ICICI or Bank of Madura : Who will benefit ?

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The scenario of mergers has influenced yet another deal in the banking industry.
After the merger of HDFC with Times Bank, ICICI has moved a step further and had merged with a traditional bank, Bank of Madura (BoM). But there seem to be variances in the corporate culture of the merger entities, which would batter the growth. At this juncture, which bank would be in an advantageous position with the merger? Is it ICICI or BoM. ICICI Bank, after having been scouting for long time to acquire a private sector bank, had held talks with Global Trust Bank and Centurion Bank and has finally merged with Bank of Madura at a swap ratio of 2:1 i.e., two shares of ICICI Bank for each share of BoM. The deal has created one of the biggest entities in the private sector with the merged entity having total assets of Rs.16,000 crore as on September 2000. The share exchange ratio was worked out by Deloitte, Haskins and Sells, which acted as independent valuers to the transaction. DSP Merrill Lynch Ltd had acted as advisors to BoM while Kotak Mahindra Capital Company advised ICICI Bank on the merger process. The proposal however is subject to clearance from the Reserve Bank of India and the shareholders of both the banks have scheduled to meet on January 19, 2001. The appointed date of merger has been set as February 1, 2001. ICICI Bank is one of the most tech-savvy and fastest growing private sector banks in the country with a presence in 106 domestic locations, including branches and extension counters. ICICI Bank is the largest ATM provider in the country with 366 ATMs. As on September 30, ICICI Bank had total assets of Rs.12,063 crore and deposits of Rs.9,728 crore. BoM is a 57-year-old South India based private sector commercial bank with a branch network of 263. It had assets of Rs.3,988 crore and deposits of Rs.3,395 crore as on March 31, 2000, with a capital adequacy ratio of 15.8 per cent. BoM had opted for the merger with a purview of consolidation and size as major requirements in the banking industry. This was necessary in terms of capital, capital base, mitigating risk and ability to absorb risk. The deal works out in favour of the BoM shareholders, given the current market valuation of the ICICI stock. The merger is expected to add to the shareholder value, besides providing technology-based, modern banking services to customers. How would the merger benefit ICICI Bank? The bank was looking at a branch network of 350-400, which would have taken at least five years to achieve. The merger would provide this network immediately and would enable them spread their network to 16 States. Moreover, to get an additional 1.2 million customers, which is BoM's client base now, it would have required a minimum of two years. Thus, the merger enables ICICI to have an aggregate of 2.7 million customer base and a combined asset base of Rs.16,000 crore, cross selling opportunities for assets and other products, and good cash management services.

The book value of ICICI Bank share is Rs.60 and that of BoM is Rs.233. The EPS of ICICI Bank is Rs.7 while that of BoM is Rs.44, and the last dividend paid by the former was 15 per cent while that by the latter was 55 per cent. Thus the merger is considered to be EPS accretive for ICICI Bank shareholders by 23 per cent, from Rs.7.10 per share annualised to Rs.8.70 per share annualised, based on September 2000 figures. Moreover, BoM is strong in south India states and ICICI is very strong in Central and North Indian states, which would give a complacent advantage to both the banks. The merger is also benifittable to ICICI amidst the recent declarations of RBI favouring promoters holding not more than 40 per cent in the banks. BoM shareholders would get a total of 2.34 million shares of ICICI Bank of face value Rs.10 in exchange for their capital of 11.67 crore shares of face value Rs.10 each. Post-merger, the shareholding in ICICI Bank would be as follows: BoM's promoters 2.7 per cent, Kotak Mahindra Finance Ltd (which holds a 11.4 per cent stake in BoM) -- 1.2 per cent, ICICI - 55.6 per cent, public - 13.6 per cent, mutual funds and banks - 1.4 per cent, FIIs - 6.1 per cent, FIs - 5 per cent, and ADS - 14.4 per cent. BoM has a paid-up capital of Rs.11.93 crore and reserves of Rs.250 crore. Dr K.M. Thiagarajan, BoM Chairman, and associates hold around 25 per cent stake. Mr Uday Kotak of Kotak Mahindra holds 8 per cent stake while employees hold another 4 per cent. The balance is held by the public. However, unlike the HDFC Bank-TimesBank merger, which was very easy as they shared a common culture, this merger (ICICI Bank-BoM) brings together two entities that have grown in different environments. ICICI follows Banks 2000 software, which is totally different from that of BoM's ISBS software package. Though the size of ICICI Bank is almost thrice that of BoM's in terms of deposits, the number of employees in ICICI is around 1400 compared to 2500 employees in BoM. With the manual interpretations and procedures and the lack of awareness of the technology utilisation in BoM, there would be many hinderances in the merged entity. Hence to eradicate all such problems, a core group from both the banks has been constituted to help in the integration. Besides, ICICI also plans to set up sub-groups to look into areas such as IT, audit and HR. The proposed merger of ICICI Bank and Bank of Madura lead to sustained market interest in the two stocks in the short-term. BoM closed at Rs.131.60 on the BSE, up from Rs 121.90 and ICICI Bank closed at Rs.169.85, up from Rs.151.40 on Dec 11, 2000. On Dec 15, 2000, BoM closed at Rs.166 on BSE and ICICI Bank ended at 157 despite the steep fall of the markets. The next few years is likely to see the most crucial period for Indian banks, both public and private sector outfits, which today stand at a crossroad in their path to prosperity. And they will have to guess right, or the road they choose could very well end up with the one leading to a flame out. And all this because the situation in the banking sector has changed dramatically. Commitments made to the WTO first forced India to open up its banking borders and later liberalise regulations further. All these consequences allude the scenario of more and more consolidations in the industry. So, which bank is going to be in the frame next, is to be seen.

ICICI Bank + Bank of Madura = ?

The proposed merger between ICICI Bank and Bank of Madura (BoM) is a remarkable one. The pre--merger market capitalisation of ICICI Bank was roughly Rs.2500 crore while BoM was at roughly Rs.100 crore. BoM is known to have a poor asset portfolio. What will the merged entity be worth? The key rationale underlying every merger is the question of synergy. Can ICICI Bank's products and technology bring new life to the 263 branches of BoM? Will ICICI Bank (which has 1,700 employees) be able to overcome the 2,600 employees that BoM carries, given that Indian labour law makes it troublesome and expensive to sack workers? As a benchmark calculation, however, suppose we pretend that there are no synergies, and focus on a purely financial evaluation of the merged entity. This is not easy to do using conventional accounting measures. Instead, arguments based on option pricing theory yield useful insights. These arguments are related to my Business Standard op-ed of last fortnight, and to the working paper, Measuring systemic fragility in Indian banking: Harnessing information from the equity market, by Susan Thomas and myself. In applying these ideas to ICICI Bank and to BoM, we need to believe that the stock market effectively processes information to produce estimates of the price and volatility of the shares of both these banks. This assumption is suspect, because both securities have poor stock market liquidity. Hence, we should be cautious in interpreting the numbers shown here. There are many other aspects in which this reasoning leans on models, which are innately imperfect depictions of reality. However, these models are powerful tools for understanding the basic factors at work, and they probably convey the broad picture quite effectively. ICICI Bank. The pre--merger status of ICICI Bank is as follows: it had liabilities of Rs.12,073 crore, equity market capitalisation of Rs.2,466 crore and equity volatility of 0.748. Working through options reasoning, we find that this share price and volatility are consistent with assets worth Rs.13,249 crore with volatility 0.15. Thus, ICICI bank had assets which are 9.7% ahead of liabilities, which is roughly consistent with the spirit of the Basle Accord, and has leverage of 5.37 times. Bank of Madura. The pre--merger status of Bank of Madura is as follows: it had liabilities of Rs.4,444 crore, equity market capitalisation of Rs.100 crore and equity volatility of 0.69. Working through options reasoning, we may say that the stock market thinks that its assets are worth Rs.4,095 crore with a volatility of 0.02. Hence, BoM is bankrupt (with assets which are Rs.350 crore behind liabilities) and has a leverage of 41 times. If we needed to bring BoM up to a point where its assets were 10% ahead of liabilities, which is broadly consistent with the Basle Accord, this would require an infusion of Rs.800 crore of equity capital.

How do we combine these to think of the merged entity? Assets and liabilities are additive, so the total assets of the merged entity would prove to be roughly Rs.17,345 crore and the liabilities would prove to be Rs.16,517 crore. The merged entity would hence need roughly Rs.800 crore of fresh equity capital in order to come up to a point where assets were atleast 10% ahead of liabilities. How can we estimate the market capitalisation of the merged entity? The value of equity is the value of a call option on the assets of the merged entity. Pricing the call requires an estimate of the volatility of the merged assets, i.e. it requires a knowledge of the extent to which the assets of the two banks are uncorrelated. We find that using values of the correlation coefficient ranging from 80% to 95%, the volatility of assets of the merged entity proves to be around 0.12. In this case, the valuation of the call option, i.e. an estimate of the market capitalisation of the merged entity, proves to be roughly Rs.2,500 crore. This number is not far from the pre--merger market capitalisation of ICICI Bank, which was Rs.2,466 crore. Hence, we can say that on purely financial arguments, the merger is roughly neutral to ICICI Bank shareholders if BoM was merged into ICICI Bank for free. Indeed, if banking regulators took their jobs more seriously, they would force the shareholders of BoM to walk into such a merger at a zero share price as a way of reducing the number of bankrupt banks in India by one. Such a forced-merger would be a politically easier alternative for the RBI when compared with closing down BoM. The shareholders of ICICI Bank have paid a non-zero fee for BoM. This reflects a hope that the products and processes of ICICI Bank will rapidly improve the value of assets of BoM in order to compensate. In addition, the merged entity will have to rapidly raise roughly Rs.800 crore of equity capital to obtain a 10% buffer between assets and liabilities. Hence, this proposed merger is a godsend for BoM, which was otherwise a bankrupt entity which was headed for closure given the low probability that it would manage to raise Rs.800 crore of equity on a base of Rs.100 crore of market capitalisation. It is useful to observe that BoM probably did not see things in this way, given the willingness of India's banking regulators to interminably tolerate the existence of bankrupt banks. Closure of BoM would normally involve pain for BoM's shareholders and workers; instead both groups will get an extremely pleasant ride if the merger goes through. The proposed merger is a daunting problem for ICICI Bank. It will need to rapidly find roughly Rs.800 crore in equity. If India's banking regulators were serious about capital adequacy, ICICI Bank should have to pay roughly zero to merge with BoM (it is doing a favour to BoM and to India's banking system); instead ICICI Bank has paid a positive price for BoM. The key question that will be answered in the next two/three years is: Will ICICI Bank's superior knowledge of products and processes revitalise the assets and employees of BoM, and generate shareholder value in the merged entity? ICICI's top management clearly thinks so, and it would be a very happy outcome if this did indeed happen.

The proposed merger is a good thing for India's economy, since the headcount of bankrupt banks will go down by one, and there is a possibility of obtaining higher value added out of the poorly utilised assets and employees of BoM. If the merger goes through, then it will reduce the say of the management team of BoM in India's resource allocation, which is a good thing.