India's first Universal Bank: Worth it or not?

Finally the concept of Universal Bank is taking shape in India. ICICI group, which has been the flag bearer of Universal Banking in India, has planned a mega merger with its banking arm. The merger would redefine the term 'banking' in the highly competitive era of globalization and liberalization. The combined entity will be the second largest bank in India with an asset base of over Rs 1 trillion. The swap ratio for the merger has been put at 2:1 in favour of ICICI Bank (one domestic share of ICICI Bank will be issued for every two shares of ICICI Limited). Consequently, for ADS holders, 5 ADS of ICICI Bank would be issued for every 4 ADS of ICICI (each ADS of ICICI represents five domestic equity shares while each ADS of ICICI Bank represents 2 domestic equity shares). The merger will be effective on March 31, 2002 or the date of RBI approval whichever is later.

The merged entity would have the largest number of clients (7.2 m) in the banking sector and will offer one-stop financial services by leveraging fully on virtual delivery channels. ICICI Bank has the largest ATM network in the country (601 as on September 30, 2001), which they are planning to increase to 1,000 by FY02. It would have 400 branches (of ICICI Bank) and 140 existing retail finance offices and centres of ICICI. This universal bank would leverage on its large capital base, comprehensive suite of products and services, technology enabled distribution architecture and a strong brand. What more?

The benefits in terms of financials would be greater for ICICI than for ICICI Bank. ICICI would benefit from low cost funds (saving and current account deposits), potential to grow its fee-based income at an exponential rate and offer transaction - banking (like clearing of cheques for corporates) services. The retail segment will be a key driver of growth for this universal bank, both in terms of assets and liabilities. With a downturn in the manufacturing sector, the entity sees more lending opportunities in the retail segment, which is still at a nascent stage in India. ICICI's aggressiveness has already resulted in retail asset accounting for 3.2% of its total loans as on March '01 and the proportion of manufacturing loans shrinking to 35% in FY01 from 58% in FY98.

It's not just the revenues that are anticipated to grow rapidly. The merger would also result in benefits from economies of scale, as the combined entity would be able to serve more customers using its existing network. Currently, 55%-60% customers of ICICI Bank use these relatively lower cost virtual channels (net banking, ATMs) thus helping in significant savings. As on September 30, 2001, the bank had 700,000 Internet banking accounts (it is among the top 12 banks in world in terms of Internet banking customers).

In the first half of the current year, ICICI Bank's cost to income ratio stood at 54% compared to 14% for ICICI. After the merger, the ratio for the new entity would come down to 27%, which is much less than its peers in the banking sector. Also, as mentioned earlier, its potential to earn fee-based income would rise substantially. Currently, due to banking regulations ICICI is not able to tap this revenue stream even with its large asst base. On the other hand, ICICI bank is facing constraints in widening this income stream due to small asset base. Now with the merger this hurdle would no longer trim the growth opportunities.

Consider this. The market for fee-based income is currently at Rs 90 bn. Out of this, ICICI expects to capture a share of at least 11%. This would be possible by catering to working capital and export credit demand from large companies apart from offering bank guarantees and letter of credit services. Consequently, the proportion of other income to total income would grow to 9% by the end of FY03 from the current 4.7%. This would be positively reflected in the combined entity's bottomline (profits before tax is expected to grow by about 13% in FY03).

Click here for detailed first half results of ICICI and ICICI Bank.

Of course, creation of a universal bank brings costs along with the benefits.

There are certain banking regulations, which ICICI would be required to follow. It will have to maintain a CRR (cash reserve ratio) of 5.5%, SLR (statutory liquid ratio) of 25% and priority sector lending of 40%. ICICI would require additional Rs 180 bn to comply with SLR and CRR norms. The institution expects to raise this amount in the current year from the market and would deploy the same in the next year. This is likely to lower its average yield on money lent, as interest on CRR balance is much lower than interest from lending to corporates (6.5% on the funds parked above 3%, i.e. 6.5% on 2.5% of funds).

Read moreon the impact of banking regulation on ICICI - ICICI Bank merger

It will also not get any tax rebates on project lending. Currently, 40% of ICICI's fund based income from long term financing (advances given for a period exceeding 5 years) is tax-free. This rebate would not be applicable to the merged entity. Consequently, its effective tax rate, which stood at 16% in the firs half of the current year, would rise to 28% in FY03.

With a long-term bias towards softer interest rates, asset liability mismatch of the combined entity is likely to increase further. Low cost funds borrowed from retail customers could be utilized for lending to corporates and project lending, which is generally for over 5 years. This would increase the risk profile of the overall balance sheet. Any fluctuation in interest rates (the RBI has already indicated a dramatic change in the interest rate environment within a short period of time) would also have a negative impact on its interest spread and asset quality.

Another concern is ICICI's escalating base of non-performing assets (NPA). As on September 30, 2001, the institution's net NPA to advances ratio stood at 5.2%, while for the bank it was just 1.4%. ICICI's net NPA outstanding at Rs 32 bn is 12 times larger than ICICI Bank's net NPA outstanding of Rs 2.7 bn. It would require the merged entity to write off its entire profits as provisions for the next two years to clean its balance sheet. Concerns are also raised about its hidden NPAs, which are not actually reflected in the amount of gross NPAs. Cotton textiles, man made fibres and steel accounted for 35% of its total gross NPAs. In a current sluggish economic environment, these sectors are unlikely to witness any turnaround in the near term. As a result ICICI's gross NPAs could increase further despite its aggressive restructuring efforts.

The merger of the two entities would be done on the 'purchase method' of accounting whereby assets and liabilities of ICICI would be valued fairly for the purpose of incorporation in the accounts of ICICI Bank. This indicates that asset base of ICICI could be lowered by the amount of non-performing assets and then merged with ICICI Bank. Consequently, overall profitability of the combined entity is likely to have some adverse impact.

As said earlier, after the merger, ICICI will have to adhere to the banking regulations. The regulations require the de-linking of such activities, which are not in consonance with activities specified for bank subsidiaries. ICICI expects to reduce the number of subsidiaries to 12 before the year-end (from the current 22). It has already indicated to merger ICICI Personal Financial Services (services retail credit products) and ICICI Capital Services (distributor of financial and investment products) with ICICI Bank. It will also sell, 42% stake in ICICI Infotech and retain the balance 49%. Its main subsidiaries after the merger would include ICICI Prudential Life Insurance, ICICI Venture Fund, ICICI Home and ICICI Securities. Its existing 46% stake in ICICI Bank would not be cancelled and the same would be transferred to special purpose vehicle at the cost price. This stake would be divested when the capital market condition is favourable and capital gain from the same would accrue to the merged entity.

ICICI is currently trading at a P/E of 2x and the bank is trading at a P/E of 9x. ICICI Bank's current price/book value ratio is 1.5x. If we were to assume the market price of the merged entity to be the same as that of ICICI Bank than the merged entity would be trading at a PBV of just 0.7x (before excluding the full impact of provision for NPAs). Considering the potential that the merger holds, large product suite, diversified resource base and economies of scale, the valuations are attractive on a long-term basis (since the merged entity is likely to take at least 3-4 years for cleaning up the balance sheet). Globally, Citigroup trades at a PBV of 3.4x and P/E of about 17.8x.