The merger mantra

The call for the merger of publicly owned banks is based on flawed arguments. The idea, it appears, is to prepare the ground for their eventual privatisation.

THE lexicon of the businessman stretches far enough to suit his immediate needs. When workers are to be fired (or `offered' voluntary retirement), it is justified on the grounds that businesses need to be lean and mean. But if the business is banking, and particularly if the reference is to publicly owned banks, things are apparently different. Public sector banks (PSBs) are being goaded to merge and become bigger, because `bigger' is supposed to be better in a globalised world.

On August 28, at the annual general meeting of the Indian Banks' Association (IBA), Union Finance Minister P. Chidambaram announced that PSBs would be encouraged to merge. On September 9, speaking after a meeting with chief executives of PSBs, he said the government would review legislation that would enable consolidation among PSBs. Specifically, he promised that the next Union Budget, due in February 2005, would provide tax incentives for profitable PSBs that merge. Chidambaram said that it was important that PSBs grow "in scale and muscle" so that they can compete effectively with "world class banks". He also said that the government, rather than the Reserve Bank of India (RBI), would address the controversial issue of foreign investment in banking.

The PSBs' chiefs, who are rarely known to unveil substantial business plans without a nod from the political bosses, were quick to take the cue from Chidambaram. Some even leaked thinly-veiled statements in the media, revealing details of their own plans to consolidate operations by either acquiring or merging with other PSBs. Media reports suggested that the Mangalore-based Corporation Bank was scouting for a partner, after getting a clearance from the Life Insurance Corporation, which has a substantial stake in it. However, the most significant speculation related to the reported moves by Union Bank of India and Bank of India to merge. The move, if implemented, would result in the combine becoming the second largest bank in India after the State Bank of India (SBI), with an asset base of more than Rs.1.43 lakh crores - Rs.84,860 crores belonging to the Bank of India, and Rs.58,317 crores belonging to Union Bank. Incidentally, V. Leeladhar, former chairman of Union Bank of India, who had said that the bank was looking out for a partner, has since joined RBI as Deputy Governor.

IBA, representing the interests of bank managements, was quick to react. Leeladhar, who headed the IBA at the time of Chidambaram's announcement, said that the IBA had established a committee on consolidation of banks, which was giving "final touches" to its report. The committee is examining the legal, regulatory and procedural issues relating to the merger of PSBs. Although Chidambaram has said that banks would not be pushed into deciding with whom to merge and on what terms, there is widespread scepticism about their acting autonomously. This is because most mergers since 1969, when banks were nationalised, have been bailouts of private banks by publicly owned banks (see table).

Those in favour of merger of PSBs rest their case overwhelmingly on a single argument - that mergers will enable PSBs to scale up their operations. The resulting economies of scale, they argue, will enable the merged entity to be comparable to some of the bigger international banks. This, they say, will be a significant advantage in a liberalised financial environment, in which financial institutions are increasingly exposed to cross-border flows of capital. In the Bank of India-Union Bank of India case, they see the emergence of a big player with a strong presence in the western region, which has a lucrative loan market. Moreover, the sheer size of the merged entity would enable it to participate in a range of financial activities, thereby generating profits from a range of operations - from the call money market to the stock market.

The announcement has come at a time when most PSBs are under pressure. During the past year the yield on government securities - an indictor of interest rates - has increased. Most banks, flush with deposits, have in the last several years parked these funds in government securities, which are safe simply because credit offtake had not increased significantly despite the hype of a `shining' India. The slack in the economy, particularly the sluggish demand reflected in sluggish industrial growth, meant that "lazy banking", by way of investment in government securities, rather than traditional, old-fashioned lending, accounted for much of the banks' profits. In fact, the profits made in treasury operations provided a cushion to most PSBs, enabling them to keep their Non-Performing Assets (NPA) levels from getting out of control.

For example, during 2002-03, SBI's NPAs increased by Rs.4,688.57 crores; in 2003-04, the incremental accretion to NPAs amounted to Rs.5,721.34 crores. Despite this, SBI's net NPA fell from 4.50 per cent to 3.48 per cent. This was made possible because the bank managed to increase "provisioning" for its NPAs by allocating funds from its balance sheet. Provisioning for NPAs consequently increased from Rs.2,959 crores to Rs.3,825 crores. The increase in profits from treasury operations - Rs.3,073 crores in 2003-04, from Rs.1,696 crores in 2002-03 - provided a cushion, which the bank could fall back on to handle its increased exposure to bad loans.

"There are too many banks in India," said Leeladhar in Ahmedabad on September 7. He said that even SBI, the biggest public sector bank, is too small compared to banks in other countries. Leeladhar argued: "Consolidation needs to take place not just between bigger and smaller banks but between big public sector banks as well."

However, the bank unions believe that PSBs can grow without having to merge or amalgamate. Mergers and amalgamations are not the only route to growth, said S. Bardhan, General Secretary, Bank Employees' Federation of India. He also warned that the unions in banks would resist the attempt to merge banks. Although the banks have spread their network across the country since nationalisation, each of them still retains a strong regional presence. Indian Bank, for instance, is a major player in the south, whereas, Bank of India has a stronger presence in western India. Bank employees argue that mergers will destroy the regional flavours that the banks enjoy, adversely affecting the institutions involved in the merger. A senior bank officer told Frontline that the argument that bigger size automatically results in lower costs for banks is "bogus". He said that there were many ways of reducing costs without pushing PSBs through the grind of a merger exercise. He also argued that the merger might actually result in the combined entity acquiring technological redundancies, which may push up costs.

T.T. Ram Mohan, Associate Professor at the Indian Institute of Management, Ahmedabad, wonders why the Finance Ministry "should be hard-selling this idea at this point". He termed as unfortunate any attempt to merge strong banks with weak ones. "Mergers," he argues, "must be dictated by the market and decided by bank boards." To do this, he suggests that the unlisted banks must be brought to the market first. "Once they are listed, we have the benefit of the market monitoring the value of the merger from the word go," said Ram Mohan.

BUSINESS organisations feel the need to merge when they exhaust possibilities of organic growth, or when the possibilities are slow in coming. The Indian banking sector can hardly be said to be in this situation. Indeed, if policymakers or bankers were to claim that, there would be no need for a public presence in banking. In fact, Ram Mohan has pointed out that even if performance is measured in purely commercial terms, the PSBs have been doing rather well. He has observed recently that profitability, measured by the ratio of net profits to net assets, increased from 0.42 in 1998-99 to 0.96 in 2002-03. That kind of organic growth, observes Ram Mohan, can only be interpreted as good going for the PSBs. "A merger makes sense when organic growth is difficult. If you can grow on your own, why undergo the hassles of a merger? The difficulties - in terms of people, culture and systems - should not be underestimated."

The argument that Indian banks need to grow in order to compete with the "big boys" on the global stage is misplaced because however big they grow as a result of mergers, they are never going to be able to compete with them on their terrain. And, the question of how well they are able to cope with foreign banks on India soil is an issue relating to regulatory approaches and policy structures that protect Indian banking. This regulation and protection is necessary not because of some vague xenophobic fears but simply because banking is far too important a tool for social and economic development. Ram Mohan believes that the PSBs have little to fear from the foreign banks; instead, foreign banks, he argues, are competing with the private Indian banks.

Why is it that the SBI Group has not ever thought of merging some or all of its entities with the parent bank? Banking industry sources say that SBI never thought of this because each of the associate banks has its own regional flavour, a clientele with which it is more comfortable after having nurtured it over many years, and therefore enjoys a niche presence. If the regional bank, for instance State Bank of Travancore, is merged into a single giant entity, it will not only affect the regional subsidiary but also the parent bank. "The potential for losing out on local flavour is something that cannot be ignored in discussions on mergers," says Ram Mohan.

Referring to the argument that mergers will unleash economies of scale in banking, Ram Mohan points out that the economies of scale also have limits. "There are economies up to a point and diseconomies beyond a point," he observes. This point, he notes, is "not some universally common point" but depends a lot on the product-mix, the technology used and other variables. He points out that the argument in favour of greater scales has a somewhat "hollow" ring to it because it has been exaggerated.

However, the most serious problem with mergers in Indian banking could be because of the higher levels of concentration. Fewer banks, less competition, and greater pressure to generate quicker profits could well result in an escalation in the cost of credit. This, says Ram Mohan, could "impact adversely on retail as well as wholesale customers." The tendency to skim the cream by focusing on larger urban corporate borrowers, and avoiding the spread of their credit portfolio among more number of borrowers could well result in adverse consequences for small borrowers. Service quality could suffer, and fees could rise, as a result. The problem of low credit availability for small and medium enterprises could worsen, fears Ram Mohan.

The rush to merge, it appears, has come at a time when the outright privatisation (or of sale to foreign entities) of PSBs has gone off the radar screens of the Finance Ministry. The shackles to aggressive economic liberalisation of the kind pursued by the National Democratic Alliance regime appear to lie in the nature of the coalition that has succeeded it. Recognising these limits, it appears that the mandarins holding the purse strings of the nation are pushing a more gradual approach by calling for the merger of the publicly owned banks, instead of selling them right away. Maybe the strategy is to fatten them for the kill.