The Deal: Too Big to Merge?

Tickers in this article: BAC C GS JPM MS WFC
NEW YORK (The Deal) -- Banks have been forced to re-think their approach to M&A as a wave of global regulation alters the appeal of deals and divestments. After three decades of consolidation -- epitomized by Bank of America Corp.'s acquisitive growth to transform itself into a national coast-to-coast universal bank -- a trifecta of economic weakness, regulatory uncertainty and shareholder aversion has produced a stagnant market for bank M&A.

Now, five years after the collapse of Lehman Brothers, new strictures are causing banks to think twice about whether the benefits of a transaction outweigh the cost, complexity and regulatory burdens of greater size or diversification.

Lazard's managing director of financial institutions group James Spencer says the new requirements change how banks view risk and reward. "They will be a lot more shrewd in allocating capital and it will color how they view acquisitions," he says. "Investment banks have had to raise capital and sell their capital-intensive private equity businesses and assets -- we are seeing that trend play out. They're in the early innings of a long baseball game."

M&A statistics show global bank M&A at its lowest level since 2008, with 712 deals so far in 2013, only marginally up from 699 during the credit crisis. This compares to 788 deals in 2007, according to Dealogic, when aggregate deal value was nearly three times higher at $324 billion. Much of this stems from the continuing Eurozone crisis, which has led to serious difficulties for many European banks.

By contrast, the U.S. banking system appears to be recovering as M&A deals hit a three-year high of 279 -- roughly on par with 2010. Yet total deal value at $10.6 billion for the year to date is low by historical standards, particularly compared to $125 billion over the same period in 2004, when 212 deals were struck. The higher number but lower overall value of bank deals points toward a concentration of M&A activity among smaller banks less affected by new regulation.

For large banks, especially those deemed "systemically important financial institutions," or SIFIs, regulation targeted at reducing their systemic risk has stifled the prospect of significant acquisitions. U.S.-based SIFIs include Citigroup , JPMorgan Chase , Bank of America , Goldman, Sachs , Morgan Stanley , Wells Fargo & Co. and State Street .

Sandler O'Neill + Partners investment banking group principal Tom Killian points to so-called speed bumps or asset thresholds, which may cause banks to re-evaluate the merits of a deal if it brings additional regulatory and capital burdens. But he still expects active pockets of M&A between these hurdles, suggesting the $15 billion to $50 billion asset range will be an busy area for bank M&A.

The "speed bumps" occur at $500 million in assets, when banks become subject to Basel III capital ratios; $10 billion, when they must undergo Federal Deposit Insurance Corp. risk assessment and stress tests; $15 billion, when they lose the ability to grandfather trust preferred securities as Tier 1 Capital; $50 billion, when they become subject to detailed stress testing, financial reporting and potentially the Basel III liquidity coverage ratio; $250 billion, when banks are subject to the January 2014 adoption of Basel rules and stricter regulation (under Advanced Approaches rules); and lastly, when banks are deemed global SIFIs and must abide by a supplementary leverage ratio and the global SIFI capital buffer.

DLA Piper partner Michael Reed says banks are likely to be particularly cautious about deals that push them across the $10 billion asset threshold. But Lazard's Spencer says regulation alone is unlikely to kill deals that are otherwise based on sound fundamentals. "If it brings them over $10 billion in assets and it makes sense, they should still do it," he says.

Both Killian and Reed say the supplementary leverage ratio is widely viewed by the banking industry as a punitive capital requirement for U.S.-based global SIFIs -- one that may force further divestments. This leverage ratio requires bank holding companies to have capital equal to 5% of their assets, while their federally insured banking units must retain capital equal to 6% of assets. Overall, banks must hold a far higher quality and quantity of capital compared to pre-credit crisis days.