Both teams put in amazing performances as
we watched one of the better Super Bowls ever
played. Both quarterbacks were tactically sound,
but Pittsburgh executed slightly more effectively.
In similar fashion, many bank CEOs are called
on to step up their game when they receive
notice from the FDIC of a receivership bid
situation. Many bank CEOs are rising to the
challenge. Being tactically sound can help with
the game.
Acquiring banks have between 1 to 2 weeks to
determine the price of a target troubled bank and
can choose to bid in one of 3 ways. They can bid
for the whole bank, all deposits or just the insured deposits. How
banks bid depends on the quality of the troubled bank and the
bidding bank's available resources. For the most part, bidders
have focused on the deposit side, since this is the easier
execution. While we will talk about whole bank valuation in the
future, today we focus on valuing the liability structure.
Most successful liability bids have been between 0.15% and a
2.00% premium (with 5.50% the recent high). This range is low
by most standards and is a function of the tight time frame given
for analysis and imperfect information. The reality is that deposits
are worth multiple times that.
There are 2 primary ways to value deposits, the Relationship
Method and the Discounted Cost of Funds Model. In the former,
bidding banks make an estimate of the lifetime value of what that
target set of customers can produce. Here it helps to know what
your bank pays to acquire customers (since you won't need to),
what the cross-sell ratio is, the net profitability of other products
and the average "life cycle" of a customer at your bank. This is a
typical valuation method for a whole bank bid, except in a deposit
bid, the cross-sell ratio is typically reduced by 33%, since some
of these customers already have loans outstanding that may go
to other institutions (but not necessarily another bank). This
calculation usually produces a higher valuation and in a world
with perfect information, would result in a premium of 6% to 8%.
The higher the acquiring bank's product profitability and crosssell
ratio, the more they should be willing to pay for average
deposits. The higher percentage of business customers, the
higher the premium should be. Some bidding banks make further
adjustments to what is known about the deposit base (such as
demographic information or average balances), as a proxy for
past profitability.
The 2nd approach is to utilize the classic cost of funds model.
Here, valuation is a function of the cost and duration of a bank's
existing liability structure and of the target liability structure. This
is basically a discounted cash flow model, where banks look at
their own structure and then calculate the value gained by
acquiring a higher or lower cost structure (usually higher). If a
bidding bank already has a low-cost deposit base, then their
acquiring premium should be theoretically lower, as the target
deposit base will increase the bidding bank's overall liability cost.
The deposit base may still be worth a premium, as the acquiring
bank can run off the higher cost/rate sensitive deposit base and
still derive core value. Conversely, if the target deposit base has
a low cost of liabilities, a long duration and positive convexity, it
should result in a higher premium. As a proxy, most bidding
banks make assumptions utilizing average balance size and
deposit composition as a way to calculate general duration and
convexity (the calculation a bank would do if it had better
information). Because the costs of fee or loan services are not
valued, this calculation methodology normally results in a
premium for a bank's liability base of between 4% and 6%.
However, since banks in receivership usually have higher cost
deposits, lower duration and less positive convexity (which all
helped drive their demise), we find premiums for these banks are
closer to the 2% to 4% range.
The reality is that given the time and information, most banks
bid the value of only the first year's earning attribution. Over the
course of this year, we expect the value to improve (as the FDIC
gets better at providing information, banks get more comfortable
with their models and the quality of troubled banks improves
slightly).