Joe Manton

Welcome to The Pipeline, the S&P Global Market Intelligence podcast that offers insights into the M&A and IPO landscape. I'm Joe Manton, Head of U.S. Financial News at S&P Global Market Intelligence. In this episode, we'll focus on the banking sector, and we'll showcase a variety of views from the investment community that were on full display at a briefing that was hosted by S&P Global Market Intelligence in New York City on May 18.

The event featured two panel discussions, one moderated by myself, and the other by Nathan Stovall, who is the Head of Financial Research at S&P Global Market Intelligence. And he also hosts the podcast called Street Talk, which takes a deep dive on banks. Nathan is joining me today, and we'll discuss what we learned at the event.

But just to set the stage a bit, the banking sector is typically an active area for M&A activity. However, the deals have come to a near halt this year as the industry has been dealing with turmoil stemming from liquidity issues and the fallout from higher interest rates. But as we'll hear, the panelists at the event expect bank M&A to ramp up once the dust settles on the industry. Before we hear from those panelist, however, let me kick it over to Nathan. Nathan, can you give an overview of your panel at the event?

Nathan Stovall

Joe, I kick things off during the two sessions we had with what we dubbed our investor sentiment panel. And it featured a group of members of the buy and sell side, including Greg Hertrich, the Head of U.S. Depository Strategies at Nomura; Jonah Marcus, a partner Portfolio Manager at Endeavor Capital; and Chris McGratty, the Head of U.S. Bank Research at KBW.

We talked about current bank valuations, which, as you'll hear, they believe do not reflect current fundamentals, how banks are reacting to the challenging operating environment that has put pressure on bank liquidity and what those impacts would have on bank strategies, including M&A activity going forward. And then that really transitioned into your session, Joe.

Joe Manton

Yes, that's right, Nathan. My panel focused on bank fundamentals and potential changes to regulation that we might see in the aftermath of the large bank failures. And the panel featured several members from the legal and investment banking community and also a policy expert.

We had Ben Azoff, who is a partner at the law firm, Luse Gorman; and we also had Isaac Boltansky, who is the Director of Policy Research at BTIG; and the other panelist was Bill Burgess, who is the Co-Head of Financial Services investment banking at Piper Sandler.

The panelists talked about some regulatory changes that banks are already experiencing. And the panelists also touched on some changes that we could expect to see going forward. And Bill Burgess offered an insider's account on what it was like advising the FDIC during the Bridge Bank sale process.

Nathan Stovall

And it was a great discussion, and we kicked things off beginning the event, really talking about Q1 earnings and what it taught us about bank fundamentals and how that compared, really differed than the views of the market. And no doubt, banks reported higher funding costs and modest liquidity pressures, but almost no deterioration in credit, one of the biggest concerns we're seeing today.

And those trends really didn't sync with the bear sentiment in the market today. Chris McGratty, the Head of U.S. Bank Research at KBW, really talked about the disconnect that exists between fundamentals that we're seeing between analysts and investors and how fear is really driving much of the investing activity in the market. And Greg Hertrich at Nomura really put a finer point on that and built on it, saying that investors were painting all banks with a broad brush.

Greg Hertrich

You may see some headlines. These headlines may not have anything to do with the solvency of these institutions. If that is the role of the regulator, if that is the role of risk, if that is the role of bank management or, frankly, if that is to role of, broadly, the media.

So I do think that where we are right now is very similar to a Bob Ross painting, insofar as he's got his big brush out. And everybody is sort of swiping all the banks to the side. And I think that is, A, irrational; and B, is probably not how we solve this.

Nathan Stovall

Our investor on the panel, Jonah Marcus at Endeavor, really had a similar take and felt that results didn't match fear in the market. But he also acknowledged we're not really out of the woods yet in terms of getting an all clear. And so we need more clarity around credit and things like commercial real estate, which is certainly weighing on many investors' minds at the current moment.

Still, at the end of the day, while Jonah said, you might face some headwinds in the near term and almost painted it as a show-me story. He said anyone taking a longer-term horizon should belong to the bank sector at this point, just given how depressed bank valuations are.

Jonah Marcus

I think you need to belong to the group for sure. If you can take a horizon and not be judged on short-term performance. And the question is, can you get a better deal in 3 months or in 6 months. But generally, in this period of time, I think you want to be, not just contrarian for the sake of being contrarian, but I think it's contrarian and right if you own the right balance sheet management teams and revenue streams.

Nathan Stovall

And KBW's Chris McGratty really struck a similar chord, and he offered a wide variety of metrics, looking at bank multiples and just really painted a picture of how distressed the space is in terms of valuations. At current levels, he noted that they were really comparable to what we saw both at the height of the pandemic as well as the aftermath of the global financial crisis, which really, really struck me as very, very depressed levels.

Chris McGratty

But if you look back historically, to Jonah's point, about buying banks below tangibles, if you look at where the group has traditionally bottomed on a pre-provision basis, it's around a 4 to 5 multiple. And it did it in COVID, and it did during the GFC. Right now, we're at 4.8x.

So we're right in that window of kind of trough valuations, which, if you believe your numbers, you would say, buy the group, go all in. I think the challenge is and I think where we could be wrong with our numbers is the mix of the balance sheet. And so the noninterest-bearing deposit base, we've seen a remixing.

I think that's getting worse because of what's happened over the last 12 weeks. But we haven't seen high rates of 5% in 20 years. So the 2004 to 2006 period, we saw rates of 5%, and the noninterest-bearing deposits are a lot lower than where they are today. And so what we're trying to do is sensitize our numbers to say what's the risk of earnings from here?

And what is the valuation -- what is the implied valuation on a pre-provisioned basis under that scenario? And if you can still buy banks below their long-term medians, when you fully palm out the earnings, then you feel pretty good about it. But I don't think we're quite there yet.

Nathan Stovall

So while the focus was around liquidity and worries about credit, and that was a lot of room in the discussions, one overhang for the group is the amount of low-yielding assets that they originated or purchased when rates were historically low in '20 and '21. And one of the discussions we had on the investor panel was talking about how many of those low-yielding assets sit in bank's bond portfolios, which are dramatically underwater.

And we've seen a handful of banks look to actually reposition those portfolios by selling bonds at a loss. So one of the discussions is, should we see more institutions try to pursue that activity as they utilize the cash from those sales to pay down higher-cost borrowings. So you get rid of your low-yielding securities and also get rid of a high-cost funding.

And our panelists agree that repositioning really does make sense, but the timing was really up for debate, and of course, depends on the institution's freight positioning and most importantly, their capital. Nomura's Greg Hertrich said, institutions might want to wait for the operating environment to get back to a more normalized place before taking action because we're not exactly sure where rates might be over the long run.

We might not be sure where regulation is over the long run. And we also expect further consolidation over the long run, and that could change the competitive landscape. But ultimately, he does expect considerable balance sheet management actions to take place.

Jonah Marcus was a little bit more explicit and said, as an investor, he wouldn't necessarily support repositioning where it required outside capital. But if a bank had regulatory capital on hand to take the capital hit associated with any repositioning of bond portfolios, he thinks an institution should consider doing that.

Jonah Marcus

The right thing about it is, if you have the regulatory capital to take the hit and have room on the back end, right now, they're dinging you for the loss as if you'd sold it, you may as well get the benefit for the earnings that you would pick up on the other side. But more importantly, I -- and so the answer to your question is yes.

But more importantly, to me, is if you can actually take the hit that you've already recognized through book value, while imputing it into your regulatory capital anyway, and take that liquidity and then go play offense and bring in clients. Not just lending clients, but also those that have -- bring deposits with them, you can really grow your client roster and your core business for -- what it comes to some fungible bond math.

Nathan Stovall

Joe, the topic of repositioning came up on your panel, too. What did you hear from your panelist on the issue?

Joe Manton

Yes, Nathan. It certainly did. Bill Burgess had a similar take to Jonah Marcus and said that having capital on hand was key for any bank that was looking to pursue this. Bill referenced that his firm worked with Eastern Bankshares on a transaction where it sold 25% of its securities portfolio at a loss, but it did so to enhance liquidity and improve future earnings.

Bill Burgess

So we worked with a New England bank to restructure their securities portfolio. And we were in the midst of helping them sell a lot of securities the same week that Wednesday 8-K came out. And the reaction, one could argue, for that 8-K was pretty violent, so they were pretty worried about that. And we've talked about that in the session. I think they handled that correctly.

I think they had the capital to make it work. And they did what we've been telling a lot clients right now, which is, no one's asking questions. Don't volunteer anything. Don't put an 8-K out. Just keep your head down. And then when you have to go through it, go through it in an intelligent manner. So I think the notion of creating a capital hole and saying you're going to fill it is ill-advised.

It's easier in hindsight. I have a fantastic Monday morning quarterback, so they shouldn't have done that. But I do think that the notion of selling securities to get yourself kind of right set for rate environment is the right thing to do. And I completely agree, which one, if you have the capital to do it, you should do it.

You shouldn't raise capital to do it, but if you have the capital to do it, you should do it. So I think that we've been pointing to the more recent announcements in conjunction with earnings versus saying, don't ever do it. With Silicon Bank, it's just night and day different.

Joe Manton

Another big topic of my panel was the potential regulatory changes that might hit the banking sector in wake of the three large bank failures that occurred in the last few months. Some of those failures got the attention of lawmakers in D.C. who held some hearings to probe the demise of the banks. And those hearings certainly grabbed some headlines. But policy expert, Isaac Boltansky, noted that change coming out of our divided Congress won't come quickly.

Isaac Boltansky

Look, DC does two things well, nothing and overreact. And I think that's exactly what we're going to see here. Congress isn't -- they're no longer nowhere on the deposit insurance issue. They're like in a town just down the road from nowhere. There will not be a bill to address and expand deposit turns. It's not going to happen, unless things get much, much worse.

And part of the reason for that is just normal political nonsense and all that. But also just think about the way that a bill would come together. You would have Democrats who say, "Hey, if you're addressing that, I want to also address CEO comp," right, which is a big issue in the earnings that we've heard. And the Republicans would say, "Hey, I also have some problems with ESG. I want to make sure that, that's in there."

And before you know it, it's overburdened and it falls on top of itself. There are -- and we can talk about this, and I hope we do. I think there are some red lines to be aware of. And really here, we're talking about volatility in banks that have a clear political constituency. I look at a bank like Regions, where -- look at their footprint.

It's in red states, and it is numerous states. Whereas I have had staffers say to me, when are we going to do a deposit insurance bill for a couple of failures of our Coastal niche banks. That's where the conversation is right now legislatively. So it's got to get much worse before you see action.

Joe Manton

However, Isaac noted that the story is different when it comes to the regulatory agencies.

Isaac Boltansky

On the regulatory side, this is what's wild about it. They were already gearing up to tighten the regulatory structure around banks, right? We already knew they were going to go after super regional banks with the TLAC rule and the single point of entry. Now on top of that, we're going to have Basel III finalization.

And then the third bucket, which we'll talk about later, which is what they're going to do to respond to this crisis. And here, we're talking about AOCI and LCR and all that. That's happening. And what makes this interesting -- I promise I'll shut up after this. What makes it interesting here is D.C. is not going from 0 to 60, right?

They were already starting to get to a sprint because look, Vice Chair Barr from the Fed was talking about at least starting the super-regional side of this, to begin with. This is just giving them more momentum to accomplish that. So nothing in Congress unless it gets much, much worse. Regulators are where it's at.

And really, the fight is going to be on implementation time line for some of these items. When we talk about AOCI, when we talk about LCR, even stress test changes, that's where the fight is because there will be a change. It's just how long do you have from an implementation time line.

Joe Manton

Others on the panel expressed similar viewpoints and noted that they've already seen changes during regulatory exams. Bill Burgess said regulators have begun testing banks against new liquidity ratios.

Bill Burgess

The regulatory changes are already underway. The OCC was sitting down with national banks in early April, like the first week of April, with a new ratio of liquidity and cash as a percentage of uninsured deposits. Ratio didn't exist on March 1, and they want that ratio at 100%. So you're going to see more securitizations. I mean they're already reacting pretty aggressively to what transpired.

And they're not going to wait for a regular way changes to -- approaches for banks overall. So I think they've been nimble after they got caught completely flat-footed, and we'll have to see how that develops over the course of coming months. But ask any OCC bank, in particular, and you'll see there's a sharp change in attitude in April. And I think that was probably a good thing to get people ready for what could come.

Joe Manton

Luse Gorman's Ben Azoff he has seen examiners impose higher capital requirements on banks. And he's seen them turn up the heat by subjecting more banks to MRAs, which are matters requiring attention, and the more serious MOUs, which are memorandums of understanding.

Ben Azoff

I mean, we're definitely seeing just a general, much like the other panelists said, intensity in the regulatory environment. That was starting, and it's definitely continued. So things that were MRAs are now -- you're seeing discussions of MOUs or even things like individual minimum capital requirements, which are often confidential, so you won't necessarily know that publicly.

They'll be put in place so that if a bank is having to say risk management issues or things with the regulators, they'll make them hold heightened capital. Even if their capital actually objectively is okay with the concept that if there's these issues here, they need to retain more capital.

And even in the environment that we've been in, we've seen all sorts of what I'll call sort of almost regulatory sort of fiat. I mean, one thing that's happened over the last month, we've seen regulators coming, asking, particularly in the community bank space, for daily liquidity reports. I've sent several clients, and again, who not sure where the line is, but looking at uninsured deposits and saying, hey, we need liquidity reports.

Even on earnings call with the banks, getting together the finance team to answer the regulator's questions, almost like you'd have as an analyst, but not really. Questions like, why do you think your stock price is down? If they knew that answer, they wouldn't be there. They'd be in Hawaii, right? So a lot of questions, but a lot of fear that's there. And we're really seeing that in the regulatory environment right now.

So we're going to see rule changes for sure. But I think even at a more granular level, you're just seeing regulators interacting with the banks in ways that we just haven't seen prior to this crisis. And how long that will continue? I don't know. But it even goes so much that you take all this attention, and that's even impacting M&A, like application processing. Because you have case managers at the FDIC who are inundated with all this day-to-day work, which they didn't have before. So it is definitely a highly unusual environment at the moment.

Joe Manton

MOUs, in particular, definitely come with some teeth, which I thought was pretty interesting, that we're already seeing that play out even -- before even new rulemaking comes at play. And that was one of the things that played into panelist belief that increased regulation, whether through actual policy change or even examination level would spur more M&A activity.

M&A activity is almost dormant right now. We're on pace for one of the worst quarters we've seen in terms of pace of activity since the height of COVID. But our investor, Jonah Marcus, thought that consolidation would eventually be huge as bankers and their boards are already fatigued after the last few years and would face even greater fatigue once new regulations surface.

Jonah Marcus

I think consolidation on the back of this is going to be huge. I mean, we saw it on the back of COVID and the stress that people were under. And you saw a huge increase of M&A in 2021. I think this is more dramatic psychologically on boards and management teams. And I think you're just going to see a ton of consolidation.

I agree with Greg. It's going to be a very small cap and micro-cap phenomenon. I don't see super regionals merging. I know there's some legislation that's been at least proposed that would streamline M&A for healthy and well-capitalized banks. So I think there's some political appetite for it.

I think the regulators actually generally want it. I think they'd like to have fewer banks to regulate, hopefully, not through a lot of failures. But I just -- I think we're going to see a tremendous amount of M&A on the back of this. And I think it's good for shareholders, the industry. And I think, look, we know that scale continues to matter more. If anything, this enhances that.

Joe Manton

Now that might take some time. And that was something that Jonah said that ultimately, you need the calendar to pass before we see transaction activity pick up. Because right now, deals remain really difficult to get done.

And KBW's Chris McGratty really highlighted the issue is that the required interest rate and credit marks that buyers have to take on sellers' balance sheets serve as a major roadblock to activity at this point. It really creates a large capital hole that can be unsurmountable. But ultimately, he expects that to change as time passes as banks seek scale.

Chris McGratty

I think putting a mark on the balance sheet is almost impossible right now. Regular way M&A feels like really difficult right now because we have the rate marks in the Qs. And if you fair value, I mean, you can run into assumptions where the equity is eliminated pretty quickly. And so I think there's uncertainty on credit marks and there's uncertainty on rate marks.

That probably means traditional, regular ways, not near term. I do think that there's different tranches of M&A that will occur, right? You go back 10, 15 years -- or 10 years, the $50 billion was important, the $10 billion was important for Durbin. If you read the legislation about $100 billion kind of being where the AOCI math would get to -- get put in your capital, you don't want to be in no man's land.

You don't want to be $90 billion because you're going to get regulated. You're $100 billion, and you don't want to be $105 billion because you're bearing the cost. So there's probably a no man's land between $80 billion and $110 billion that you don't want to be in. But there's a lot of banks that are in the $20 billions that can certainly double the company, create more scale.

But I think it's healthy to have competition for the 4, 5 G-SIFIs, right? I don't think they wanted to give First Republic to JPMorgan, but it was the best solution. But I think healthy competition and having a handful more of super regionals at the $500 bill level, I think, would be, from a regulatory perspective, less of a burden.

Joe Manton

What area where we have seen some deal activity is with the recent failed bank transactions. Bill Burgess' firm, Piper Sandler was hired by the FDIC to help shop the Silicon Valley and Signature Bridge Banks that were created in the aftermath of their failures. Burgess said he was impressed by the FDIC, but he was surprised by the lack of interest from potential buyers, particularly since the failed bank deals don't require the same long regulatory approval process that the open bank transactions do.

Bill Burgess

I was brought into the boardroom at Piper Sandler at 5:00 on Sunday after Silicon Bank had failed, and they let us know about Signature as well. And they were trying to get that done in the next week, and it ended taking up two weeks. I'll give the FDIC credit for rallying at 7:00 on Thursday and then kind of sounding the alarm bell. So they were caught flat-footed. They tried to get it sold that week and they failed. And then they brought in some folks to help.

We had manpower. We had the ability to stand up quickly and try to find a way to get the buyers organized. What I was surprised with, I think, in terms of the first week was how difficult it was to get regional banks to pay attention. One of the thoughts that has been going through my mind in terms of regional bank consolidation is that it has been just a very painful exercise.

Ask U.S. Bank how much fun it was. They spent a year trying to get Union Bank closed. Or Bank of Montreal to stand in front of Congress and talk about why they should be able to close Bank of the West. Or even Truist, way back when, had some issues. And what TD had to pay for a ransom and fail to get First Horizon closed, it was astonishing to me.

And so I'm talking to these same large banks saying, "I can have this closed for you on Sunday." Sunday. You can go see Liz Warren if you want to. You don't have to. It can close in days, and we really didn't have anyone who's paying attention. Now that may be because First Republic was going on in parallel. They never told us what was going on there and the FDIC, was remarkably adept at kind of compartmentalizing the ongoing processes.

But I'll tell you this, the FDIC, they basically said, "We need help. We got caught flat-footed." And over the course of the next couple of weeks, they got up to speed very quickly, and they were looking at every possible bank that could fail. There were data rooms built on every one of them. They were not going to get caught flat-footed again.

I was incredibly impressed with how talented the teams were, particularly in D.C., because in order for us to sell these 2 companies, we needed liquidity facilities that approximated $0.25 trillion. The discussions to get the okay to back up these balance sheets went all the way to the White House because they were concerned about the debt ceiling.

Pretty sure I haven't had a lot of debt ceiling discussions with my M&A history. But $60 billion of unfunded commitments at Silicon Valley, who's going to fund that? A bank doesn't have that kind of liquidity. One of the -- some regionals told me and said, "Look, if we buy this, and we have $42 billion leave on Monday, the same way it happened in Silicon Valley, then I'm on your list." Self-preservation is one of the characteristics of the most CEOs and CFOs. They don't want to kill themselves.

So all of this required liquidity in terms of backup facilities and the like was put together by some incredibly talented people. And those guys are working around the clock. So say what you will about the regulators and kind of their Docksiders and their khakis from Marshalls, but they worked their a**** off, and they were incredibly, incredibly adept at what they were doing. I was really surprised and impressed.

I don't know if we have a chance to work with them again, so I think they've kind of got their feet beneath them. But it was a learning experience, and it was really -- I was impressed with how focused they were on trying to find a solution. I guess the last thing I'd say, too, is they absolutely do not want to fail any more banks over the course of the coming weeks.

And that may surprise a few folks. And we work with a couple right now that are -- the FDIC is not going to shock you. They're on site with some of these banks, trying to see what the deposit outflows are every single day. And they're looking at CNBC and the panic porn of who's going to fail next. But they do not want to fail these banks.

And they'll do all that they possibly can to facilitate a sale or a capital raise to avoid any more hits to the diff. And so I've been impressed with how they pivoted and how they're now going about trying to find orderly resolutions for institutions that are kind of in extremis right now.

Joe Manton

But ultimately, Burgess does think the current interest rate environment and the potential regulatory changes will spur more bank M&A activity down the road because it just means that there will be more pressure on bank earnings going forward.

Bill Burgess

All of this is just terrible in terms of bank profitability. All of this is going to be more liquidity, more capital, more expenses, lower returns. As an M&A banker, I think that's absolutely fantastic because it's going to mean that all the smaller banks that were earning capital earn 10% on capital, and they're going to be forced to run for the exit.

We only need 4,300 banks in the country, but it will take some time to get there. But all of this is kind of horrible, with respect to just profitability for banks overall. We're seen margins. I think margins have already topped, frankly. And we'll see how that unfolds in the next few quarters.

But I mean, everything about this is kind of unfortunate, particularly for banks that are below, call it, $5 billion, $1 billion of assets. They're really going to suffer. They don't have the scale. And let's see how this M&A cycle restarts. And when it does, it could be -- by the end of the year, it's probably next year post credit, once we find out what's going to happen in terms of the economy.

Nathan Stovall

Well, Joe, at the end of the day, it seemed like most of our panelists thought that the current market environment where hysteria is ruling the day is misplaced. But it's going to be some tough sledding for banks sort of in the near term, and that time will ultimately get us to the other side where we could see a big pickup in M&A activity and more transaction activity in bank land.

Joe Manton

Yes, Nathan, I think you summed it up well. And I'm sure there's a lot of investment bankers out there who are hoping to see bank M&A pick up. But in the meantime, we thank you for your insights here. And that will do it for this episode of The Pipeline.