Sterne Agee analysts Todd Hagerman and Robert Greene provide thoughts on the bank tax and heavy regulatory burden in their report dated March 19, 2014.
Large banks in danger
The convergence of regulatory and political will inside the beltway is rapidly becoming insurmountable. While certain investors would argue that the ever increasing bank supervisory power is a de facto attempt to break up the largest banks, we simply view current public policy as the preferred pathway to steadily raise capital levels higher than expected over an extended period. The persistent onslaught of changing regulatory policy, federal investigations, and record settlements/penalties only serves to prolong the economic recovery and further punish shareholders and customers alike.
Proposed taxes, regulatory assessments, and persistent regulatory settlements and investigations only serve to benefit the government versus the consumer. New laws, regulatory reform, and pending rules established under the unprecedented Dodd-Frank Act have only resulted in skyrocketing risk management costs and muted economic growth. As we have seen in past economic cycles, the initial regulatory response is increasing regulation tied to the underlying problem versus reigniting the economy and growth. However, with the opaque and secular changes tied to Dodd-Frank, we believe this cycle will undoubtedly last far longer and extract more pain, but will likely result in increasing M&A activity beginning in 2015. Quite simply, skyrocketing compliance costs and the pronounced toll of the financial downturn will likely drive M&A as the acquirers further develop a better relationship with the bank supervisors, continue to build capital, and create greater operating scale.
The recent tax reform proposal introduced by the Republican party just further adds to shareholder and company angst alike. The proposed 0.035% tax on assets on the biggest banks follows the Fed’s final rule adopted in August 2013 establishing an annual assessment fee on CCAR banks ($440mm in 2012) tied to a laundry list of direct and indirect regulatory costs—including a bank’s proportional share of the Fed’s pension costs. While many of these direct and indirect “bank taxes” passed in recent years are ultimately finding their way to the banks’ customer base, the rapidly rising cost structure in the industry is clearly beginning to take its toll—even as legacy mortgage-related costs continue to moderate. Incremental efficiency gains are tougher to come by and earnings growth is rapidly slowing to mid to high single digits as the underlying economy remains weak and rates continue to hover near historical lows. In Figure 1 we outline the earnings impact of the proposed bank tax against the estimated share buyback under the 2014 CCAR program. In addition, in Figures 2 and 3 we outline an evaluation of employee efficiency for both banks with $1-$50B in assets and greater than $50B (CCAR banks) as one measure of potential takeover candidates. In terms of the proposed bank tax and estimated share buyback, the estimated earnings impact is roughly 9% dilutive to current 2014E EPS estimates.
Evaluation of efficiency on a per employee basis
With efficiency a continuing focus for the banking industry, we evaluated bank efficiency in terms of assets, revenues, and expenses per employee. We focused our analysis on banks with $1-$50B in assets due to the higher probability of initial M&A, in addition to our sense that larger-scale deal activity is likely to remain dormant in the near term. However, with the merger and acquisition market appearing poised for a 2014 revitalization, our view is that the companies best positioned to acquire (and subsequently integrate) tend to skew toward the banks with the highest employee efficiency.
Size doesn’t necessarily equal scale
Generally speaking, the larger the bank, the greater productivity per employee (in terms of assets and revenues per FTE). However, within asset size segments, some banks are able to leverage significantly more production on a per employee basis than similarly sized peers. Although portfolio composition and business mix account for much of the difference, for the banks with <$10B in assets, employee productivity was 3x-4x higher among the most efficient banks relative to the least efficient (this despite a negligible difference in asset size).
Employee incentives matter
The top banks (across asset sizes) generally have higher compensation/employee ratios anywhere from 40% to 60% higher than less efficient counterparts. Additionally, while the employees were higher paid, corresponding production per employee (in terms of adjusted EBITDA) was also 150%-290% higher, with overall lower adjusted expense ratios.
Positioning for M&A
We would note that of the 21 deals announced thus far in 2014, the average buyer size was roughly $5.4B in assets (average target was about $720mm). Our sense is that the companies currently maximizing employee productivity are likely better positioned to execute (and ultimately successfully integrate) M&A transactions. Of note, CVB Financial Corp. (NASDAQ:CVBF) sits atop the most efficient $5-$10B banks and has already announced one transaction in 2014 (and is presumably still in the market for another). PacWest Bancorp (NASDAQ:PACW) also ranks among the best operators, and appears well positioned to integrate its pending acquisition of CapitalSource, Inc. (NYSE:CSE). Other potential buyers which appear among the most efficient operators include New York Community Bancorp, Inc. (NYSE:NYCB), Oritani Financial Corp. (NASDAQ:ORIT), Customers Bancorp Inc (NASDAQ:CUBI), and Center Bancorp, Inc. (NASDAQ:CNBC). For the large cap banks, we believe BB&T Corporation (NYSE:BBT) and U.S. Bancorp (NYSE:USB) are best positioned to return to traditional bank acquisitions as early as late 2014. Several of the “Deal Dozen” names also appear in both the most and least efficient lists (Dime Community Bancshares, Inc. (NASDAQ:DCOM) and Brookline Bancorp, Inc. (NASDAQ:BRKL) – most efficient, Metro Bancorp Inc (NASDAQ:METR) and First Commonwealth Financial (NYSE:FCF) – least efficient). We would also note Bank Mutual Corporation (NASDAQ:BKMU), Fidelity Southern Corporation (NASDAQ:LION), and Renasant Corp. (NASDAQ:RNST) as potential sellers, which also appear among the least efficient banks.