How Will Banking Turmoil Impact Agency M&A Trends?

By anyone's standards, these are tough times for the banking industry.  The subprime credit crisis and record losses in trading activities are among the issues that have taken a heavy toll on recent bank financial performance.

Why should these problems matter to independent insurance agents?  Because in 2007, when many of these problems first hit the headlines, the number of agency acquisitions by banks was down one-third from its peak reached in 2000.  It's yet to be seen if the banking industry will return to its previous level of agency deals.

Will the lessons of this challenging period change the banking industry's interest in the insurance distribution business?  If so, will we see a surge in agency acquisitions by banks, or will we see declining interest?

First, let's take a hard look at how bad it really is for the banking business these days.  The following are a few indicators of how deep the impact has been.

• Industry Bottom Line:  Net income for the fourth quarter of 2007 was the lowest reported by the banking industry in 16 years.
• Margins:  Nearly 60 percent of banks saw a decline in net interest margin during the fourth quarter of 2007, as the average NIM fell to 3.3 percent - the second-lowest level reported since 1989.
• Individual Earnings:  Over half of all FDIC-insured institutions reported a year-over-year decline in net income in 2007.  For those with assets over $10 billion, one-in-four reported a net fourth-quarter loss.

Another example of the challenges facing the financial markets is the stunning collapse of Bear Stearns earlier this year.  Though not a commercial bank, Bear Stearns once was one of the nation's largest investment banks.  It was also one of the largest underwriters of mortgage bonds.  Its enormous exposure to mortgage-related risk was its ultimate undoing.

To be fair, performance has not suffered for all banks.  But it has for many, and the end of the suffering will not come quickly.  Credit problems in the real estate market will take time to unwind.  There will be ample time for reflection.

So, as banks lick their wounds and prepare for the future, what effect will we see in terms of the impact on the acquisition of insurance agencies?

Evidence over the near term may be difficult to interpret.  As the banking industry wrestles with current bad-loan write-offs and the expectation of more to come, conventional wisdom is that most banks will be in a capital-preservation mode.  This suggests that merger and acquisition activity will take a back seat. 

But agency deals are usually less capital-intensive than bank deals.  Will this exempt them from the M&A respite?  Probably not.  The uncertainties of the current economy, combined with balance sheet pressures for banks, are enough to diminish M&A activity across the board.

For now, expect less focus on deals of all types-including agency deals.  Therefore, don't look for a surge in bank-agency acquisitions in 2008.

However, what about the longer-term effect?  Some banks are using this time to reconsider their growth strategies, and they are rethinking and challenging some old beliefs.  Here are two conclusions reached by more than a few banks as they consider the current state of their industry.

A "Stick to Your Knitting" Strategy is High-Risk.  In recent years, as banks have ventured beyond the traditional loan-and-deposit world of traditional banking, there have been plenty of naysayers.  Critics charge that banks should stick to their knitting, focus on the business they know best, and not venture onto less familiar turf.  It's too risky, these observers warn.

However, ironically, the current problems for banking originated largely from their lending practices.  That's their core business-their knitting right?

Therefore, defenders of the stick-to-your-knitting approach must now acknowledge both the inherent risk of the lending business and the difficulty posed by the largest net interest margin in 19 years.  They then must argue that the risk-reward ratio for bank can't be improved upon through greater expansion into fee businesses.  This is a tough argument to make.  As one bank executive put it, "strategic revenue diversification is no longer a luxury."

Lower-Risk, Fee-Based Business Are Key.  Understandably, "risk management" is a current catchphrase in banking.  Revenue diversification will be part of the solution.  But to improve its risk-reward scenario, a bank will need to take a thoughtful, strategic approach to diversification that fairly anticipates the impact of entry or expansion in a particular line of business. 

There is not a one-size-fits-all answer.  Diversification into fee-based businesses in which they believe they can achieve meaningful scale while maintaining reasonable risk.  Against this scorecard, the agency business gets mixed results.

• It scores well on risk, it's a one-sale business that produces recurring revenue.  Banks understand this since the lending business operates the same way:  Get the business on the books and expect revenue for years to come.
• It is not as operationally or technologically intensive as banking, and doesn't have many of the diversification alternatives available to banks.
• Scale is another matter.  As evidenced by their agency divestitures, some very large banks have concluded they can't achieve scale in the insurance business.  But scale is relative and is achievable in insurance for all but the largest banks.

So where does this leave independent agencies looking to do deals with banks?  Here's what we know:

• Pain is causing banks to take a hard look at their future growth strategies.
• More diversification is needed.
• Fee-based business with low-risk and scalability is the answer.

This sounds like a formula that could lead growing numbers of smaller and midsize banks into the independent insurance agency business over the next few years.