Deposit Divestitures in Bank Merger Models

In this lesson, you’ll learn why banks are often required to divest deposits in M&A deals due to federal regulations; you’ll also learn how to estimate the lost Net Income and the Net Income benefit from a deposit divestiture, and how it affects the pro forma balance sheet.

Deposit Divestitures in Merger Models Transcript

In this lesson we’re going to move into the next step of our bank merger model here, which is to look at something called the “deposit divestitures.” Now, you know what deposits are and you know what a divestiture is. Divestiture just means that you sell part of your company or a division of the company rather than the whole thing. And when you put the two words together, the deposit divestiture, the meaning becomes clear, because really what we’re talking about here is when a bank buys another bank, what may happen is that, due to federal regulations in the country that they’re both in, they may have to divest a portion of the other bank’s deposits.

Now, why would they have to do this? Why would they be required to divest part of the deposits? Well, as is the case in the U.S., as you see right here, where we have this national deposit limitation of 10%, in many countries, especially in the developed world, they set a limitation and say that, as a bank, you can only have a certain number of the total deposits in the country, so only a certain percentage of the total nationwide deposits.

In the U.S., as of the time of this deal, 2009 through 2010 or so, that limit was around 10%. Sometimes it changes. In other countries it may be different. So if you’re in the U.K. or you’re in Japan or you’re in South America or another region, the exact number may be different. Sometimes you may not have this at all, but that’s rare. Usually there’s some kind of limitation around how much of the total deposits of the country any one bank can have at a certain time.

Why would they have such a restriction like that in place? Well, part of it is because they don’t want any bank to become so big that if that bank fails, then the entire rest of the country is going to go down with it. We saw that in the financial crisis, something similar happened when banks like Lehman, Merrill, and Bear Stearns and so on got into a lot of trouble, and systemic effects resulted from that.

Now, you could argue here that 10%, the limitation in the U.S., is still very large, and the bank, any bank that has this amount of deposits is still going to be quite substantial, quite sizeable. And I don’t disagree with that, but that is just what the law is and how it works in the U.S. But really the point of this is to prevent systemic crashes that happen from one bank having too much of the deposits in the country. Let’s say they own 50% percent. If the bank goes bankrupt or gets into serious difficulty, well 50% of the country’s population is going to be in a serious amount of trouble. So that’s why they have this kind of national deposit limitation in place.

Now if you want to see more explanation, you can pull up the PDF that I’ve labeled “JP Morgan, RBC Equity Research,” and if you go to page 21 here, they go through some of the rationale for why they think SunTrust, the company we’re analyzing here, the company we’re creating the merger model for, is an attractive acquisition target for JP Morgan. As you can see from this map, SunTrust has a much more extensive retail branch in the Southeast of the country, whereas JP Morgan is more in the North and Northeast. Then they get into this business of deposits, and they say right here, “There exists a national deposit concentration limit where the pro forma entity’s deposit market share cannot exceed 10% of the total U.S. deposits.” And they go through their own calculation here of how many deposits JP Morgan and SunTrust will have to divest, and so they go through the calculation as well. So you can take a look at this if you want.


Much of our case study really comes from the mention that this equity research analyst made of JP Morgan potentially acquiring SunTrust, just saying that post financial crisis and post increased regulation, they might need more Tier 1 Common. They might need a higher Tier 1 equity ratio. They might want to shore up their deposit base, get more of a presence in the Southeast and so on. So that’s some of the rationale here for why they might actually want to acquire SunTrust. And then you can look at their calculation for how they came up with the amount of deposits that they could potentially have to divest right here.

So in terms of our calculation now, note that we are going to start with the core deposits for both the buyer and the seller here. The reason is, going back to what I mentioned in one of the previous lessons, the core deposits generally refer to U.S. based deposits, so anything domestic, anything that represents a more stable source of funding for the bank. So core deposits tend to be a better bet. Remember that even if they have foreign deposits, this is a national deposit limitation in the U.S. They’re not saying worldwide they can only have a certain mount. They’re saying just in this one specific country they can only have this percentage.

So we are purposefully excluding foreign deposits and other types of deposits here. You could argue, perhaps, that we should be including broker deposits and other types that are not necessarily foreign, but which are not included in core deposits. I am not going to worry about that type of detail. Instead, we are just going to go with the core deposits number and assume that it roughly approximates the U.S. deposits.

This calculation is inherently not precise anyway, because these numbers are all coming from different time periods. For the seller, for SunTrust here, they’re coming from the end of 2009, and then the same for JP Morgan. So these are also from their 2009 annual report, and then the total here, as you can see from the footnote I pulled it from the RBC Equity Research Report I just showed you, and this one, the timing on this is not clear. It might be the middle of 2010. So the timing here is slightly off. It’s not 100% precise, but that’s okay because it’s never going to be. We just kind of want to get a rough idea of how much they may actually have to divest.

So, to go through and calculate this number now, we are going to take the total U.S. deposits of almost $7 trillion, multiply it by the deposit limitation of 10%. So it gets us to around $700 billion here, nearly $700 billion, and then for the required divestiture, we are going to compare the buyer’s core deposits plus the seller’s and then subtract the allowed deposits at a single bank. Now, if this comes out to be a positive number, it means we have to divest, because it means that our seller and buyer, their two deposits together add up to more than this national limitation number right here. If, on the other hand that comes out to be a negative number or zero, then it means we don’t have to divest anything.

So that’s why we’re wrapping a MAX function around this entire formula. I’m going to say MAX between that and zero. So it’s $69 billion right there. So this is telling us how much in deposits we’re going to have to divest. This is important because, as you know from basic accounting, if you divest deposits on the liability side of the balance sheet, what has to happen? You have to get rid of something on the asset side of the balance sheet. That something is usually in the form of interest earning assets. So securities, loans, other types of investments, most of what you could potentially divest on the asset side of the balance sheet are going to be earning interest, and so as a result of this required divestiture, your interest income is going to go down. Your net income and net income to common are both going to go down, and that is why it is so important to get this number maybe not exactly right, but to have a rough idea of how much they would actually need to divest here.


In this case, I would argue that our number here, the required divestiture is actually too aggressive. It’s probably too high. If you go in and actually look at the report once again, they say that the first quarter, year end 2010 or first quarter 2011, when U.S. deposits are likely to be higher and possibly exceeding $7 trillion. So really, in my view, the number that we came up with here should really probably be more like a divestiture of, say, $59 billion rather than $69 billion, but that’s okay. We are going to keep this in place for now. It is quite significant, quite substantial compared to the total deposit base, but that’s okay. We are going to go with it and use it in this simple model.

Now another thing that happens when you divest some of your deposits, is you may receive a premium for them. Remember that in one of the previous lessons we said that oftentimes buyers will pay a premium for the deposits, and you get this intangible asset called the core deposit intangible. Something related happens here where if we divest some of these deposits, we may get more than what their balance sheet value indicates that they’re actually worth, more than their book value. Now, it’s not a precise science figuring this out. You sort of just make rough estimates in models and go with it, but a typical number you see here might be anywhere from 5% to 15% percent. We’re going to say 10%. Not because we’ve done a complicated analysis and come up with this, but really just so I can show you the mechanics of it and how it works. But usually, you see some kind of slight premium. It might be 5%, 10%, somewhere roughly in that range.

This will also come up later on, because as you might have already guessed, if we receive a premium when we divest deposits, that may actually help us out because we’ll have extra funding on hand, and we won’t need as much of our interest bearing liabilities to fund our operations. So both the required deposit divestiture and then the premium we receive will factor in by changing our net income and net income to common.

We also have to look at a couple of other metrics down here. The loan to deposit ratio. So for this one, the idea is that on our balance sheet, on the asset side, when we go in and divest some of these deposits, they have to correspond to something on the asset side of the balance sheet, but they’ re not necessarily going to be all in the form of loans. They might be partially in securities or partially in, really, anything else. Furthermore, some of these might be coming from JP Morgan. Some of these might be coming from the seller. So it really depends, and you can’t tell for certain where they’re going to come out of actually. So what we’re going to do is say that on the assets side of the balance sheet, a certain percentage corresponds to loans, and then the rest, the remainder of that will come from other items, like securities, other types of investments.


Here I’m going to say 25% for this loan to deposit ratio. Maybe this is a little bit too conservative. Sometimes you see much higher numbers for this because you assume that the deposits and loans are linked one to one. But here, I’m just going to go with the 25% number because I want to show you later on what it looks like when we have different items that these deposits are detracting from, subtracting from on the asset side of the balance sheet.

Now, another thing that happens when we get rid of deposits is that our risk-weighted assets will go down. Now, again, it’s not a 100% correlation. Some of these deposits may actually correspond to non-risk-weighted assets, or rather assets that have no risk, that are assumed to be risk-free. And that could certainly be the case. So what we’re going to do here is just come up with a simple estimate and say that 80% of them will correspond to actual assets that have some type of risk associated with them. So you can see right here, I’m just saying we’re approximating this, and we just don’t have enough information to really tell. They’re not breaking out the risk-weighted assets in enough detail for us to make a more precise estimate here.

And then the final thing we need to do is come up with a return on assets number. Where do we get this from? Well, if we go to SunTrust, we actually made this calculation previously. Return on assets was around 1%, 0.5% to 1%. It drops to a negative number in 2009 because of negative net income. But other than that, it looks like it’s roughly staying in that same range, which is about normal for banks. So we’re going to go back here and just say 1% for the return on assets. Maybe it’s a little bit too aggressive, given the numbers that we have and given the fact that we’re not even reaching 1% by the end of the period, but that’s okay because, again, there’s no telling. There’s no way to actually look this up in precise detail and say what type of return on assets they could expect from the assets that correspond to the deposits that they’re divesting.

So we have all these assumptions set up. Now, what we’re going to do is go down and actually trace what happens post-acquisition and see what the impact of divesting these deposits is, both the negative impact, in terms of the lost net income from the deposits themselves, and then also the positive impact, in case, as we do here, we have some kind of deposit premium that we receive.

So let’s go down to the schedule and the impact of deposit divestitures. So, once again, I’m going to set up a frame here so you can see this a bit better. We have that, and actually I should change that slightly. Okay. So this is not terribly complicated. Basically, we start with the deposits divested and the return on assets. That tells us what the lost net income is.

Remember, we don’t have to worry about multiplying by the tax rate here, because return on assets is just net income divided by assets or average assets. It doesn’t really make a difference here because it’s the same number each year. But we don’t have to worry about that. And then, of course, we are also going to receive a benefit from that premium that we received that I just mentioned before.

So for the deposits divested, we are going to link this to the deposit divestiture number, $69 billion, and copy this across. The return on assets, we are going to link it to another named cell, ‘Deposit Divestiture ROA’, which I have right there. Copy that across.


Then, for the combined company, we need to look at the funding cost. This relates to the benefit that we’re going to receive from divesting the deposits. Remember that if we divest deposits, then we have extra cash, extra funding on hand, which we can then use in place of our existing interest-bearing liabilities, thereby saving us some interest expense with this company. So for the funding cost for the combined company, we’re going to go over to the JP Morgan operating model right here, and go down to the interest-earning assets and interest-bearing liabilities, and take the average interest on interest bearing liabilities. We have to be careful to make sure we’re pulling it from Column K, because this is 2011, and now I’ll copy this across.

So what is the net impact of these divestitures? Well, we’re going to lose net income from our initial divestiture here, but then we’re also going to be helped out by the fact that this premium we received will allow us to reduce our interest-bearing liabilities. So, for the lost net income, we’ll use a negative sign, and then multiply the return on assets times the divested deposits in each year. Copy that across. Change the decimal places there, so we have that.

Then for the after-tax divestiture benefit. So, for this one, we’re going to take the divested deposits, multiply by the deposit premium, because remember, if we get a premium of 10%, then that just means 10% times this $69 billion, or around $6.9 or $7 billion here. That’s how much extra we received that we were not anticipating before. Then we’ll multiply by the combined company’s funding cost right here, because again, what it’s saying is that now, as a result of this, we have around $7 billion of interest-bearing liabilities that we no longer have to pay this average cost of funding on. So that is saving us a huge amount of interest expense. You can see here, it’s around $140 million a year. Of course, we also need to take into account taxes, because that is a pre-tax number, so we’re going to multiply by 1 minus the buyer’s tax rate. So we have that, and I’ll copy that across. So we have all those.

Now, what I can do is sum up these in each year, and we can see that overall when all is said and done, we are still losing a lot of net income and a lot of net income to common as a result of this massive deposit divestiture. As I said before, my personal opinion is that this is probably way too high. If you look at the RBC report, they say somewhere here that, “It would be required to divest approximately 40% percent of SunTrust deposits.” So definitely lower than the number we have, but not altogether that much different. They are under 50%. We are well above 50% here. So our number is probably on the high side. That is something to keep in mind. This number is probably overstated, but even if we adjusted it, it’s not as if this would drop to only $50 million of lost net income. It would probably drop to maybe $400 million or $500 million of lost net income. So still quite a substantial effect, just not quite as much as what we stated here in the model.

So that is how you go through and calculate the impact of deposit divestitures. Just to sum up what we did, basically we calculated how much in deposits from the buyer and seller will actually have to divest, because, nationwide, any single bank can only hold 10% of the total national deposits. Then we figured out the kind of premium we would receive from selling them. We would look at the ratio of loans to deposits to see how much in gross loans we’re going to lose versus how much in securities or other types of investments we’d lose on the asset side.


Risk-weighted assets to deposit ratio, we are not going to use that for a while yet. We will get to that in our pro forma capital coming up much later on. And then return on assets we have to estimate how much net income we’re going to lose from divesting these deposits. Once we had all those in place, we just went down to our schedule down here. We calculated the lost net income, but then we also receive the benefit from having fewer liabilities from that premium we received. When we went to sell the deposits, we received a premium. As a result, we could reduce our interest-bearing liabilities, and so as a result, our interest expense here falls. And then you can see at the end, our net impact still very, very negative, but not quite as much as it would be if we had not assumed that premium. So that is how you estimate the deposit divestiture impact and the purpose of it in a bank merger model.

Coming up next, we are going to jump into the restructuring funding and how to think about that in relation to the cost savings that we estimated before. Once that’s done, then we will get back to the heart of our merger model, estimating the purchase price allocation, combining the balance sheets, combining the rest of the statements, and then looking at some analysis around all of that.

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