Consolidation in the US banking industry will create a fertile ground for merger arbitrage strategies over the next several years, according to Steve Gerbel, founder and president of Chicago Capital Management.

A year on from the meltdown of Lehman Brothers, the repercussions for the US banking sector are only just beginning to manifest, according to Gerbel.

While the largest banks in the US have been propped up with government funds, a significant number of small and mid-sized banks could collapse over the next few years due to impairments on their loans and the continuing economic malaise.

The Federal Deposit Insurance Corporation (FDIC) closed 95 banks in the first three quarters of 2009, up from 25 in all of 2008. The FDIC believes a further 416 banks are at risk of failure.

Gerbel expects the US banking sector will see a spate of mergers and acquisitions over the next 2-3 years. With more than 8,000 banks operating around the country, he said the US was significantly over-banked compared to the rest of the world and primed for consolidation.

"The smaller community banks and regional banks have to explore opportunities to merge with larger institutions that can either commit capital to the business or fix the balance sheet by the selling off bad loans. They do not have the sophistication to work their way out of the problems they face on their own," said Gerbel.

He sees a scenario where the large national banks will acquire the weaker regional banks, while stronger community banks snap up their smaller rivals.

The regional banks are in the greatest difficulties, said Gerbel. "They made the bulk of the loans to the commercial real estate sector. These are severely impaired," he added.

Increased regulation could be a major problem for the smaller banks, acting as a catalyst for acquisitions, he added. "Will these institutions continue to be profitable when you factor in the cost of complying with the new regulations that are coming down the pipeline on top of all the other issues they face?" asks Gerbel.

An acquisition strategy could be a profitable one for large financial institutions with strong balance sheets, added Gerbel. These institutions have an opportunity to acquire books of loans at a significant discount to their inherent values with a view to selling them at a profit when the market recovers.

Despite the distress in the banking sector, only a handful of acquisitions of regional and community banks have been completed in the past 18 months.

Gerbel said the relative scarcity of deals so far was due to the uncertainty surrounding how banks will be regulated in the future.

Politicians and regulators have proposed changing the rules governing everything from capital adequacy to executive compensations. World leaders meeting at the G-20 summit in Pittsburgh agreed to establish a broad global framework for financial sector reform.

The G-20 meeting created a platform for international organisations like the Financial Stability Board and domestic regulators like the US Treasury and FDIC to overhaul the rules and regulations governing the banking sector.

"A lot of people want to know what the rules will be before they make an acquisition. Once the first transaction happens, there will be a flurry of them," said Gerbel.

A handful of banks have already signalled their intention to make acquisitions. In September, Fifth Third Bancorp said it planned to buy failing banks with the assistance of the FDIC.

Fifth Third was one of the few banks to make an acquisition in 2008 when it bought the deposits of Georgia's Freedom Bank after it had been taken over by the FDIC.

Chicago Capital Management invests in merger arbitrage situations in the financial sector. The strategy involves simultaneously buying and selling stocks in two merging companies with a view to realising a profit when the deal is consummated.

Hedge funds focused on merger arbitrage are up almost 8% this year, according to data from Hedge Fund Research.

Gerbel said there was more opportunity for merger arbitrageurs in the current market due to reduced competition from proprietary trading desks and rival hedge funds.

He expects to see the performance of merger arbitrage funds improve in 2010 as a result of the anticipated increase in merger and acquisition activity in the banking sector. He said investing in bank mergers was "a very attractive strategy because bank transactions almost never fall apart".