The Hindu Business Line : Banking consolidation must be synergy-driven

Consolidation emerged as a defining characteristic of the modern banking world, primarily to leverage the benefits of large size, expanding and diversifying bank loan portfolios to lessen the likelihood of failure and harnessing core competencies. But consolidation is no panacea for all the ills of banking and size has to be seen as a facilitator rather than an all-inclusive means to efficiency. Given such apprehensions, mergers may be a mixed blessing unless they are market-led and synergy-driven.

A SOUND and fundamentally strong financial system is a prerequisite to the growth of a vibrant economy. The globalisation of financial markets led to the establishment and growth of monolithic financial institutions.

The rapid growth of international trade, the possibility of banks abroad pursuing activities prohibited in the home country and the distinct opportunity of tapping the eurodollar and other markets fuelled a global move towards consolidation — massive reorganisation and expansion of banks in the US (1980s), Europe (1990s) and Japan (late 1990s).

With consolidation in the financial services industry, megacorps now provide retail customers not only traditional deposit and lending services but also mutual fund, insurance, and brokerage services. Such companies provide lines of credit and payments, risk management, and securities underwriting services. Despite this, refocussed strategies are needed because evidence of the impact of consolidation on efficiency, competitiveness and profitability is not incontrovertible.

Transforming Indian banking

Banking sector reforms as an integral part of financial sector reforms commenced in the early 1990s.

They led to a heightened consciousness of ownership and capital structure, enhanced competition, increased autonomy, technological upgradation and performance change reflected in broad indicators of net worth, net NPA/net advances ratio, Return on Assets (RoA) and Capital to Risk Weighted Asset Ratio.

The increased profits of banks, particularly in recent years, however, stemmed largely from the buoyancy in treasury incomes and high returns from the retail segment.

Historical setting

The first Narasimham Committee Report on the financial system (1991) recommended a broad structure of the banking system.

This envisaged three or four large banks (including the State Bank of India), which could become international in character; eight-10 national banks with a network of branches throughout the country engaged in `universal' banking; local banks whose operations would be generally confined to a specific region; and rural banks (including RRBs) confined to rural areas predominantly engaged in financing agriculture and allied activities.

Since then, the size, structure and performance of banks has evoked considerable debate across the development spectrum. An important strand of this debate, particularly in the context of Basel-Il requirements of prudential norms and sound financial parameters such as higher capital adequacy ratio (CAR) and low non-performing assets (NPAs), relates to mergers and acquisitions (M&As) in the banking industry.

The recommendations of the New Capital Accord document are based on a `three pillars' approach of minimum capital requirements, supervisory review process and market discipline.

Major drivers for attaining economies of size in India are intensified competition and thinning operating spread. Mergers, though at a nascent stage, are picking up in the private banking sector. Geographically well-spread banks are customarily less vulnerable to economic shocks. Cost-efficiency and profit efficiency depend significantly on volume of funds deployed and prudence in asset quality management. Similarly, size offers greater manoeuvrability in enhancing business volume and productivity.

Changing financial markets, institutions and products create new avenues and opportunities for banks in India to expand their global presence through self-expansion, strategic alliance among themselves and foreign-based banks under WTO regime. Market as a key facilitator for consolidation has not yet been optimally harnessed. But in the medium term, M&As may intensify through strategic alliances.

Theoretical underpinning: Key learnings

In the steadily burgeoning literature on banking transformation, four economic forces driving mega mergers can easily be isolated and identified. These relate to:

Economies of scale — the relationship between the average production cost per unit of output and production volume;

Economies of scope — a situation where the joint costs of producing two complementary outputs are less than the combined costs of producing the two outputs separately;

Potential for risk diversification with geographic expansion providing diversification benefits to a banking organisation not only by reducing its portfolio risk on the asset side, but also by lowering its funding risk on the liability side, as it spreads funding activities over a larger geographic area; and

Bank managements' personal incentives, including the desire to run a larger firm and to maximise their own personal welfare.

There is considerable merit in these and other arguments for Indian banks to strengthen their core competencies while exploring new vistas, increasing size and substantially enhancing their technological capabilities to surmount competition domestically and globally.

But consider the following dissonance: Economies of scale envisaged through bank mergers may not markedly enhance margins in an increasingly competitive scenario. It would also be unrealistic to be oblivious to the obstacles hampering consolidation. It needs no clairvoyance to perceive that consolidation is no panacea for all the ills of Indian banking. Size has to be seen as a facilitator rather than an all-inclusive mean to efficiency. Given such apprehensions, mergers may be a mixed blessing unless they are market-led and synergy-driven.

While PSBs have striking commonalities of policies and approaches, they and `new generation' banks differ significantly in terms of operational issues, NPAs, organisational culture, mindset, attitude to work and HR issues — salary structure, role of trade unions, age-profile, promotions, transfers and postings.

The strategy-driven merger of Times Bank with HDFC Bank was a flash in the pan. Most mergers, such as those of Nedungadi Bank with Punjab National Bank, Laxmi Commercial Bank with Canara Bank, Benares State Bank with Bank of Baroda, Sikkim Bank with Bank of India and Global Trust Bank with Oriental Bank of Commerce occurred because of precarious financial position.

To acquire both muscle and reach, a reverse merger of IDBI Bank with IDBI took place on July 7.

Mergers are now a matter of choice and no longer of compulsion. Size matters, but not size alone.

There is also no unanimity on the optimal size of a bank. The optimal size is, inter-alia, a function of the size of the economy, its diversity in various segments, level of financial intermediation and, above all, degree of market mechanism and competition.

Fragmented topography

The fragmented organisational structure is reflected in that India had 20 banks within the top 1,000, of which only six were at the top. Fragmentation is manifested even more starkly in the recent DSP Merrill Lynch report that nearly 80 banks have a market share of less than 2 per cent, with the number two player having a market share of just 6 per cent.

Several old private sector banks with capital bases ranging from Rs 75 crore to Rs 150 crore make it difficult to prevent abuse of fiduciary responsibility.

Critical success factors

International criteria for efficient banking stipulate capital adequacy ratio (CAR) above 9 per cent, minimum one per cent return on assets, less than 3 per cent net NPA, low short-term borrowings, efficient payment systems, prudential regulations, least exposure to sensitive sectors, disclosure norms, international accounting standards, consolidated accounts and supervision, deposit insurance cover, non-interest income (NII) to cover staff expenses, efficient use of funds and corporate governance.

Against the context of increased vulnerability of financial system and the consequent need for improving efficiency and stability, major banking concerns include the relatively high costs (intermediation or transaction cost), check on operating cost through higher labour productivity, technology, innovation and organisational effectiveness, further reduction in NPAs, greater internal control system and sound business practices, prudential norm and supervision, streamlined risk management system and diversified loan portfolio.

Looking ahead

Liberalisation of markets, privatisation of ownership and globalisation of economy provided an impetus to consolidation and convergence. The former could strengthen the system and reduce the vulnerability to macroeconomic shocks.

Hence, synergy-based M&A and taking over of weak banks by strong ones are critical in ensuring long-run viability and sustainability of the system.

But the complexities and long-term implications involved necessitate coordinated and concerted measures by all stakeholders — the government, the RBI and the banking sector itself — if the avowed objectives are to be achieved.

(The author is chief economist, Canara Bank, Bangalore. He can be reached at sharma-m@canbank.co.in)

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