Who pays when you make a mistake? You do. Who pays when the government makes a mistake? Yes, Still you…..Anonymous

In a bizarre move the government, which controls seventy per cent of all bank assets in India through state-controlled banks, decided to merge three banks into a larger entity. Two smaller banks, Vijaya Bank and Dena Bank, were combined with a larger bank, the Bank of Baroda. Each of these banks, like all other state-run banks, are in trouble from bad loans– Dena Bank’s bad loans are 22.5% of its total loans, Bank of Baroda’s at 12.2% and Vijaya Bank at 6.2%. For the merged entity, bad loans will constitute 13% of total loans—much higher than the level of the largest contributor to the merger, Bank of Baroda.

The notion that merging two or more banks will create a larger, more viable and profitable bank and somehow magically increase shareholder value sounds good in committee discussions. But it has not worked in practice. In 1993, a profitable Panjab National Bank (PNB) merged with the smaller New Bank of India. But the clash of cultures and turf protection by entrenched employees created significant personnel issues that destroyed morale, and efficiency, as a result of which PNB posted its first loss of Rs 96 crore in 1996. More recently, in 2017, five associate banks of the State Bank of India, each with substantial bad loans on their books, merged with the parent bank and in the process wiped out all the net profit of SBI for 2016-17 resulting in the first-ever loss for SBI in 19 years. Even the much-touted 2009 merger between Merrill Lynch and Bank of America destroyed almost $50 billion in shareholder wealth in addition to $20 billion of bailout money from US taxpayers.

Mergers are tricky business for the best professionals. Corporate mergers do not have a good track record. Evidence shows that the vast majority of mergers fail. A recent Harvard Business Review study shows that the failure rate of mergers is anywhere from 70% to 90% depending on the industry. So bad is the success rate of mergers that investment bankers often jokingly say that every merger negotiation must start with the warning that “this activity is bad for your corporate health.”

There are several reasons for these failures, with the main problem being the inability to define the strategic rationale for the merger and to pinpoint the attributes that make the merger attractive. I have yet to see a well-articulated reason from the government for this proposed bank merger. It is clear that the decision makers haven’t thought through things carefully. For them, the most significant risk is the perception of inaction. They need to show that they are still relevant, so better to do something even if it is not the right thing. None of these decision-makers, whether bureaucrats or politicians, have any skin in the game. These are public-sector banks and the taxpayers eventually bear all the risk. Bureaucrats, who are conveniently separated from the consequences of their decision, have no compunction about transferring the additional risk from this merger on to the taxpayers.

There are many reasons for companies to merge, but the principal benefit eventually has to be an increase in the value of the combined entity brought about through synergy. Two entities merge because they can either jointly capture a bigger market by offering a broader range of complementary products, or open new business opportunities from the combination of proprietary technologies and processes. It makes sense for a fruit and vegetable seller to merge because people who buy vegetables also end up buying fruit. But a merger of two fruit sellers makes little sense since there no benefits from synergy for the combined entity. Similarly, there are no synergies at play in the merger of three troubled banks into one big troubled bank.

There could be other reasons for this merger: efficiency and scale. Efficiencies and cost reduction will come only if the combined entity can operate more efficiently with fewer people, but the government has already indicated that there will be no retrenchment of staff. Bank of Baroda is the most efficient of these banks with each employee generating Rs 13.3 crores in business. In contrast, each employee creates only Rs 8.5 crores in business at Dena Bank and Rs 11.1 crores at Vijaya Bank. The merger makes the sum worse than the parts. There is also the risk of turf wars between the competing interests which increases the likelihood of the new entity being less efficient.

Another reason to merge is scale and the improvement in capital adequacy that comes with size and diversification of the loan portfolio. Banks must have enough capital to meet regulatory norms. India is a signatory to the Basel-III agreement which makes it mandatory for all banks to meet the minimum capital adequacy ratio (CAR) of 10.5 % by March 2019. The capital adequacy ratio (CAR) is a measure of how much capital a bank must have in relation to its risk-weighted loan exposure. So, if a bank has risky loans of Rs 100 it must have capital of 10.5 (including reserves) to meet the requirements of Basel III. The more bad loans a bank has the riskier its assets, and the smaller its capital adequacy ratio. Of the three merged banks, Dena Bank has the worst CAR at 10.3, Bank of Baroda is at 11.8 and Vijaya Bank at 12.9. The combined CAR for these banks weighted in proportion to their assets would be 11.7. So, merging these banks and creating a bigger bank in the hope of getting a significant improvement in capital adequacy for the overall entity is unlikely.

What does the market think of this merger? In free capital markets, the final adjudicators are the millions of market participants. Of the three merging banks, only one bank, Vijaya Bank, was profitable last year. It had a net profit margin of 5.8%. Dena Bank was hugely unprofitable with a net profit margin of –21.5%, and Bank of Baroda had a net profit margin of – 5.6%. The combined net profit margin of the merged entity is – 6.1%. The merger, therefore, short-changes the stockholders of Vijay Bank and its stock price tumbled 20% after the announcement of the merger. Shareholders of Bank of Baroda also disapproved of the merger and its stock price has dropped 17% since the announcement. The only company whose stock went up was Dena Bank. Its shares are up 14%.

Collectively, the three merging banks have lost almost Rs 7,000 in market value since the announcement on September 17th. Almost all the public sector banks have seen their stock prices drop—the index of public sector banks is down 7.1% since the merger announcement. The message from the market is clear: mergers of public sector banks are non-accretive and a terrible idea. In today’s banking model acquiring additional branches through mergers is less important to serving customers than acquiring innovative fintech firms with new technologies. In a world of rapid change, low-cost and high-technology, the old, staid, non-innovative public sector banks are getting increasingly irrelevant.  In this environment selling off smaller banks to strategic buyers makes more sense than merging them into a bigger entity.

It is a shame to see the government systematically destroying the value of public sector banks. Since May 2014 the collective value of all public sector banks has dropped by almost Rs 1.4 lakh crores. The government’s stubborn refusal to privatise these banks has created systemic risk in the banking sector and resulted in a massive loss for the shareholders of these banks—the citizens of the country. The state-run banks control 70% of all banking assets, yet their total market capitalisation of Rs 4.37 lakh crores is less than a third of the Rs 14.32 lakh crores market cap of private banks. This is astounding evidence of the lack of trust that capital markets have in state-run banks: the value of the group that controls 70% of the industry is one-third of the group that controls 30% of the business. Just a single private bank, HDFC, has a market cap of Rs 5.4 lakh crores which is Rs 1 lakh crore higher than the combined market cap of all public sector banks.

There is an adage in the financial world—listen to the markets, they never lie. The markets are sending a clear signal to the government—stop patchwork policies and do the imperative and do it soon:  Privatise all the state-run banks, because each passing day further erodes the value of these banks. The government desperately needs experts experienced in the world of financial markets that can advise them on how to maximise the shareholder value of public banks. Otherwise, these assets belonging to the citizens of India will keep losing value. As always, it is the citizens that suffer when governments screw up.

This article has been published in India Legal:


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2018-10-01T15:04:06+00:00 October 1st, 2018|

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