Street Talk | Episode 139: Balance sheet, M&A and capital raising strategies for a volatile environment

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Nathan Stovall 

Welcome to Street Talk, S&P Global Market Intelligence podcast that offers listeners a deep dive into issues facing financial institutions and the investment community.  

I'm Nathan Stovall. And on this episode, we're talking about how banks should prepare for swings in the rate environment and how to position balance sheets for the future, whatever that might hold, be it rates up or down. We're also discussing how regulators are looking at liquidity and credit risk at this point in the cycle and what strategic actions banks can take to manage through the operating environment, whether that means pursuing a deal or raising capital.  

Those topics were covered by some of the most respected market participants in bank land at our Annual Community Bankers Conference in late May. Attendees were keen to hear how to best prepare for periods of volatility. like the one we've witnessed over the last few months since the Trump administration announced a broad suite of tariffs on April 2, which sparked fears in the market, leading to spread widening in the credit markets and prompted a significant sell-off in bank stocks.  

Bank stocks have rebounded but remain at depressed valuations. And the path of interest rates remains just as uncertain as the Fed and the bond market weigh the prospect of slower economic growth against inflation and a wider deficit. We led a discussion on balance sheet management at the conference and began by asking Scott Hildebrand, the Chief Balance sheet Strategist and Head of Depository Fixed Income at Piper Sandler, how banks should prepare for changes in rates and whether or not institutions should prepare for rates to decline as many expect. Scott said banks are not in the prediction business and instead should be in the preparation business. Over the last 5 years, he believes it's become clear that banks are not asset or liability sensitive, meaning which side of the balance sheet will price more quickly as rates move one direction or another. Instead, he believes it's clear that banks are sensitive to changes in yield curve movements. 

Scott Hildenbrand 

I think we're not in the predicting business. We're in the preparing business, right? So any time I walk into a boardroom and there is a bias for one specific rate movement, I'd like to dig in a little bit and have an argument or et cetera. But I think, Nathan, what we've all learned through the last 5 years and certainly for me is I've learned that no longer is a bank asset or liability sensitive. We're just sensitive to changes in rates and yield curve right? And so if you kind of take a look at it from that perspective, it almost changes the overall conversation. So I would say, without a doubt, the last, I don't know, 6 months have been the most fun I've ever had doing balance sheet management. If you think about it, every day, I get 10 to 15, 20 basis points higher or lower depending on a little bit of news. I mean I spent -- I could have taken my first 20 years off because I saw very little rate movements. Everybody told me rates were going higher. We finally got it, and it was a lot of fun for about 6 weeks and then everybody hated it again. And I think what we've realized from that is that our balance sheets are much more athletic and nimble. And what we don't know is we know how to -- everyone in this room has forgotten more about their balance sheet than I know for sure. But what I can tell you is they all know how to address an interest rate risk issue. The real question becomes when. We have a problem, in my opinion, in this industry because it's not about predicting where rates are going. It's about knowing what you're going to do when you see small move in rates or yield curve shifts that are either drastically leading to more opportunity or addressing more exposure, one or the other. But the fact that a lot of folks haven't transacted small strategies within the last 6 months is a little scary to me given all the different movements in rates and the balance sheet movement. 

Nathan Stovall 

Picking up on that, are you talking about almost creating triggers where you start to say, okay, if the yield curve moves up 50 basis points, 100 basis points, I know I need to try to do X or think about doing X. 

Scott Hildenbrand 

Right, right. And the way I always think about it is most folks in here, not everyone, and people will hate the way I say it. But I'm obsessed with yield curve risk, right? Spread between Fed funds and about the 5-year, you've heard me say this, is a big driver of where bank margins are going. Two years ago, we were historically inverted. We're still inverted, and we're moving in a different direction. Everyone should understand that 80% of your spread business is driven off of only 20% of the yield curve. Yet we don't understand what parts of the curve drive our business, number one. And number two, once we understand it, then 30, 40 basis point moves, we should have triggers. And in ALCO, and I know Joe will agree with me on this, we've talked a lot about this. We don't use the word authority. We should be walking out of ALCO already knowing what we're going to do when we hit those triggers so that I don't write a memo to my boss after everything has happened to talk about how to protect what just happened. 

 

Nathan Stovall    

Joe Kennerson, a Managing Director at Darling Consulting Group, spends a lot of time in ALCO meetings as well. We asked them the same question about how banks should prepare for rates and whether or not institutions should set their balance sheets up to be agnostic to changes in the market. 

 

Joe Kennerson 

It's fun to talk about like where rates are going, where we think rates are going, right? But we know that the market is frequently wrong, and that we also have 0 control over it, right? So let's focus on what we can control. And again, it's hard to have -- I think everybody in this room preaching to the acquire. But when you get together maybe once a month to really get into these conversations, maybe it's just once a quarter, to really get everybody in the room to buy off on that, and it's hard to visualize rates going up 100 basis points and what that could mean. We try to continue with those darky themes of listen to your balance sheet and stay true to it. But you got to really continue to push it. 

Nathan Stovall 

Rate cuts by the Fed late last year have put peak deposit costs in the rearview mirror, but further declines are up for debate as the Fed appears to remain on hold. A key driver of deposit costs will be the maturity schedule of CDs, which have grown to more than 27% of deposits at community banks. As those CDs mature, to keep the funds, banks like will have to meet the market rate. There's no doubt promotional rates aren't as high as they were. And Joe Kennerson believes that banks will record some funding cost relief as CDs mature. But he noted that institutions are going to struggle with the balancing act of lowering cost against growing their deposit base. 

Joe Kennerson  

Obviously, we've realized a lot of cost savings on the CD book over the past 8 months, and that's going to continue. We get deep into the data. We've got this deposit module called Deposit 360. We collect data from about 300 community banks and regional shops. On the CD side, get a little geeky, but the average CD portfolio rate at the end of April was 390 was 3.90%, okay? And the average rate, and this is in April of putting on a new CD. So that's bringing on a new CD account, but also rolling over what we have is about 366. So we're still in the money by about 24 basis points. ''', generally from the finance side. You got a little taste of it, rates are going down. Let's continue to accelerate and get our margin up -- on the other side, you've got this desire for continued deposit growth. And generally, that's like on the retail side or deposits. And we're going to get both of those throughout this year, right? The question is how much. And of course, the Fed has been on hold for 5 months, likely to be on hold for maybe a few more, who knows. But the point is the longer the Fed is on hold, the harder it is to get both of those in mass, right? And so we're trying to find that sweet spot in thatuga-war battle because the interesting thing with -- we talk about CDs.maturity deposit costs in aggregate, right, for our client flat year-to-date, flat. So we haven't been able to continue to get that nonmaturity deposit cost relief in the wake of the 100 basis points of Fed cuts. And I know you've lowered some top-tier rates and your public fund rates. But that mix change I mentioned before is eating into that, eating it. So how does that storyline play out, again, if we're still on hold for the next few months? And how do you facilitate that challenging conversation on the ALCO side. So we're -- little things, right? It's kind of almost getting surgical with a lot of these pricing strategies. 

 

Nathan Stovall  

Regulators have been focused on bank's liquidity and the stability of their deposit bases since the liquidity crunch in the spring of 2023. There were great hopes that the regulatory environment would ease under the Trump administration. And bankers and their advisers hope that, that would show up in regular examinations as well. They've had reason for such optimism with the FDIC's acting Chair, Travis Hill, pushing for reforms to banking supervision. Mark Caney, a partner at Allison Bird, said at the event that he was hopeful changes would have already shown up in exams. But he said the inexperience of younger examiners have prevented that from happening yet. 

Mark Kanaly 

So like everyone in the room, I was encouraged when I heard Travis Hill talk about the new agenda with the FDIC. He was going to focus on total operating and business risk within a bank and let's stop focusing on climate and environment and everything else. But the reality is if I ask each of you who are bankers in the room, tell me about the exam team that last came in your bank, right? What's the average age of the examiner you deal with? -- guessing you'd say 27, 28 years old. And if I ask you how many of them were trainees when they showed up at your bank, you'd probably say about half of them. And so what's happened is we've left that political dynamic, and we've kind of arrived at a practical reality, which is a lot of the senior folks from the agencies are taking early retirement packages. We've all read the headlines about that. We're getting a little bit of a barbell dynamic. The younger teams have had training modules on what they're supposed to be policing out there. Their training module is still what's governing the day when it comes in to deal with liquidity, Nathan. And so yes, to answer your question, we are still seeing some friction there. If there is some maturity that's developed, it's probably manifested itself in the form of examiners are now moving away from the L and camels and focusing more on E. They're talking about the implications now for everybody's earnings. I see some nodding out there around what your liquidity looks like. I can't tell you whether I think that's constructive or not. What I will say is that's about as far down the spectrum as we've gone from putting this in our rearview mirror. It is still front and center. And until these young examiners get trained up and sort of the totality of risk that we're hearing from the sort of would-be agency heads now, I don't think that's going to change in the near term other than people already haven't taken their lis on the liquidity downgrades. 

Nathan Stovall 

There's been some evidence of regulators approving deals more swiftly, but deal activity has remained relatively slow. In recent years, there were a number of things standing in the way of bank M&A activity. The rate marks that buyers have to take on Target's balance sheet have been punitive. -- valuations have been depressed or volatile for much of that time. And regulatory approval was often difficult to obtain or at least took considerable time to get it and introduce more risk into the transaction. While the latter seems to have improved, Mark Kanaly said that pricing remains a stumbling block. He said Board still focus on getting what he called the country club valuation that they can tout to others. He noted that roughly 2/3 of boards think of the dollar per share number when they think of the price they would take when selling. Valuation troubles aside, we ask if he expected more banks to look at acquisition as a way to bolster their funding. In the last tightening cycle, more than a handful of banks in metro markets look to a rural market to purchase a deposit-rich institution with a low loan-to-deposit ratio. We haven't seen many of those deals recently, but Mark expects more on the horizon. 

Mark Kanaly 

I think we're going to see more of those. I do think it will pick up. I think, as acquirers get the multiples back in their stock. I mean, right now, if you're an acquirer and you're watching your stock price every day, hard, whether you're chasing pay-to-trade ratio or any other metric to tangible book value earn-back period, whatever your poison is that you're faithful to. hard right now with multiples where they are to get excited about that. I think when the multiples return, it gets a lot easier to go pray upon a smaller bank that's going to take your stock. You'll hit that Country Club valuation I alluded to just because of the pop you have in your stock. As we return and there's some stability in the space again, maybe that's later this year, maybe it's next year, I do think the M&A wave that we've been talking about will gradually pick up. It's not going to be explosive, but I think it will gradually pick up again. I think a lot of these smaller core deposit franchise that you're talking about, the low loan-to-deposit ratio, I think they'll finally see clear sky to get that magic number they want. 

Nathan Stovall 

Other deal advisers took part in an M&A and capital raising discussion at the conference. Scott Studwell, Managing Director, Head of U.S. Depositories and Co-Head of Equity Capital Markets at Stephens, kicked things off noting that M&A activity showed signs of picking up earlier in 2025, but the emergence of tariffs and fears over potential issues in the macro economy pushed passive investors to the sidelines for the banking group. He still believes fundamentals to support deals remain in place, but said the macro picture will drive capital flows. 

Scott Studwell 

I think when you peel back all the noise that we've seen post being liberated, you've got, I think, really good fundamentals going on within the industry. You have operating trends that are improving, I think, each quarter. So profitability enhancements. You've got -- I think if you go back to pre-liberation Day, you started to really see a theme of M&A picking up again. There were a lot of smaller deals announced, not the big ones, but there's a lot of activity. And so I think that's a catalyst. I think the biggest issue, though, is just the macro environment. When that settles, the -- I think the power of the passive market coming back into the industry is what lifts all tides. And that's where the risk on trade happens, where the money comes off the sidelines, it plays the market through ETFs and the tide rises, which becomes a catalyst for generalist investors, I think, to really step into the market. But it's cautionary. I think every 7 years now, we've -- or every -- over the last 7 years, we've had, what, 4, 1 in 100 storms hit. So it's not going to be linear. But I think overall, when you peel back the noise, sentiment is still pretty good despite all the challenges we seem to be faced with. 

Nathan Stovall 

Ken King, the Founder and CEO of bank-focused Investment Fund, KSK Investors, agreed that stabilization or greater clarity in the macro environment might need occur to see a pickup in consolidation. 

Ken King 

Yes, I agree with everything that Scott said. I mean we came into the year with a lot of optimism around reduced regulation, maybe increased consolidation. We were going to get some Fed cuts and increased economic activity. That's really nirvana for banks. As we heard in the last session, some of those optimistic things have been taking at least pushed out. And so any return we can get to increased economic activity and growth in the general economy starts to take the risk of recessions and credit challenges off the table. And I think as we all know, generalists will not come into the space if there's any concern around recession and credit challenges within banks. And I think as we talked a little bit about yesterday in the room, a flat to inverted yield curve is just challenging for banks. And so if we can get the Fed to move even a time or 2 or at least have some visibility to them being able to do that towards the back half of the year or into next year without having to do in a panicked state, then there's a lot to be optimistic about. 

Scott Studwell 

Just one other point, though. I mean, the sector is still trading at 9.5x forward earnings. So that's cheap, right? I mean that's a catalyst in and of itself. So if you can get comfortable with the volatility and have a positive view around some of the macro trends that could develop here, the sector is cheap. And I think that in and of itself is going to keep eyeballs on the sector. You've had 2 years of of really kind of improving earnings growth in the next 2 years look like we're going to see double-digit earnings growth again for the industry. So I think the setup is still pretty good despite the noise. 

Nathan Stovall 

Michael Corso, Principal and Head of Depositories at Hovde, shared a similar view. He said that valuations in the sector likely will be capped until the macro backdrop becomes more certain. However, he also noted that most sellers are taking a buyer's currency in a transaction. So they should focus on the exchange ratio in the deal rather than the sticker price. with the macro backdrop is kind of the biggest driver. We're 30 days into a 90-day pause. We were kind of on the brink of a self-induced recession with meaningful impacts. And so I think we're hopeful over the next call it, 30, 60, 90 days, we do start to see some of these deals appear where there's -- the volatility remains contained. And I would say just optimism in the sector continues to grow. But until that happens, I think valuations are somewhat capped. And so for expectations related to M&A, I think 175 of tangible book value is kind of the new 225 of tangible book value. And so price expectations are being adjusted. But at the end of the day, if you're doing an all-stock transaction, you're really making an investment in the acquirer, right? And so based on a fixed exchange ratio, if we do get some of this good news over the next several months, that's going to be reflected in the buyer's currency. And in that scenario, valuations are going to increase and all that are going to be lifted. And so I think over the next, call it, 3 to 6 months, that's what we're certainly hoping for. Advisers were also hopeful that capital raising activity will eventually rebound, including banking IPOs. Few banks have gone public in recent years, but Scott Stewell said there's a number of banks evaluating going public right now. He ultimately believes that a rebound in M&A activity will bring a resurgence of IPOs as well as investors still want to see capital with a purpose. 

Joe Mantone, US FIG News Desk Manager at S&P Global Market Intelligence     

Do you think we might be seeing IPOs pick back up? 

Scott Studwell  

I've got no doubt we're going to see them. The timing of them is whether -- and I think we may see them as early as this year. There's definitely planes on the runway. A lot of companies during this volatility maybe paused those processes, but there's some that kept going. They've been out testing the waters and really getting themselves ready because I think if you are prepared to go, if you're starting from scratch and IPO is a 4- to 6-month process, but the rules now allow you to kind of do a lot of that work confidentially. And if you get to a point where you can manage market risk more effectively, I think you're going to be able to see activity pick up this year. And there are probably a dozen or so companies around the country we're aware of that are either on the runway or getting ready to get on the runway. So there's going to be a return of IPO IPOs. M&A will be a catalyst. I believe that the capital with a purpose, so capital to support M&A is something that everybody still wants. They want to connect with the deals we're going to see. So I think that's going to probably lead us out of here. We probably see a few of those style deals again. And again, I think the bar for investors to support capital, it's a high bar. It's got to be a good deal. But I think what we found there's been maybe stepping back, investors have put guardrails around how companies think about M&A. A certain level of dilution is accepted and earnback of a certain period is is not accepted. But what we found, and we tested this a year ago, we did a large strategic deal for a Southeast company that went to market with an earn-back that fell outside the norm. I can tell you that investors did not push back because they actually, in that case, put some value on the fact that investment banks didn't try to keep the earnback sub-3 years, and they did a real bottom-up analysis, and they were able to really kind of see the value in the deal, the strategic importance. So our view is capital to support this strategically important deals, that's what investors want right now, being able to pinpoint where the capital is being deployed and how a company is going to come out the other end better. 

Nathan Stovall   

Uncertainty continues to hang over the group, but the advisers in attendance agreed that transactions are merely in a holding pattern rather than installed completely. That could set the stage for a busy end to 2025. As we wait, our panelists noted the importance of executives working to educate their boards on what matters. Boards approved the biggest swings banks take. But as Scott Hildenbrand noted, there's often a big knowledge gap between management teams and Boards that often causes great strategies to die. 

Scott Hildenbrand 

One of the things that I typically -- because I'm sort of in a weird position where a CEO or Chief Financial Officer will -- he or she will say, "Okay, I want you to cover these 3 topics. But whatever you do, do not mention this word, that word, this acronym or that word because it will start a whole different conversation. And what I'm realizing is we have used our Board in a way that isn't always efficient. And what I mean by that is most of your boards, if not all of your boards are made up of incredibly talented folks who are successful at something other than a bank. something really successful other than managing spreads. So I want everyone to think about that concept for a second. The education around spread management versus most folks are asset managers is wild to me. Those conversations are why great strategies go to die in boardrooms because we're always trained as a very successful nonbank person, you are trained to win every single transaction you make when in reality, what you're trying to do is deliver a consistent spread so the changes in rates will never dramatically shift the earnings stream because we have 2 sides to it. And boards are intelligent, but they really struggle there. And I think we've got a problem, and we've got to mine that gap of the education around how the highest valued companies in the country are not based on their margin. They're based on consistent earnings based on management, a great deposit base. We can go down the line, but it's not margin. right? Banks aren't thrilled with their valuations right now and bank margins are improving. Nobody is really that excited, right? It's not about your shiny margin. It's about other components. And I think having hard conversations, maybe I'm just used to it in my seat, having really hard conversations about who we really are and why we're making decisions that we're making, but I see great strategies dying when it comes to managing balance sheet because of the Board management dynamic. 

Nathan Stovall   

Thanks to all our speakers at the Community Bankers Conference and all those who attended. And thanks to you for listening.