The last few years of uncertainty in the economy, both nationally and globally, have led to the creation of new, far-reaching reforms that carry with them additional burdens for the banking industry. From Dodd-Frank to Basel III, these new regulations result in an increase of time and cost spent ensuring compliance, both of which are proportionally greater for smaller institutions. This environment creates an opportunity for larger financial organizations to acquire their smaller competitors.

There are some 6,700 banks and thrifts in the United States with assets of $1 billion or less. These smaller institutions are under increasing pressure to be able to satisfy the regulatory requirements of recent legislation, as they lack the scale to be able to spread the cost of compliance. Until recently, smaller institutions have been able to get by with a few employees acting in a compliance capacity, but new regulations bring with them new burdens in time and cost, and many of those banks who may have had a single individual ensuring compliance now have full-time staffs of six to ten employees.

Larger scale is an underlying factor of significant advantage for institutions of $2 billion or more in assets. There is a natural break in efficiency ratio for banks of $2-10 billion averaging 67-62%, while the efficiency ratios for banks of $1 billion or less average 74-69%. The strong correlation between efficiency ratio and institutional size is clear.

Compounding the greater costs is the increased accountability executives bear for compliance. Although it has been in effect for 10 years now, the personal liability aspects of Sarbanes-Oxley are still being felt across all banks, but most particularly the smaller institutions, whose employees are charged with ensuring compliance yet they may not equal those of larger banks in terms of resources, education or expertise. Moreover, the long-term effects of Dodd-Frank remain uncertain. In its third year now, the legislation is still being changed and revised, and the ABA estimates the list of regulations contained within it will grow from its current 2,300 pages to as much as 5,000 pages, which in turn will only increase the pressure on smaller institutions.

Mergers and acquisitions in the industry reached their peak in 2007, only to fall off dramatically along with the economy. However, even with slow to moderate economic growth, M&A activity will likely heat up again in the next few years. Core earnings have typically been the most significant enabler of M&A. Reduced expenses for loan losses and rising noninterest income helped lift insured institutions' earnings to $37.6 billion in third quarter 2012. This quarterly net income represents a $2.3 billion (6.6 percent) improvement over third quarter 2011, and is the highest quarterly total reported by the industry since third quarter 2006.
The added regulations and their impact on institutions, from increased compliance cost to executive concern over accountability to simple fatigue of the boards of smaller institutions, may become a significant driver encouraging consolidation and enticing small organizations to pursue acquisition.

Larger organizations should be mindful of the opportunities the current climate presents. By leveraging the advantages that come with their size, they are more easily able to focus on and absorb the costs of compliance and business in today's world, while positioning themselves to expand their scope and strength through the acquisition of smaller institutions that are, quite simply, under extreme pressure on their own.