Bank merger: Swap ratio favours BoB investors; factors in balance sheet weakness of Dena Bank

The swap ratio for the amalgamation of Vijaya Bank and Dena Bank with Bank of Baroda, which factors in the weak balance sheet and asset quality of Dena Bank, has lifted a key overhang for investors in Bank of Baroda (BoB).

The swap ratio that works out to 1:9.1 for BoB:Dena and 1:2.5 for BoB: Vijaya Bank implies a 27 per cent discount to Dena Bank’s share price (based on January 2 closing), and 6 per cent discount to Vijaya Bank’s price; this was reflected in the decline in stock prices of Vijaya Bank and Dena Bank on Thursday.

The share swap appears to have been decided based on the adjusted book value (adjusted for net non-performing assets) of Vijaya Bank and Dena Bank. Given the weak financials of Dena Bank, the swap has worked marginally in favour of BoB investors, though the 11 per cent fall in stock price since the announcement of the merger last year has hurt them.

While the uncertainty over the swap ratio is done with, concerns over who will take over the reins of the new entity (the term of the current MD of BoB, PS Jayakumar, expires in October) and integration issues persist.

The merged entity is also fully valued at about 1.4 times adjusted book (based on BoB’s January 2 closing price), leaving little upside for investors. Also, while capital under the merged entity appears adequate to the meet the mandated requirement in the near term, scaling up provision cover and credit offtake will require additional capital.

Hence, the quantum of capital allocation by the Centre will be keenly awaited by investors.

Among the three, Vijaya Bank had the lowest gross NPA ratio of 5.86 per cent as of September 2018. Dena Bank, on the other hand, has been one of the few banks whose asset quality and finances have been deteriorating sharply. BoB and Dena Bank had gross NPAs of 11.7 per cent and 23.64 per cent, respectively, as of September 2018. Considering the net worth and net NPA (unprovided bad loans) for Dena and Vijaya Bank as of September 2018, it appears that the swap ratio has been determined based on the adjusted book value of these banks. This has led to large discount in the pricing of Dena Bank.

The swap deal leads to an equity dilution of about 29 per cent for BoB, which is reasonable.

While Vijaya Bank and BoB enjoy a strong capital position – Tier I capital ratio of 11.36 per cent and 10.25 per cent – Dena Bank had a weak Tier I capital ratio of 7.63 per cent as of September 2018 (mandated Basel requirement is 7 per cent).

A back-of-the-envelope calculation suggests that the merged entity’s Tier 1 and minimum common equity Tier I (CET 1) works out to about 10.1 per cent and 9.1 per cent, based on capital and risk-weighted assets numbers as on September 2018.

While this may appear adequate, a higher provisioning and ramp-up in credit growth will require additional capital.

While the gross NPA ratio of the merged entity will be more or less at the same level as that of BoB’s September quarter 11.8 per cent mark, the provision cover falls to about 58 per cent (from 61.8 per cent for BoB as of September 2018). Scaling up provision coverage to earlier levels or embarking on a clean up exercise (₹32000-odd crore of unprovided NPA of the merged entity), will require additional capital. Any nasty surprises on the asset quality front can add to capital woes.

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