WORKING PAPER: 06-13

11 2006

Motives for Mergers and Acquisitions in the Indian Banking Sector A Note on Opportunities & Imperatives

Jay Mehta XLRI School of Business, Jamshedpur E-mail: jay1.mehta@gmail.com and Ram Kumar Kakani S P Jain Center of Management, Singapore Campus 119579, Singapore E-mail: ram.kakani@spjain.org

Electronic copy available at: http://ssrn.com/abstract=1008717

SPJCM Working Paper: 06-13 (Nov.)

Motives for Mergers and Acquisitions in the Indian Banking Sector A Note on Opportunities & Imperatives
Jay Mehta & Ram Kumar Kakani

Abstract
Recent reports on banking sector often indicate that India is slowly but surely moving from a regime of `large number of small banks' to `small number of large banks'. The aim of this paper is to probe into the various motivations for mergers and acquisitions in the Indian Banking sector. Thus, literature is reviewed to look into the various motivations behind a banks merger/ acquisition event. The paper also takes us through the international mergers & acquisitions scenario comparing it with the Indian scene. Given the increasing role of the economic power in the turf war of nations, the paper looks at the significant role of the state and the central bank in protecting customers interests vis--vis creating players of international size. While, gazing at the mergers & acquisitions in the Indian Banking Sector both from an opportunity and as imperative perspectives, the paper also glances at the large implications for the nation.

Key Words: acquisitions, banking supervision, commercial banking, competition, India, international,
mergers, motive JEL Classifications: G21, G28, G34, K21, L40

Electronic copy available at: http://ssrn.com/abstract=1008717

SPJCM Working Paper: 06-13 (Nov.)

Motives for Mergers and Acquisitions in the Indian Banking Sector A Note on Opportunities & Imperatives

Introduction
Generally speaking a bank is an institution dealing in money. The origin of the word bank is traced to the Italian banca, banc or banque, which means a bench. It is stated that in Middle Ages the European money changers and moneylenders displayed their coins on their benches and conducted their business. Hence the term bank refers to the bench on which the business of money changing and money lending was conducted. Hence, the term banking is defined as accepting for the purpose of lending or investment, of deposits of money from the public repayable on demand or otherwise and withdrawal by cheque, draft, and order or otherwise. In the recent past, the Indian banking system has been undergoing major changes that have affected both its structure and the nature of strategic interaction among banking institutions. Different strategies have been adopted to tackle the demands of this new operating environment, one such strategy having been consolidation via mergers and acquisitions. The Government and the Reserve Bank of India are in favour of this change and consequently arises a desire to study this aspect in detail. Considering the maturity of certain international markets an attempt would be made to obtain certain practices from them as well. However the paper takes cognizance of the fact that Mergers and Acquisitions (M&A) is highly environment dependant and hence there is a constant focus on this aspect while pertaining to practices. It is observed that the banking industry is moving from traditional savings-cum-lending functions to other services as well such as Bank-assurance and securities trading. In recent times, banks have also diversified their activities to cover a wide range of activities. They arrange remittance of funds from one place to another, they act as agent of their customers in certain activities like payment of subscription, and they also act as guarantors for their customers. Thus banks in India need to change in form and structure so as to adapt to meet these changing scenarios of being a total financial services provider and for this a preferred route ought to be inorganic growth due to time advantages and hence mergers and acquisitions for consolidation. In the recent times, there have been numerous reports in the media on the Indian Banking Industry. Reports have been on a variety of topics. The topics have been ranging from issues such as user friendliness of Indian banks, preparedness of banks to meet the fast approaching Basel II deadline1, increasing foray of Indian banks in the overseas markets2 targeting inorganic growth. Reports from the western markets of increased M&A activity have also aroused a deep sense of keenness in the authors to compare the various aspects of M&A in the Banking sector in India and the international arena. In the turf war of nations, given the increasing role of economic power over other types of powers, one can even see that the state, the regulatory authority, and even the states politicians are keen on playing a role and having their say. Recently, the finance minister of India had stated that Indian Banks would be requiring more than Rs. 590 billion3 to sustain their current growth and at the same time adhere to the
1 2 3

Banking Sector may see M&As as Basel II Deadline nears, Business Standard, 8th August 2005 SBI eyes four foreign banks for acquisition, Business Standard, 26th July 2005 Banks may need Rs.60,000cr more capital, The Hindu Business Line, 24th October 2005

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new Basel norms. An obvious way to reduce this requirement and meet the norms would be through industry consolidation. This paper is a short note taking a holistic approach to compare the rationale behind M&A in India and the international arena. The approach is non-empirical and draws from a mix of recent literature review and interpretations of a few recent observations. Relevant observations have been cited at every stage to reinforce the reasons. While evaluating the various reasons for M&A in the banking sector we have consciously focussed the discussion on the imperative and the opportunistic needs for M&A in the banking sector.

M&A in the Indian Banking Sector as an Imperative

Multiple reasons force us to believe that M&A in the Indian Banking Sector is an imperative. We list them down below: Stability: Fragmentation poses increasing risk in the Indian Banking Sector. During the financial period 2001-2005, only four banks have been able to cross the market capitalization of Rs. 50 billion included Bank of Baroda, HDFC Bank, ICICI Bank, and State Bank of India. Considerable fragmentation exists in the Banking sector for banks with market capitalization of less than Rs. 50 billion. Moreover the created value is moving away from the top 5 banks thus indicating fragmentation indeed has increased over the period of last five years. Shown below are the deposit shares of the Banks operating in India over the period 2000-2004. Data was drawn from around 45 banks which included state-controlled public sector banks, private sector banks and even foreign banks operating in India. It is observed that the share of the top 5 players has eroded and been consumed by the next fifteen players. Considering that the base of total deposits has been consistently increasing, consequently the value in deposits gained by the next 15 banks has been tremendous (see table below). Year Top 5 Banks Next 15 Banks 2000 52.40% 34.39% 2004 47.09% 38.04%

Remaining Banks 13.21% 14.87% Source: Data on Deposits from the RBI Website Similar trends are observed in profit after tax, borrowings and interest and non interest incomes of the banks, thereby hinting at increased levels of fragmentation in the top 20 banks. Though this could be the sign of a competitive bank market with healthy banks remaining in the market the goal of globally competent banks would be missed. In other words, while a fragmented Indian banking structure may very well be beneficial to the customers (given increased competition due to lower market power of existing players), at the same time this also creates the problem of no player having the critical mass to play the game at the global banking industry level. This has to be looked at significantly from the states long-term strategic perspective. Furthermore, it is observed that in an increasing competitive arena the smaller fragmented banks with no economies of scale, low capabilities to manage risks and poor market power at times end up taking

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excessive risks resulting in irreparable loss to their depositors. This also results in affecting the state and its regulators i.e., central bank negatively. Take the following cases of trouble in the recent past: a. Global Trust Bank: Significant exposure to high risk mid size corporates and an excessive exposure to capital market operations. b. Madhavpura Mercantile Co-operative Bank: Nineteen customers had unsecured loans of more than Rs. 10 billion. c. South Indian Co-operative Bank: Non Performing Assets (NPAs) from excessive lending to small group of clients

d. Nedungadi Bank: This bank based in Southern part of India had significant exposure to plantation industry and had weak credit risk management systems and processes. Further recent cases (in 2005-06) of two banks in India namely United Western Bank and Sangli Bank became attractive targets for acquisition by private sector banks because of their risk profile. The merger with these larger banks is expected to improve the asset profile, NPA management and protect the depositors at the same time offer the acquiring private sector banks further reach in terms of branches and customer base. Returns and Risks to Shareholders: A small analysis of performance of the bank sector and the equity market benchmark index in India and USA showed the following results: India Bankex Beta Mean Returns (daily) Std. Devn. 0.1719% 1.974% 0.807 0.1218% Nifty Beta Mean Returns (daily) 0.0595% United States of America (USA) NYSE Financial NYSE Composite 0.950 0.0558% 0.7756%

1.4% Std. Devn. 0.8418% Source: Own analysis, Data from NYSE and NSE sites

The above table clearly indicates that the banking portfolio in US is as risky as the composite portfolio which is not the case in India. Though the returns are more in India the risk is also higher as shown by the standard deviation. A report as early as August 1991 recognized the trend in shareholder returns in the US and hence was one of the reasons for the bank M&A wave in the USA4. Benefits to the customers5: Benefits to customers can be seen in a number of ways. One such way being lowering in the intermediation costs. A 10 year trend in the intermediation costs as a percentage of Total assets in Indian Banks shows that the Indian private sector banks have the least intermediation costs as a percentage of total assets (see graph below). During the time frame of study, a significant decreasing trend can also be observed in the Private Sector banks of India in the decade. Being non fragmented they could claim greater efficiency and hence lower intermediation costs. A sample t-test6 of the results

4 5 6

U.S. Banking Industry Finds Salvation in Merger Binge, By John J. Duffy International Herald Tribune FICCI Presentation on M&A in Banks, 2005 T-test was carried out at http://home.clara.net/sisa/t-test.htm

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indicated that the above ratio was significantly different. Thus, building a strong case where intermediation costs can be lowered and M&A could be a way for the same.
Intermediation Costs
3.5

3 Intermediation costs as % of Total Assets

2.5

2 Private Sector Banks Public Sector Banks 1.5

0.5

0 1991-92 1992-93 1993-94 1994-95 1995-96 Year 1996-97 1997-98 1998-99 1999-2000

Source: Our Own Data Tabulation and Analysis Adhering to the International CAR7 norms and Supporting Regulatory Framework: Supporting institutional and regulatory framework in India is vital for domestic banks aspiring for global operations. The Central Bank i.e., the Reserve Bank of India (RBI) has suitably changed the countrys regulatory framework from time to time to support Indian financial institutions to withstand the competitive pressures placed on them by increasing globalization. Proper steps have been taken to guide the banking sector to see that the banks pass through this transition phase by and large successfully. With the RBI regulating the Capital to Risk-Weighted Asset Ratio (CRAR) at 9%, a percent above the Basel II CRAR, going forward many banks would not be able to meet these requirements and may have to go through restructuring in order to meet the regulatory requirements. Furthermore there are a number of banks in India whose growth is restricted due to unavailability of capital. These banks have a significant depositor base but the market perception does not enable them to raise further funds.8 Hence such banks also become potential targets of acquisition.

7 8

Capital Adequacy Ratio

Take a look at the banks that have raised equity from the capital markets at least twice in the past five years to get indicative cues.

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Average Capital Adequacy Ratio of Banks in India Category of Bank Foreign Banks Private Sector Banks Public Sector Banks 2000-01 17.04 12.13 10.98 2001-02 20.22 12.64 10.81 2002-03 24.58 12.66 12.05 2003-04 32.28 13.41 13.18 13.02

State Bank of India Group 12.43 12.96 13.11 Source: Data from www.indiastat.com

The reforms initiated in the banking sector have now reached a crucial stage. Governments stake in many Public Sector Banks (PSBs) has gone down and as a consequence other shareholders equity ownership in these PSBs has gone up. This leads to greater responsibility on the bank managements since the level of accountability has increased. Pressures of performance and profitability will keep the PSBs on their toes all the time as the public shareholders expect good financial performance along with good returns on their equity. Many PSBs have already started the exercise of cleaning up of their balance sheets by shedding the excess baggage. The Voluntary Retirement Scheme (VRS) in the recent past in some of the banks was aimed not only at downsizing the manpower but also at cutting down the future staff costs and increasing the performance levels of the staff in the long run. Some of these PSB banks are able to run the show to a certain extent by low cost funds that are available thanks to the branch network spread over the length and breadth of the country. M&A activity will further boost this process for many other banks that cannot go through this exercise individually and need larger partners to execute them in terms of processes and resources. Managing Bankruptcy Risks Recent studies (see, Hannan and Pilloff, 2006) have established that if merger and acquisitions in banks if allowed in a controlled manner would significantly reduce the bankruptcy risk of the merged entity. Obviously, mergers would also provide these benefits to banks in India reducing their bankruptcy concerns. Bottom Line Growth: Mergers and Acquisitions or Restructuring may also help banks improve in three other areas as listed below: 1. Economies of Scale: An acquirer would have the capabilities to improve the collections, service processes, distribution, infrastructure and IT of the target bank 2. Economies of Scope: An ability to grow products and segments and an opportunity to cross sell would enhance revenue. This could also result in more geographic growth could also be obtained. 3. Synergy Benefits: Treasury performance would be improved as the cost of funds would reduce (hence, improve spread) as it would have a better credit rating. A bank would also be able to leverage scale and improve its trading income.

SPJCM Working Paper: 06-13 (Nov.) M&A in the Indian Banking Sector as an Opportunity
Two prime reasons force us to believe that M&A in the Indian Banking Sector is an opportunity. Creation of a Financial Super Market or a Universal Bank:9, 10, 11

A recent trend is to promote the concept of a financial super market chain, making available all types of credit and non-fund facilities under one roof under one umbrella organization (or through specialized subsidiaries). An example of such a financial supermarket would be the reverse merger of ICICI and ICICI Bank. ICICI Bank today stands as Indias second largest bank offering its clients both in India and overseas a product range as varied us retail banking products to exotic investment banking and treasury solutions. Similarly, IDBI and IDBI Bank treaded the same route. Though one has to state that consolidated accounting and supervisory techniques would have to evolve and appropriate fire walls built to address the risks underlying such large organizations and banking conglomerates. Technological Expertise: New entrants in the banking sector are armed with technological expertise while older players are well equipped with experience in practices. Mergers would thus help both parties gain an expertise in areas in which they lack. In India, the retail banking market biased towards the urban markets is growing at a Compounded Annual Growth Rate (CAGR) of almost 18-20% while the rural market is yet to be fully tapped. Keeping in focus the population profile, technology would be a major enabler for banking in the future. A number of state owned banks in India are adopting sophisticated core banking solutions and these are just the larger ones. For smaller banks to adopt technology platforms the expenditure may not be sustainable and hence this may be one more reason for M&A. Growing integration of economies and the markets around the world is making global banking a reality. The surge in globalization of finance has also gained momentum with the technological advancements which have effectively overcome the national borders in the financial services business. Widespread use of internet banking, mobile banking, and other modern technologies (such as SWIFT) has widened frontiers of global banking, and it is now possible to market financial products and services on a global basis. In the coming years globalization would spread further on account of the likely opening up of financial services under WTO. India is one of the signatories of Financial Services Agreement (FSA) of 1997. This gives Indias financial sector including banks an opportunity to expand their business on a quid pro quo basis. An easy way for this is thus to go through adequate reconstruction to acquire the necessary technology and get an early mover advantage in globalizing the Indian Banks.

9 RBI, Deputy Governor, V Leeladhars speech on March 11, 2005 to the Kanara Chamber of commerce and Industry, Mangalore. 10

More on Universal Banking in Germany, US can be obtained from H R Machirajus book titled Modern Commercial Banking.

Saunders, Anthony, A and Walter Ingo, Universal Banking in the United States, Oxford University Press, New York, 1994.

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Cross Border M&A in Banks

One more reason for M&A which has sprung up in the recent years is Indian Banks seeking international presence. In the last two decades, there has been a jump in the Indian diaspora working abroad. A new recent trend is the increase in the interest of foreign expats to work in India. Both these communities seek banking products in remittances and other cross border retail products. Further firms are looking for funds overseas for various purposes ranging from capital expenditure to leveraged M&A financing. Hence, Indian banks are setting up branches and subsidiaries overseas and foreign banks are expanding their operations in India. These bank branches (set up abroad) further target the local population to be profitable and hence target local acquisitions. Evidently, this results in an M&A opportunity for Foreign Banks to acquire an Indian Bank and also Indian Banks to acquire foreign banks. For example, ICICI Bank has made an acquisition of a bank in Europe in 2006 to establish itself in a geographical area.

Discussion
The European Bank Experience13 To make a comparison, we looked into a report by the Centre for European Policy Studies. The figure below shows the main reasons why banks were involved in mergers. One can observe the concentration in the assurance and universal banking sections.

. Source: Strategies of Mergers followed in Europe, Centre for European Policy Studies

13

Mergers and acquisitions in European banking: Overview, prospects and future research, Rym AYADI, Paris Dauphine University / Centre for European Policy Studies (CEPS), May 2004

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10

In Europe, the motive for M&A is dependant on the environment of the bank. In countries where concentration threshold admitted by the competition authorities is reached cross border consolidation is motivated. Cavallo and Rossi (2001) use empirical work and point to a significant existence of economies of scale and scope in European banking industries, after a merger being tagged along. The reform of the European community merger regulation has also been motivating bank mergers in the European Union (EU). Moreover, as global investment banking is highly concentrated it also drives EU to help in creating a fewer players. The above discussion also hints to us that the primary drivers of M&A in India are different from the primary drivers of M&A in Europe.

Conclusions
Mergers and Acquisitions (M&A) have immensely evoked and still continue to capture scholars interests. More so, M&A in the banking sector evokes high interest simply for the fact that after decades of strict regulations, easing of the ownership & control regulations has led to a wave of M&A in banking industry throughout the world (Focarelli, 2002). We started this work to look into the motives behind M&A in Indian banking sector. Considering the changed environment conditions, we believe that M&A in the Indian Banking are an important necessity. The reasons include (a) fragmented nature of the Indian banking sector resulting in poor global competitive presence and position; (b) large intermediation costs and consequent probability in increasing its risk profile; and (c) meet the new stringent international regulatory norms. While a fragmented Indian banking structure may very well be beneficial to the customers (given increased competition due to lower market power of existing players), at the same time this also creates the problem of not having any critical mass to play the game at the global banking industry level. This has to be looked at significantly from the states long-term strategic perspective. Given that economic power is increasingly used as a tool by nations to defend their position, to signal power, to signal intent, and to establish their supremacy over others hence owning and managing large powerful global banks would be an obvious interest for every country. Additionally, given the recent advances in electronic technology (especially wireless) makes the traditional occupation of land theory redundant, increasing the importance for the state to intervene and create large sized banks using the M&A route. Hence, it is imperative for the state to create a few large sized banks even at the cost of hurting its other stakeholders including customers.

SPJCM Working Paper: 06-13 (Nov.) References

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Ayadi, Rym; Mergers and acquisitions in European banking: Overview, prospects and future research, Paris Dauphine University; Centre for European Policy Studies (CEPS), May 2004 Business Standard, Banking Sector may see M&As as Basel II Deadline nears, 8 August 2005 Business Standard, SBI eyes four foreign banks for acquisition, 26 July 2005 Cavallo, L. and S P Rossi; Scale and scope economies in the European banking systems, cited in: Caruso, A. and F Palmucci, Measuring value creation in bank mergers and acquisitions, Journal of International Money and Finance, Vol. 31, 2005, pp. 1-32. FICCI, Presentation on M&A in Banks, 2005 Focarelli, D. F. Panetta and C Salleo; Why do banks merge? Journal of Money, Credit, and Banking; Vol. 34(4); 2002, pp. 1047-1066. Hannan, Timothy H. and Steven J. Pilloff; Acquisition targets in the banking industry, Finance and Economics Discussion Series, Federal Reserve Board, Washington, Paper # 2006-40, September 2006. Hindu Business Line, Banks may need Rs.60,000cr more capital, 24 October 2005 International Herald Tribune, U.S. Banking Industry Finds Salvation in Merger Binge, By John J. Duffy Machiraju, H R; Modern Commercial Banking; Vikas Publishing House; New Delhi; 2005. RBI, Deputy Governor, V Leeladhars speech on March 11, 2005 to the Kanara Chamber of commerce and Industry, Mangalore Saunders, Anthony, A and Walter Ingo, Universal Banking in the United States, Oxford University Press, New York, 1994