California Banks Merge to Get Smaller

Mergers usually make the combining companies bigger. A new bank deal does the opposite in one important way—and that may be a key to unlocking more lender deals.

As regional banks seek to recover from the deposit crisis and loss of market confidence sparked by the collapses of Silicon Valley Bank, Signature Bank and First Republic Bank earlier this year, some have argued that combining could be a way to make them more resilient, anticipating a surge of coming deals.

One problem is that bank mergers creating bigger lenders can be highly controversial in Washington. Treasury Secretary Janet Yellen recently said that combinations may be healthy, yet still expressed concern about overconcentration of bigger banks.

But on Tuesday, a deal emerged that might just fit the parameters and show a way forward. Beverly Hills-based PacWest, which saw a sharp outflow of deposits in the first quarter and its shares decline from the end of last year by almost 90% at one point, is merging with a smaller rival, Santa Ana, Calif.-based Banc of California.

The deal will combine two Golden State lenders that focus on business banking across over 70 branches, which the banks say would create one of the largest banks by deposits based in California. Yet the merger would also ultimately result in one smaller bank, as measured by total assets, than the two lenders together represent on paper at second-quarter levels. Executives told analysts on a call on Tuesday that the banks had previewed the deal for regulators, and believe it is achievable to close the deal later this year or early next year.

How can they shrink by combining? Because the transaction will enable the lenders to sell assets, like mortgages and securities, which are paying 3.75%, and pay down wholesale funding, like government-backed borrowing, costing 5%. As of the second quarter, the two banks together had roughly $48 billion in assets. After the combination, they expect to emerge with $36 billion. Yet the banks project this repositioning can grow the merged banks’ net interest income next year.

Selling low-yielding assets has been a goal for regional banks, but it can be difficult to do. Such sales would generate losses since higher market rates have suppressed the value of those assets. This in turn would deplete lenders’ capital levels, threatening to take them below ratios required by regulators.

This deal suggests further solutions are now available that other banks might tap, too. For one, it helps make low-yielding asset sales feasible in part by bringing in outside capital. Warburg Pincus and Centerbridge Partners will invest $400 million in newly issued equity. The presence of that money is itself a sign of how things have changed for banks, and why more deals like this may now be possible.

Investors would likely have sought far more punishing terms earlier this year, partly because waiting to takeover a failed bank could result in an extremely attractive deal. But after a series of second-quarter reports that cleared investors’ low bar and demonstrated stability in deposits, potential acquisition targets may have gained some leverage.

Many regional banks are already going on asset “diets” to try to get smaller ahead of Federal Reserve capital requirements that are expected to rise even for midsize banks. Smaller banks with relatively excess capital might now be able to strike deals with rivals on attractive terms.

This new deal won’t resolve every question investors might have about regionals. For example, the question of customer concentration may still loom over banks whose strategic rationale for combining is that they have similar geographies or customer types. Part of the problem identified for failed banks this year was that they had like-minded depositors that acted in concert. Executives at the merging banks told analysts that having primarily deposit funding from core customers, plus lots of liquidity, can help manage concentration risk.

But bank crises can’t be resolved in one big step. Only many small ones.

Write to Telis Demos at [email protected]