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Banking M&As: Set to flourish

May 4, 2002

The Reserve Bank of India’s (RBI) recent clarification for enhancing the FDI limit to 49% in private banking sector has sparked a rally in private banking stocks. The RBI’s announcement is likely to spur M&A activity in the sector and would push foreign banks for considering taking stakes in domestic private banks. On the other hand, government banks would continue to remain out of the cluster as a potential acquisition target. This is due to the fact that FDI cap on these banks still remains at 20% level. Although, the government intends to reduce its stake in these banks to 33% while retaining the management control, the privatization of these banks is unlikely to take place in the near term. Employee issues and relatively low adherence to new technology is likely to make these banks unattractive acquisition targets. Thus, consolidation in the sector as a whole would be limited, as the government banks still dominate 80% of the sector.

However, the balance 20%, which is fragmented among the large number of private sector banks, is likely to see consolidation. In order to maintain a high growth rate in earnings private sector banks are in search of potential sellers. The acquisition is to enable new generation banks to gain market share and to stand in line with the foreign banks. Also, increasing competition in the retail finance market and capital constraint would speed up the M&A activity in the sector.

In the current scenario, there could be three possibilities for consolidation. Firstly, large private banks like HDFC Bank and ICICI Bank can target small private sector banks as candidates for acquisitions. Consolidation of the small private sector banks among themselves is the second possibility. The latest example is the unsuccessful deal of UTI Bank and Global Trust Bank. The third and the most likely option in the near term would be foreign banks infusing capital to gain stake in private banks.

Comparative ratio analysis of new generation banks
FY01BranchesBusinessInterest incomeProfitsNIMCost to incomeROACARNPA ratio
 (Nos.)Per employee (Rs m)     
Citibank15 133.6 11.9 1.9 4.3%46.5%3.2%11.2%0.7%
HSBC28 52.9 4.4 0.7 3.3%47.8%1.3%12.4%1.0%
ABN Amro94 86.8 9.4 0.4 4.1%42.4%0.4%11.4%1.2%
HDFC Bank13159.2 4.6 0.8 4.0%44.8%1.5%11.1%0.5%
UTI Bank86117.4 7.5 0.7 1.2%49.3%1.0%9.0%3.4%
IDBI Bank5368.

But before this consolidation game begins, the acquirer has to consider many factors in mind. Asset quality and distribution network would play a critical role in deciding the target bank, as against only market valuations based on financial performance and risk. New private banks are highly tech savvy with a strong business growth. Their network and organization culture is much better than old private sector banks.

On the other hand, the old private sector banks, which are considered to be potential takeover target, are burdened with many problems that are not faced by foreign banks and new private banks. Loan growth is a concern for these banks and so is the asset quality. This is reflected from their high non-performing assets to advances ratio. Consequently, any merger would entail a substantial cleanup of the bank’s assets thereby reducing its net worth and book value. Also, over manned and low tech branches would only inflate the cost structure of the acquiring bank. But as it is been rightly said, ‘Any change, even a change for the better, is always accompanied by drawbacks and discomforts’.

Takeover targets burdened with high NPA ratio and low productivity
FY01BranchesBusinessInterest incomeProfitsNIMCost to incomeROACARNPA ratio
 (Nos.)Per employee (Rs m)     
Karur Vysya Bank206 20.5 1.6 0.3 4.1%47.2%1.7%15.6%4.7%
Federal Bank404 19.8 1.5 0.1 3.0%48.3%0.7%10.3%10.1%
Vysya Bank377 19.7 1.5 0.1 2.0%61.5%0.4%12.1%4.8%
Jammu & Kashmir Bank426 24.6 1.7 0.3 3.2%37.7%1.3%17.4%2.5%
Bank of Punjab55 64.6 4.8 0.5 3.6%59.0%0.9%11.0%2.3%

There are obvious advantages to merger, apart from increasing capital and facilitating business growth of the acquiring bank. The most significant is increase in the distribution strength, which would allow the acquiring bank in maintaining higher growth rates in future. Most of the old private sector banks are regional and have their presence in rural parts of India through a comparatively large branch network. This is the attractive factor for foreign banks, which were restricted earlier for extending their branch network. Also, considering the amount of investments and time taken from widening the reach, it presents better opportunity to foreign banks to go for inorganic growth.

The RBI has however, restricted the attractiveness of the sector for foreign banks by limiting their voting rights to 10% and restricting their stake in the sector to 49%. Holding of less than 51% would not allow foreign banks to consolidate the acquired bank. It can only offer the bank the advantage of network. In terms of addition to profitability, the acquired bank will only remain as a dividend paying investment.

After having analysed business fundamentals, lets see some of the valuations parameters, which are central to the banking M&As. For the banking sector, price to book value ratio is taken as the standard benchmark for valuing reasonableness of that merger. The attractiveness of any acquisition is highly dependent on lower price to book value ratio (apart from the business and financial parameters stated above). Any acquisitions concluded at higher valuations are unlikely to add to ROE of the bank. The two mergers, HDFC Bank-Times Bank and ICICI Bank-Bank of Madura were fairly valued and there has been no attempt for forced merger until now. The last but most important factor is the RBI approval and government regulations. The experience so far has been positive for India and going forward, it would depend on whether the mergers are able to create any shareholder value.

Comparative valuations
FY01PBV (x)P/E (x)Market price (Rs)
HDFC Bank*3.220.5217.0
ICICI Bank*1.910.1115.0
UTI Bank*1.85.840.3
IDBI Bank*1.87.628.1
Karur Vysya Bank0.73.3399.5
Federal Bank0.53.494.0
Vysya Bank0.915.3260.0
Jammu & Kashmir Bank0.62.589.0
Bank of Punjab0.84.314.4
* Results for FY02 and price to book value (PBV) ratio calculated after adjusting for net NPAs.

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