Smaller U.S. banks with assets of less than $10 billion are stepping up M&A activity at a time when weak organic growth prospects and rising regulatory costs are driving a need for increasing scale, according to Fitch Ratings. Fitch believes that these catalysts, combined with acquirers' higher stock prices, should promote additional deals over the coming months as some institutions under $1 billion look to sell in an increasingly difficult operating environment.

Community bank M&A activity has remained relatively strong in the first months of 2014. Fitch believes that regulatory exhaustion and an inability to improve returns on equity have led many banks with assets under $1 billion to sell, particularly as transaction multiples have improved.

The number of small bank M&A transactions where the target bank was less than $1 billion in assets and the acquirer was near $3 billion rose to 31 in 2013 from 17 in 2012, according to data provided by Highline Financial. We expect deal activity in 2014 to remain near last year's levels, or potentially rise, in light of the growing competitive pressure felt by the smallest institutions.

Some recently announced deals include Montana-based First Interstate Bank's acquisition of Mountain West Bank in essentially a 50/50 cash/stock deal, and Citizens Business Bank's all-cash purchase of American Security Bank. While both deals have been well received by equity investors, Fitch believes both deals reflect increased interest among some larger community banks (those with assets of between $3 billion and $10 billion) to capitalize on higher stock prices and deploy built-up capital to acquire smaller competitors.

Furthermore, Fitch believes weak net interest margins, rising compliance costs and stiff competition for loan growth are forcing acquiring banks to look at prospective acquisitions of branch networks and deposits more carefully. The pressure to grow deposits is building in part as a result of the outlook for rising interest rates. Acquirers likely see this as a good time to add low-cost and relatively sticky deposits housed at smaller community banks as rates begin to rise.

While Fitch expects further M&A activity in smaller chunks within the community bank space, it also believes that many banks approaching $10 billion in assets will likely be hesitant to cross over that threshold, given the significant costs associated with doing so. Larger banks face more rigorous stress-testing expectations as well as loss of fee income related to the Durbin Amendment. Therefore, Fitch anticipate that most banks close to the $10 billion mark will seek to do larger deals, potentially even a merger of equals, to gain immediate scale in dealing with increased regulatory costs.