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Ardmore’s Executive Vice President of Credit Technology, Peter Cherpack, recently had the opportunity to sit down with Brian W. Jones, President & CEO of the First National Bank of Elmer, to discuss the current state of the financial services industry, and, in particular, the potential for merger and acquisition activity to increase in 2024.

Brian recently attended Bank Director’s “Acquire or Be Acquired” M&A Conference and spoke candidly on many of the main themes discussed, which revolved around the direction institutions should take regarding mergers and acquisitions, and how they pertained to his community bank.

The transcript of their discussion from February 26, 2024 follows:

Peter: Please discuss what you thought were the main themes of this year’s Bank Director “Acquire or be Acquired Conference” held in January 2024:

Brian: I feel that when you attend this conference, it really is about helping you understand what directions your institution may take, and whether you think you’re in a position to acquire or to be acquired. And of course, there is a third alternative, which is to remain independent and profitable.

The process is becoming more and more challenging, especially with certain-sized institutions. In 2023, there were 98 mergers and acquisitions which represented around over 2% of the banks in the country. And as recently as 2019, there were over 260 mergers so, you can see that there’s been a lot of downward pressure.

There are a lot of reasons for this pressure. It has a lot to do with whether you have sufficient capital to pursue an acquisition. Many institutions are dealing with substantial comprehensive losses which has reduced their book value, making an acquisition more challenging. There is also a lot of margin pressure and deposit decay, which can drive financial institutions to migrate toward larger institutions. The impact of rising interest rates on loans presents another challenge to manage. When you take a look at the portfolio you could have had as much as 50 percent reduction in book values due to credit marks and other variables. I also think banks that have low leverage ratios are indirectly getting some pressure from regulators. I think there’s a high value in scale and scalability for most regional banks.

Peter: Do you think 2024 will be a big year for banking M & A?

Brian: I think there is pent-up demand for acquisitions. There are probably 4,600 banks in the US at present. One of the themes from the conference was that in the next five to ten years, that number may be reduced by as many as 1,000 banks. I think M&A will most likely pick up towards the end of 2024.

I think there are a lot of financial institutions that have experienced challenging interest margins. Some of these banks had issues that were masked by income that came from PPP, essentially being supported by government intervention. Scalability remains an important factor since smaller institutions tend to struggle for lower efficiency ratios as there is an economy of scale that is a distinct advance to larger institutions.
At one time in New Jersey, there were over 100 banks, and there’s probably about 50 today. So, depending on your location and your desire to go outside of the market, it really impacts your ability to acquire institutions or be acquired. For example, Texas is packed with almost 375 banks headquartered there. Or go to Vermont, there are very limited partnership opportunities and there are competitive issues.
Institutions that had challenging financial metrics before COVID may find remaining independent difficult and these issues may have been masked by government funding programs.

Changes in the margins this year, along with reductions in interest rates will supply more energy toward acquisitions. I think we see increases in activity in the next two years.

Peter: And there is going to be pressure from regulatory oversight like last year. Please talk a little bit about that.

Brian: This regulatory oversight illustrates how important it is to have a firm like Ardmore Banking Advisors review your loan portfolio. I think that we will see higher cap rates and office vacancies going forward. Sufficient amounts of commercial mortgages are maturing in 2024 and 2025 that will be repricing causing stress on cash flows. This could result in cash flow coverages being reduced by as much as 50%.

Peter: Are acquisitive banks still going to be waiting on the sidelines until rates come down?

Brian: It really depends. We just had an acquisition in our market from a bank in the central portion of the state acquired a bank in the southern region. Target market penetration, scalability, profitability, and deposit acquisitions are driving factors, so sometimes waiting for the market to adjust to a more dynamic environment doesn’t make sense. Institutions that may be on the market may have difficult scenarios to deal with or may just not be able to sustain profitability, these presenting opportunities.

Peter: Board Fatigue?

Brian: Well, I think that for the last three or four years, there are certain institutions that have gone through a lot. They’re just ready to sell. I think that it’s been very challenging for a lot of different reasons, the Boards may want to maximize their value and just get out.

Peter: So, is it a buyer’s or a seller’s market in 2024?

Brian: It’s definitely going to be a buyer’s market. Smaller institutions that are under $500 million generally are being sold at diluted book value. If you’re a relatively strong institution, you’re not going to want to do that. Size does matter due to scalability and the benefit that can deliver, so large M&A transactions result in superior returns.

Another thought is banks interested in being acquired don’t always properly incorporate sufficient marks against their portfolio, and perhaps overvalue what a buyer will pay. What is their true market value, that is always the issue to address between merger partners.

Peter: Do you think that the recent announcement of the Capital One/Discover deal will start a trend and break the M & A logjam?

Brian: I don’t know if any one isolated deal makes a trend. On the other hand, I think that you can talk about mergers with Fintechs or non-bank banks as a continuing trend. In 2005, I think eight of the top mortgage producers were banks and in 2023, you’d see that maybe three or four more still are holding that position. Larger institutions have started to form partnership with Fintechs, to remain competitive and relevant – though we’re seeing that they always don’t work out the way they planned.

Peter: Sound like it’s going to be a tough road to hoe for sellers in 2024.

Brian: It could be a rough year for sellers but many factors which dictate these transactions in flux are present. One of the most overlooked aspects of a M&A transaction is your regulatory relationship, not just for the buyer, but also for the seller.

I think the most important thing is to start developing relationships with those folks prior to making a deal. Someone from the local regional office is sending something to Washington, DC. You’re trying to find out or reach out to the proper people at the national level. You have to build your local relationship but sometimes your reports kick out from New York, let’s say, and they don’t know who you are and they are just reviewing sterile financial metrics. I think you need to find out who’s making the decision, and make sure that you know who that is ahead of time and start trying to develop relationships with the people that you need to communicate with.

Peter: You have already commented on the question about the drivers for M & A. It’s not really asset quality as much as it’s the need for scale in 2024, is there more?

Brian: Scalability and responding to regulatory requirements and asset quality, but I would say that number one is scalability. I wouldn’t overlook asset quality there could be issues in that area soon. Pressure is going to be placed on repayment ability and collateral value.
I think before you get full bore into a sale scenario, you need to know what you have to offer. If you’re serious about selling, you should have a third-party come in and take a look at your asset quality. Part of the problem is that many institutions really don’t prepare ahead of time – they don’t bother to adequately examine all the aspects of a merger prior to going out into the market. If they did, they would be more realistic about who they are and what the real value is for their institution.

Peter: To wrap things up, there’s a lot of talk about the fact that smaller community banks may really not be able to exist in the future. In a general sense, do you feel there’s an inevitability that banks of your size are going to be forced to merge or be acquired to survive?

Brian: For me, I look one to five years out (but it’s even hard to look one year out). A lot depends on who your client base is, your cost of funds, and your regulatory exams result. I don’t know how long you are going to hang in there when your net margin is 1.80% and where your returns are coming from at this point. Those types of metrics don’t seem sustainable to me.

On the other hand, and I’m including our institution in this, there are three or four local institutions around here that are our size and have very strong metrics. And, if you keep yourself in a good place with your regulators and have good asset quality and no compliance issues, you will be OK.

I feel it is critical to do what you do well to maintain your core business model. You must have a complete and up-to-date strategic plan that is constantly evolving.

There is going to be a large transfer of wealth in the coming years from one generation to another. If you don’t react to that transfer of wealth, if you don’t get prepared for that, if you don’t start supplying the services and the types of products that are required for that evolving client base, then you’re going to have an issue staying relevant and independent.

There are drivers in the market that are going to make it difficult to survive as a smaller institution. You must continue to be proactive. I think customers are seeking institutions who are forward-thinking, and prepared, who are agile. And it really, really depends on the management team and the board sharing a culture and strategic vision.

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