The Great Get-Together

Over the past ten months, two domestic regional banks within our coverage universe announced competitor bank acquisitions with the transactions generating a fair amount of headlines in the financial press. The first of the two was the October 30, 2015 announcement by KeyCorp that it was acquiring First Niagara Financial Group, Inc. (First Niagara). Huntington Bancshares Incorporated (Huntington Bancshares) followed suit on January 26, 2016, when it announced its acquisition of FirstMerit Corporation (FirstMerit). While the targeted institutions are smaller than their respective acquirers, both transactions are nevertheless regarded as "transformational" in nature, as each increases the acquiring institutions' total assets by over a third.

Transformational acquisitions tend to be viewed warily by the ratings agencies given the attendant risks of integrating operating systems and blending distinct corporate cultures. As such, the reactions to KeyCorp's announcement were not entirely surprising, with Standard & Poor's (S&P) downgrading its outlook to "Negative" from "Stable" on October 30, 2015 and Fitch following suit three days later. Moody's went a step further and initiated a full blown credit review with negative implications on October 30, 2015. Although our conviction was mildly tested, after examining the available quantifiable information our internal opinion was that KeyCorp's credit ratings at Moody's would hold at the pre-announcement levels. Our position ultimately was vindicated when Moody's walked its credit review back on July 14, 2016 and affirmed KeyCorp's current ratings with a "Stable" outlook. 

Interestingly, Huntington Bancshares' ratings were never in doubt across the major agencies despite its limited history of making large-scale acquisitions. We are, however, in agreement with the agencies that the bank's current ratings are appropriate with a stable outlook (for those so inclined, a more technical discussion and analysis of the respective transactions follows in the Appendix). These two transactions are part of a broader trend that has been evolving over the past three decades - and with the pace of consolidation not exhibiting signs of moderation it is likely that institutions within our coverage will be participating going forward. We continue to be constructive on the domestic banking sector despite the resultant headline noise that is generated from merger and acquisition activity. As acquisitions to date have proven manageable from both operational and ratings perspectives, we particularly favor bank level debt issued by regional banks most likely to be active in acquiring smaller competitors.

Beginning in 1985, the domestic banking sector has experienced an unprecedented wave of consolidation, with the number Federal Deposit Insurance Company (FDIC) insured commercial banks declining every year and the total number of chartered institutions being reduced from 14,507 at the end of 1984 to 5,386 at the end of 2015.

Source: FDIC

Intuitively, a large degree of the attrition would seem to be attributed to elevated levels of bank failures that followed the Savings & Loan Crisis across the 1980's and the more recent recession in the wake of the Lehman Brothers bankruptcy in the third quarter of 2008. A closer examination of regulatory data, however, does not support the thesis of failure-driven consolidation across the industry. In fact, since 1985 the FDIC has issued more commercial bank charters (3,509) than the total failures the system has experienced (3,135) despite failures surpassing new charters over the crisis periods, as illustrated below. This holds true despite only two new charters being granted since 2010, with one each issued in 2013 and 2015.

Source: FDIC

The reality remains nevertheless that more commercial banks have ceased to exist since 1984 (9,121) than were in operation at the end of 2015 and the reduction has not been the net result of widespread failure. The underlying catalyst has been something less ominous - garden variety mergers and acquisitions driven by broader industry characteristics and developments that transcend normal economic cycles. Nearly 80% of the contraction since 2008 occurred after 2009. The overwhelming preponderance of consolidation since 2010 has taken place among smaller institutions. Since January 1, 2016 alone, there have been 153 announced merger and acquisition transactions among domestically chartered banks and thrifts, including 10 announced since mid-July.

The prevailing low interest rate environment, while manageable for the larger banks, is proving a more difficult headwind for smaller banks to overcome in growing top-line revenue. They lack the geographic reach to source loan growth outside of their traditional footprints and generally lack the franchise breadth to grow noninterest revenue. Simultaneously, the elevated regulatory burden that has arisen in the wake of the 2008 panic presents an additional earnings impediment from the expense side of the income statement. Squeezed vice-like from both sides of the income statement, smaller institutions appear to be seizing the most expedient relief by selling themselves.

The four largest banks in the U.S. system have largely built out their respective franchises and are precluded by deposit share regulations from acquiring other commercial banks. The majority of institutions with the capability to absorb the remaining excess capacity in the system will by default be among the domestic regional and super regional cohort. We view the current trend as the natural evolution of the banking system that represents opportunity for our covered regional banks to extend franchises, deepen market penetration and improve operating performance. Finally, as the capitulating institutions are overwhelmingly small and have uncomplicated business models, we anticipate limited negative ratings impacts to acquisitive institutions. Consequently, we continue to maintain a constructive view the domestic regional banking system broadly, and KeyCorp and Huntington Bancshares specifically, headline risk notwithstanding.


Huntington Bancshares Incorporated and FirstMerit Corporation Merger Document, December 31, 2015

Securities and Exchange Commission Report on KeyCorp, May 17, 2016

SNL Business Intelligence and Financial News

The Federal Deposit Insurance Corporation

Appendix: KeyCorp / First Niagara vs. Huntington Bancshares / FirstMerit

As discussed above, Moody's reaction to KeyCorp's (KEY) acquisition of First Niagara Financial Group (FNFG) was categorically negative, while that to Huntington Bancshares' (HBAN) acquisition of FirstMerit Corp. (FMER) was essentially neutral. In our opinion, the initiation of a credit review of KEY's ratings was excessively draconian on its face and ultimately it did not stand up under quantitative scrutiny. We agreed with agency reaction to HBAN's announcement and in both cases our internal opinion was that both banks' ratings would hold at their preannouncement levels.

A Closer Look

Significant geographic overlap of respective branch networks exists in both transactions, providing opportunities to wring out operating leverage through reduction of noninterest expenses. Moreover, both target institutions have deep deposit bases and both extend the acquiring banks' franchises into new and attractive state markets, with KeyCorp entering Connecticut and Pennsylvania and Huntington's franchise being extended through Illinois into Wisconsin.

The KeyCorp / First Niagara transaction is modestly larger than Huntington / FirstMerit in terms of target acquired assets as a percentage of the purchasing institution's balance sheet (42% vs. 36%) and, while First Niagara's profitability and capital measures are noticeably lower than First Merit's, its loan impairment rate and deposit mix are stronger (highlighted in green in the tables).

After applying consolidation adjustments provided by respective regulatory filings, corresponding profitability measures and net charge-off experience are remarkably similar (highlighted in blue). All other ratios at the consolidated KeyCorp / First Niagara entity are visibly stronger however (highlighted in orange), indicating that KeyCorp should emerge from its transaction with stronger asset quality, deeper capitalization and a superior liquidity profile than will Huntington.

Given the similar risk characteristics inherent (size and the lack of management experience in executing on transactions of this scale) in both acquisitions, the negative reaction to the KeyCorp / First Niagara transaction was puzzling in light of its stronger quantitative outcomes. Neither agency was very specific in its rationale for the unenthusiastic view, although both insinuated that their opinions had less to do with a jaded view of KeyCorp than they did with First Niagara's recent acquisition history.

First Niagara had been relatively active in acquiring both branch networks and smaller competitor banks outright since early 2009, although its integration history of acquired platforms was weak. Operating performance consequently was anemic, with its returns on assets and equity being 0.12% and 0.94%, respectively, on average since 2010 including a $715 million net loss reported for 2014 driven by a $1.1 billion impairment of goodwill related to its post-2008 acquisitions. Huntington's marriage to FirstMerit does not come with similar baggage.


Another factor that appeared to be influencing the agencies' corresponding views is the geographic reach of the acquiring banks' branch networks. While Huntington operates in a tight and contiguous physical footprint radiating out from its headquarters in Columbus, Ohio, KeyCorp's branch network operates across a patchwork of unrelated geographic regions stretching across the northern tier of the United States from Maine up through Alaska.

As more of Huntington's branch network exists within close proximity to FirstMerit's, its combination prospectively offers more immediate opportunity to squeeze operating efficiencies from the merged entity than appear to be available to the KeyCorp / First Niagara amalgamation. Ultimately as it relates to credit ratings, execution and underlying fundamentals outweigh the hypothetical and Moody's came around to our view when it affirmed KeyCorp's current ratings with a "Stable" outlook.