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Banking Consolidation The Next Frontier in Indian Banking Industry By Mahesh Bendigeri Emp. ID: 18R06192 Faculty Member, ICFAI National College, Hubli. Email: Ph: 9342585290 Abstract In present context of banking industry, the concept of banking consolidation has become a buzz word. Today Indian banks are not able to compete internationally in terms of funds' mobilization, credit disbursal, investments & rendering of financial services due to their relatively small size. Indian banking industry is highly skewed and almost 80 banks have a less than 2.0% market share in India. Though the top five occupy more than 50% market share in India, they are much smaller by global standards. Many Indian banks are unprepared for Basel II implementation due to capital inadequacy. Findings of Top 1,000 Banks of the World by The Banker (London), July 2007 revealed SBI has 70th Rank and ICICI Bank has 147th Rank in Global Rankings. Even within the Asia region, the Rank of SBI is 11th and that of ICICI Bank 25th. Thus, India's largest banks are relatively smaller compared to other leading banks in Asia. India though the 13th largest economy of the world, does not have a decently sized bank that can compete globally. No doubt the banking industry has undergone sea changes in various areas like information technology and communication system, customer service facility, risk management techniques, cost management. At the same time Indian Corporates are globalizing very progressively and now it is the time for our banks to keep a pace in tune with corporate to service them much better. This is possible for those bigger players (banks) who can afford to invest in requisite technology and play globally to take the advantage of global opportunities. More over the confidence of international investors in Indian banks has increased manifold in recent times and this offers our banking sector a good opportunity to restructure itself. An attempt has been made in this article to bring out the very concept of banking consolidation with real life examples and survey results, focusing on domestic as well on international front in banking industry and the role of policy makers in process of ensuring better coordination in support of consolidation process. Finally the article concludes stating that banks operate in a fast changing environment, where product life cycles are short, time to market is critical and "first mover" advantage could be decisive. Size should not defeat the very purpose of institution. The aim should be to create a nimble giant and not a clumsy dinosaur Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 1

Foreword of Banking Industry The banking sector reforms undertaken in India from 1992 onwards were basically aimed at ensuring the safety and soundness of financial institutions and at the same time at making the banking system strong, efficient, functionally diverse and competitive. In order to check the decrease efficiency, productivity and profitability of the banking sector various measures were included in the reforms. Furthermore, it was recognized that the Indian banking system should be in tune with international standards of capital adequacy, prudential regulations, and accounting and disclosure standards. Financial soundness and consistent supervisory practices, as evident in our level of compliance with the Basel Committee’s Core Principles for Effective Banking Supervision, have made our banking system resilient to global shocks.

Force of Changes: India has not faced any major economic/financial crises, though in 1990-91, there was some pressure on the external sector with the current account deficit and external debt servicing reaching large proportions. However, due to prudent macroeconomic policies, it was possible to return the country to a sustainable growth path. As well as the long history of regulation and supervision, Indian banks have limited exposure to sensitive sectors such as real estate, equity, etc, strict control over off-balance sheet activities, larger holdings of government bonds (which helps limit credit risk), relatively well-diversified credit portfolios, statutory restrictions on connected lending, adequate control over currency and maturity mismatches, etc, which has insulated them from the adverse impact of financial crisis and contagion. Banks have occupied a vital role in the progress of Indian Economy. However, with the structural reforms initiated in the real economy from the early 1990s, it was imperative that a vibrant and competitive financial system should be put in place to sustain the ongoing process of reforms in the real sector. The financial sector reforms have provided the necessary platform for the banking sector to operate on the basis of operational flexibility and functional autonomy, thereby enhancing efficiency, productivity and profitability. The reforms also brought about structural changes in the financial sector and succeeded in easing external constraints on its operation, introducing transparency in reporting procedures, restructuring and recapitalising banks and enhancing the competitive element in the market through the entry of new banks. The ongoing revolution in information and communication technology has, however, largely bypassed the Indian banking system given the low initial level of automation. The competitive environment created by financial sector reforms has nonetheless compelled the banks to gradually adopt modern technology, albeit to a limited extent, to maintain their market share. Banks continue to be the major financial intermediaries with a share of 64% of total financial assets. However, Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 2

non-bank financial companies and development finance institutions are also emerging as alternative sources of funding. Out of the total assets of the Indian Banking system, the contribution of foreign banks accounts for only 8%. Moreover there are restriction for keeping deposits abroad for domestic households. Similarly, conditions for accessing overseas capital markets by domestic corporates have been stringent, in terms of size, maturity, pricing, etc. The impact of the entry of foreign banks on domestic banks is likely to depend on various factors such as the structure, strength and competitiveness of domestic banks, the share of foreign banks, and the regulatory/supervisory framework. While the entry of foreign banks could definitely improve the competitive environment, they are not likely to weaken domestic banks. With better technology and expertise in offering specialised banking products such as derivatives, advisory services, trade finance, etc, the entry of foreign banks can enhance healthy competition and has a positive spillover effect on the domestic banks. The domestic banks would be under peer pressure to improve operational efficiency. It needs, however, to be recognised that the banking system in India is quite competitive with the presence of public, private and foreign banks.

Thus, the major forces for change in the Indian context have been the following:  Consistent and strong regulatory and supervisory framework;  Structural reforms in the real and financial sectors;  Commitment to adopt and refine regulatory and supervisory standards on a par with

international best practices; and  Competition from foreign banks and new-generation private sector banks.2.

Need for Consolidation of Banks: The need for consolidation of banks arises on account of following reasons:  To take advantages of economics of scale and scope by increasing the volume of

business by lowering the margins.

Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 3

 Consolidation helps in product and geographic diversification in terms of assets and

liabilities sides and helps in operational efficiency and risk absorption capacity of banks.  To minimize threats of withdrawal of funds from intermediary financial institutions .  Finally it is said that bigger the size, lower is the probability of failure. So

consolidation facilitates bigger size.

Snap shot of How Banking has changed 1998 – 2009.  In 1998 loan application would take at least a week to be cleared, But now 48 hours

has become the unwritten norms, while some banks even do it in 24 hours.  In 1998 Debit and Credit cards were something to show off, usually meant that the

customer were a high – value client of a foreign bank, but now plastic has replaced currency notes in most wallets. And travelers cheque is used very rarely now.  In 1998 Banks stayed open from 10 am to 2pm for all transactions on weekdays, and

up to 12 noon on Saturdays. Now some branches stay open from 8 am to 8pm, there are weekend branches and ATMs in every nook and cranny.  In 1998 customers went to bank, it never came to their doorstep, now banks routinely

send people over to clients homes to deliver drafts and talk loans.

Globalization and its impact on Banking Consolidation: Globalization has brought about much of the transformation in the domestic banking industry operation. Increasing globalization has brought increasing sources of revenue for banks – as also greater competition and greater risk. The capital base and capital adequacy ratio of banks reflects the significance of bank in bearing the risk. In spite of this of the top 1000 banks in the world only 20 are Indian Banks this shows that the size of Indian Banks is still very small to compete in the list of top banks in the world. There is clearly a strong case for consolidation in the Indian banking sector – prompted by the need for size, and forced by shrinking margins. Size certainly matters, for the following reasons:  To gain larger business volumes, and therefore an increased market share, which can

make the most of economies of scale? Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 4

   

To secure easy entry to the capital markets. To enhance the presence from regional level to national level. To ensure cost is under control by increasing capacity utilization. To gain better positions for Indian Banks by figuring out in the top 50 or 100 banks in the global list, thus increasing the status of Indian banking sector.

The existence of large number of small and medium sized banks in India and also the need for size of banking operation highlights that consolidation has to take place to change the large number of small banks into few large banks. Driving such consolidation would in turn add benefit on account of following reasons.  Smaller and Medium size private sector banks in order to comply with the RBI

guidelines on ensuring minimum net worth levels and diversified ownership finds mergers as the last option to fulfill the RBI requirement.  As majority of banks offer similar kinds of financial products on account of increase in commoditization, this result in duplication of cost, by consolidation of banks it is possible to eliminate these costs.  By sharing of physical infrastructure such as office, ATM etc cost savings can be achieved.

Fundamental of Consolidation Bank consolidation is a means of making Indian banking globally competitive. In this regard in India there are seven public sectors banks which have been identified by the Government which are in the race of consolidation process to name them - Central Bank of India, Bank of Baroda, State Bank of India, Punjab National Bank, Bank of India, Union Bank of India, and Canara Bank. The rationale behind identifying these banks in the consolidation process is mainly on account of the owning assets exceeding Rs. 50000 crore and possessing bigger size of balance sheet. Government also feels that these bank may take over another bank, either private or Government-owned thus proving themselves to be the fore frontier in process of consolidation this is mainly on accounts of the assets and size of balance that these bank possess which gives them edge in takeover of small banks. With a population of 102 crore if is not possible to have only one large bank i.e State Bank of India. There is expectation of four or five other public sector banks to grow in size and reach the level of SBI to become globally competitive.

Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 5

The fundamental reason behind such thinking is based on the belief that globally the banking industry has become very competitive and challenging. To face such competition it is believed that only those banks which are large and well capitalized will be ready to face the challenge. One can find from the list of world’s top most banks, that majority of the banks in the list are invariably several times bigger than the public sector bank in India other then SBI in terms of both assets and profitability. It is only the SBI which has a potential of making the position in the list of world’s top 100 banks. As competitive environment is building up and technological advancement is gearing up, banking and its associated field of financial services started becoming more complex, even with respect to the financial transaction that take place and its associated risk exposure doesn’t restrict to national boundaries, but spread globally, this lead to substantial exposure of risk. Banks with sound financial backup will be ready to take up such higher risk; this is done by setting aside a proportion of their capital to face contingencies. Even the Regulatory Authority RBI has directed the Indian Banks to equip themselves with Basel Two guidelines in two years time. Even though Government has not publicly stated, yet it is felt that to increase the capital base, few of the larger public sector banks may opt for issuing additional shares into the market and raise money to meet the requirement. However, the limitation is that the share of Government would decline with every issue. Moreover it should be kept in mind that the Government stake should not shall fall below 50%, hence public issue route may not be feasible for all banks except few banks. However still a question arises to what extent investors will be ready to accepts these shares issued by banks.

International Scene in Banking Consolidation Global trends indicate that US, Europe and Japan are already in the race of Banking Consolidation process, this is evident from the fact that more than 25 to 30% banks in USA are closed/merged in the last 2 to 3 decades and the basic reasons for banks to merger in USA are failure of business, removal of inter-state barriers, etc. With respect to Europe dismantling inter-country barriers through European Union led to bank mergers within Europe. Finally it is the structural reforms that have given rise to mega-mergers among Japanese corporate and banks. All these development states that the trends of mega-mergers very much dominate the global scene. The official statistics shows that acquisitions of banking firms accounted for 70% of the value of all financial mergers in the 1990s. The world's biggest Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 6

ever banking deal happened in October 2007 when the consortium of RBS, Santander and Fortis took over ABN Amro Bank for $101 billion. Asia is rapidly emerging as "the home of growth" and hence a great deal of "M& A" is taking place in Asia.

Domestic Mergers of Banks According to the Banking Regulation Act, Banks are not allowed to merger without the approval of the Reserve Bank of India. The government and the Reserve Bank do not play a proactive role in either encouraging or discouraging mergers. It is our Endeavour that the government and the RBI should only provide the enabling environment through an appropriate fiscal, regulatory and supervisory framework for the consolidation and convergence of financial institutions, at the same time ensuring that a few large institutions do not create an oligopolistic structure in the market. 5. 6. For example the most recent, HDFC Bank's (HDBK.BO) $2.4 billion purchase of Centurion Bank of Punjab CENB.BO in February 2008, was the biggest banking sector takeover. Merger of State Bank of India (SBI) and State Bank of Saurashtra (SBS) has benefitted all stakeholders — shareholders, employees and customers and has brought lot business synergy and helped in enhancing the capital and balance sheet of SBI. Pros and Cons of Consolidation: While there is no regulatory deterrence to bank mergers, their incidence has not been significant and hence no problems have occurred in India. Mergers of banks help to reduce the gestation period for launching/promoting new places of business, strengthen product portfolios, minimize duplication, gain competitive advantage, etc. They are also recognized as a good strategy for enhancing efficiency. Ideally, mergers ought to be aimed at exploiting synergies, reducing overlap in operations, “right-sizing” and redeploying surplus staff either by retraining, alternate employment or voluntary retirement, etc. As banks are leveraged and the credibility of the top management has tremendous supervisory implications, preference is given for consensual mergers to hostile takeovers. The takeover codes should, therefore, reflect the supervisory concerns.

Impact of Consolidation: Since the consolidation process has not gone very far in India, its impact has not been significant. Mergers of certain foreign banks at the global level have also not affected the Indian market, as their market share is currently very low. However, the deregulation process Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 7

has brought in more competition in the banking sector, resulting in delivery of innovative financial products at competitive rates. The consolidation of banks may not significantly affect the functioning of various segments of the financial markets. Further consolidation would results in more competition, better pricing mechanism, smoother liquidity and limit the spreads in foreign exchange transaction this account for presence of large banks. Survey Result on Banking Industry for consolidation: Survey conducted by the Federation of Indian Chambers of Commerce and Industry among banks has come up with interesting finding on banking industry for consolidation.  95 per cent of the respondents said that the Indian financial sector is ready for consolidation and feel that mergers should be purely on voluntary basis rather then forced. Further with increase in competition and implementation of Basel II norms in coming years it is expected that six to seven banks would be competing in par with State Bank of India.  About 92% of the respondent from public sector banks opinioned that they do not adequate power to provide attractive incentives to employees to ensure higher commitment level.  83 % of respondents said that the instruments in the market are sufficient to meet increased capital requirements of banks under Basel II norms. Further few banks expressed that banks need to be allowed to issue preference shares in one year time to meet capital requirements.  75% of the foreign banks that took part in the survey viewed that they were happy with their working experience and India begin the potential market, these banks have started designing strategies for expansion in future.  The survey reveals that the major strength of Indian Banking Industry lies in risk assessment systems, quality of credit, regulatory systems, and technological advancement.  From the survey it is found that some of the area in Banking Industry needs to be improved such as infrastructure, human resource management, size of banks, diversification of markets, high transaction costs and labor inflexibilities.  To achieve performance in banking system, few strategies have been identified from the survey like encouraging for higher FDI limits, Consolidation, strict corporate governance norms, regional expansion within the country and outside, Free Trade Agreements with countries where India has comparative advantage in banking sector.  Finally customized quality products are available and are confined only to big cities. Hence it is necessary now to expand the scope of banking operation and services within India as well as outside. Competition and Consolidation With the intensification of competition through deregulation, privatization and entry of foreign banks in the emerging markets, consolidation has become more market-driven. Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 8

The Reserve Bank has been encouraging the consolidation process, wherever possible, given the inability of small banks to compete with large banks which enjoy enormous economies of scale and scope. The consolidation drive witnessed by the Indian banking industry during the past few years has gathered further momentum with the first acquisition of a subsidiary bank by a public sector bank to reap the benefits of synergy. The business, geographical, technological and personnel synergies offered by the consolidation process could act as a strong motivating factor for the banking sector in the coming future. Despite the mergers and amalgamations that have taken place in the recent past, the competition in the banking sector has increased as mergers involved smaller banks. The Government may have to allow public sector banks to raise capital from the market. Also, the roadmap for foreign banks is due for review in 2009. To maintain competitive pressures in the banking system, any development that take places in the market system need to be supervised and directed in the benefit of overall banking efficiency. Conclusion The financial sector reforms have brought about significant improvements in the financial strength and the competitiveness of the Indian banking system. To make the banking system more vibrant to global shocks measures like risk management practices, prudential norms, accounting and disclosure norms need to keep on updating. The consolidation and convergence of banks in India has, however, not kept pace with global phenomena. The efforts on the part of the Reserve Bank of India to adopt and refine regulatory and supervisory standards on a par with international best practices, competition from new players, gradual disinvestment of government equity in state banks coupled with functional autonomy, adoption of modern technology, etc are expected to serve as the major forces for change. In the emerging scenario, the supervisors and the banks need to put in place sound risk management practices to ensure systemic stability.

Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 9


Article on Competition, consolidation and systemic stability in the Indian banking industry by S P Talwar 2. Consolidation Boosting the banking sector - The Financial Express.htm 3. Paper presentation on Consolidation of Banks – some thoughts by Dr Rupa Rege Nitsure, Chief Chief Economist, Bank of Baroda at “Financial Sector Seminar Series” ICRIER April 8 2008 Source available at 4. The Hindu, Saturday, Sep 17, 2005 inducing consolidation by banks. By CRL narayan 5. Competition, consolidation and systemic stability in the Indian banking industry by S P Talwar 6. Reuters, April 17, 2008 India central bank sees supportive role in consolidation 7. Survey Report on Banking Industry for consolidation. Business Line, 25th Sep, 2006 8. Article on perpectives chapter VIII Dec 17, 2008 Reserve Bank of India 9. Outlook money, 30th June 2008 special issue, pg. no. 26. 1.

Published an Article on “Banking Consolidation – The next frontier in Indian Banking Industry” in Professional Banker – Journal, Vol-IX, Issue-7, ISSN no. 0972-5156, July 2009. Of The ICFAI University Press. Page 10

Final banking consolidation article