Last week I attended the Bank Director’s annual M&A conference. Each year it attracts a large group of commercial bank leaders, investment bankers, and vendors, all focused on discussing industry trends and the likelihood of increased M&A activity. The sessions are very informative, but the meetings outside of formal sessions are often even more helpful and useful to those pursuing deal opportunities.

My view of one of key messages coming out of the official and unofficial sessions is that consolidation will inevitably occur, but it may take place at a substantially slower rate than many observers (me included) first thought. Self-delusion, inertia, and short-term tactics will allow mediocre and slow growth performers to continue to exist for at least awhile longer.

The Fact Base.

Statistics were flying across the rooms at this conference as IBKer after IBKer presented analyses on the state of the industry. Virtually all presenters agreed that smaller banks had underperformed the rest of the industry and that various challenges would result in consolidation:

• Fee income as a percentage of operating revenues for banks below $1B ranges from 15-18% versus about 24% for banks from $5-5B and 41% for $50B+banks.

• The operating expense percentage is above 76% for banks less than $500mm while slightly less than 60% for banks from $5-15B. Only 487 banks out of 6,522 operate with an efficiency ratio of less than 50%. Over 2,700 banks operate with an efficiency ratio that exceeds 75%. Yikes!

• For banks below $1B, ROE is less than 6% versus 9%+ for most larger groups. The entire industry has suffered dramatic ROE contraction. For example, $50B+ banks generated an ROE of 13.4% in 2005 versus 9.7% in the most third quarter 2013.

• As for valuation, price to tangible book value for banks below $500mm and $500mm-1B is 0.94x and 1.05x, respectively compared with 1.98x for banks from $5-15B.

In general, analysts saw a difficult growth scenario for smaller banks with mediocre loan demand, lower net interest margins, and increased regulatory costs. Of course one piece of good news involves the generally improved environment for credit quality and portfolio performance.

The M&A Reality.

The above statistics and many others point to the likelihood of significant consolidation as smaller banks face up to their at best uncertain futures and larger players look for increased scale in part to cover increased technology and compliance costs as well as to generate growth. However, despite the facts and the inevitability of consolidation, no mass industry consolidation is going to occur anytime soon. Why?

1. Management self interest. Senior management of small banks may not be able to grow their banks and they may see the writing on the wall, but if they can put off the inevitable for four-five years, why not? In some cases their self-interest may conflict with the interest of other stakeholders, but who is there to challenge them?
2. Weak Boards. The Board should actively be determining a bank’s future path, but all too often it leaves decisions up to management. For many banks, today seems to be a good time to sell. Portfolio quality is strong, many buyers are looking to expand, and the future for most small banks is uncertain at best. However, many bank boards lack the leadership and do not take the time required to assess near-term sale versus continued operation.
3. No pressure to sell. Whether implicitly or explicitly, government regulators are harming community banks and will continue to do so, saying they support small banks while instituting requirements that make the banks’ existence difficult, if not untenable. However, unless these banks are under a C&D order or have other operating constraints, they can continue to operate with subpar returns for the foreseeable future.
4. Disciplined buyers. There is no surprise that a gap continues to exist between what a bank thinks it is worth to a seller and how the potential buyer values that target. In the past I have seen buyers stretch and overvalue targets, pushing too hard to capture potential revenues and supposed operating efficiencies. Buyers today appear to be more disciplined and know, to quote one attendee at the conference, “There’s always another deal.”
5. Unattractive sellers. As noted above, just as during the crisis of the last decade, many of those selling are doing so because they have no choice. In many cases these banks offer limited franchise value and, therefore, attract limited suitors. In addition over 4,100 banks have assets below $250 million. Many acquirers do not want to deal with a bank that small because of the costs related to acquisition and integration and the limited value a bank of that size provides to a larger institution. For many it simply is not worth the effort to take on a bank that small.
6. What’s logic got to do with it? Unless they are in crisis mode, bank management can keep going, even with little prospect for growth. One of the telling stats discussed at this conference is that something like 40-50% of banks said they were buyers and only 10-20% said they were sellers. That’s indicative of the type of deal gridlock that still exists.

The current environment is one in which many small banks will hold on, M&A specialists will see some uptick in their business but not what they were hoping for, and the small bank customer will either learn to live with less technology and services or move to a more capable competitor. One topic not sufficiently discussed at this or most other conferences is the impact of the increased importance of non-baby boomers, namely, Gen X,Y, and Millennials, now the majority of the population. Another involves the increased shift back to cities from suburban and ex-urban areas. These trends are likely community bank value destroyers. You can only keep the dam from overflowing for so long.