For the last five years, when it comes to the banking industry’s size and structure, the topic most hotly debated has been some version of “too big to fail.” That’s logical, given that it was the collapse or near-collapse of some of the country’s biggest financial institutions that turned the U.S. government into the single largest shareholder of Citigroup and prodded a reluctant Congress into approving the $700 billion Troubled Asset Relief Program.
But while regulatory changes seem to have consolidated the position of a handful of giants at the top of the pyramid, there’s a less-discussed dimension to the “too big to fail” question: whether the financial services industry has banks that are simply too small to thrive amidst the new and more intensive regulatory environment. True, the consolidation that began back in the 1970s when barriers to interstate banking began to collapse has already trimmed the number of commercial and savings bank insured by the FDIC from more than 16,000 institutions to fewer than 7,000 today. Since the fourth quarter of 2007, when the credit and mortgage lending crisis gripped the banking industry, the number of FDIC-insured commercial banks has tumbled 18%.
This, however, is the tip of the iceberg. What remains today is a financial services industry that is oddly misshapen. At the top of the heap are a tiny handful of mega-banks, whose market share stretches into the double digits. But while there are less than 100 banks with assets of more than $10 billion, the single largest group – approximately 4,000 institutions – has somewhere between $100 million and $1 billion in assets. And an astonishing large number of those surviving FDIC-insured institutions – 1,898 at last report — have less than $100 million in assets: this means there are banks that are the same size or even smaller than is a single branch of a typical Bank of America or JP Morgan Chase branch in a mid-sized city. If the regulatory changes that followed the crisis have consolidated the status of those behemoths at the top of the heap, they appear likely to ensure that this large group of tiny entities will vanish from the scene, whether it’s because they fail outright or because they are absorbed into larger institutions through a new wave of merger and acquisition activity.
Of course, some of the factors that will contribute to this aren’t new. The need to spend heavily on technology has been a big driver of M&A in the banking space for two decades or more, for instance. It has always been tough for smaller institutions to boost productivity to the same extent as they do their larger counterparts. True, productivity levels are rising industrywide, but at smaller institutions, those gains are about half of what they are at their larger counterparts.
The aftermath of the financial crisis, however, has left the country’s tiniest banks shouldering new burdens. Industry-wide, compliance costs were estimated to have risen from $26 billion in 2010 to $32 billion in 2012. Even the megabanks complain loudly and bitterly about the impact of these costs on their profit margins and bottom lines; the impact is far more serious for a smaller institution. Nor is it simply a matter of finding the money to put new systems in place, but of finding new risk management models that will convince bank examiners that they aren’t falling behind the curve. In the past, the latter might have been fine with a small bank’s decision to base its calculation of loan loss reserves on historical trends and patterns. These days, they are much more likely to push back, demanding that bankers justify their reserve calculations with a forward-looking analysis of economic and business trends. In the absence of a well-polished and fully functional crystal ball, that has required small banks to hire more staff to review loans and even slow down the rate at which they make new loans in order to conduct this kind of more detailed analysis. All of which simply adds to both the financial cost and management headaches of small banks already struggling to compete against their larger rivals for what little loan growth there is to be found in a slow-growing economy.
Testifying to Congress in 2012, William Grant, chairman and CEO of First United Bank of Trust in Maryland – and past chair of the American Banking Association’s Community Bankers Council – captured the mood of smaller institutions wrestling with these new realities. “There is a tipping point beyond which community banks will find it impossible to compete,” he said. “Each new regulation or law in isolation might be manageable, but wave after wave, one on top of the other, will certainly overrun many community banks.” Estimating that compliance costs represented 12% of annual operating expenses for the typical bank, he argued that the share for smaller financial institutions is two and a half times larger than it is for their larger rivals.
Nor is the added regulatory burden the only headwind which smaller banks face. Many still cling to the long-established model of branch banking as the way to deliver services to their clients, even though more of those clients – especially the younger demographic – clearly express a preference for online and mobile banking. Then there is the question of liquidity. To the extent that any of the smaller banks need to raise new capital, they’ll find it tough: institutional investors have demonstrated a clear preference for putting their money to work in banks with assets that are north of $2 billion.
In some cases, that has been exacerbated by a regulatory demand that the smaller bank raise new capital, as was the case with Central Virginia Bank of Powhatan County, Virginia. Starting in June 2010, CVB was operating under a written agreement with both state and federal regulators that required it to boost its capital levels – but it hadn’t been able to do so. After three years of futile efforts, Central Virginia Bankshares Inc. threw in the towel and agreed to be acquired by Citizens and Farmers Bank for only $855,000. The latter bank, in contrast, posted record profits in 2012.
That was the second merger involving small-scale banks in a single week in the Richmond, Virginia area alone, following hard on the heels of the agreement by Union First Market Bankshares Crop. To merge with StellarOne Corp. of Charlottesville, a transaction valued at $445.1 million. After the merger, the new entity will have $7.1 billion in assets. For its part, Union First Market is the product of another merger in 2010, between Union Bank and Trust Co. and First Market Bank. The goal of all this, G. William Beale, CEO of that bank, is to create “the next great Virginia bank.”
These two transactions, both of which were announced in mid-June, are likely to be repeated with increasing frequency over the coming weeks, months and years on a nationwide basis. Indeed, after a slow start in early 2013, there were only 107 merger and acquisition transactions, totaling $5.05 billion during the first six months of 2013. But in the first ten weeks of the second half of the year, banks negotiated 44 transactions, worth another $6.33 billion, as merger partners come to terms with the new realities of their business environment.
In some cases, as with Central Virginia Bankshares Inc, the driver for these transactions is likely to be exhaustion on the part of management and directors of small banks. Five years of bad news and underperformance, combined with the growing regulatory burden, is a toxic brew. Throw in the early signs that real estate lending – the mainstay of the vast majority of small banks – is likely to falter further as interest rates creep higher, and the interest of the smallest banks to find a face-saving way to throw in the towel is only likely to grow. In others, such as the Union First Market/Stellar One pact, mergers will be driven by strategic thinking of the kind described by Beale: an attempt to seek out synergies, drive down the ratio of regulatory compliance and other costs to assets and boost market share. A bonus? The stocks of both of the latter two banks have seen a big boost since the announcement: in the last three months, both have generated returns more than double that of the S&P 500 index (which was up 4.75% in that period) and have left the KBW Bank Index’s 1.42% return in the dust. Tower Financial’s shares have soared 52% since the announcement in early September that it would be acquired by Old National Bancorp.
The focus of a lot of the activity thus far has been among the smallest institutions, and in particular, among community banks. But to the extent that consolidation buoys the value of the stocks of banks like Union First Market and West Virginia’s United Bankshares Inc., their ability to not only conclude deals but to make these accretive to earnings within the first year or two of the merger taking effect, will soar. That’s a great way for a bank confronting a relatively sluggish outlook in its home market to reposition its business and profit from faster-growing regions or business segments. That helps explain transactions like United Bankshares’ $495 million purchase of Virginia Commerce Bancorp Inc.
To be sure, there are some headwinds that may block or delay some proposed transactions. Some smaller banks are still encumbered by the need to repay TARP funds, or stuck with portfolios of non-performing assets that make them unappealing to potential acquirers. One larger transaction – the proposed purchase by regional bank M&T Bank Corp of Hudson City Bancorp. Inc, a $3.8 billion deal – was put on hold after the Federal Reserve publicly disclosed that it didn’t think M&T’s anti-money-laundering program was up to snuff.
Nonetheless, the trend remains clear. Small to mid-sized banks are as intent on breaking out of the “too small to thrive” as the megabanks are when it comes to persuading the public that “systemically important” doesn’t mean that they’ll be looking for fresh bailouts in the years to come. The sweet spot clearly lies between assets of $5 billion and $10 billion. Below the former threshold, and the odds increase that a bank will struggle to grow. Above the latter figure, and the institution will find itself coming under a lot more regulatory scrutiny, including the oversight of the Consumer Financial Protection Bureau, higher deposit insurance expenses and mandatory stress tests by the Federal Reserve.
What is taking shape? A banking industry that looks a lot like an Oreo cookie. The top layer – the top of the cookie – won’t change all that much, being made up of the megabanks that simply can’t grow any larger and that aren’t remotely interested in breaking themselves apart, either. The big change will come to the bottom layer, which is likely to shrink dramatically as more of its members merge, are acquired or simply fold up their tents and retreat from the battlefield. What will be left is a much fatter middle – the sweet spot – made up of everything from significantly larger community banks to mid-sized regional banks. The process of getting there may be evolutionary, but the result may be revolutionary.