Banking sector needs consolidation

 The volatility of the business environment has altered the ways and means by which transactions are carried out. Perpetual existence of an enterprise has become very difficult, given the complex and fluctuating nature of the surrounding environment. There is thus, a need for almost continuous streamlining of business organisations.
The objective of the business firms in the new environment is to take measures which would result in high levels of sustained profitability so that the expectations of various stakeholders, and in particular, the shareholders are adequately met. Profitable growth can be achieved internally by developing new product lines, expanding existing capacity, acquiring new assets, moving on to technologically advanced equipment and appreciating the need for investments in research and development. Alternatively, the growth process can be facilitated through various forms of corporate combinations such as absorptions, acquisitions, amalgamations, de-mergers, divestures, joint ventures, leveraged buyouts, mergers, selloffs, spin-offs, strategic alliances, takeovers, and so on.

Consolidation through M&A
Mergers and acquisitions (M&A) as a means for inorganic growth are increasingly being used the world over to undertake restructuring of leading business enterprises. It is followed as a part of the strategy to achieve a larger size and faster growth in market share and reach, and to become more competitive through economies of scale and scope. India too is witnessing one of the highest capex cycles, with most of the companies aggressively building capacities via M&A to cater to growing domestic and global markets.

Numerous examples of M&A bids can be seen in manufacturing industries and in financial services sector. According to RBI’s Annual Report 2007-08, the year witnessed maximum mergers in financial services (15.7 per cent) and the acquisition activity was also the largest (17.9 per cent) in the sector. The underlying cause is the greater degree of liberalisation in the services sector. Consolidation as a practice in the banking arena commenced a couple of decades ago in developed economies like the US and UK. It also gained momentum in some emerging economies like India, Japan, Korea and Malaysia.
The US observed a number of mergers and acquisitions in the late 1990s. About 25 to 30 per cent banks in the country have been merged or closed in the last 2-3 decades. The domestic lending market in UK has become relatively concentrated as a result of a wave of consolidations. In Europe too, more than 7,300 bank mergers took place during 1990-99. Countries like Malaysia, Singapore, Taiwan and South Korea have also supported consolidation of the banking industry. An attempt has been made to trace the origin of M&A  in the banking industry and to cover the challenges that crop up in the process. The existing strengths and weaknesses of the Indian banking system have also been highlighted to explore the opportunities waiting to be seized by the banks as a result of consolidation.

Indian banking industry
The banking industry in India has been in the process of transformation and consolidation ever since 1961. The Banking Regulation Act, 1949 empowers the regulator with the approval of the government to amalgamate weak banks with stronger ones. Majority of the mergers in India have been crafted to bail out weak banks to safeguard depositors’ interest and to protect the financial system. The report of the Committee on Banking Sector Reforms (the Second Narasimham Committee - 1998), however, discouraged this practice. It recommended a multi-tier banking system with existing banks to merge into 3-4 international banks at the  topmost level, 8-10 nationalbanks engaged in universal banking at the next level and local and rural banks confined to specific regions.

Prior to 1999, the amalgamation of banks was primarily triggered by the weak financials of the bank being merged, whereas in the post-1999 period, there have also been mergers between healthy banks driven by business and commercial considerations. Thus, the new generation mergers on the lines proposed by the Narasimham Committee are a recent phenomenon in the country.
Following are the existing strengths and weaknesses of the Indian banking system and potential opportunities and threats if it undertakes consolidation by M&A as an avenue of inorganic growth.

Strengths
Liquidity: Liquidity has been a traditional strength of the Indian banking system. Banks are required to keep a stipulated proportion of their total demand and time liabilities in the form of liquid assets which affect their liquidity position. RBI has been easing the requirements with several roundsof reduction in the Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR).
Sound banking systems: The banking system in India has generally been stable and sound in terms of growth, asset quality and profitability. It is because of healthy, prudent and well capitalised policies and practices implemented by the RBI from time to time. The same is evident from the remarkable resilience of the Indian financial sector to the global financial turmoil which erupted during 2008-09.

Weaknesses
Competition from foreign banks: Foreign banks will be soon allowed to spread their business in India which will create intense competition for Indian banks. The RBI Report on Currency and Finance presents the view that mergers are the only way to face competition from foreign banks. High cost of intermediation: Intermediation cost (operating expenses as a proportion of total assets), an indicator of competitiveness, is higher in India as compared to international levels. High level of fragmentation: There is a high level of fragmentation, especially among cooperative banks, as compared to some of the advanced economies of the world, which poses a serious threat to their profitability and viability in conducting business. About 1,00,000 entities in the cooperative sector share just 4 percent of the total banking assets in the economy.
Lack of product differentiation: The financial products offered by banks in India are similar across the industry with no distinctive features, thereby leading to unhealthy competition.

Low penetration: There is an uneven distribution of banking services in the country. It is limited to few customer segments and geographies only. Of the total 611 districts in the country, 375 districts are under-banked. There is a need for banks to open branches at these locations and establish connectivity with the help of a core banking solution.
According to a report on banking sector consolidation by Ernst & Young, the country would require 11,600 branches by 2013 and an additional 20,300 branches by 2018 in order to achieve the desired penetration levels of 74 per cent and 81.5 per cent in 2013 and 2018 respectively.

No competition at international level: Indian banks are not able to compete globally in terms of fund mobilisation, credit disbursal, investment and rendering of financial services. The main reason behind it is the size of the industry. State Bank of India (SBI), is the world’s 57th largest bank in the list of the top 1,000 banks in the world carried in the July 2009 issue of The Banker based on its tier-I capital, or equity and reserves, for the fiscal year ended March 2008. Similarly, in terms of assets, SBI is now the world’s 70th largest bank. On the other hand, ICICI Bank Ltd, the largest private sector lender has attained the 150th position. Based on assets, ICICI Bank’s world ranking is 148th. None of the other Indian banks featured among the top 200 banks in the world-in terms of tier-I capital. In 2008, there was only one Indian lender - SBI, at eighth place among the top 25 Asian banks. Industrial and Commercial Bank of China, the biggest Asian bank and the world’s eighth biggest bank, is four times bigger than SBI, both in terms of tier-I capital as well as assets. Another recent study ‘Report on Currency and Finance’ released by the RBI reveals that the combined assets of the five largest Indian banks - SBI, ICICI Bank, Punjab National Bank, Canara Bank and Bank of Baroda are just about half the asset size of the largest Chinese bank, Bank of China. The bank is 3.6 times larger than SBI in terms of assets, branches and profits.

Opportunities
Advanced technology: New generation private sector banks and foreign banks are technologically more advanced in terms of management information systems, delivery mechanisms, etc. These systems and processes require substantial investments which may be possible after consolidation. Cutting-edge technology may lead to acceleration of service delivery and broadening of customer relationships.
Basel norms: Basel II requires banks to meet tougher and higher capital adequacy norms such as capital allocation towards operational risk, in addition to credit and market risks. Many Indian banks, especially public sector banks, cooperative banks and regional rural banks are unprepared for this implementation due to capital inadequacy. According to the report, every category of bank has to arrange additional capital from its own internal sources. To maintain the 51 per cent minimum government share, PSBs cannot collect additional capital directly from the public and with this view it promotes bank mergers. Consolidation may be a route for smaller banks to infuse funds to strengthen their capital base.

Cost cutting: Many branches and ATMs of various banks are congregated in the same areas leading to pointless outlay on premises, manpower and maintenance facilities. Consolidation may lead to redeployment and rationalisation of such infrastructure, human resources and other administrative facilities thereby undercutting the cost factor. Consolidation will lead to cost efficiency which will enhance profitability.
Enhancement in risk absorption ability: The risk management capabilities of the banks may improve. Larger size improves the risk bearing capacity of a bank and strengthens its balance sheet. Biger organisations have inherent advantages and they are too big to fail.

Enlarged customer base: The combined customer base may increase the volume of business. The enhanced rural branch network may lead to increase in microfinance activities and lending to the agriculture sector. M&A may be a far-sighted conclusion to increase the market share. The time required to expand inorganically may be less than that of an organic route.

Geographical spread: Banks can diversify the risk of concentrated lending through mergers. They can also have a greater market access thereby widening the deposit base. The RBI has imposed strict licensing norms for opening of new branches and hence via consolidation, the acquirer will have access to ready physical infrastructure. Pan-India presence of the combined entity may enhance convenience for the customers.
Improvement in operational efficiency: The operational efficiency of banks may improve owing to bigger size. There may be increase in financial capability greater resource/deposit mobilisation, output and better pricing of products.
Product diversification: Merger creates the opportunity to cross-sell products and leverage alternative delivery channels. Old generation banks can merge with the new generation private sector banks and foreign banks to diversify their credit profile. They can sell technology-based innovative products.
Tax shields: In case of bailout mergers, the accumulated losses and unabsorbed depreciation of the amalgamating bank can be carried forward and set off against the future profits of the amalgamated bank.

Threats
Alignment of technology: The technology infrastructure, system platforms (Finnacle, Flexcube, etc), network architecture, database vendors and IT-enabled synergies (customer service, payroll, back office operations, risk management, etc) should be compatible in banks desiring to merge. Most of the public sector banks are at different stages of technology implementation. It would pose a stiff challenge to such merging entities to integrate their technology and working platforms.
Assimilation of systems and processes: The cost of integrating diverse systems and processes should be paid due attention. Bancassurance is one of the areas where merging entities may face problems.

Customer dissatisfaction: The change in the nature and quality of financial products may dissatisfy the customers, even if the products are better. In some cases customers may be deterred by the acquiring company for various reasons which may affect brand loyalty of the combined entity.

Integration of people: The acquirer bank may have to absorb the entire workforce of the target bank which may push up the wage cost. It also requires the integration of the heterogeneous work cultures. The views of the employees towards various aspects of the new organisation, management styles, training, leadership, etc are to be considered in a critical manner. The varied aspects of the work environment, if not handled properly, may lead to resentment and shrinkage in productivity.

Marginalisation of small customers: Larger entities may neglect small customers and concentrate on affluent customers or High Networth Individuals (HNIs).
Regulatory hurdles: Some of the legal barriers need to be removed to make PSBs, which still control about 68 per cent of the Indian banking sector, active participants in the consolidation process. It will help realise the true benefits of consolidation. These hurdles include bringing down the government ownership from the statutory 51 per cent and amending certain clauses in acts governing these banks to facilitate their merger. On the cooperative banking side too, issues of dual control should be resolved to facilitate a smoother consolidation exercise.

Rise of monopolistic structures: Mergers are an impediment to perfect competition. They may give rise to monopolistic structures and lower competition. Monopolistic entities may charge higher fees for services rendered in case there is no effective competition. The motive should be to increase the size but not in isolation. Size should be measured in terms of efficiency with which interests of various stakeholders are adequately met. In order to leverage the benefits of bigger size, geographic expansion, huge loan portfolios, improved technology, product diversification and reduced transaction costs, Indian banks are gradually but surely moving from a cluster of ‘large number of small banks’ to ‘small number of large banks’. Consolidation will positively amplify the business prospects of the industry in the domestic as well as international market place.
References: 1. RBI Annual Report, 2007-08, 2. RBI deputy governor, V Leeladhar’s speech on ‘Consolidation in the Indian Financial Sector’, 3. RBI Report on Currency and Finance, 2006-08
(Source: The Indian Banker, a publicaton of Indian Banks’ Association)