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Buying Spree Ahead for Regional Banks

Never mind the glamour of Wall Street's enormous institutions -- the real banking action is in the heartland.

Larger regional banks are already gobbling up smaller rivals as the business suffers from reduced profitability, increased red tape and the hefty cost increases. It's a trend that looks likely to continue indefinitely.

Recently announced activity. Last year, KeyCorp (ticker: KEY) announced it would take over First Niagara Financial Group (FNFG) in a deal that would make the nation's 13th largest bank.

Likewise, New York Community Bancorp (NYCB) agreed to purchase Astoria Financial Corp. (AF) in the fourth quarter of last year. And more recently, Huntington Bancshares (HBAN) announced it would take over Firstmerit Corp. (FMER).

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[Read: 7 Tips to Help Your Portfolio Keep Up With Inflation.]

These recent announcements won't be a flash in the pan. Indeed, the factors supporting them are not going away: notably, a bad outlook for profits.

"Results in the fourth quarter were generally weak across the board, it's a challenging operating environment," says Julie Solar, senior director for banks at Fitch rating service in Chicago. "Regional banks are facing various headwinds (in getting more profitable.)"

The increased costs of doing business are becoming a burden, so some companies are responding by acquiring smaller financial institutions, Solar says. "You have a larger cost base to spread out technology and regulation expenditures."

More regulations, but less profit. Since the financial crisis, banks have been slapped with more regulations, at least partially designed to safeguard taxpayers as well as consumers. But the cost of implementing regulations isn't really dependent on size.

"The cost to implement the new regulatory reforms is similar for a $500 million institution as it is for a $5 billion one," says Tim Johnson, banking merger and acquisition specialist at professional services company KPMG. "Those increased costs at some of the smaller institutions are dramatic because they don't have enough clients spread it out." The smaller banks lack economies of scale.

[See: 5 Common Mistakes Investors Make With Social Security.]

On top of that, banks are suffering from the Federal Reserve's policy of keeping the cost of borrowing unusually depressed. Profits are being reduced. While it is still true that the Fed has increased short-term interest rates once since the end of the financial crisis, they are still very low by historical standards and are expected to remain so for the foreseeable future.

"We do not think interest rate hikes will provide much uplift to overall bank earnings in 2016 as the operating environment remains challenging," Fitch analysts say in a recent report.

Where should investors look? Usually, when a company makes a bid to buy another, the stock price of the buying firm drops, but the shares of the company which is to be purchased tend to rally. That's true with banks as much as it is with other corporations.

The trick for investors is to identify those likely takeover candidates before they get bought and then buy the stock before the company gets taken over.

Erik Oja, U.S. and Canadian banking analyst at S&P Global Market Intelligence in New York, says large regional banks are more likely to buy medium-sized banks. "I think the sort of consolidation that we have seen recently will continue," he says "There is just dozens of those sort of mid-size regional banks that would make acquisition candidates."

Likely candidates are those with a market capitalization of $1 billion to $5 billion -- or asset size from $15 billion to $50 billion, Oja says. First Niagara, Firstmerit and Astoria all fall within that range.

[See: Keep Volatility From Hurting Your 401(k).]

The place to look for such banks is in the Standard & Poor's 400 index, which tracks mid-cap stocks, or the SPDR S&P MidCap 400 exchange-traded fund (MDY) that tracks the index. Alternatively, try the SPDR S&P Regional Banking ETF (KRE), which tracks regional financial services stocks.

Unlike prior to 2006, there will not likely be any so-called mergers of equals, where two similar sized banks combine into one bigger company, Oja says. Since the financial crisis, the general practice has been for a larger bank to purchase a mid-sized bank.

Will there be acquisitions coming from the mega-institutions that were deemed too big to fail, such as J.P Morgan Chase & Co. (JPM) or Bank of America Corp. (BAC)? It seems unlikely, because those and similar institutions are actually reducing the size of their operations.

"Lots more reserves are required so that taxpayers don't get stuck with another huge bailout bill," Oja says. "The penalty for being so large is to have high capital ratios."

Simon Constable is a columnist and author. In addition to following the financial markets, he likes to watch his cat play with string. You can follow him on Twitter @simonconstable.