The share swap ratio for the proposed merger of IDFC Limited with IDFC First Bank is in favour of IDFC, whose stock commands a higher value than the stock of the bank. Shareholders of IDFC will be allotted 155 shares of the bank for every 100 shares held.

This is despite the fact that the bank is the primary asset of the holding company following the sale of the latter’s mutual fund business to Bandhan Bank. IDFC holds a 39.93 per cent stake in the bank as of June 2023.

In an interview, MD and CEO V Vaidyanathan said that the merger will result in a 4.9 per cent increase in book value for IDFC First Bank. Thus, to be fair to both shareholders, the share exchange ratio takes into account the value of IDFC’s holdings in the bank and the holding company discount.

However, the minimal business under the parent company implies a lower discount, which begs the question: Did shareholders of IDFC First Bank get the short end of the stick?

Steady improvement

Over the past four years, IDFC First Bank has battled weak financials across legacy portfolio stress, a high cost-to-income ratio, a low share of retail liabilities, and weak capital adequacy and profitability. However, with the financials steadily improving, shares of the bank have been among the top gainers among private sector banks over the last year.

Deposits have grown at a CAGR of 36 per cent, with the CASA ratio increasing to 49.77 per cent as of March 2023 from 8.6 per cent, and the share of retail deposits increasing to 76 per cent of total deposits from 27 per cent a year ago. Assets stood at around ₹1.6-lakh crore, and the bank posted a net profit of ₹2,437 crore in FY23. It has also been building its digital capabilities and was selected by the regulator for pilot projects for initiatives such as CBDC and UPI for foreigners.

Last week, the bank raised ₹1,500 crore via tier-II bonds, following which the capital adequacy ratio improved to 17.68 per cent.

Share exchange ratio

While the gross NPA ratio has also improved to 2.51 per cent overall and 1.65 per cent for retail loans, concerns regarding the share of high-risk or unsecured loans remain even as negative legacy perceptions continue to work against the bank. It then makes sense that the bank would look at a share exchange ratio that incentivises IDFC’s shareholders to remain invested in the bank.

In exchange, the benefits for the bank are seen in the simplification of the corporate structure, streamlining of regulatory compliance, and diversified shareholding, which will allow the bank to garner scale. The merger is also seen as helping improve the bank’s margins and contain expenditure, in addition to the cash reserve of around ₹600 crore that will come with IDFC from the sale of its MF business.

Vaidyanathan has said the merger will resolve the issue of the overhang of IDFC’s 40 per cent stake in the bank. Even so, the overhang of the largest shareholder—the government—remains, in spite of the merger-led dilution. It remains to be seen whether direct government control through a nominee or representative could change the dynamics of the bank in terms of its offerings, operations, and strategy.

With the merger expected to take about 12 months, this could weigh on the bank’s stock and widen the arbitrage. The true test for IDFC First Bank may then not be if IDFC’s shareholders continue to remain invested given the sheer advantage, but for how long they stick around based on their long-term assessment of the bank.