Fewer deposits will mean fewer banks

Author: Richard Magrann-Wells, Willis Towers watson

Banks are continuing to merge, however the motivations for mergers are changing. Expect the next wave of mergers to be driven, at least in part, by the anticipated change in available bank deposits over the coming years. Management needs to be aware that increases in M&A activity, regardless of the cause, will likely lead to increases in shareholder litigation.

 

Between 2009 and 2014, the Federal Reserve injected excess deposits of $2.5 trillion into the banking system — the so-called quantitative easing — to encourage lending and help jumpstart the economy following the 2008 financial crisis. Now, as the Federal Reserve plans to slowly raise rates, part of that strategy will include unwinding those excess deposits.

 

Fed Chair Janet Yellen has already announced the third central bank rate increase in the last 15 months and stated that waiting too long to raise rates would be “unwise.” A report this month from JPMorgan Chase & Co. estimates that $1.5 trillion could be sucked out of the system over the next five years if the Fed follows through with recent guidance and begins its reversal of the quantitative easing before the end of the year.

 

In the past, brokered deposits had provided relief from shortfalls in funding. Recent regulatory guidance suggests regulators are unhappy that such funding has been exploited to fund “unsound or rapid expansion of loan and investment portfolios,” and overuse of such funding has “contributed to bank failures and losses.”

 

Without brokered deposits to ease any shortfalls, some banks are likely to experience liquidity pressures and banks dependent on retail deposits will be forced to scramble to remain competitive for new assets. As Fed Vice Chair Thomas Hoenig has said in the past, “small banks are more dependent than large banks on deposits as their source of funds for making loans” and “small banks cannot so easily make up the shortfall of funds by borrowing on the capital markets.”

 

If deposits fall as predicted, banks are likely to search for merger opportunities that will broaden their deposit base. Mergers are nothing new. Banks fail, or merge. The shrinking of deposits, however, is likely to exacerbate already troubled community banks.

 

If the trends of the last two decades continue, half of the regional and community banks in the U.S. will be gone before today’s infants finish college. Despite a growing economy and a stock market near record highs, start-up (de novo) banks are largely a thing of the past.

 

Just twelve years ago in 2005, 237 new bank charters were approved in a single year; but in the six years from 2009 to 2015 the FDIC approved a total of three. There’s been a small uptick in interest in opening specialized banks recently, but potential charters represent a fraction of the number of banks that will be lost through failure or mergers in the coming year. So while factors like Fintech competitors and increased regulatory burden may be stealing the limelight, it may be the more mundane ‘lack of deposit growth’ that will ultimately cause more banks to look for the exits.

 

There is some silver lining to this turn of events. Bank stock indexes are up approximately 20% since last year’s election. This move is in large part a result of the anticipated relaxation of financial regulation. This rise in stock prices may give community and regional banks a window of opportunity to negotiate merger transactions from a position of strength.

 

Consolidation brings its own set of risks. Federal securities class actions are at their highest level in two decades. Cornerstone Research reported a record 270 federal securities litigation filings in 2016, 44% higher than the historical average of the last two decades. Most critical is that 80 of those filings were M&A related – a four-fold increase over the previous year.

 

As M&A activity heats up, the potential for more securities derivatives cases grows. Bank management will need to weigh the risks of securities litigation when evaluating merger opportunities, and consider articulate and document goals, and work with legal and risk management staff, well in advance of any M&A commitments.

 

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