Amid tougher financial conditions and high levels of industry uncertainty, the long-running consolidation of the U.S. banking sector ground to a halt last year, and that deal flow is expected to remain slow in the short term, even as the demand for scale grows, says Morningstar DBRS.

In a new report, the rating agency said U.S. bank merger activity hit a 30-year low in 2023.

The drop in deal activity came as high interest rates prevailed, economic prospects dimmed, and the U.S. banking industry faced intensified stress.

“The decreased appetite was inevitable as the combination of higher interest rates (depressed the value of investment securities and fixed-rate loans), lower valuations (mismatched buyer/seller valuation expectations), and macro uncertainty (regional bank failures/potential recession) drove banks to the sidelines,” Morningstar noted.

Looking ahead, deal activity is likely to stay subdued in the short term, the report said, given ongoing concerns about banks facing credit losses on the commercial real estate sector, and growing regulatory impediments (in the wake of the bank failures last year, which sparked proposals that will curb large bank mergers).

“Although conditions have since improved, our view is that consolidation will likely remain muted in the near term given existing headwinds, such as uncertainty around commercial real estate,” said Morningstar.

That said, the need for scale in the banking industry continues to grow, which will ultimately underpin a revival of deal activity, it noted.

“The industry’s homogeneity and the need for increasing tech spend has further driven the desire for scale, and we expect consolidation to pick back up as cyclical headwinds abate,” it said.

The banking industry has always benefited from scale, as “the act of acquiring another bank is simply much quicker and easier than attempting to poach customers from a competitor,” the report said, adding that scale improves operating leverage as large fixed costs can be spread over a larger entity, creating a significant structural cost advantage for bigger firms.

The same impetus to serve a larger customer base more cost effectively has driven growing reliance on technology in the banking sector.

“However, investments in technology/digitization require significant capital and resources,” the report said. “With the ever increasing cost of these investments, scale matters more than ever given the need to spread these higher fixed costs across a wider base.”

So, while prevailing impediments to bank consolidation are expected to persist in the short term, eventually the benefits of industry M&A will drive renewed dealmaking, it suggested.

“Given the changing competitive landscape, the need for scale will only continue, which should further stimulate the need for smaller banks to consolidate,” it said.