The Jury is still Out on Bank Mergers

A sound, robust and resilient financial system is a prerequisite for a modern economy. Weeks ago, the Modi government announced the mega merger of 10 Public Sector Banks (PSBs) into four, in a bid to consolidate and create stronger banking entities. Meanwhile, India’s growth rate has decelerated for five straight quarters to its weakest level since 2013, and the economy is crying out for reforms.

Reforms are an on-going process. This year marks the 50th anniversary of bank nationalisation, arguably the biggest structural reform introduced in the financial sector during the post-Independence period.

Evolution of banking in India

Post-Independence, India inherited a system where small private banks proliferated—56 per cent of all bank deposits in 1947 lay with the 81 scheduled and 557 non-scheduled private banks. These private banks were lopsidedly concentrated in the provinces of Madras, West Bengal and Bombay. Between 1947 and 1955, there were 361 instances of bank failures, with many depositors losing their life savings as well as their faith in the banking system.

It was in this backdrop that new laws of banking regulation, capital adequacy, licensing and inspection were enacted followed by a phase of liquidation and amalgamation, which brought down the number of scheduled banks to 71 and non-scheduled banks to 20, by 1967. The Government of India issued the Banking Companies (Acquisition and Transfer of Undertakings) Ordinance. Within two weeks the Parliament passed and it received presidential approval on 9 August 1969.

Government nationalised the 14 largest commercial banks with effect from the midnight of 19 July 1969. These banks contained 85 per cent of bank deposits in the country. A second round of nationalisations of six more commercial banks followed in 1980. The stated reason for the nationalisation was to give the government more control of credit delivery. With the second round of nationalisations, the Government of India controlled around 91 per cent of the banking business of India. Social Welfare was one of the main objectives of nationalization of commercial banks—Agricultural sector, small and cottage industries were in need of funds for their expansion and further economic development.

The liberalisation of the nineties

In the early 1990s, the Narasimha Rao government embarked on a policy of liberalisation, licensing a small number of private banks. These came to be known as new generation tech-savvy banks, and included the Global Trust Bank (the first one to be set up), which later amalgamated with Oriental Bank of Commerce; IndusInd Bank, UTI Bank (since renamed Axis Bank), ICICI Bank and HDFC Bank. This move, along with the rapid growth in the economy of India, revitalised the banking sector in India which has seen rapid growth.

Until the 1990s, the nationalised banks grew at a pace of around 4 per cent, closer to the average growth rate of the Indian economy. The new wave ushered in a modern outlook and tech-savvy methods of working for traditional banks. All this led to the retail boom in India. People demanded more from their banks and received more.

With state policies shifting towards liberalisation and privatisation in the last three decades and with the entry of new private sector banks, the dominance of PSBs has been on a decline. The share of PSBs in the total assets of the scheduled commercial banks, which was over 80 per cent in 1997-98, declined to around 70 per cent by 2007-08, and further to below 66 per cent in 2017-18.

In the immediate aftermath of the global financial crisis in 2007-08, which had exposed the dubious financial practices of private multinational banks, both deposit mobilisation and credit flow of the public sector banks in India had witnessed a phase of higher growth compared to the private sector banks.

Since 2011-12 though, the deposit and credit growth rate of the PSBs declined progressively, with the private sector banks and Non-Banking Finance Companies (NBFC) gaining in market share at the cost of the PSBs. Why did this happen?

With declining corporate profitability after 2011-12, loan defaults became the norm with the private corporates offloading their losses onto the PSBs. This phenomenon was termed as ‘riskless capitalism’ by a former Governor of the Reserve Bank of India (RBI).

In this context, successive doses of capital infusion by the government have not been able to improve the capital ratios of the PSBs significantly. PSB recapitalisation under the present dispensation has been more of a taxpayer funded bailout of the loan-delinquent corporates and fraudsters. The process so far has not been very effective in yielding timely Non-performing Assets (NPA) recovery. The average recovery rate is currently 43 per cent, which implies 57 per cent haircut for the banks.

Mergers as a quick-fix

Although it doesn’t qualify as a reform, mergers have been seen as a tool to tackle the problem of NPAs. In 2017, India’s largest lender, the State Bank of India (SBI), merged with five associate banks and the Bharatiya Mahila Bank to enter the league of the world’s top-50. The government allowed state insurer Life Insurance Corporation of India (LIC) to take over IDBI Bank, the worst performer in terms of bad loans.

Last year, the government had merged Mumbai-based Dena Bank, Bengaluru’s Vijaya Bank with Bank of Baroda (BoB) from Vadodara, Gujarat. The merged entity, with total assets of over Rs14 lakh crore ($190 billion), will be India’s third-largest lender behind the State Bank of India and HDFC Bank. One of the reasons for choosing these three banks was that the two stronger ones will be able to absorb the weaker entity—Dena Bank.

With the merger announcement on August 30, the number of PSBs has come down to 12, including the State Bank of India and Bank of Baroda. Oriental Bank of Commerce and United Bank will merge into Punjab National Bank to form the nation’s second-largest lender; Canara Bank and Syndicate Bank will merge to form the fourth-largest; Union Bank of India will amalgamate with Andhra Bank and Corporation Bank to be the fifth-largest and Indian Bank will merge with Allahabad Bank to be the seventh-largest public sector bank. Six PSBs will remain independent: Bank of India, Central Bank of India, Indian Overseas Bank, Uco Bank, Bank of Maharashtra and Punjab and Sind Bank.

The merger proposal will first have to be approved by the Board of Directors of the three banks. Then the government will prepare a plan to be vetted by the Union Cabinet and both houses of parliament. The process can take up to a year.

Mergers, if implemented well, will bring synergy. This would help lower operational and funding costs and strengthen risk management practices for banks. As a result, operational efficiency could go up significantly. This would also bring about governance reforms through the streamlining of appointment process, effective control mechanisms and increased compliance. The merged bank could become a strong competitive bank with economies of scale, network synergies, low-cost deposits and subsidiaries, and the possibility of greater outreach and expansion.

On the other hand, many experts have dismissed PSB mergers and disinvestments as non-solutions which will only serve to further weaken the PSBs. What is required is a major course-correction, they say. We need to wait and watch. Some of the banks should perform better post the merger and some might not be able to synchronise and just wither away. It will take a minimum of three years to know the outcome. The jury is still out on this one.

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