Banking: Financial Reform Takes the Spotlight

New regulations like Dodd-Frank and Basel III have sweeping implications for the banking industry, including the merger and acquisition (M&A) arena. Banks will likely focus on acquisitions within the core banking environment — and stray away from principal-based businesses. And an emphasis on systemic risk considerations will affect the M&A approval processes.

In this episode of Deloitte Insights, our professionals discuss new opportunities in the M&A marketplace, as well as how banks should take new laws and regulations into account when developing M&A strategies.

Guests:

Jason Langan, Partner, Merger & Acquisition Transaction Services, Deloitte & Touche LLP

Thomas C. Kaylor, Principal, Valuation Services, Deloitte Financial Advisory Services LLP

Transcript: 

Sean O’Grady, Host, Deloitte Insights: Hello and welcome to Deloitte Insights. Today we are talking about Mergers & Acquisitions in the banking industry, and how new laws like Dodd-Frank and Basel III may change traditional M&A processes. Joining the discussion with us in the studio is Jason Langan, a partner in M&A transaction services, Deloitte & Touche LLP and Thomas Kaylor, a principal in Valuation services in Deloitte Financial Advisory Services LLP.

So, gentlemen, Dodd-Frank and Basel III, are these laws creating new opportunities in the M&A marketplace and are they changing the processes in the M&A world?

Thomas Kaylor: Yes, certainly we don’t know the full ramification of the regulations, but with respect to transactions, what I think we are going to see is that the banks are going to focus on acquisitions within the core banking environment. Loans to strong creditors, deposit gathering, asset management fee-based income and getting away from the type of businesses that are principal based, i.e. proprietary trading, private equity that are really limited by the Dodd-Frank regulation. So I think that’s what we going to see happening, it is just a flow out of what that regulation is intended to do. I think there will be couple of other issues – I think we’ll see attention paid to systematic risk, and that will be how big can a bank get before they become systematically important, and have a new layer of regulatory body as part of the consideration. I think that will be an issue and then certain acquirers will have to consider a new regulator because the OTS (The Office of Thrift Supervision) has gone away. So now banks will have the new regulator, they will be involved with respect to acquisition particularly through the approval processes and that will be a change for the M&A processes within the banking environment as well.

SOG: Jay, your thoughts

Jason Langan: I agree with Tom, I think we are going to see a back-to-basic strategy for most money centered banks and large regional banks. I think there will be a lot of divestiture activities. Like Tom said, some of the businesses like proprietary trading, if they can sell it, they are going to sell it. If there is a ready market for them out there, and marketplaces are going to pay to recapitalize those businesses, yet to be determined on that end but I think that’s an interesting opportunity. An especially interesting opportunity will be the Volcker rule fallout, from the perspective of the three percent limit on Tier I ownership of private equity businesses and hedge fund businesses, so I think we’ll see a lot of divestitures in that area. So, I think the key is not just management and general partnership but also the interest in those funds. The good thing on that note is that those types of businesses have lower regulatory threshold of ownership, so there are lot more buyers out there, you know, private pools of capital, so they can buy those businesses. So, I think they will spur a lot of activity. On the pure play bank side from the small and medium community banks, there is a lot of pressure to sell. You factor in the regulatory overhead cost operation system to enhance your oversight - that’s costly. You add in the possible Basel III capitalization requirements; it really ties up more capital from the IRR perspective. Then you think about the things like the Durban amendment, taking away interchange, cutting interchange fees, you think about the restrictions on overdraft charges - that hurts the fees streams of those businesses, impacts the business model. I think that’s going to cause a lot of firms over the next 12-18 months to reassess where they are at the marketplace and consider themselves for sale.

SOG: So Jay, sticking with you, how do you think these banks should take the new laws and regulations into account when they are developing M&A strategy?

JL: Well, I think regulatory will be the main driver. So, I think you need to model in the new impacts, whether it is new capitalization levels, the lost fees, higher costs, and I think that’s going to spike more activity. I think it will be a change in type of activity we have had in the last two years, away from FDIC closed banks resolution process to more open bank transaction. Banks to banks buying each other; I think the asset values improved enough that the capital holes in those businesses will be resolved to some extent to make these more saleable assets.

TK: I think Jay you made some excellent points. I think with respect to regulatory capital it’s going to be critical, and it is going to create a lot of opportunities. And I think the other opportunity is that those companies are really generating a lot of earnings right now. They have the opportunity to really deploy that in a really economic way, because there is a bifurcation between the acquirers and the sellers and I think as we see that happen it is going to make a lot of sense to consolidate this industry very quickly.

SOG: So if we’re talking about “right now,” what’s the most important thing a bank should prioritize if they are considering an M&A, right now?

JL: I think issue one is regulatory capital, thinking about purchase accounting and impact on proforma regulatory capital. It saves a lot of time for a buyer who does an analysis- day one versus down the line. I think 7,000 institutions out there, over 700 on the watch list, so there are plenty of targets out there to consider, but there are lot of targets out there that have some problems with it. So when you factor in the fair value marks on those businesses, the capital hole coupled with the purchase price is just too much for an economically viable deal. I think what Tom’s group does used to be something more, at the end of the deal, kind of valuing the assets doing purchase price allocation, that’s has been accelerated to the front of the deal. And we have seen a lot of targets get screened out because of that, we’ve seen buyers get much smarter, not wasting the deal cost, and kind of weeding out the guys that don’t fit right away.

Additionally, along the same lines, SOP 03-3, accounting for distressed loans is quite complex and from the business model perspective, I think the folks are missing a little bit, the fact if you fair-value those loans in purchase accounting, there is an impact in the implicit yield therein, that’s going to impact regulatory capital going down the line. So, I think, in fact you deal viably from day one and what your earnings would be going forward in the deal. From the seller’s perspective, we are seeing a lot more preparations. I think during the crisis firms were quick to sell assets and try to gain capital, a lot of people we dealt with have struggled mightily trying to find the answer. What’s the business metrics? What’s normalized EBITDA? What does my balance sheet working capital look like? I think we are seeing a much more prepared seller in telling the story of the business, making sure the information hangs together from the CIMs all the way through to the detail data room making the process go much smoother and keeping more buyers in the game so it actually enhances your purchase price gets more people bidding up the assets.

SOG: And Tom from your side too, bankers thinking about divestiture, mergers or acquisition, right now, what’s the most important?

TK: Of course I would agree with Jay, the regulatory capitol is going to drive it. When I say regulatory capitol it IS the deal creator, or diluter, with respect to capital; tangible capital or Tier I, whatever you want to look at. I think that’s going to be critical and overlay that with that new capital requirement so everyone is going to pay attention to the balance sheet. One thing that we didn’t discuss is integration and what is critically important, and could give acquirers competitive advantage, is how they get data from acquired target. How do they manage it? How do they feed it into their system and integrate it, and how do they gain a better share of wallet from the customer they acquire and keeping those customers.

SOG: So the world has changed and expect to change with it?

JL: Absolutely

TK: Absolutely

SOG: So that’s all the time we have for this edition of Insights. If you liked to learn more about Jason, Tom or any of the information we discussed on today’s broadcast you can find that and much more by clicking away on our site. It’s www.deloitte.com/us/podcasts.

For all the good folks at Deloitte Insights, I’m Sean O’Grady – we’ll see you next time.