Efficiency and Its Impact

The banking industry is consolidating. This is not shocking news to most people. The number of financial institutions in the U.S. has declined from 15,158 in 1990 to 6,940 as of June 30, 2013, according to the Federal Deposit Insurance Corp. Not a single de novo institution has been approved in more than two years. This is astonishing considering 144 were chartered in 2007 alone. However, a look below the surface is required to get a better understanding of bank consolidation and how it is reshaping the industry.

The economics of the banking business have changed. Discussions about increased regulatory burdens and higher capital requirements have been common during the past few years. We believe the financial impacts of producing an acceptable return to shareholders in spite of these challenges will continue to be an integral theme in the banking industry. Earnings from traditional spread income are under pressure for most banks due to a prolonged low interest rate environment (especially for those banks without a robust lending team to generate loans with good yields). Furthermore, increased regulation and compliance requirements have driven up fixed operating costs. These factors, collectively, have resulted in lower returns on tangible common equity for shareholders—arguably the most important measure of profitability from an investor’s perspective.

To adjust to the changing regulatory and operating environment, bankers are looking for strategies to cope with these challenges. With margins under pressure and increased fixed operating costs, many bankers are looking to achieve economies of scale and utilize more technology to manage more earning assets and more cheap liabilities per dollar of operating expense. While there are many strategies to pursue to improve shareholder returns in a challenging operating environment, empirical evidence shows that focusing on efficiency is certainly an effective strategy. Below is a chart illustrating the stock prices of publicly traded banks with assets of between $1 and $25 billion with efficiency ratios in the third quarter of 2013 in excess of 80 percent (we’ll call those inefficient banks) and those with efficiency ratios below 60 percent (we’ll call those efficient banks). Although 2013 has been a good year for bank stocks overall; the stock prices of efficient banks have increased by nearly 40 percent on average, while inefficient banks have only increased by 17 percent on average. Simply put, efficient banks have bested the market while inefficient banks have lagged behind.

The efficient banks have stronger earnings (averaging more than a 12 percent return on tangible shareholders’ equity versus 5 percent for inefficient banks). Currently, inefficient banks are trading at an average price-to-tangible book ratio of 113 percent versus 190 percent for the efficient banks group. Having a stronger currency (e.g., a stock trading at a higher multiple) is an advantage when structuring a merger; it allows the transaction to be more accretive (or less dilutive) to tangible book value per share for an acquirer when stock is used as consideration. Thus, efficient banks also have an advantage in pursuing acquisitions over the inefficient banks.

This leads to our next point: During the past year, 74 percent of public buyers have seen their stock prices appreciate during the month following the announcement of an acquisition. Additionally, buyers that have announced deals representing about 10 percent or greater of the buyer’s pro forma assets have seen their stock prices appreciate 8.4 percent on average during the next 90 days post-announcement. In short, the market has been rewarding buyers for pursuing efficiency through size and scale. While a deal can make sense if it has financial merit alone, it is truly great if there is a combination of strategic and financial rationale.

The industry is in the best shape in five years and continues to strengthen. Stressed and troubled institutions are being placed in the hands of strong, capable buyers. The number of failed banks has declined from 157 in 2010 to only 23 during the first 10 months of 2013. The landscape is changing from an environment dominated by FDIC-assisted deals and open-bank acquisitions of stressed banks to a much healthier M&A landscape. While buyers have been rewarded for pursuing accretive FDIC-assisted transactions, they are now also being rewarded for paying a fair premium for high-quality community banks that offer strategic value and make financial sense. The industry dynamics today are ripe for continued consolidation. The efficiencies gained through strategic M&A will continue to be noticed and appreciated by bank shareholders.