What Event-Driven Investors Should Understand About Bank M&A
The evolving regulatory landscape introduces new challenges for investors focused on bank mergers and acquisitions ("M&A"). Where once investors could rely upon regulatory process and precedent, deals are now postponed indefinitely as regulators’ approvals are withheld and transactions are subject to heightened scrutiny.
Below we review the regulatory-approval process and highlight recurring impediments in recent deals to discuss how investors can navigate these challenges.
Regulatory Approval Process
Bank M&A transactions require various regulatory pre-approvals depending upon the structure of the transaction and entities involved. For example, a state-chartered bank’s acquisition of a national bank entails various regulatory approvals and required notices. These include pre-approvals from several U.S. regulatory authorities, including the Federal Deposit Insurance Corporation (FDIC) and relevant state regulators, as well as notice and waiver requests to the Office of the Comptroller of the Currency ("OCC") and to the Board of Governors of the Federal Reserve System (the "Fed"), respectively.
The Antitrust Division at the U.S. Department of Justice ("DOJ") separately assesses competitive factors to determine whether a deal will lessen competition and harm consumers in locations where the combined institution will operate.
The regulatory approval timeline varies based on examination findings, competitive concerns, and the size of the institutions involved. The majority of bank M&A deals are approved within 90 to 120 days from the date approval applications are filed, but regulators can take as much time as may be warranted.
Larger M&A transactions generally require more time for approval. For example, an institution that, post-merger, will maintain a national presence and exceed $50 billion in total assets will undergo a much lengthier review than a smaller regional firm with a limited geographic footprint.
The review timeline is also longer for any M&A deal receiving negative public comments or protests in response to the published media announcement of the transaction. Adverse public comments frequently arise in larger deals and can add several months to the government’s review as regulators evaluate any concerns raised.
Impediments in Bank M&A
Recent impediments in bank M&A transactions have related to:
Confidential Supervisory Information. Confidential supervisory information, or “CSI,” is non-public information that regulators obtain while supervising an institution. This can include examination reports, supervisory ratings, and communications between regulators and the institution.
While most institutions address CSI issues prior to seeking regulatory approval, the regulatory review process may uncover new issues. CSI matters are especially challenging when they arise during the pendency of an M&A transaction. It is incumbent upon the acquirer to demonstrate to the satisfaction of regulators that it has the ability to resolve these issues.
Where either the acquirer or target has CSI concerns, receipt of regulatory approval will often extend beyond the termination date in the merger agreement. In several recent instances where CSI issues have arisen during the regulatory review period, the parties’ applications for approval were withdrawn and the deal terminated. In other cases, parties have worked to resolve CSI issues and obtain regulatory approval. Depending on the specific issues, it can take several months, and even years, for the parties to resolve them. Where CSI issues arise, investors should expect that the deal will not close on time.
Antitrust Review. In reviewing bank M&A deals, regulators and the DOJ focus on whether the transaction will have an anticompetitive effect in markets where the combined institution will operate. As part of this assessment, the DOJ prepares a report that addresses competitive factors and market concentration, as measured by the Herfindahl-Hirschman Index ("HHI"). The DOJ has traditionally not challenged a bank M&A deal unless the transaction exceeds 1800 HHI, and the HHI increase is at least 200 in each market where the combined institution will operate. Institutions often sell branches and divest business lines to address these issues and win regulatory approval, typically adding months to the approval timeline.
The DOJ’s enforcement of competitive factors is dependent on the political climate in Washington. Recently, the DOJ retained advisors to review its guidelines for bank mergers. Some advisors have advocated for more stringent bank-merger measures, arguing that the traditional competitive metric of HHI is insufficient to assess anticompetitive effects. Such advisors instead favor review that would evaluate the impact of the deal on consumers and address financial stability risks.
Separately, the White House in 2021 signed an Executive Order directing regulators to strengthen oversight of bank mergers. This dramatically slowed the Federal Reserve’s timeline for reviewing transactions.
Collectively, these changes have added several months, and even years in some recent deals, to the review process.
Financial Stability. The Dodd-Frank Act updated banking laws and regulations, requiring regulators to consider the risks to the stability of the U.S. banking or financial system in all bank M&A transactions. When evaluating the financial stability factor, regulators on a case-by-case basis consider the size, interconnectedness, complexity, substitutability, resolvability, capital and liquidity of the combining institutions. To date, however, regulators have provided limited guidance and there is a general lack of clarity regarding interpretation of these metrics. This ambiguity has enabled regulators’ use of the financial stability factor as a pretext for revision of the M&A regulatory review process.
DOJ advisors evaluating the bank merger process have recently argued that the current review does not adequately consider the impact of bank mergers on financial stability. Such advisors have advocated for the adoption of quantitative systemic risk limits in bank M&A, using the commonly accepted metrics noted above. As a result, regulators’ renewed focus on financial stability has prolonged the review process and made it difficult for large banks to complete deals within the same timeframes as done historically.
Optimizing Investment Strategy
Under the current regulatory regime, it is probable that any large institution over $50 billion seeking to acquire or combine with another institution will not close as scheduled in the merger agreement.
Armed with this knowledge, event-driven specialists may consider different investment strategies. Here we provide a few basic strategies to consider, with the caveat that idiosyncrasies and other factors can affect these strategies, which should not be viewed in isolation:
Volatility Hedging. Typically, the announcement of a bank M&A deal can reduce implied volatility of any option on the target’s stock, thus reducing the time value of such option. A skilled arbitrageur, with knowledge that a proposed merger is less likely to close on time, can capitalize on rising volatility that may emerge as it becomes apparent to the broader market that the deal will not close on time–or at all.
Reverse Merger Arbitrage. This is a riskier strategy that involves taking a short position in the target firm to profit from the “spread,” or the difference between the proposed acquisition price offered for a target and its current trading price. This approach can be successful if the closing date is extended, or if the M&A deal ultimately fails. This strategy, however, presents significant challenges and risks that merit further discussion.
Outlook
Regulators’ concerns regarding competition and bank size are unlikely to abate in the near future. Investors should expect further changes that depart from historical regulatory requirements and expectations. In the wake of the Silicon Valley Bank failure, regulators are now considering tougher rules for even smaller institutions, which may place more deals in limbo.