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Don’t Dismiss Deposits When Pursuing Aquisitions

Attention bank buyers: danger may be lurking in your target’s deposit book.

There is a growing sense that merger and acquisition activity will heat up this year, propelled by healthy stock prices, relaxed regulations and intense competition for deposits. Some potential sellers want to cash out because they can’t afford — or are just unwilling — to make the necessary technology invest­ments that are essential in today’s banking environment.

The “for-sale” vibe was going strong in January at Bank Director’s annual Acquire or Be Acquired conference in Phoenix. In addition to M&A, participants talked about the impact of tax reform, how community banks can make themselves distinct to their customers, and the prospect for bank IPOs and de novo institutions.

They also lamented the difficulty of attracting young, fresh talent to the banking industry at a time when the fast pace of fintech may be more appealing.

But even as they think about M&A, the need for deposit due diligence isn’t usually a big consideration, said bankers attending the Acquire or Be Acquired conference. Instead, acquiring institutions typically focus on assessing the quality of a target bank’s credit portfolio during due diligence.

Asked how much time was dedicated to due diligence on the deposit side, one banker laughed. “About 1%,” he admitted. Another banker acknowledged, “I’d say very little. We were all focused on credit quality.”

Novantas believes buyers must apply the same discipline to evaluating a target’s deposit portfolio as they historically have given to the lending book. The importance of such rigor has increased with higher rates: the low-rate banks of yesterday can wind up with unattractive deposit positions tomorrow.

Indeed, Novantas estimates that even mild variances in estimated deposit costs can lead to significant changes in the intrinsic value of a target bank (by 20% or significantly more), leading to potential erosion in shareholder value if inaccurate estimates drive purchase price.

That is particularly important in today’s banking world, where larger banks are capturing a disproportionate share of attractive deposits from consumers and businesses whose preferences are rapidly shifting towards technology-oriented and scale-friendly banking solutions.

Many banks are — and should be — looking to make acquisitions. The low-rate environment, however, has muted some of the hidden long-term “costs” associated with the deposit business; underestimating these costs can lead to significant overestimates in transaction value. On the flip side, target banks that will benefit from a higher rate environment could be underpriced “gems”.

If an acquirer doesn’t understand how a target bank’s deposit portfolio will react as rates rise, it runs the risk of overpaying for the deal.

As previously noted, Novantas estimates that acquiring banks risk miscalculating the value of their targets easily by as much as 20%, and potentially much more. We do so by considering the variances in relative deposit costs observed in the last rising-rate environment between 2004 and 2006.

First, the difference between low and high-cost funded banks is currently muted by the sustained low rate environment. Variances are much greater in a more normal rate environment and they expanded significantly at the peak of the last rising-rate cycle, with the difference in cost of deposits between high and low-cost funded banks reaching almost 200 bp (vs. a current difference of only 66 bp). We expect to see similar trends as rates reach more normal levels in coming years.

Second, relative deposit costs at the bottom of a rate cycle are not necessarily a good predictor of costs at the top of a rate cycle. We saw significant movement in relative deposit costs the last time rates rose, indicating that there are several factors “under the hood” of a deposit portfolio that affect costs in a higher rate environment.


We see three problems that may create bad estimates in deposit costs:

  1. Using static and aggregated deposit assumptions. Acquirers lose out on critical information when they look at basic, high-level data about the target’s deposit portfolio, and assume no change to the portfolio under dynamic rate environments. Doing so fails to capture key segment-specific behavior — for example, the expected deposit outflow between operating and non-operating deposits as rates rise, or between higher-priced “hot money” and more stable, lower-cost deposits
  2. Underappreciating the impact from changes during conversion. Acquired customers experience anywhere from mild to significant disruption when their original bank is converted post-acquisition. Understanding the customer impact from expected integration decisions will enable the acquiring institution to estimate post-integration deposit run-off with greater certainty. Significant conversion-related impacts include product migration, particularly the move to less attractive checking product offerings that may include higher fees or higher waiver requirements addition, post-branch closure attrition tends to vary based on the acquired customer’s attachment to the branch, distance to the new branch, and quality of communication pre-consolidation.
  3. Assuming the target’s network production levels will reach the acquirer’s immediately. Acquirers often look at a target bank’s branch and RM production numbers — which are often well below that of the acquirer — and see an opportunity. They believe that with new product capabilities, sales capabilities, better brand awareness, etc., combined with a more efficient and consolidated network, legacy target branches and RMs will be able to match the acquirer’s production levels. However, rarely does this occur right away.

Banks are destined to see both opportunities and challenges in the higher rate environment in 2018. The prospects for M&A represent just one implication of the trend, but one that will take on increased significance in the evolving industry. The ability to conduct due diligence that goes beyond traditional metrics will be key to determining which banks emerge as winners in the current round of deal-making.

Mike Jiwani
Director, New York

Andrew Frisbie
Managing Director, New York

Bob Warnock
VP of Industry Analysis, Chicago

Robin Sidel
Director, New York

For more information, contact Novantas Marketing

+1 (212) 953-4444

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