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Listen: Street Talk | Episode 123: Bank regulators are tipping the scales, could push even harder

Regulatory scrutiny has intensified in the aftermath of the liquidity crunch that erupted in 2023 and could play an even larger role in bank M&A activity in 2024 by motivating more banks to consider selling, while also standing in the way of some transactions. The episode features views presented by advisers at Hovde Group, KBW and Luse Gorman at the Acquire or Be Acquired conference, commentary from executives at Community Bank System and Columbia Banking System on the current state of bank M&A, and some discussion of the unfolding situation at the New York Community Bancorp.

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Street Talk - Episode 123 Bank regulators are tipping the scales, could push even harder - S&P Global Market Intelligence

Table of Contents

Call Participants.............................................................................................................. 3

Presentation.................................................................................................................... 4

Call Participants

ATTENDEES

Nathan Stovall

Unknown Attendee

Unknown Attendee

Presentation

Unknown Attendee

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.

Nathan Stovall

I'm Nathan Stovall. And on this episode, we're talking about bank M&A activity and the role that regulators could play both in forcing deals, by making an already challenging operating environment even more difficult as well as the flip side, potentially standing in the way of transactions or at least making them harder to close.

Both items were often discussed at the Acquirer or Be Acquired Conference in Arizona a few weeks ago, many of the most active advisors from the sell-side community presented at the event, while they were hopeful that [ dealer ] activity could rebound from abysmal levels in 2023, they went into great detail of what was holding up transactions.

Perhaps the largest item was the required marks that buyers have to take on sellers' balance sheets when closing a deal. The reason for that is the sharp rise in interest rates since early 2022 has pushed bank balance sheets deeply underwater. And for buyers of bank deals, that means that the rate mark they have to take it close often leaves a target with little or no capital.

Those marks still remain the biggest hurdles with deals, although recent declines in intermediate long-term rates improved that some. In fact, Dimitar Karaivanov, President and CEO of experienced acquired Community Bank System said on his company's fourth quarter earnings call a few weeks ago that he thought the decline in rates would bring clarity to the M&A market.

Unknown Attendee

Certainly, on the bank side, it's been a couple of years of headwinds, I would say, from an M&A perspective in terms of kind of figuring out the values, the rates, the marks. So we're hopeful that this year, there's going to be a little bit more clarity and stability in the market, which would allow folks to kind of really understand what's on the balance sheet.

We're hopeful that as we see more deals, they're also going to move a little bit faster through the approval process as well. But banks are sold, not bought. And we need to have willing sellers as well. So we just think that the past couple of years were pretty hard. So hopefully, it should get better from a pretty low base in terms of opportunities.

Nathan Stovall

And there was a belief at AOBA but that regulators could begin to pressure banks with low capital levels to raise capital or sell. Certainly, a motivated seller would help buyers get a transaction done. And a number of banks find themselves in that position.

While they might have adequate regulatory capital, they are reporting weak levels of tangible common equity, which captures the large amount of unrealized losses in their bond portfolios. Curtis Carpenter, Senior Managing Director at Hovde Group said at AOBA that regulators are beginning to become more aggressive with institutions with low levels of TCE.

Unknown Attendee

The regulators were very patient about this for a while, but they're taking notice and they're starting to make some noise, especially for the banks that we thought are critically low on capital. And we're seeing kind of a familiar tool kit come out from 14 years ago during the great financial crisis.

And there's tough conversations going on. And what they're telling these back is you need to raise capital or merge your institution. And they're applying some force there, even though tangible common equity is not a component of regulatory capital. They're using critically low levels as a proxy for lack of liquidity and kind of outsized exposure to interest rate risk.

This then create some [ distress ] sell opportunities in 2024. Meanwhile, the industry is in a declining profitability cycle right now. We've had consistently lower profitability each quarter for the past several quarters. In Q4, although it's not totally reported yet, basically the ones that have reported is following suit. And all of this is being caused by apparently by that interest margin contraction that we're all feeling because of the interest rate environment as deposits are repricing faster than fixed rate assets.

Nathan Stovall

KBW CEO, Tom Michaud, made a similar comment at AOBA. While outlining a variety of reasons that he believes that deal activity could pick up, he said that regulators could become a bigger factor.

Unknown Attendee

Regulation is very important. There's a finger on the scale that I think is going to affect the competitive balance, and I think that finger is pushing harder.

Nathan Stovall

Later in his presentation, Michaud went on to talk about how regulation has already changed the makeup of the banking industry. And he noted that the Basel III endgame, which will subject banks with more than $100 million in assets to new rules, including higher capital requirements will play a role in future deal activity.

Unknown Attendee

So we've had some major regulation in the last couple of decades, and it allows us to use data to see what happens. So real quickly here, if you look at the SIFI rules right after the global financial crisis, I remember Barney Frank was interviewed, he was one of the authors of that report, he goes we picked $50 billion because we just didn't know what to think.

You could always change it. I remember what I'm saying. So when they pick $50 billion that's they become a systemically important financial institution, they got to do a lot more for the regulators. That was in place for 8 years. Over those 8 years, two banks crossed $50 billion, okay?

They get a new administration, they say, [indiscernible] 50 was too low. let's do 250. So we had 250 as the system threshold for the higher cost. That's the shoot part, not the latter. So over those 5 years, 15 banks cross 50 billion. So you can see what happens when there's less regulation and banks don't have to worry about that as part of their growth plans.

So now we go to today where the proposal is to go back to $100 billion. So there are 8 banks where we think this matters the most for. I know many of these banks very well. I can tell you this issue is paramount for their management teams and their boards, I have spoken to many of them about it.

And you can read transcripts of conference calls. What is a popular range is we think we're going to spend $50 million to $100 million more every year to be $100 billion bank. And again, I'll ask you, why isn't it 120-plus? Why isn't it 90? It's 100. And these banks have to deal with. And by the way, beyond outside of this room, what we call popular opinion not in this room, popular opinion is you get to 100, you start thinking about it, I know better, you know better.

When they're 80 billion, they know exactly what they're going to do, these bankers have responsible managers, and they know the dangers of not been responsible. So it's really -- it's going to be 80 billion worth of planning starting, and again, my view is, are we really a lot safer for this and what impact this had in the economy and go back to a wheel chart.

What is this going to do to midsized banks, where they were maintaining share in the last 20 years? Is this going to make their share go up or down when it's done getting implemented. It's going to impact it. And I don't believe that, that dialogue has had enough conversation in the market.

Nathan Stovall

Harder pushes from regulators likely means a greater focus on all sorts of capital, greater scrutiny over banks with elevated commercial real estate concentrations as well as a push to build cash and liquidity. Having to hold more cash and liquidity would eat in the margins for some banks, that pressure could prove too much.

We've already seen higher rates push funding costs materially higher across the banking industry, and that has led to pressure on margins. And at some institutions, that's moved margins below 2%. There's 250 banks in that group at the end of the fourth quarter, up from about 220 at the end of the third quarter.

When you think of community banks, they most of their money off of spread, it's pretty hard to think of a bank that can breakeven at least a small one, when earning a NIM under 2. At least one bank already appears to have felt the sting of regulators pushing to build more liquidity and hold higher levels of reserves.

New York Community Bancorp finds itself in that camp, but the shares having plummeted since reporting a fourth quarter loss at the end of January. It was driven by a jump in its loan loss provisions and efforts to shore up liquidity. New York Community also cut its dividend and preserve capital.

The moves reportedly came at the behest of regulators, but the company's Executive Chairman, Sandro DiNello wouldn't comment on the influence of regulators during a special call with the Street on February 7th, instead focused on how the actions the company has taken have left it in a stronger position.

Unknown Attendee

So Sandro, I guess question is coming out of the fourth quarter results. Just speaking to investors, it feels like you may or may not be able to comment on this, but management's hand was forced by regulators to take actions that in normal course, you may not have taken. I'm just wondering, do you feel confident…

Unknown Attendee

Let me put that to bed right here, okay? What we did was what we needed to do, all right? We did the proper review of our loan portfolio. We made some changes in the way we risk weighted our loan portfolio and came to the conclusion that we needed to take action and we did.

And with respect to the dividend, if we're going to be a strong capital organization, then we have to be mindful of how much of a dividend we can afford to pay. So we made the decision to preserve capital by cutting the dividend, and we're going to go forward with that. Those are two important steps that were taken to build the foundation of this organization. So this speculation of why and when and who, look, we did the right thing, and we're going to go forward now.

Nathan Stovall

New York Community has said that it would entertain a variety of actions, including shrinking its balance sheet, pursuing asset sales or even raising capital. Many people we've spoken with have questioned whether or not the company will choose to remain independent in the face of the current operating environment.

One challenge to any deal involving such a large institution is not only that there are only a few buyers with the wherewithal to execute on such a transaction. But regulators have also been hesitant to greenlight many big bank deals. We're at the very least, those deals can face long delays.

Columbia Banking System President and CEO, Clint E. Stein is no stranger to delays like that, having seen his company's merger with Umpqua take 15 months to receive regulatory approval. Stein said at AOBA that the deal shouldn't have taken longer than 6 months to receive regulatory approval. But as soon as the application goes to Washington, D.C. and away from the primary regulator, the timeline gets longer.

Unknown Attendee

Talk about the importance of having a good relationship with your regulators. And I think most banks do a really good job with that. I know over time, we have constant communications with the regional offices. They were great. But as soon as it goes to D.C., what we saw was all the dysfunction that is out there in terms of from a political standpoint, I am taking a political statement from one party or the other.

It's just that dysfunction, we experienced through the regulatory process and it was even evident that one agency was trying to step over other agency. And that just created delays of two very clean banks, outstanding CRA rating 15 months for approval should have been 6 months...

Nathan Stovall

When asked if he would ever pursue another deal again or what he would do differently, the executive noted that you need to have a strong stomach, but said he's ramped up to his engagement with local representatives.

Unknown Attendee

Well, you have to have a strong stomach and 2 years ago, 2.5 years ago, I had a full head of hair [indiscernible] so it does, it's a lot of work. I think that what we would do differently, we've already started doing it. And that's, we've ramped up our direct engagement. I guess all the stakeholders, whether it's regulators in D.C. We've always continued to have a good relationship [indiscernible] and then working in many different fashions and many different aspects of regulatory conditions.

When they are back in their own districts, going back to D.C. just so that they know who we are, and they know the kind of company that we are. I think the other thing that we didn't hear this one that honestly, neither bank did in prior acquisitions, and that was proactively reach out. And that was a difference maker because if you have the community groups that they are at the end of the day, they realize you're not going to be able to solve every problem they have.

They just want to know that they're going to engage in key issues and be a good community partner and we still consider ourselves a community [ management ] at $52 billion. It's not about an asset size. It's about how we're dealing in the market and how we support [indiscernible]. So if you can develop that relationship, you just take one more [indiscernible].

Nathan Stovall

Lawrence Spaccasi and Scott Brown at Luse Gorman spoke at length at AOBA about what can drive deal delays. They said larger deals tend to receive the most attention from regulators. But the degree and focus of scrutiny on a deal also depends on the quality of the buyer and seller, particularly when it comes to the capital of the pro forma organization.

Unknown Attendee

Another roadblock today, roadblock or delay from a regulatory standpoint is low pro forma capital or liquidity issues on day 1. So as we talked about the spare market value [ hitting ] our analysis, People say, okay, it's okay. We're going to take this big hit right now. Our capital is going to go down. But the way the accounting works, we're going to earn it back 2 years from now.

So if we buy at the institution is $100 million in capital, but it's going to get written down to $40 million. We're going to make up that $60 million just by the passage of time in the way the accounting works and accretive factor to our income and our capital. That's not good enough.

They want to know on day 1, what your pro forma capital is going to be, and they're not going to focus so much on what the earn-back is or how you're going to creep that back into your [ path ] . They want to know what your plan is for having that little amount of capital on day 1 and how you're going to fix it.

Unknown Attendee

And what we're seeing from regulators too, is a higher expectation of what your ratios are going to be day 1 on the [ restore ]. Really a lot of ratio of about 8.5% and a risk-base of about 12%, which has higher than what we've seen historically. A lot of that has to do with the bank errors and marginal sensitivity to capital and liquidity issues. And like a regulator something happens to the pendulum this way until it gets too far and then swings back and it's certainly swinging in a more conservative direction.

Unknown Attendee

If you acquire, you're going to be below those numbers. And also I want to qualify that thing, if you're an acquirer, you got concentration issues or you've got other liquidity issues. Those ratios that Scott talked about, 8.5%, 12%, 11.5%, they might not be enough, okay? They may want to see more capital in your institution on a pro forma basis when you close that deal.

So you may have to go in thinking, "I'm going to have to do this with the capital raise to get up to another percent higher in terms of that capital." So going and understanding you can't go in with a 6-handle, what you see sometimes a 7-handle on that Tier 1 leverage ratio and expect you're going to get your deal done without some type of financing or really having to work system.

Loan concentration issues. If you've got a deal and you're already pumping I guess a 300% pre-limitation, and you do another deal, you're going to go now over that. That's going to be a hard deal to get done unless you show them how you're going to on day one, maybe get rid of some of those loans.

Nathan Stovall

The influence of regulators seems unlikely to change anytime soon. While some market watchers talk about the prospect of changes coming in the aftermath of an election in the fall '24, assuming there is a change in leadership in the White House, we think it's worth noting that changes in the regulatory community take a while to occur.

New regulatory heads will be put in place and examiners will need to be given new direction. And that will take time to filter down. At the moment, there seems a little focus on reducing scrutiny in the current framework, and developments in recent weeks only seem to underscore that further. That seems to mean that exams will remain difficult and that might be enough to tip the scales on some institutions considering their independence. And while deal approvals take work, the advisory community is working hard to help guide banks through it until next time, thanks for tuning in.

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