The Deal: Too Big to Merge?

NEW YORK (The Deal) -- Banks have been forced to re-think their approach to M&A as a wave of global regulation alters the appeal of deals and divestments. After three decades of consolidation -- epitomized by Bank of America Corp.'s acquisitive growth to transform itself into a national coast-to-coast universal bank -- a trifecta of economic weakness, regulatory uncertainty and shareholder aversion has produced a stagnant market for bank M&A.

Now, five years after the collapse of Lehman Brothers, new strictures are causing banks to think twice about whether the benefits of a transaction outweigh the cost, complexity and regulatory burdens of greater size or diversification.

Lazard's managing director of financial institutions group James Spencer says the new requirements change how banks view risk and reward. "They will be a lot more shrewd in allocating capital and it will color how they view acquisitions," he says. "Investment banks have had to raise capital and sell their capital-intensive private equity businesses and assets -- we are seeing that trend play out. They're in the early innings of a long baseball game."

M&A statistics show global bank M&A at its lowest level since 2008, with 712 deals so far in 2013, only marginally up from 699 during the credit crisis. This compares to 788 deals in 2007, according to Dealogic, when aggregate deal value was nearly three times higher at $324 billion. Much of this stems from the continuing Eurozone crisis, which has led to serious difficulties for many European banks.

By contrast, the U.S. banking system appears to be recovering as M&A deals hit a three-year high of 279 -- roughly on par with 2010. Yet total deal value at $10.6 billion for the year to date is low by historical standards, particularly compared to $125 billion over the same period in 2004, when 212 deals were struck. The higher number but lower overall value of bank deals points toward a concentration of M&A activity among smaller banks less affected by new regulation.

For large banks, especially those deemed "systemically important financial institutions," or SIFIs, regulation targeted at reducing their systemic risk has stifled the prospect of significant acquisitions. U.S.-based SIFIs include Citigroup ( C), JPMorgan Chase ( JPM), Bank of America ( BAC), Goldman, Sachs ( GS), Morgan Stanley ( MS), Wells Fargo & Co. ( WFC) and State Street ( STT).

Sandler O'Neill + Partners investment banking group principal Tom Killian points to so-called speed bumps or asset thresholds, which may cause banks to re-evaluate the merits of a deal if it brings additional regulatory and capital burdens. But he still expects active pockets of M&A between these hurdles, suggesting the $15 billion to $50 billion asset range will be an busy area for bank M&A.

The "speed bumps" occur at $500 million in assets, when banks become subject to Basel III capital ratios; $10 billion, when they must undergo Federal Deposit Insurance Corp. risk assessment and stress tests; $15 billion, when they lose the ability to grandfather trust preferred securities as Tier 1 Capital; $50 billion, when they become subject to detailed stress testing, financial reporting and potentially the Basel III liquidity coverage ratio; $250 billion, when banks are subject to the January 2014 adoption of Basel rules and stricter regulation (under Advanced Approaches rules); and lastly, when banks are deemed global SIFIs and must abide by a supplementary leverage ratio and the global SIFI capital buffer.

DLA Piper partner Michael Reed says banks are likely to be particularly cautious about deals that push them across the $10 billion asset threshold. But Lazard's Spencer says regulation alone is unlikely to kill deals that are otherwise based on sound fundamentals. "If it brings them over $10 billion in assets and it makes sense, they should still do it," he says.

Both Killian and Reed say the supplementary leverage ratio is widely viewed by the banking industry as a punitive capital requirement for U.S.-based global SIFIs -- one that may force further divestments. This leverage ratio requires bank holding companies to have capital equal to 5% of their assets, while their federally insured banking units must retain capital equal to 6% of assets. Overall, banks must hold a far higher quality and quantity of capital compared to pre-credit crisis days.

The proposed supplementary leverage ratio requirement goes beyond those approved by the Basel Committee on Banking Supervision in 2010 and has drawn criticism because it provides no incentive for U.S. banks to hold less risky assets. The Basel rules require a leverage ratio with a 3% minimum of equity to assets, allowing banks to decide whether certain loans or securities are risky and require more equity to cover a potential default.

By contrast, the U.S. supplementary leverage ratio has higher absolute capital requirements and weighs a government bond for capital purposes in the same manner as a risky commercial loan. It also counts off-balance sheet exposures such as the grossing-up of derivatives toward a bank's capital requirements. Despite this -- and cries of foul play from U.S.-based SIFIs -- ratings agencies such as Fitch have characterized the leverage ratio as "tough but manageable" by the proposed 2018 effective date.

Some observers believe that additional capital levies might prompt some U.S. SIFIs to push into riskier areas as they seek higher returns. Killian argues that banks may also focus on business areas that do not require much capital support such as operations and payment processing.

Skeptics note that reorienting a business model toward processing may be challenging given it is a capital-intensive, commoditized business that has already consolidated. Among those that dominate the financial processing business are Bank of New York Mellon ( BK), JPMorgan Chase and State Street.

More broadly, Spencer notes that new regulatory and capital requirements have already slashed returns on equity for large banks -- risking their appeal to investors if returns fall much further.

"For global SIFIs, returns on equity are about half what they were pre-crisis: ROEs were about 12% to 13% between 2004-2006 and today they are 8% or 9 %, so there's tremendous downward pressure on returns caused by the new rules," he says, adding that banks need both stronger loan growth and rate increases for sustainable earnings improvement. "Large banks' book-to-value ratios were at 2.5 to 3 times pre-crisis and are currently 1.5 times, so investors have concern about industry growth prospects."

Advocates of higher capital requirements argue that while ROEs are falling, the longer-term pay-off is far greater: a capital cushion to absorb losses and reduce the fragility of the banking system, slashing the risk of taxpayer bailouts in times of crisis. The intense focus on ROE is relatively recent. Banks in the 1950s and '60s were heavily regulated and had low ROEs while still providing ample lending for a booming, if very different, economy. Fierce competition in finance, public ownership and the ascendancy of shareholders put increasing focus on ROE in the 1970s and '80s, driving bank mergers, both geographically and by product line, and boosting leverage.

These advocates insist that a more sustainable banking system need not significantly stymie lending so long as lower ROEs are accepted as a reality of prudent banking. Critically, they argue, a banking system that aims for high ROEs is also one that incentivizes banks to move up the risk curve -- lifting the threat of potential losses. In any event, the rise of the financial markets have lessened banks' central role as a capital supplier, certainly in the U.S. and U.K.

Regulators are also turning increasing attention to the so-called shadow banking system of hedge funds, non-banks and money market funds. The Basel-based Financial Stability Board -- a regulatory task force for the world's top 20 economies -- published the first set of standards for the $60 trillion shadow-banking sector in August.

One result of this re-regulation will see larger banks continue to divest assets to try and avoid more punitive rules or exit businesses that no longer provide sufficient return. This is part of a larger reshaping of the Wall Street, or wholesale, end of banking.

Since the credit crisis, Citigroup has been shedding pieces of its global consumer finance operations, including the sale of its final 35% stake in the former Smith Barney brokerage for $4.7 billion to Morgan Stanley this June. In May, Goldman Sachs sold the majority stake in its reinsurance business to high net worth clients for an undisclosed price and in July unloaded its hedge fund administration arm for $550 million to State Street. Also in July Credit Suisse Group sold its private equity and alternative assets business to Grosvenor Capital Management LP for an undisclosed sum. Bank of America has peddled off dozens of branches for an undisclosed price and divested its remaining 1% stake in China Construction Bank for $750 million this month while Barclays plc put its retail business in the United Arab Emirates up for sale. Morgan Stanley and JPMorgan are exploring sales of their commodities businesses.

Further divestments may be on the horizon. In November, the Basel committee will publish more information on the calculation of the proposed global SIFI buffer (another level of capital requirements for SIFI banks). This will enable U.S. SIFI banks to calculate and prepare for their higher loss absorbency requirements, which take effect in 2016. As they are able to better weigh the risks and returns of their business lines, further asset sales or re-pricing of risk could follow.

Spencer says more capital-intensive businesses that banks may seek to divest include commodities, derivatives, fixed income, sales and trading, and non-rated securities.

On the flipside, some investment bankers say wealth management remains an attractive sector for acquisitions, as it provides strong fee income without the need for additional capital holdings. Royal Bank of Canada ( RY) chief financial officer Janice Fukakusa said in June that the bank was willing to pay up to C$5 billion ($4.8 billion) for wealth acquisitions, with Wells Fargo also voicing an appetite for the business. Historically, U.S. banks have a spotty record in the business.

"For large banks, wealth management is attractive because it diversifies their business lines and with the slowdown in mortgage origination, it's a healthy revenue offset," says Sharon Weinstein, head of Deloitte Corporate Finance LLC's financial institutions practice.

Spencer agrees but notes wealth management businesses are generally expensive to acquire, and require significant upfront capital. Big U.S. banks also once dominated wealth management through trust operations but lost out to more aggressive non-bank rivals such as investment banks and specialty asset managers in the '80s and '90s.

Among smaller banks, regulatory costs coupled with slow loan and deposit growth will be ongoing impetus for consolidation. "The only way you can get growth is either from niche businesses like energy lending or cutting costs via bank acquisitions. With less regulatory overhang these deals can get done," Spencer says.

Killian says the majority of bank holding companies, some 5,323 or 80% of the total, have less than $500 million in assets and will be largely unaffected by the new requirements. These smaller banks, however, comprise just 5% of bank assets in the U.S., with the bulk of assets held by 37 banks over $50 billion.

DLA Piper's Reed predicts that around 7,000 U.S. banks may consolidate to between 4,000-5,000 over the next five to seven years. "There are institutions that have no ability to grow because they can't raise capital -- they can't support acquisitions or organic growth, so there's a need for consolidation," he says.

Despite the incentives for some banks to merge, other sources point to another, less obvious brake on deal activity: a perceived reluctance from the FDIC to approve deals. Dealmakers say potential clients have cited regulatory delays around M&T Bancorp's ( MTB) $3.8 billion acquisition of Hudson City Bancorp ( HCBK), announced last August. The deal is yet to close, with M&T Bancorp only reaching agreement with the Federal Reserve this June to improve its compliance before any merger takes place.

-- Written by Jane Searle in New York

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