Consolidation in any sector is an interesting subject and banking is no exception.
– B Mahapatra
Consolidation in any sector is an interesting subject and banking is no exception. Of late, the topic assumed importance when the central government, vide its press release dated August 23, 2017, announced that it has created an alternative mechanism (AM) to facilitate consolidation among the public sector banks (PSBs) to create strong and competitive banks to meet the credit needs of a growing economy, absorb shocks, and have the capacity to raise resources without depending unduly on the state exchequer.
The salient features of the approval framework for consolidation of PSBs under AM are:
i. The decision regarding creating strong and competitive banks would be solely based on commercial considerations;
ii. The proposal must start from the Boards of PSBs;
iii. The proposals received from PSBs for in-principle approval for amalgamation would be placed before AM;
iv. After in-principle approval, PSBs would take steps in accordance with law and Sebi requirements;
v. The final scheme would be notified by the central government in consultation with the Reserve Bank of India (RBI).
Without going into the theoretical underpinnings of the motives of consolidation—in advanced economies, it is mainly market-driven, whereas in emerging and developing economies it is mostly driven by governments in order to restructure the banking systems in the aftermath of a crisis—it may be useful to know that maximisation of value is the prime consideration behind mergers and acquisitions, and consolidation. Maximisation of value can be achieved either through increase in revenue or reduction in cost, or a combination of both. Cost reduction could be achieved on account of economies of scale, economies of scope, diversification of risk due to geographic or product diversification, etc.
Increase in revenue could occur due to larger size servicing large number of customers, offering one-stop shop for a variety of products, increased product and geographic diversification, etc.
Against this backdrop, let us analyse whether the proposed consolidation of PSBs would serve the intended purpose. It is argued that the Indian banking system, and more so PSBs, are fragmented; uncompetitive; do not capture scale benefits in risk diversification, IT and back-office processing; and lack skills in risk management, IT and product innovation. Furthermore, most PSBs are mid-sized or “stuck-in-the-middle,” operating with similar business models, and some consolidation among PSBs may be the need of the hour.
The issue as to what should be the nature and extent of consolidation in the Indian banking system was examined by various committees. The Narasimham Committee I (1991), looking at international trends, argued that consolidation would make economic and commercial sense where the whole would be greater than the sum of its parts, and have a “force-multiplier effect.” The committee recommended three to four large banks (including SBI), which could have international presence, while eight to 10 national banks with a network of branches across the country engaging in general or universal banking. It also recommended local banks whose operations would be confined to specific regions, and rural banks.
The Narasimham Committee II (1998) reiterated the recommendations of the previous committee for creation of new mega banks for international and domestic competition. It questioned the need for the then 27 PSBs and underlined the need for banks to be of a size that could offer greater competitive thrust to banking operations. It emphasised that consolidation process in PSBs needed to be based on synergies, and locational and business-specific complementarities.
The Committee on Fuller Capital Account Convertibility (2006), on the other hand, sounded a word of caution. It observed that some of the smaller banks that specialise in certain areas of business or regions may have a comparative advantage over larger banks by virtue of their core competence. As such, the emphasis on consolidation to mean larger banks, merely by merger, may not lead to strengthening of the banking system. The committee favoured emergence of strong and professionally-managed banks, and not only large banks.
The Raghuram Rajan Committee (2008) also favoured some consolidation among banks that aim to play on a larger stage and takeover of PSBs by other PSBs should not be discouraged, though there is no point in one weak bank taking over another.
It may be observed that the logic for consolidation among PSBs is based on two explicit or implicit assumptions. One, there are too many PSBs in India. Two, if the banking sector has to be assessed in the international context, size is the most important factor.
A lot of water has gone under the bridge since then. The global financial crisis of 2008 and the stressed assets of PSBs in India in recent years have altered the situation drastically. One of the lessons learnt from the crisis of 2008 is that moral hazard problems created by “too big to fail” banks are real and must be addressed. “Too big to fail” banks create externalities for the economy, and when they fail, public authorities have no alternative but to bail them out. With a view to obviating any need for public infusion of capital to rescue such banks, the Basel Committee has tried to self-insure the Global Systemically Important Banks (G-SIBs) by prescribing additional capital, depending upon the global systemic importance of a bank. A similar structure has been prescribed for Domestic Systemically Important Banks (D-SIBs).
To further fortify capital cushion, G-SIBs are required to have the Total Loss Absorbing Capacity (TLAC), almost double the capital requirement. Size is no more looked at with favour.
In the Indian context, no doubt the banking system is skewed with the largest bank (SBI, after the merger of its subsidiaries and the Bharatiya Mahila Bank with it) being about five times the size of the next large bank. Much consolidation has happened in the private sector banking space.
The PSB space is too fragmented with 20 PSBs (even after merger of subsidiaries of SBI) with almost similar business model, geographic spread, product line, skill-set, managerial efficiency, etc. Many of them are mid-sized. Therefore, some consolidation may be needed.
However, even after merger of a few PSBs, no Indian bank, including SBI, will be able to become an international bank in true sense of the term. After the merger, as per Bloomberg data, SBI improved its international rank in terms of assets (2015) from 52 to 45. Consolidation among other PSBs would not likely to take any bank to the club of 50.
Will consolidation among PSBs help creating eight to 10 national banks? Maybe that is possible. Consolidation may help those PSBs to rationalise geographic spread, product line, and scale and scope efficiencies. However, it cannot be said that skill-sets and managerial efficiency would improve. Similarly, it cannot be said that fewer banks would be more competitive—at least theoretically, as per the Herfindahl-Hirschman Index (HHI), they would bring down competition.
Will consolidation help in creating valuable strong banks? At present, almost all PSBs are beset with stressed assets problem, with varying degrees of stress. As a crisis management tool, the government may like consolidation of relatively stronger with weaker banks. That would be unhelpful to the minority shareholders of the relatively stronger banks, if consolidation is done at book value. That would also not make any bank stronger or valuable.
Even after consolidation, if strong and valuable PSBs do not emerge, their capacity to raise resources from the market without unduly depending on the state exchequer would be constrained. Mergers are never smooth. Apart from recent merger of some PSBs with SBI, there is only one previous instance of a merger between two PSBs—the New Bank of India (NBI) was merged with Punjab National Bank (PNB) in 1993. This was done to rescue the stressed NBI. The major issues in merger, apart from making the “ideal match,” would be resistance from trade unions, integration of human resources, culture, technological systems, business and accounting practices, etc.
Is it an opportune time for PSB consolidation? Since the setting up of SBI and nationalisation of banks, PSBs have done a wonderful job of spreading the branch network to far-flung regions of the country, mobilising deposits and dispensing credit to the unserved and the under-served. However, currently, they are going through a painful process of resolution of stressed assets. PSBs are also now deficient in capital and profits.
Howsoever laudable the objectives of consolidation may be, the immediate endeavour should be to clean the balance sheets of PSBs of stressed assets, rather than to divert managerial attention from the problem. Consolidation can wait; instead, the government may seriously consider privatising PSBs, which will alleviate all the ills associated with public ownership of banks.