Regulatory change: a key driver for banking sector M&A
Financial institutions will have to determine how to adapt their businesses to the new regulatory and economic environment, but this means more than simply deleveraging.
From the global Basel III bank regulations to the EU’s Solvency II insurance regulations, and from the UK Vickers Report to the US Dodd-Frank Act, significant change is sweeping the financial sector. This will not only alter the way individual financial institutions do business, but also the market and competitive environment in which they operate.
As a result, companies in the sector will seek to grow into areas where they can profit, and withdraw from areas where regulatory change prevents them from achieving a satisfactory return on capital. This will in turn drive merger and acquisition (M&A) activity as players sell or buy assets in order to meet these new realities. Already a number of broad impacts can be highlighted.
The first of these is the trend for banks to get ‘back to basics’. As proposed new requirements make certain areas of banking activity too capital-intensive, and regulators seek to reduce systemic risk by changing the size and structure of banks, we are seeing a retreat to core business. We have already seen banks work to increase liquidity and reduce capital requirements through disposals of non-core businesses. As greater capital requirements on lenders may limit access to funds, institutions will have to sell assets to improve their liquidity.
Economies of scale
But it is also about reshaping and not simply downsizing and deleveraging. Where permitted, economies of scale remain important. Several banks such as Barclays, HSBC and South Africa’s Standard Bank are already selling non-core assets while acquiring businesses in those areas in which they wish to focus and achieve greater scale. Despite uncertainty giving rise to pricing challenges, good quality assets are coming to market. Deutsche Bank's asset management business apparently sparked initial interest from more than 50 different parties when it was recently put up for sale.
Specific regulatory changes will have some predictable results. Dodd-Frank requires private equity business disposals, while the Vickers proposals will lead to significant group restructurings as investment banking and retail banking divisions are separated.
The prevailing uncertainty means... there is an increased focus on due diligence
There are also less explicit regulatory trends that may drive M&A and reorganisation. For example, national regulators are putting increased pressure on banks to restructure along national lines, requiring the housing of businesses in separate subsidiaries. As local entities need to be separately capitalised and maintain their own liquidity, concentrating funding at group level may be difficult. So the challenge will be to identify ways of concentrating resources within a group. Outsourcing of central or specialist functions will usually still be allowed, so we may see operations being concentrated at certain locations to reduce costs.
Tougher terms
Turning to what the prevailing uncertainty means for the conduct of bank M&A, both in terms of regulatory change and the economic environment, there is an increased focus on due diligence. This means not only a focus on the valuation of the target business, but also on compliance issues and risk management controls. Buyers may want to look back as much as five years in order to analyse whether a compliance culture exists and whether risk management has always been sound and robust. However, with some banks exhibiting increased sensitivity to revealing data, buyers may find access to information limited.
Buyers are also having to take into account the target’s ability to cope with new regulations, seeking to get certainty over whether its business model will still be supported by the new rules. As a result, we are seeing greater contract protection for buyers surrounding the impact of regulatory changes on the markets. For example, buyers are negotiating greater indemnity protection as well as arguing for higher liability caps and lower de minimis claims thresholds on sellers. The use of regulatory 'material adverse change' conditions is also on the rise.
The separation of intellectual property and customer ownership between seller and a divested entity will also be a real issue going forward. So too will be the cost and ownership issues surrounding services, such as human resources and information technology, that are usually organised at group level within large financial institutions.
As the regulatory changes come into force, it is likely that those who have prepared adequately, either by defending their existing structures or moving to the higher ground of new opportunities, will be the ones to prosper. Keeping abreast of these developments, not only on an individual but on a market-wide basis, and anticipating the impact of change will prove key to success. Yet any sale or purchase of assets is likely to have added complexities as a number of variables, from the changing regulatory landscape to market volatility, will mean that careful planning, thorough due diligence, nimble execution and wise counsel remain essential.
Alex Erasmus and Timothy Page are corporate/M&A partners at international law firm Clifford Chance.
