The US banking industry is one of the most fragmented in the world, with more than 4,000 federally insured depository institutions. The economic case for consolidation in the industry is strong, driven by the rising burden of regulatory and technology costs that all banks must bear to compete.
Yet the volume of non-crisis mergers and acquisitions (M&A) in the past five years has declined to less than 50% of the post-global financial crisis (GFC) historical average. And M&A activity among large banks with more than $100 billion in consolidated assets has fallen to just 10% of pre-GFC levels. This is due in large part to a strong anti-consolidation stance from US regulators.
However, there is strong conviction across the industry that this stance will change under the new administration. We expect new megabanks to emerge through consolidation and organic growth among US regionals — assuming global systemically important banks (GSIBs) don’t make the acquisitions first.
US regulatory framework hinders growth of regional banks
The US regulatory framework itself has created disincentives for regional banks to scale. While regulatory standards and supervisory expectations rose across the industry following the GFC, the tailoring rules finalized in 2019 placed higher regulatory burdens on the largest GSIBs, requiring them to hold more capital and liquid assets than regional banks. We estimate that at its peak, this dynamic created a 4% return on equity (ROE) advantage for major regional banks relative to their GSIB peers.
As a result, regional banks have clustered around three key asset thresholds: below $700 billion in consolidated assets, which coincides with US regulators’ Category II threshold for capital and liquidity requirements; below $250 billion, the Category III threshold; and below $100 billion, the Category IV threshold.
Although the specter of higher regulatory requirements has dampened enthusiasm for growth via M&A, the allure of scale is real. Alongside revenue diversification, the cost burden of remaining competitive in banking has increased. Over the past 15 years, banks have increased their technology spend by about 65% and are expected to grow these budgets roughly 10% yearly over the next five years. As of 2023, the largest banks’ technology budgets are more than 10 times those of regional banks, and this differential continues to widen. Without an accelerated path to scale the business, many midsize banks may find themselves unable to remain competitive in businesses with rapid innovation cycles, such as payments, transaction banking, and liquid securities trading.
Key drivers of regional banking M&A
There are two broad changes that we believe will drive a wave of regional bank consolidation in the years ahead.
A more supportive regulatory stance
We expect the recent Office of the Comptroller of the Currency’s guidance on bank mergers to be overturned, and the explicit statutory requirements of the Bank Merger Act and the Dodd-Frank Act will become the defining supervisory test for bank M&A.
Broader shifts in regulatory and supervisory intensity
We expect the differential regulatory burden of being a bigger bank to diminish. This will come from a combination of reduced capital requirements on the largest banks alongside continued supervisory focus on regional banks following the events at Silicon Valley Bank. Since 2016, the share of supervisory findings on banks with less than $700 billion in assets has increased from about 25% to 50% of systemwide findings. While we do anticipate reduced supervisory intensity across the board, we think regional banks will continue to receive a larger relative share of this focus given the systemic concerns raised by the bank failures of 2023.
If M&A activity is anything like previous, more active cycles, we could see nearly 40 deals per year involving a bank with more than $100 billion in assets. This could create up to seven new megabanks with more than $1 trillion in assets emerging in the next five to ten years. This could play out in many flavors based on recent trends and stated growth strategies, including traditional bank roll-ups, targeted M&A to double down on strategic priorities, revenue diversification through new business lines, and the acquisition of capabilities from outside the traditional banking sphere to offer innovative propositions.
Three surprises that could shake up the future of US banking
There are at least three considerations that may lead the US banking industry down a different path in the years ahead.
1. Regional bank valuations are too high for most buyers
Already more highly valued than their global peers, US banks saw their stocks rally the day after the US election. At these valuations, many regional banks could struggle to find targets at prices that can contribute to shareholder value and/or scare away potential acquirors.
2. The GSIBs may end up as the buyers
If regulators open the doors for the GSIBs to grow via acquisition, an option that has largely been unavailable to them outside moments of crisis, the sheer size and scale of GSIBs’ capital positions would allow them to absorb even richly valued regional bank targets.
3. Regulatory changes might be less dramatic than expected
Given the uncertainty surrounding deregulation, it is possible that the ROE advantage of remaining smaller will persist and sustain the equilibrium that currently exists in the market.
This article is part of our Known Unknowns report highlighting the debates that will shape the future of financial services