5 mins readIt is that time of the year again within the banking industry in the Middle East. The move for bank consolidation and the need to roll out and brush the dust off our bank M&A models. \u00a0Like every other industry banking also runs in cycles. \u00a0The 2008-9 financial crisis brought with it a wave of bank mergers that saw many a big names stumble, fall and disappear into obscurity. \u00a0Within the Middle East, multiyear oil price highs and the ensuing low interest rate environment created liquidity buffers that allowed local banks to ride that initial wave of bank failures. However with the recent triple whammy of decline in oil prices, state sponsored restructuring in Saudi Arabia and hiccups in the real estate sector, time is ripe for a new wave of banking consolidation in the region.What drives bank consolidation and bank M&A?Driving bank consolidation. Scale. Process. Customer access.There are three core drivers behind a bank consolidation wave. These are the drivers that we use to evaluate possible combinations of bank balance sheets.Access to:Scale. Scale is a function of size and spreads. Large well run banks are able to tap financial markets and raise funding (deposits) at lower costs. As long as they do this efficiently it improves the financial spread they earn on their core business of borrowing short term and lending long term.Processes. Compliance, sales, collections, product development, technology, branchless banking and banking regulations are all areas that can do with improvement in a typical bank. Small banks generally are short on talent and resources to adequately staff all of these functions. Sometimes a process driven acquisition aims to acquire a new license. It looks at opportunities to apply an optimized and profitable process play book to a larger landscape by acquiring similar sized banks or a stable of less efficient smaller banks that can be assimilated within the acquiring bank infrastructure. As we will see within the context of one of our case studies, sometimes just moving a loan book across a cheaper balance sheet is enough to create value.New customer segments or products. The desire to explore new geographies or customer segments in order to short circuit the branch and book build out period. A commercial bank moving into consumer business, a telco exploring branchless banking, a payment integrator and provider experimenting with SME credit are all instances of segment acquisition as the core driver for a transaction.Within the context of our two case studies, DIB \u2013 Tamweel and EBI-NBD, we take a quick look at the first of these drivers. Scale. There is a reason for our choice. Off the three drivers, Scale is the easiest to implement and execute, as we will see with the DIB-Tamweel case study.Process efficiency requires a great deal of effort, pain and restructuring and the savings realized often remain under 10% of the original cost base. Access to customer segments, looks great on paper but historically speaking in the region, geographic expansion and addition of new customer segments has generally never gone down as planned. Two recent regional transactions priced at half a billion dollars each based on access and process efficiency play book ended up providing for the entire amount. So on paper yes, in reality a very different story.Scale \u2013 Regulatory arbitrage and economic valueThe DIB Tamweel acquisition provides a great opportunity to examine funding and regulatory arbitrage within the banking industry setting. \u00a0It shows how a simple transformation such as the move of a loan book from an expensive to relatively cheaper balance sheet creates instant value for the acquirer.We start\u00a0with a look at a simplified loan pricing model for Tamweel.Typically a loan pricing model allocates a mix of deposits and capital to fund a loan. Cost of funds for deposits and cost of equity for capital become the basis for the breakeven rate that should be charged on that loan. \u00a0In the above context a breakeven rate leaves no room for operational expenses and credit losses. To build a profitable book of business we have to add additional spreads on top of our break even rate. These additional spreads range anywhere from between one hundred basis points to two hundred and fifty basis points and covers expense recovery and profitability for the lender.In our simplified model we have ignored the additional spread. We take that as a given. Still without the spread Tamweel should be able to recover its funding costs for the loan.If it can\u2019t charge enough to cover its funding costs, every new loan Tamweel writes destroys economic value. Theoretically speaking, Tamweel may still book accounting profits, but shareholders may be better served by selling their interest and investing their proceeds in a business that can at least compensate them with and opportunity cost equivalent rate. In reality shareholders receive partial compensation from the breakeven rate and the rest from whatever is left over after expenses have been allocated against the additional spread.Within the timeline of our DIB Tamweel case, there are three specific points where the Tamweel loan pricing model comes into play. In the very beginning when Tamweel securitizes the loans on its balance sheet and books the present value of the multiyear stream of additional spread on it book. In the middle when hit by the financial crisis it restructures its expense base to lower the burden of operating expenses on profitability. And finally immediately after the acquisition when DIB does a revaluation of its acquisition on a fair value basis to book the anticipated instant gain from the transaction within a few months of the deal closure.We will revisit all this later but for now within our example, capital allocation for both DIB and Tamweel is held constant at 8%. The lending rate is market driven and there is some (not a lot of) flexibility in tweaking it.\u00a0 Compared to Tamweel which borrowed wholesale and lent retail, DIB has its own pool of long term low cost deposits (current and savings accounts) that can be used to fund mortgage assets.When we plug in these value in our loan pricing model what do we expect to see? What does the model indicate?Remember we are still not covering our operational expenses. The expenses included in the loan pricing model only include the cost of funding. No provisions have been made for potential credit losses, loan origination and servicing expenses and corporate overhead. Also excluded are additional cost allocations not directly related to the business line. Our objective is to see what our pure model shows about Tamweel\u2019s core business profitability.Loan Pricing model – bank consolidation example – ScaleSo even without allocating expenses and overheads, the Tamweel business model as it existed in early 2010, just prior to the acquisition was not profitable on an opportunity cost basis. If you ignored the cost of capital charge, you could show accounting profitability. But on a residual value basis, with the specific set of parameters we have used Tamweel would destroy value with every new loan it wrote.Interestingly enough the same loan became profitable when moved to DIB\u2019s balance sheet. Two factors result in this transition. A lower cost of funds at DIB and a lower cost of capital required by DIB\u2019s shareholders. By moving the loan book from Tamweel\u2019s balance sheet to DIB\u2019s balance sheet you created instant value simply because the loan pricing model parameters changed.