Caveat Emptor: Community Banking M&A in the Post-recession World

By Kamal Mustafa

Nearly every aspect of community banking has changed radically since the 2008 recession: the economic environment, regulatory oversight, federal monetary policy, deposit and liability structures, and capital requirements. This has led to major adaptations in the analytical methodologies that underlie capital and strategic planning activities. The one glaring exception has been in mergers and acquisitions.

Legacy methodologies and processes continued to dominate this critical segment, even as regulators are paying close attention. It’s with good reason that the Office of the Comptroller of the Currency said in its latest semi-annual risk perspective that its examiners were going to begin to assess community banks’ “merger and acquisition processes and procedures.”

Although every acquirer recognizes that its own bank has changed dramatically since the recession, a vast majority fail to investigate how potential target banks have changed. This article explores these common mistakes and oversights:

Regulatory Capital and Acquisition Pricing

The new regulatory environment has imposed higher leverage ratios across the entire community banking system. For more than 80% of the U.S. banking market, regulators have required stress testing to accurately estimate capital requirements. In the remaining 20% — the community banking system — regulators have imposed leverage ratios on a more subjective basis. The community bank benefits of not having to stress test themselves have been offset by the naturally more conservative ratios that have been used to ensure sustainability within the community banking system.

Traditional accounting statements have extremely limited value when assessing a bank’s capital requirements in this post-recession world. Yet these legacy statements – and pro formas generated from them – are still used to analyze most M&A transactions.

Some acquirers take false comfort in the loan review due diligence process, the limitations of which will be discussed in the next section. The reality is simple: Without stress testing the target, it is practically impossible to get an accurate assessment of the regulatory capital required to support the assets of the bank being purchased.

An Invictus Consulting Group comprehensive review of post-recession community bank M&A transactions shows massive variances between the capital requirements of seemingly identical transactions. These variances turn seemingly great acquisitions into gross overpayments and sometimes — fortunately for the acquirer, unfortunately for the seller—the reverse. (Editor’s Note: Bank Insights will begin publishing reviews of transactions in the coming months.)

Loan Review and Classification-based Due Diligence

In the pre-recession world, the due diligence process of reviewing a target’s loans and loan classification system was a critical part of an acquisition. Historically, this allowed the acquirer to impose its asset quality discipline on the target and make adjustments to the final purchase price for improperly classified loans. In the steady-state pre-recession environment, this exercise was also a limited proxy for future performance. Regulatory capital adequacy mirrored this approach; regulators evaluated a bank’s capital based on annual historical performance.

The recession of 2008 totally disproved the validity of this historical method. Classification systems based on historical performance were no longer reliable because history was no longer a predictor of future economic events and/or their magnitude.

The loan review process is still an important exercise in evaluating the present condition of a bank’s assets, but it cannot be used to estimate future performance under diverse economic conditions. Under the new economic environment, monetary policy and regulatory response, extrapolating loan review/loan classification analysis to the future will provide misleading answers.

The only proper way to gauge the pro forma performance of an acquired portfolio involves a detailed evaluation of loan vintage. Identically classified loans of different vintages will have different risk criteria. Every banker knows that collateralized loans made during depressed real estate prices have very good loan-to-asset values, while identically classified loans made during real estate booms have questionable loan-to-asset values. Under existing loan review processes, two ostensibly identical performing loans with the same loan-to-asset value (on the books) are treated the same, irrespective of their vintages. The false comfort from a detailed loan review process will not only skew the purchase price in the wrong direction, but it will also create potential performance issues under changing economic conditions. In summary, the loan review/re-classification process is an excellent tool for evaluating historical performance, but misleading and dangerous when extrapolated into the pro forma.

Remember: M&A is nothing more than a compressed contribution to a bank’s long-term strategic plan. Having the correct assumptions about loan performance becomes even more critical in the evaluation of potential targets.

Loan Portfolio Yield Analysis

The post-recession era has been dominated by an “unnatural” rate environment, due to a monetary policy designed to deal with the global recession. This rate environment has had a substantial impact on bank portfolio yields. Interest rates artificially controlled by monetary policy have created periods of low yielding loans across different loan categories. Different rates of loan growth during these time periods have in turn created different loan yield mixes in bank portfolios. These varying rates of growth, coupled with different maturities established during these periods, have substantially affected loan portfolio yields.

Audited financial statements, loan reviews and other outdated analytics cannot quantify and segregate these parcels of loans with unique maturities and yields, which are driven by loan growth rates during different periods. The only tool for quantifying this critical information is vintage/origination analysis of a target’s portfolio. Relying on average return on assets or even marginal return on assets is a formula for gross misinformation. Two banks with identical average return on assets could have radically different actual pro forma performance.

These three areas reflect a few of the more common and serious flaws in present-day M&A analytics. While the short-term impact of these analytical deficiencies might seem negligible, and perhaps even offset by the perceived success of a transaction, many acquirers and their shareholders will pay the price in the intermediate and long term.

Concluding thought: – if you’re an acquirer and your investment banker loves you, watch out.