects of a combination: 

The competitive analysis of banking acquisitions begins with an initial screen based on market shares and market concentration for the local banking markets in which the parties to a transaction have overlapping operations. Market shares for a local banking market are based on the deposits of depository institutions in the market. The Herfindahl-Hirschman Index (HHI) is the usual measure of market concentration and is calculated as the sum of squared market shares in a local banking market. For these initial calculations, the deposits of all institutions with a commercial bank charter receive 100 percent weight and the deposits of all institutions with a thrift charter (i.e. savings banks and savings and loan institutions) receive 50 percent weight in computing market shares. This weighting indicates that the Fed doesn't think thrifts offer a full retail banking suite of products and/or they are concerned about the anti-competitive effects for in-market commercial banking. Although readers know that many thrifts pursue business banking strategies. And to a lesser degree, credit unions. Which are not part of the HHI calculation.

The Board delegates merger approval to individual Reserve Banks unless, among other reasons (i) the merger or acquisition would raise the HHI by 200 points or more to a level of 1,800 or higher in any local banking market in which the parties to a transaction have overlapping operations, or (ii) the merger or acquisition would increase the post-transaction market share for the acquiring firm to more than 35%. If these are triggered, off to Washington the merger application goes.

On how the Fed defines geographic markets:

No hard and fast rule. Many geographic markets follow Metropolitan Statistical Area (MSA) definitions or rural county lines, but some markets comprise multiple MSAs/counties or parts of MSAs/ counties, reflecting that economic activity does not always track political boundaries. Up-to-date geographic market definitions are available at the St. Louis' Fed CASSIDI database or from the relevant Reserve Bank. Banks can dispute the definition of a geographic market relevant to their application by proposing an alternative market definition and providing evidence supporting the alternative. Such evidence should focus on retail banking customers' substitution behavior (emphasis mine) or on the economic integration of the relevant economic areas for the proposed geographic market definition. 

This runs contrary to the deposit weighting of 100% for commercial banks and 50% for thrifts. Why discount thrifts, and not even count credit unions if the true concern is retail customers' ability to substitute?

And what about branchless banks? This gets to the crux of Governor Bowman's comments, in my opinion. Why do we not count virtual banks such as USAA, Discover, and Ally, or neo banks such as Chime (Stride Bank or The Bancorp Bank)? 

What I would suggest to regulators in contemplating change is to have FDIC and NCUA insured financial institutions report deposits by geography, such as Zip code, and break it down further between business and consumer. Let that be the new Summary of Deposits from which the anti-competitive effects of a merger is calculated. If you continue to weight deposits by institution type, determine first what anti-competitive risk we are trying to mitigate. Are we concerned more about business banking than retail banking? Then perhaps business deposits get 100% weighted in the HHI calculation and retail deposits get something less than that. Or, alternatively, perhaps Americans value a bank with a physical presence in the market, and therefore financial institutions with a physical presence get 100% weighted versus something less for institutions with no in-market presence. But the bank/thrift weighting scheme currently in effect does not reflect reality.

So in terms of how competitive analysis is now performed, I agree with Governor Bowman's comments. Change is coming. And welcome.

~ Jeff

Why Did Oritani Sell For No Premium?

On June 25th, Oritani Financial Corp (ORIT) common stock closed at $16.21 per share. The next day they announced they were selling to Valley National Corp. for $16.29 per share. Virtually no premium. And less than ORIT traded one year ago. Why?

I was not part of the discussions regarding the transaction, and am not an advisor to either bank. I have no inside information to share. Only some observations and opinions. 

ORIT has historically been a high performing financial institution in a highly concentrated deposit market. For the calendar first quarter 2019 they had a 1.22% ROA, which was down from 1.31% in fiscal 2018 (ORIT is on a different fiscal year). Their efficiency ratio... fuggetaboutit! Thirty six percent for the quarter ended 3/31. 

So why did they receive 138% of book value, and 14x earnings when nearby (5 miles between headquarters) Stewardship Financial Corp. (SSFN) announced their sale to Columbia Financial (MHC) for 167% of book value, 17x earnings, and a whopping 77% premium. This transaction was also announced in June. ORIT is 4x the asset size of SSFN.

There are many factors that go into pricing merger transactions. Cost savings opportunities, attractiveness of markets, niches or specialties, seller's capitalization, buyers' stock valuations, etc. And in fact, ORIT was relatively highly capitalized compared to SSFN, with a leverage ratio of 12.92% versus 9.48%. That plays a role in price/book merger pricing. But ORIT consistently outperformed SSFN in financial performance. Yet received a lower valuation.

Bank Brand Value

You may recall I wrote about the value of brand in a post entitled: Bank Brand Value: Calculated! And I am very familiar with financial institutions in the Mid-Atlantic. So I suspected a key factor leading to the no-premium deal between ORIT and Valley might be related to ORIT's brand value. 

So I did the calculation described in the linked post (see table).

I searched for regional peers with total assets between $1 billion and $10 billion. I then filtered for loan peers that had multi-family and commercial real estate loans greater than 60%. ORIT's was 92%. These are highly competitive, transactional loans. And in the New York metropolitan area, are significantly originated by loan brokers and bid on by banks.

Even though I searched for peers with high levels of these types of loans, ORIT earned seven basis points less than peer in Yield on Loans minus NPAs/Assets, negatively impacting bank brand value (BBV). 

For deposits, I searched in the same region and size as loan peers, but controlled for banks that had total time deposits as a percent of deposits greater than 30%. ORIT's was 42%. The Cost of Interest Bearing Liabilities was the same as the deposit peer group. So it did not add or subtract from BBV.

So, although I filtered for financial institutions with a similar balance sheet composition, ORIT had an inferior Yield on Loans minus NPAs/Assets, and equivalent Cost of Interest Bearing Liabilities.

Leading me to the opinion that, among other factors, ORIT received no premium because it had a negative BBV.

Why do you think the bank received no premium?

~ Jeff

Why SunTrust and BB&T? Why?

I know on the investor conference call, Kelly King of BB&T and Bill Rogers of SunTrust spoke to why. But I may not have been listening well.

I suppose much of the discussion revolved around scale. So, along with my first inclination, my second inclination was also... why?

The Numbers

Here are their slash lines (read: Assets/ROA/ROE/5-Year Annual EPS Growth/Dividend Yield)

BBT: $225B / 1.47% / 10.95% / 9.5% / 3.3%

STI:  $216B / 1.34% / 11.50% / 15.5% / 3.1%

BBT (bank only) had $6.3B in operating expenses in 2018, five percent of which is in the Call Report category "Data Processing Expense", defined as expenses paid for data processing and equipment such as telephones and modems. It does not include employees. STI (bank only) had $5.4B, 10% of which was in Data Processing Expense. I find it difficult to believe they can't find enough money in that pot or outside of the Data Processing pot for technology innovation. It would be a travesty of management. 

Perhaps they would find it difficult to maintain that level of EPS growth, given the law of large numbers. But they chose to solve that problem by becoming larger? BB&T will issue 1.295 shares for each SunTrust share outstanding, increasing their share count from 777 million to 1.4 billion. So to earn one cent per share more, the combined company would have to generate $14 million in additional net income. And at the 1.5% ROA BB&T already achieves, they would have to grow $933 million for each penny of EPS growth. To maintain 10% EPS growth, the combined bank would have to grow about $39 billion per year (42 cents x $933MM).

Perhaps they felt the pressure "to do something", as my BB&T regional business banker friend told me, saying that at their size they were in "no man's land". I don't know what that means. But an investment banker told me today that investors are intolerant of tangible book value per share dilution of more than three years. So if you feel you need to "do something", and can't overly dilute your book value, perhaps a merger of equals (MOE) makes sense.

I have preached MOE virtues for banks that could actually benefit from scale to achieve better efficiency ratios. Statistically, banks between $5B and $10B in total assets are better at it than larger financial institutions. But I digress.

Law of Large Numbers

I have written in the past about financial institutions running into the law of large numbers, leaving only acquisition as its means to meet shareholder expectations. I'm not saying it's impossible, as JPMorgan Chase did it ($2.6T in total assets, 14% EPS CAGR since 2014). But it's difficult. And JPM received a huge boost from tax cuts. 

Financial institutions, in my experience, are not keen on turning themselves into cash cows, maximizing their profitability with slower growth and paying a higher proportion of shareholder returns in dividends. Financial institutions also don't tend to buy and divest lines of business as a means to stoke shareholder returns, as very large industrial firms do (i.e. GE).

So if BB&T and SunTrust have ample operating budgets to invest in technology, and are delivering strong shareholder returns, in good markets.. i.e. almost the same markets... 

I ask: Why merge?

~ Jeff

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For Financial Institutions, Is There Such A Thing As Too Much Capital? Yes. Yes There Is.

I was on a panel at a bankers conference with an investment banker and two bank fund investors. One of the investors' opening remarks was about banks that were over-capitalized. I panned the audience to see if regulators were present.

But there were enough open jaw gapes to see that many bankers share the regulatory belief that there is no such thing as too much capital. And that may be true for financial institutions that don't take investor money. But if your bank is shareholder owned, then you may be hoarding their money. And as a bank shareholder myself, I like to make my own hoarding decisions.

I have written on these pages about a method to estimate your "well capitalized", a question your regulators may have asked you. Having done this, and seeing that your strategic plan has you comfortably above your well capitalized and trending higher, what do you do with the excess capital?

Derek McGee of Austin law firm Fenimore, Kay, Harrison, and Ford had four to-the-point ideas in a recent Bank Director Magazine article. I would like to lay out his four ideas with my take on them.

1. Dividends. "Returning excess capital to shareholders through enhanced dividend payouts increases the current income stream provided to shareholders and is often a well-received option. However, in evaluating the appropriate level of dividends, including whether to commence paying or increase dividends, banks should be aware of two potential issues. First, an increase in dividends is often difficult to reverse, as shareholders generally begin to plan for the income stream associated with the enhanced dividend payout. Second, the payment of dividends does not provide liquidity to those shareholders looking for an exit. Accordingly, dividends, while representing an efficient option for deploying excess capital, presents other considerations that should be evaluated in the context of a bank's strategic planning." 

My take: Amen Derek! In a blog post this year, Bank Dividends: Go Ahead and Drink the Kool Aid, I called for the same thing. And to use special dividends and deliberate shareholder communications to help overcome shareholder expectations mentioned above. I have not experienced a bank that made the pivot from being a growth company to a cash cow, where profits are maximized and dividends are plentiful. It is a natural evolution of a company built to endure. 

2. Stock Repurchases. "Stock repurchases, whether through a tender offer, stock repurchase plan or other discretionary stock repurchase, enhance liquidity of investment for selling shareholders, while creating value for non-selling shareholders by increasing their stake in the bank. Following a stock repurchase, bank earnings are spread over a smaller shareholder base, which increases earnings per share and the value of each share. Stock purchases can be a highly effective use of excess capital, particularly where the bank believes its stock is undervalued. Because repurchases can be conducted through a number of vehicles, a bank may balance its desire to effectively deploy a targeted amount of excess capital against its need to maintain operational flexibility."

My take: Institutional shareholders own greater than two thirds of publicly traded financial institutions' shares outstanding. And share buybacks are a favorite of theirs. The challenge is that they would like to liquidate their ownership when the value is at its peak. Meaning the financial institution purchasing its shares would likely enjoy minimal earnings accretion and create book value dilution. But, as Derek pointed out, it is a highly effective use of excess capital when the bank believes it is undervalued. One bank stock analyst thinks every bank should calculate the earnings accretion of a prospective merger versus the earnings accretion of a share buyback. If the buyback is more accretive, why do a riskier merger?

3. De Novo Expansion in Vibrant Markets. "Banks can also reinvest excess capital through organic expansion into new markets through de novo branching and the acquisition of key deposit or loan officers."

My take: When a race car enters the pits, it is losing time. If not to recalibrate, refuel, and re-tire, drivers wouldn't do it. If you compare bank strategy to a 500-mile race, banks would also enter the pits. But if you compare bank strategy to a few times around the track, you would be foolish to do so. Think of the short race as budgets, and the 500-miler as strategy. You have to be willing to accept the short-term setback of entering the pits (i.e. making strategic investments like Derek mentioned) to position you to win the race. 

4. Mergers & Acquisitions. "Banks can deploy excess capital to jumpstart growth through merger and acquisition opportunities. In general, size and scale boost profitability metrics and enhance earnings growth, and mergers and acquisitions can be an efficient mechanism to generate size and scale. Any successful acquisition must be complementary from a strategic standpoint, as well as from a culture perspective."

My take: Derek's "complementary" comment was right on. Listen to my firm's most recent podcast on M&A cultural integration featuring an interview with Jim Vaccaro, Chairman and CEO of Manasquan Bank, that is in the process of merger integration as I type. In addition to a cultural fit, the geography and balance sheets should be complementary, and the earnings accretion should exceed what the buying institution could achieve on its own. Tangible book value dilution, which tends to get a lot of play in the investment media, should not be to the level to cause long-term downward pressure on the buyer's stock price. 

Out of the four, M&A is the least within the control of the financial institution, as this takes a willing partner.

What other uses of excess capital do you propose? 

~ Jeff

Schmidlap Bank, A Division of Community Bank

"We want to keep our charter because the OCC is a more distinguished regulator." Seriously, that is what a bank chairman told me when arguing to keep his bank's charter during merger negotiations.

But I try not to judge. Perhaps, if I thought the argument weak, which I did, there was something else behind it. Something like "we've spent 100 years building the reputation of this bank and 'poof', it's gone at the stroke of a pen." Or, "my grandparents, parents, and now me served on the board of this bank and I owe it to their legacy..."

Why not just say that? Perhaps there is little evidence of the benefit of your 100-year brand, so it's a difficult argument to make. But more difficult than claiming the OCC is a better regulator? 

In more recent merger discussions, however, I have heard more refreshing arguments that it is not necessary to re-brand every nook and cranny of your bank into one. Because one key argument to combine brands is the efficiency of advertising into one or more media markets. Does this make sense today?

I think not. Take the accompanying picture, all from my Twitter, Facebook, and LindedIn streams. Three different "promoted" posts. All specific to me. Based on all the intel gathered on me. My neighbor, or even my wife, see different ads. So combining names so you can realize synergies in your billboard strategy doesn't make sense like it did 20 years ago.

More success stories of the divisional approach are cropping up in our industry. One of my favorites is the affinity brand Red Neck Bank, a division of All America Bank. All America Bank is a traditional community bank located near Oklahoma City, and has been around since the 1960's. And yes, they recently switched names from Bank of the Witchitas. But did they have to? For the traditional bank, I'm not so sure.

Aside from the traditional bank, they thought out of the box, and established a digital-only division to appeal to a specific niche. And it has done well. Marvelously well. Even though it has not reached the "critical mass" that your investment bankers insists that you need. See the accompanying table.

On a more traditional front, I point to UNSY Bank in upstate New York. This bank, unlike All America Bank, is relatively new, having been formed in 2007. It's strategy, however, is to build brands that resonate closer to the communities where they operate. For example, the $349 million bank has only four branch locations, each USNY Bank. But they operate as Bank of the Finger Lakes, or Bank of Cooperstown, divisions of USNY. Their financial performance doesn't seem to be hampered by bifurcated branding.

The divisional approach is becoming more important as relatively small financial institutions worry about keeping up with customer preference, technology, and regulatory changes. Although I mock the investment banker that always seems to think your institution needs to be twice the size you are now, regardless of the size you are now, there is merit to achieving a certain size.

Merits that include: increased stock trading multiples, greater employee development opportunities, the ability to absorb regulatory costs, and greater resources to invest in technologies to afford you a long-term future.

But you need not give up your name to get a merger of like-sized institutions done. Nor dump your local brand for a homogeneous one that spans geographies.

~ Jeff

Five Challenges to Your Bank of the Future and Ideas to Overcome Them

I recently spoke at a Financial Managers' Society (FMS) breakfast meeting on this subject and thought I would share my comments with you.

With all of our anguish, torment, debate, and deliberation about the future of our country, our industry, and our bank, here are some common themes that I have been seeing that can be improved should bank management commit to making them happen.

Forget the things outside of your control. These five themes are firmly within your ability to make a positive impact on your future.

1. We merge, citing economies of scale, but fail to realize them. In 2006, when the median asset size within my firm's profitability outsourcing service was $696 million, the operating cost per business checking account was $586 per year. In 2016, the median sized financial institution is $1.1 billion, and the operating cost per business checking account is $710. In other words, the financial institutions grew, and the cost per account grew. This is the theme across nearly every product category. Don't believe me, check your banks' expense ratio (operating expense/average assets) or efficiency ratio as you grew.

Idea: Create measurable incentives to support centers to provide more efficient support to profit centers and for risk mitigation. For example, deposit operations' expense as a percent of deposits should decline as the bank grows. Loan servicing expense as a percent of the loan portfolio should do the same. 

2. We over-invest in under-performing branches. I recently mentioned to a community bank management team that community financial institutions are slower to close branches because their decision making goes beyond the spreadsheet and market potential. Community bankers know the town mayor, and key business leaders. So they worry about other things that go beyond the fact that their branch in that market has little chance of being profitable. But allowing branches to operate at losses takes resources away from areas that need immediate resources, such as technology acquisition and deployment.

Idea: Develop objective analyses for entering markets. If the branch does not meet profit objectives within a reasonable period represented in the original analysis to open it, close it. Make it near-automatic.

3. Our brand awareness and customer acquisition strategy is moving at a turtle's pace, not the hare pace of the industry. In my firm's most recent podcast, we discussed the recently released FDIC Summary of Deposits data that showed, with all of the negative press surrounding large financial institutions, FDIC-insured banks with greater than $10 billion in assets moved from an 80.6% deposit market share in 2012 to an 80.7% today. This phenomenon was brought home when a banker told me that, in the Philly suburbs, Ally Bank was the most recognizable banking brand. Aren't they still owned by our government? 

Idea: Develop a clear message on what your bank represents and align your culture, and all sales and marketing channels to deliver your value proposition. 

4. We embrace complexity when we should be seeking simplicity. The decline in defined benefit pension plans combined with the increases in defined contribution (401k) plans, the abysmally low US savings rate (31% of non-retired people have no retirement savings), and the increasing complexity of running family and business finances presents an opportunity for community financial institutions to make their customers' lives simpler. We should start with ourselves. For example, when onboarding a customer, an FI can perform needs assessments, risk assessments (needed for risk management purposes), and customer capital allocation needs all at once, and add value to the customer relationship. 

Idea: At account opening, build an automated business process that includes the needed Q&A to assess customer needs that spurs post-account opening follow up, know-your-customer information, and risk assessments required to risk rate customers that assigns a rating that drives capital allocations to that customers' balances and rolls up to determine the bank's capital requirements.

5. We under-invest in the people that can build our bank. Because of over-investment in areas such as regulation and unprofitable branches, we under-invest in elevating the abilities of our employees to serve as advisers to customers, as highlighted above. Also, we tend to buy key people on the street, such as commercial lenders, rather than raising them within our bank, because of the time and resource investment needed to turn junior level people into productive commercial lenders.

Idea: Build a bankwide university that includes on-the-job training, web-based seminars, in-person training, and banking schools to create career paths for junior-level people that will reduce our need to buy senior-level people on the street, and elevate the skill sets of employees to actually advise customers, rather than only sell to them.

If I were to end this post with a theme, it would be urgency. We are past the time to lament about the interest rate and economic environment, and Dodd-Frank. They are outside of our control.

We are intuitively aware of the above challenges. The good news is we can do something about them. Address them this year, this month... no, this week! And your bank will move forward to an independent future for your employees, customers, and community. 

Did I miss any challenges within our control?

~ Jeff

Buy Versus Build for Financial Institutions

If I mention "buy versus build" to a bank CFO friend one more time, he's going to punch me. Why do I keep bringing it up? Because the potential acquisition targets that are available don't fit his bank's strategy very nicely. Not even like OJ's glove. So I ask, did you think about building your own franchise in the geographies that you want?

Talk to the hand. 

Acquisition pricing is on the rise. It may be tempered somewhat by the general market decline this year, but the pressure is definitely upward. And would-be acquirers are feeling it. Should they bid high, increasing tangible book dilution, decreasing earnings accretion, and reducing the deal's internal rate of return? Or should they sit on the sideline and run the risk that all of their potential acquisition partners go to competitors?

And sometimes the targets are not prizes. So I ask, if you could have the franchise you want, in the geographies you want, would you do it?

This, of course, speaks to building one. And I think bankers ought to go through this exercise when considering submitting bids on targets. What would it cost and what would be the return to build it ourselves?

I did a sample analysis with the accompanying table. I used an extended period, 10 years, to reach more mature profit numbers of a build it yourself franchise. I assumed either buying a $1 billion in assets bank, or building a similar franchise in the geographies that were consistent with your strategic plan. All "build" branches, and I assumed 13 of them, would cost $500,000 each in leasehold improvements and FF&E for leased branches.

Now I see why bankers are favoring buy. The buy scenario, because you start with $1 billion in assets spewing earnings, plus the traditional transaction cost savings (I assumed 30% pre-tax), delivers profits immediately and throughout the projection period, delivering far superior NPV.

The build scenario takes a while to get off of the ground.

The NPV and ROI numbers at the bottom of the table should not be the end of the story. When a bank buys another, it typically uses its stock as part of the consideration. The premium in our example is $60 million. But the total consideration is $150 million. If your stock traded at $20, and you used all stock, you would issue 7.5 million shares in the buy scenario. Breaking down profits per share may be a different story. Tangible book dilution would also favor the build scenario.  

I should also note that I did not tax effect the Leasehold Improvements and FF&E expenditures. They do count as operating expenses over time but are capitalized and expensed over their useful lives. So I took the conservative approach.

When you build, you select the locations, employees, and markets. Maintaining your culture is easier, as opposed to acquiring an existing culture. 

One reason to buy versus build, however, is the accounting treatment. Sad, but true. The transaction expenses are mostly expensed immediately upon transaction consummation, and do not impact the bank in the next quarter or subsequent periods. The premium paid over the target's book value is mostly put into goodwill on the buyer's balance sheet and is never expensed so long as the buyer suffers no impairment on the acquired franchise. So any "investment" in an acquired franchise has little tail effects on the acquiror's income statement, with the exception of the per share numbers, mentioned above.

The build scenario, on the other hand, can be said to inflict pain over multiple periods. Because the investment and operating losses run through the income statement, albeit over time for the leasehold improvements and FF&E. So senior executives tend to favor buying, so they don't have the long hangover of building it themselves. 

Am I missing something?

Do you run a buy versus build analysis when considering a strategic entry into new geographies? Because target prices are getting higher.

~ Jeff

Bank Deals: How Are They Working Out for You?

Bank mergers are picking up steam. Technological change, regulation, and scale are cited most often by sellers. Take a premium now, rather than drift slowly into the abyss of irrelevance.

But what about buyers? I have written about achieving positive operating leverage in the past. In fact, it is one of my most read blog posts. In his most recent Chairman's letter, Warren Buffett weighed in with the following about buyer performance post acquisition:

"We've also suffered financially when this mistake has been committed by companies whose shares Berkshire has owned (with the errors sometimes occurring while I was serving as a director). Too often CEOs seem blind to an elementary reality: The intrinsic value of the shares you give in an acquisition must not be greater than the intrinsic value of the business you receive.'

'I've yet to see an investment banker quantify this all-important math when he is presenting a stock-for stock deal to the board of a potential acquirer. Instead, the banker's focus will be on describing "customary" premiums-to-market-price that are currently being paid for acquisitions - an absolutely asinine way to evaluate the attractiveness of an acquisition - or whether the deal will increase the acquirer's earnings-per-share (which in itself should be far from determinative). In striving to achieve the desired per-share number, a panting CEO and his "helpers" will often conjure up fanciful "synergies." (As a director of 19 companies over the years, I've never heard of "dis-synergies" mentioned, though I've witnessed plenty of these once deals have closed.) Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. The should instead be standard practice."

How can Warren's words be put into practice? To exemplify, I took two of the largest acquisitions in 2011 to back-check if it improved the buying bank's EPS and efficiency ratio. I went back over three years because mergers should be considered and executed with long-term financial improvement and overall bank strategy in the forefront of the "should we buy" decision. Citing the first few "clean" quarters after closing the transaction perpetuates the short-term budgeting culture that plagues our industry and prohibits long-term investing. By looking three plus years after merger announcement, I avoid that self defeating game.

I didn't take the largest deals from 2011, which were: Capital One Financial/ING Bank ($9.0B), PNC/RBC Bank (USA) ($3.5B), and Comerica/Sterling Bancshares ($1.0B). These transactions were so large, and two were foreign banks selling US subs, that it doesn't relate to my readers. But the next two deals in the table certainly relate.

Both deals look like they improved the buyer's EPS, with People's United achieving a 10.8% annual growth rate and Susquehanna achieving an even better 19.9%. People's efficiency ratio, a measure of how much in operating expenses it takes to generate a dollar of revenue, went down slightly. Achieving economies of scale should drive down the efficiency ratio. Although People's decline in this ratio was small, the relative size of Danvers ($2.6B) was only 10% of People's size ($25.0B) at the time the deal was announced.

Susquehanna's efficiency ratio went up. This is counter-intuitive, especially since Tower's relative size ($2.6B) was more significant to Susquehanna's ($14.2B) at the time of announcement. One would think that realizing the necessary cost savings to justify paying a premium would result in a lower efficiency ratio. Susquehanna was unable to achieve this "economy of scale". It is also worth mentioning that Susquehanna's earnings were sub-par at the time they announced the Tower deal. They had a 0.32% ROA at announcement. Not something to include in the shareholders' letter. Nowhere to go but up, right?

People's, on the other hand, had a better ROA (0.84%) when they announced the Danvers deal than in the fourth quarter (0.74%). The primary culprit was a precipitous decline in net interest margin of 116 basis points (yikes!). The fact that their efficiency ratio went down tells me they hit their operating expenses hard. As Warren alluded to above, I bet that wasn't in their post-merger projections.

I don't think it's very complicated to decide to do a transaction or not. What fits your strategy? Can you build it or must you acquire it? If an acquisition, can you afford the premium for the target so your bank is better off for having done the deal than passing?

Once you land a deal, accountability should be equally uncomplicated. My firm once represented a bank that had an activist investor on the Board. All that guy wanted to talk about was the efficiency ratio. Very one dimensional. But I digress.

He did hold management accountable for achieving the cost savings in the projections. So management prepared a spreadsheet of the phase-in of cost savings and the overall cost structure of the combined bank once all synergies were achieved. It wasn't a very complicated spreadsheet, and also gave management some leeway to alter where things were cut, so long as they achieved their aggregate numbers.

At the end of your strategic measurement period post-acquisition, the value of your bank (intrinsic value mentioned by Warren) should be greater for having done the deal than if you went it alone. If People's and Susquehanna could not achieve the earnings growth in the table above, then doing those deals improved their value.

If each could have achieved those numbers on their own, and there are reasons to believe they could have, then why do the deal at all?

Is it a fair question?

~ Jeff

Say It Ain't So Doug! Square 1 Bank Sells to PacWest

In the name of head scratchers, Square 1 Financial of Durham, NC, one of the most successful startup banks in a generation, is turning over the keys to PacWest, a California bank. The deal left me scratching my head, because at first glance it made little sense that a bank with Square 1's earnings trajectory would sell.

Niche banks are a growing part of our financial institutions landscape. I often cited Square 1 for their focus and success. In their own words, "Square 1 is a financial service company focused primarily on serving entrepreneurs and their investors." A bank with a focused strategy! Brings a tear of joy to my eye.

It had one banking office (in Durham), and twelve loan production offices located in key innovation hubs across the US. Its Chairman and CEO, Doug Bowers, was a 30-year BofA vet and more recently a member of a private equity firm. So the niche Square 1 adopted made sense.

But why sell Doug?

An industry reporter hypothesized that it was the price... 22x earnings, 262% of tangible book... c'mon?! But that was close to where Square 1 was trading at announcement. So there was no price premium. In fact, the below chart demonstrates that if Square 1 remained independent, their stock price would soar past the value received in this merger.

Like most projected performance, the devil's in the details. What I did was assume Square 1's 3-year compound annual growth rate in EPS (86%) linearly came down to earth to 12% by the end of the projection period, which is PacWest's 3-year EPS CAGR. I assumed PacWest's 12% would continue throughout the projection period. If all were true, it would have been more beneficial for Square 1 to go it alone. It is what I term "earning their right to remain independent."

So if future valuation wasn't the reason, then why? Perhaps they are receiving an outsized portion of the resulting bank than their current contribution. As I mentioned above, Square 1 did not receive a price premium from PacWest. So their pro forma ownership of PacWest is pretty much in line with their contribution (see table). Usually in a merger the seller receives a larger pro forma ownership stake because they receive a premium on their stock and they are relinquishing control. Not so, in this case.

So why did they sell? Here is what Bowers said in the press release: "Joining PacWest will be a terrific opportunity for our clients, employees, and stockholders. Square 1 offers PacWest a complementary line of business and significant core deposit growth. As part of PacWest, we will maintain our steadfast commitment to the entrepreneurial and venture communities, will be able to offer clients a wider array of products and will be well-positioned to continue to serve them through all stages of their growth."

That seems to tell us why PacWest bought Square 1, not why Square 1 sold to PacWest. So with Doug silent on the issue, here are my opinions on why one of my darling niche banks turned over the keys:

1. Institutional Ownership - Square 1 went public last March, raising $52 million at $18 per share from primarily institutional owners. The company was 70% institutionally owned with such names as Patriot Financial Partners, Castle Creek Capital, Endicott Opportunity Partners and other notables. Some had 5%-10% stakes, or about two million shares. Square 1 traded about 30,000-40,000 shares per day until around February 24th, when volumes soared (a fact that will not be lost on FINRA, although increased volumes prior to a merger announcement are not uncommon due to speculation). With such significant institutional ownership and relatively light normal trading volume, it would have been very difficult for those investors to lock in the trading gains experienced by Square 1 from November-February. How do you lock it in.... sell. Even if you are paid no premium. You can still lock in the price appreciation since you bought into the IPO.

2. Law of Large Numbers - As Square 1 grew larger, it would have to generate larger and larger amounts of business volume just to keep pace. For example, they had a $1.3 billion loan portfolio, the vast majority of which was commercial business loans. If 25% of that portfolio turned over every year, and I suspect it was more because business loans churn faster than commercial real estate loans, they would have to originate >$400 million of new/renewed loans per year to keep pace. Never mind growth. Which brings me to my third potential reason for selling...

3. Growth Trajectory - Square 1 was trading at 22x earnings when they sold. Banks their size typically trade around 13x-14x earnings. The premium was most likely the result of their balance sheet and earnings growth. Perhaps Doug and his senior management team were staring down the barrel of normalized growth. As investors began to recognize the slower growth, multiples would intuitively come down to the planet earth, suppressing stock price appreciation until the multiple normalized. That could have meant trading in a tight price range for a number of years. Why not lock in your tremendous gain since the IPO, and move on?

Square 1 was truly an extraordinary financial institution and I am sorry to see them go because I held them up as a premier example of how focused effort can lead to superior results.

If Doug Bowers and team were facing normalized growth and stock price appreciation, they could have decided to "cash cow" the bank, turning over a significant part of their earnings to investors in the form of dividends. In 2014, they enjoyed a 1.25% ROA and a 12.85% ROE. A great candidate for a cash cow. 

But alas that ship may have sailed when they backed up the truck to the institutional investor loading dock. They were numbers on a spreadsheet and were supposed to deliver the fund managers a big win. 

They did.

What else could Square 1 have done to satisfy their investors?

~ Jeff

Ever test the theory that acquiring banks is good? I did.

Every strategic planning retreat has its own flavor. This one particular retreat included a parade of investment bankers conveying the virtues of deal making while the audience of senior bank executives and board members nodded their heads in unison and solidarity.

One question that was unasked was whether it is better to seek acquisitions or go it alone. The conventional wisdom being that doing deals is better than not doing deals. I didn't know the answer, and figured asking an investment banker the question would be like asking a Beverly Hills plastic surgeon if it was better to do a little nip-and-tuck or let nature have its way. (Disclosure: I am also an investment banker, but don't like to admit it at cocktail parties. I am not a plastic surgeon.)

So I went to the spreadsheets. It always comes down to the spreadsheets. The operative question was does doing deals result in better financial performance and total return than not doing deals?

First I had to create some criteria to control for some variables that impact total return and financial performance greatly, such as bank size and asset quality. So I chose publicly traded financial institutions between $1 billion and $20 billion in total assets, with non-performing assets to assets of less than 2%.

I then divided the group into two, deal makers and non deal makers. Deal makers did two or more merger deals for whole institutions since 2010. Non deal makers did one or no deals. There were 46 deal makers and 173 non deal makers. A decent sample, in my opinion.

Their Return on Average Assets and Average Equity performance, at the average, were as follows from 2011 to present.

Deal makers had a better ROA year-to-date: 0.96% versus 0.90% for the non deal makers. But non deal makers had a better ROE: 8.57% versus 8.47% for the deal makers. This may be why you hear so many deal makers talk about return on tangible equity (ROTE) in their earnings conference calls. Better to ignore that goodwill they keep building on their balance sheets as a result of paying premiums for selling financial institutions. Because for ROE, it looks like non deal makers take the brass ring.

And what about three-year total return? Deal makers delivered 73.97% to their shareholders. Non deal makers did better... 75.56% on average.

Does your FI pursue acquisitions? If so, have you tested the conventional wisdom that doing deals is better than going it alone?

~ Jeff