By CKG Nair and Rachana Baid
The merger of the HDFC twins, effective July 1, 2023, has created the fourth largest bank in the world with a market capitalisation of Rs 14.37 trillion ($175 billion). Understandably, it has generated considerable interest in the media, corporate, and banking circles in India as well as abroad. A moment of pride for India, as finally, we have a Global Systemically Important Bank (G-SIB), a ‘global lion’. This merger has the potential to influence the financial services industry in several ways. Apart from heightened competition, expected compression of interest rates and margins, changes in valuation and so on, it can act as a major trigger for further mergers and acquisitions in the financial sector space as other banks and NBFCs would strive to maintain/consolidate their positions. As of now, all attention is focussed on the mega size of the merged entity; market capitalisation, assets and liabilities, and potential growth. Reportedly, the bank expects to double its balance sheet every 4 years.
However, the merger signifies much more. From an economic-financial policy-regulatory perspective, it heralds immense significance. Given the size and magnitude of business and the combined operations of two differentially regulated businesses (housing finance/NBFC and banking), it could generate profound changes in the business models of financial sector players through competition, mergers as well as co-option. That would necessitate major policy-regulatory changes, the trajectory of which depends on the interplay of non-linear factors.
For decades, NBFCs have been playing a significant role in financial intermediation by complementing and competing with banks. NBFCs, even at the top end of the spectrum, had enjoyed greater operational flexibility due to less stringent regulatory provisions as compared to banks. They were thereby able to provide services to niche sectors. Such regulatory arbitrage had also been a major reason for their mushrooming. Given their increasing size, complexity of operations, and interconnectedness, with resulting concerns on systemic stability, RBI has been trying to ‘align’ the regulations of NBFCs with those of banks. RBI underscored such concerns in its financial stability report of 2019, acknowledging that failure of large NBFCs can disrupt the financial system seriously, since many of them have huge exposure to banks as borrowing from banks is the main source of their funds. On October 22, 2021, to reduce the regulatory arbitrage between banks and non-banks, RBI issued a Scale Based Regulatory Framework (SBRF) for NBFCs; putting them into four baskets on the basis of asset size, business activities, systemic importance, and risk. NBFCs in the top layer have been subject to similar regulations as banks such as on capital norms, liquidity coverage ratios, asset quality norms, norms for non-performing assets, and so on.
The reduction in the regulatory arbitrage and the mega merger of the HDFC twins is likely to lead to more such mergers, particularly because in terms of market capitalisation, close competitors like ICICI bank and SBI are a little less than half and little more than a third respectively of HDFC Bank. The resulting competition will force these and other smaller entities to redraw their strategies on consolidation and scaling up. Earlier, public sector banks addressed their concerns on consolidation and scale by mergers. Now, the bank-NBFC merger route has successfully been demonstrated as another option even for very large entities.
There have been mergers of NBFCs with banks in the past too—Industrial Development bank of India (IDBI), a development financial institution (DFI) and IDBI Bank Limited merged in 2005; Capital First Limited (an NBFC) merged into IDFC Bank Limited in 2018; and IndusInd Bank Limited and Bharat Financial Inclusion Limited (an NBFC) merged in 2019. However, they were of modest scale and driven mainly by the need for survival or better prospects. But for the HDFCs, with both doing very well in own business, the motivation was an ambitious, even audacious strategy; part of which was driven by the regulatory developments.
Many big banks (both in private and public sector) have their own NBFCs as group entities. Hence, consolidation becomes easier. If reduction in regulatory arbitrage and own strategies motivate more NBFCs to fold into the arms of banks (own group or otherwise), alternative to bank funds would become scarce. IDFC First Bank, in a recent regulatory filing, has already announced a merger with its parent entity, IDFC Ltd. The consolidation of three specialised NBFCs of the Shriram group into Shriram Finance in 2022 is another related strategic development. Potential restructuring by many players is going to influence the competitive landscape of the financial sector, impacting choices and opportunities available to the consumers. The efficiency and diversity provided by the NBFCs would shrink leading to the dominance of large banking institutions. That, in turn, would invite policy-regulatory responses.
Regulations and policies will also have to respond to concerns on size, of the too big to fail (TBTF) type. There are costs and benefits associated with size, and the evidence is mixed. Economies of scale and scope may lead to increasing return to scale. It can also lead to large negative externalities. With HDFC becoming the fourth largest banking entity in the world, and a part of G-SIBs, it could invite strategic responses from other peers as well. The unleashing of various non-linear responses, both from domestic policies and regulations and from domestic and foreign competition, will be interesting.
More than the mega size of the HDFC Bank and its growth trajectory, which definitely will be of great interest, it is the new complexities of the market in terms of players, products, and process, availability and costs of various credit instruments, the policy-regulatory changes, and the consequential overall financial sector churning that will define the final outcome. The resulting corporate and public policy changes will also be interesting to watch. This HDFC milestone could indeed be another defining moment in the annals of India’s financial sector landscape and one necessitating paradigm shifts in policies and regulations.
Writers are respectively, director, and professor, National Institute of Securities Markets
Views are personal