A sustained economic downturn invariably leads to the clamour for a consolidation of systemic institutions, such as banks. It’s among the lowest hanging fruits in an adverse internal macroeconomic environment, cutting across economies.
The IMF’s Global Financial Stability Report released in April made a strong case for bank consolidation, particularly in Europe. It argued that banks whose business models are no longer viable following the financial crisis held some 15 per cent of bank assets in advanced economies. Already, an ongoing global readjustment to the new regulatory structure — including the TLAC requirements (total loss-absorbing capacity requirements for global systemically important banks), the Dodd-Frank Act compliance, the Vickers Commission reforms and the Likanen group reforms — has forced banks in the US, the UK and the EU to rearrange businesses and move towards consolidation.
In this context, bank consolidation in the NPA-ridden Indian banking sector appears to make imminent sense. The idea is evidently not new. Way back in 1991, when India was faced with a forex crisis, the Narasimham Committee Report had recommended a three-tier banking structure through the establishment of three large banks with international presence, eight to ten national banks and a bevy of regional and local banks. In his Budget speech for 2016-17, finance minister Arun Jaitley had mentioned the spelling out of a roadmap for consolidation of PSBs.
The need for consolidation may appear to be more attractive if one were to consider that although India is seventh largest economy in terms of nominal GDP, there is no Indian bank in the list of 70 large banks in terms of asset size. At present, there are 27 public sector banks (PSBs) with varying sizes. State Bank of India (SBI), the largest bank, has a balance sheet size that is roughly 17 times the size of smallest public sector bank.
In this context, the SBI proposal to consolidate five of its subsidiaries (the State Banks of Bikaner and Jaipur, Hyderabad, Mysore, Patiala and Travancore) as well as the Bharatiya Mahila Bank into itself, presents a rather compelling case. Apart from a balance sheet size of Rs 37 lakh crore that will push the SBI into the league of top 50 global banks, synergies in business and treasury operations, branch rationalisation and the access to tap into cheaper funds are expected to prune the merged entity’s costs. The efficiency gains resulting from lower cost and higher quality of services is too attractive to ignore, if the SBI experiment were to be replicated further across the banking sector.
As pointed out by R Gandhi, RBI deputy governor, in an April 22 speech, large banks reap certain advantages in terms of efficiency, risk diversification and capacity to finance large projects. Plus, there is the implicit assumption that a larger bank may be less risky than a smaller one as the former will have a more diversified portfolio, resulting in less vacillation in its earnings and consequently, higher credit ratings. Plus, recent proposals on Large Exposure norms, which limit banks’ exposure to a group by 25 per cent of their common equity, will further limit their capacity to fund large credit demands. It is therefore imperative that some consolidation among PSBs do happen to support the growth potential of the economy.
A consolidated banking structure, according to Fitch Ratings, would be “a positive development” in the long term for the banking system and that consolidation coupled with higher capital needs and governance reforms “would position the banking system better in support of a more open and higher-growth economy”.
More stable banking systems, according to Fitch analysts, tend to be structured around a number of large ‘pillar’ banking groups. There are good examples across the Asia-Pacific, including Australia, Singapore, as well as some less developed banking systems in Thailand and Malaysia.
In the Indian context, the financial systems would benefit from more banks of a similar size to SBI. The Indian banking scene is extremely fragmented at present, with 48 domestic banks (excluding RRBs and LABs). A comparison of performance of larger PSBs with smaller PSBs indicate that larger PSBs perform better.
Larger PSBs such as SBI and Bank of Baroda are trading at higher Price to Book Value ratio in comparison to smaller ones. SBI has been able to maintain relatively strong capital ratios and appears to be in a better position to withstand shocks to asset-quality.
Clearly, SBI has performed much better than its PSB peers through this credit cycle, largely due to greater scale benefits, which enhance pricing power from a funding perspective and diversification.
While large banks do benefit from economies of scale in terms of risk diversification, the benefit turns into a liability when they become excessively large beyond a certain threshold. This threshold size has been subject of much debate in the discipline of finance, according to Gandhi, there is no clear research which may point towards an optimum size for a bank in a particular country.
Existence of excessively large banks may also create significant moral hazard costs for the entire system. A failure of a very large bank may have systemic implications and therefore, there is a perception that large banks may be bailed out during stress periods.
Plus, as the RBI points out, it has to be ensured that mergers among two banks should not be seen as a fix to short term problems as being faced by certain PSBs. Merger of a weak bank with a strong bank may make combined entity weak, if the merger process is not handled properly.
The problems of capital shortages and higher NPAs may get routed to the stronger bank due to a badly managed merger process. Then there is a serious employee unrest threat to any consolidation plan that is taken up.
Consolidation, according to Gandhi, should not be seen from the sole perspective of creating larger sized banks. While there is an emerging consensus on creating a few large size banks, it is more important to ensure that this is a well calibrated process.