Optimizing merger and acquisition strategies through asset liability management (ALM)
Does your organization know how to merge in another bank’s balance sheet while keeping your financial performance ratios in good place? Effectively using asset liability management (ALM) to assess liquidity risk can provide peace of mind when assessing if a target is attractive, optimize your liquidity performance, quantify impacts of funding in today’s high interest rate environment and identify asset and liability mismatches. Even if your organization is not merging anytime soon, focusing on modeling can create a competitive advantage by mitigating risks, identifying opportunities and maximizing value.
The current merger and acquisition (M&A) environment
Since the COVID-19 pandemic, the banking industry has experienced several ups and downs, including swings in loan and deposit growth, and interest rates. In the United States, M&A activity has also varied over the past couple of years, increasing dramatically in 2019 before plummeting in 2020, only to increase dramatically again in 2021. However, now that the economic market is volatile, many management teams are refraining from M&A activity until they see interest rates stabilize. Aug. 2023 saw the highest rate of M&A activity in over a year, showing signs that the market may stabilize sometime soon. Despite this, many industry professionals are expecting 2023 to be one of the slowest M&A years within the banking industry on record.
The midwestern United States continues to be a hotbed for M&A activity and is currently the most targeted region due to the large concentration of community banks. According to a 2023 Bank Director M&A survey, 85% of respondents said their bank either “plans to be active acquirers or were at least open to acquisitions. However, only 11% were very likely to acquire a bank this year, and of the 85% that were actively looking for or open to acquisitions, 34% said there were not enough suitable acquisition targets.
Our banking industry specialists have found that deposit base is the number one top target attribute for most M&A activity within the industry. Some other key focus areas are loan growth potential, branch locations, complementary balance sheets, complementary culture, efficiency gains and liquidity.
Asset liability management (ALM) modeling
Asset liability management (ALM), an important component of M&A transactions, is the process of managing financial risks that result from mismatches between assets and liabilities and the timing of cash flows. It focuses both on short-term (earnings) and long-term (market value of equity) risks and is a regulatory requirement for banks and credit unions to monitor interest rate risk. By calculating the economic value of equity (EVE), financial institutions can measure long-term interest rate risk by measuring the fair value of its assets and liabilities over their respective terms. On the other hand, net interest income (NII) reflects short-term interest rate risk, and NII scenarios typically project future earnings on assets and cost of funds on its liabilities. EVE and NII are both important factors that must be considered when determining whether a potential merger or acquisition would be a good fit for your financial institution.
A cash flow tool at its core, an ALM model can be used for more than just standard interest rate risk (IRR) measurement. It can be used as a powerful tool to utilize when looking at not only your organization’s balance sheet, but also the balance sheet of another organization you are considering a close relationship with. Looking at their ALM models and comparing them to your own can be a really good way to do your due diligence.
M&A strategies through ALM
Scenario analysis is a crucial part of ALM, as it is responsible for connecting the dots between IRR modeling, budget analysis, M&A strategies and its impact on liquidity. As mentioned previously, ALM models can be used for more then just standard IRR measurement – they are especially useful to incorporate growth into the balance sheet in order to gauge drivers of interest income and interest expense when analyzing M&A potential. In particular, a scenario analysis can identify profitable loan portfolios, funding sources and strategies, duration mismatches and the impacts to short-term and long-term liquidity.
The three key focus areas of scenario analysis/modeling are loans, deposits and investments. As a part of M&A strategies, scenario modeling can be used to run a combined balance sheet through an ALM system for budgeting purposes when evaluating M&A opportunities. Using an ALM system allows you to combine your current balance sheet with a potential balance sheet of differing concentrations, and it allows management teams to gauge impacts to NII in varying interest rate environments. Combination modeling can analyze financial performance ratios over the next 12 to 24 months, and can answer three important questions:
- What are the impacts of the potential target’s liabilities on your cost of funds and NIM?
- Do you have any duration mismatches or cash flow short falls?
- What are the impacts to your fair values with higher interest rates?
With combination modeling, an ALM team isn’t responsible for identifying the sensitivity of various balance sheet structures because the target bank’s structure is already there, which allows management to identify what type of bank is the most suitable institution for M&A based on your current balance sheet structure.
The three main focus areas in ALM M&A analysis are the loan portfolio, investment concentration and the deposit portfolio.
- Concentration of the portfolio: Is the portfolio residential, commercial or consumer heavy? Does the portfolio look similar to yours or is it complementary? What is their liquidity strategy with the sale of loans?
- Yield of the portfolio: Does the portfolio feature adjustable or fixed loans? If adjustable, what is the timing of the adjustments? These are both factors that ALM modeling takes into consideration.
- Duration: How long are the loan terms? Does the portfolio consist of mainly mortgages or is it consumer based? Also, what is the prepayment history?
Rising interest rates have resulted in both challenges and opportunities in the banking industry over the last year. Many institutions increased their bond holdings during the period of relatively weak loan demand during the COVID-19 pandemic. Now during a time of high interest rates, fixed-rate bonds have lowered values. What are the impacts to capital from the target’s investment concentration? Does their investment portfolio consist mainly of mortgage-backed securities (MBS) or U.S. treasuries with longer durations?
A key focus when performing combination modeling is analyzing the duration gap of the combined balance. The difference between the duration of the combined assets and liabilities shows how well matched are the timings of cash inflows and cash outflows.
- Positive duration gap: In the case that asset duration is greater than liability duration, should interest rates fall, assets will gain more value than liabilities, which increases the value of the firm’s equity.
- Negative duration gap: In the case that asset duration is less than liability duration, should interest rates fall, liabilities will gain more value than assets, decreasing the value of the firm’s equity.
Understanding your target’s deposit customer base is essential, especially in an environment where changing interest rates mean liquidity can become a concern if customers leave for higher returns or online competitors. Is the concentration of the portfolio mainly commercial or is it consumer-based? Do a lot of the customers have high net worths or do they have low balances? Focus also on nonmaturity deposits (NMD), whether they are high-yield or low-yielding, and also certificates – are they short-term or long-term?
M&A announcements create volatility in some deposit accounts, so be prepared with scenario modeling. It is important to have a thorough understanding of the target’s customer profile and average deposit balance. Some modeling key points:
- Review ALM assumptions of target institution, including betas, decay rates and maturities.
- It is important to compare your betas to theirs. If you target institution’s prices are more aligned with market changes, their customers will expect faster moving rates which impacts NIM.
- Review certificate rollovers and aging schedules for movements in funds once certificates mature.
Liquidity management basics
Liquidity can be used as a system to measure projected cash flows across the combined balance sheet in order to identify liquidity surplus and deficits, on a day-to-day, near-term and long-term basis, which helps identify risk in liquidity. Like ALM, liquidity is built from the cash flows of instruments on the balance sheet, and the contractual data of the loans, investments, deposits and borrowings are key factors.
ALM and liquidity are two essential tools that can benefit your financial institution during M&A activity. For more information on these subjects, refer to the recording from our recent webinar, Optimizing merger and acquisition strategies through ALM: a Compliance+ webinar. If you have any questions regarding ALM and handling your organization’s liquidity models, including a review or model validation of your bank’s current ALM and liquidity process, schedule a 30-minute meeting with one of our banking industry specialists.
Register now for our next webinar, Beyond compliance: Optimizing the Three Lines Model, taking place on Thursday, Oct. 5, at 1:30 PM EDT.
