PacWest Bancorp was making progress against its plan to shrink its balance sheet as it coped with destabilizing deposit outflows, and its agreement to merge with the smaller Banc of California Inc. looks set to bring it to the finish line faster than it could have accomplished on its own.

PacWest had been at the center of the turmoil that erupted in March and had another episode of deposit flight after the failure of First Republic Bank. It scrambled to shed assets to match its shrunken deposit base, earmarking billions of dollars of loans for sale and pivoting back toward its conventional community bank operation.

The bank finished the second quarter with $38.34 billion of assets, down from $44.30 billion the quarter prior and well on its way to a target — articulated in April — of about $35 billion. Now, it and Banc of California, with $9.37 billion of assets at June 30, are planning to shrink by another approximately $12 billion as they target a return on assets of more than 1.1% by late 2024.

The deal "accelerates our stand-alone plan" and will deliver "long-term shareholder value being created to a greater extent than what we believe we could create as a stand-alone PacWest," PacWest President and CEO Paul Taylor said during a conference call on the transaction.

Crash diet

A string of recent asset sales by PacWest included loans and unfunded commitments in its national construction portfolio totaling $4.9 billion at a 4.5% discount; $2.1 billion of loans and $200 million of unfunded commitments from its lender finance portfolio at a 3% discount; and loans from its Civic subsidiary, a business that finances renovations of rental properties that PacWest bought in 2021 and is winding down.

A novel element of the Banc of California deal is that while PacWest investors will receive Banc of California shares, the smaller bank will nevertheless be the accounting seller.

Merger accounting requires fair value marks against seller balance sheets, an enormous hurdle to M&A after a surge in interest rates has left large portions of banks' asset books underwater. Since Banc of California's balance sheet is far smaller than PacWest's, the hit will be far smaller than if PacWest had also been the accounting seller.

The difference between the carrying value of Banc of California's balance sheet and fair values it has given in its filings was $303.5 million including a hypothetical tax adjustment, or 36.2% of tangible common equity, as of the first quarter, according to data from S&P Global Market Intelligence. For PacWest, it was $1.12 billion, or 49.9% of tangible common equity.

The banks estimated that the after-tax interest rate mark would be $369 million against Banc of California's loans and $44 million against its held-to-maturity securities. They plan to sell $1.8 billion of single-family mortgages and $1.2 of multifamily mortgages at Banc of California, and a combined $3.5 billion of securities from both banks as they cut $13 billion of wholesale funding.

They are seeking to become the leading business bank in markets in southern and central California. Neither originates single-family mortgages, and the national lending portfolios included "larger loans [that] didn't generate deposits," Banc of California Chairman, President and CEO Jared Wolff said.

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Core deposits

PacWest's total deposits fell to $27.90 billion at June 30, down from $28.19 billion at March 31 and $33.94 billion at the end of last year, with outflows concentrated in its venture banking business, an exposure that contributed to Silicon Valley Bank's demise.

But the banks said PacWest's deposits have generally been increasing since hitting a low at $25.9 billion on May 18 after the flare-up following First Republic's failure, and the outflows this year have contributed to a rapid shift in PacWest's deposits toward insured accounts, which represented about 81% of its deposits at June 30, up from 48% at the end of last year.

Banc of California said it has had success adding new commercial accounts and that its deposits started growing during the second quarter despite a sequential ending period decline of 1.2% to $6.87 billion.

The banks have also been paring buildups of expensive borrowing added to boost liquidity in the aftermath of the March turmoil. PacWest's Federal Home Loan Bank advances fell from $5.45 billion at March 31 to nothing at June 30, though its borrowing from the Federal Reserve's emergency Bank Term Funding Program (BTFP) was unchanged at $4.91 billion. PacWest plans to pay off the BTFP borrowing before the deal closes.

Net interest margin engineering

The expensive borrowing and the deposit outflows have contributed to heavy compression in the banks' net interest margins (NIMs). PacWest's fell to 1.81% in the second quarter from 2.85% in the first quarter and 3.44% in the fourth quarter of 2022.

Banc of California's fell to 3.11% from 3.37% in the first quarter and 3.72% in the fourth quarter of 2022. However, the bank said its NIM was 3.24% in June after unloading some of its expensive borrowing late in the period.

The banks' target of cutting wholesale funding by a combined $13 billion includes a planned reduction in cash by $6 billion. They projected that the maneuvers would drive the NIM higher by 170 basis points relative to the balance sheet before the restructuring.