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StreetTalk – Episode 70: Banks' Liquidity Conundrum Could Fuel M&A Activity

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StreetTalk – Episode 70: Banks' Liquidity Conundrum Could Fuel M&A Activity

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Excess liquidity will continue to weigh on bank margins and could push a number of institutions to pursue deals, including possible sales, to help drive earnings higher.

Banks have continued to see deposits flood into the industry, often to the chagrin of bank managers who have few attractive opportunities to put the cash to work in the absence of loan demand.

On the latest "Street Talk" podcast, Greg Hertrich, head of U.S. depository strategies at Nomura Securities, said actions by the Federal Reserve and consumers and commercial customers seeking safety in banks have caused deposits to increase by more than $2 trillion from year-ago levels. While banks added $525 billion to their securities portfolios through the first half of 2020, those investments are in turn generating historically high levels of liquidity due to "outrageously" high prepayments on loans tied to mortgage-backed securities, he said. As long-term interest rates have plunged to historical lows, mortgage refinancing activity has spiked.

"This liquidity issue really sort of continues to build upon itself on a weekly, monthly and quarterly basis," Hertrich said in the episode recorded Oct. 13. "We do end up in this scenario of there is excess liquidity. It's not obvious that it's going to go away anytime soon. And moreover, it's not obvious that it's going to be allocated in the same way that it traditionally has been allocated when rates are this low."

The abundance of liquidity and lack of attractive yield opportunities will put pressure on net interest margins, he said.

A number of banks seem to have recognized that the excess liquidity will not be fleeting and said during their respective third-quarter earnings calls that they plan to take cash held in excess reserves at the Federal Reserve and put it work in their bond portfolios.

Truist Financial Corp., which had nearly $500 billion at the end of the third quarter, reported that it used excess reserves at the Fed to purchase $5 billion in securities in the period, adding 1 basis point to their core margin. Simmons First National Corp., which had $21.4 billion in assets at the end of the third quarter, also said it plans to reinvest approximately $500 million in excess liquidity.

Moving cash from excess reserves into securities should help mitigate additional margin pressure but will not generate the same level of income that would come with stronger loan demand. Hertrich said persistent margin pressure could encourage many bank boards to include M&A in their future strategic plans as they struggle to grow earnings. M&A could also help institutions cut costs as the two parties involved in the transaction consolidate their branch networks.

Old National Bancorp Chairman and CEO Jim Ryan III struck a similar chord on his company's third-quarter earnings call. He said the interest rate environment will be a challenge for the banking industry and could create some M&A opportunities as banks put together their forecast for the next year.

Current bank stock valuations could also support deal activity in the coming year. Hertrich noted that large and midcap banks are trading around 130% of tangible book value, while small-cap banks trade at roughly 110% of tangible book value. That spread could allow larger banks to use their stock currencies to acquire smaller institutions.

"I can easily see a scenario where most banks are beginning to do sort of their 2021 planning right now, and M&A considerations are probably on the short list that boards are thinking about either as a buyer or as a seller," Hertrich said. "And I'm not sure that there's anything that would sort of put a complete halt to that between now and the foreseeable future."

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