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Event update: Financials; State banks mergers – Negative in the consolidation phase

The Finance Minister has announced four bank mergers involving ten state-owned banks. The rationale behind the mergers is to create banks of scale. According the FM, large (merged) banks with scale 1) have better ability to absorb shocks, 2) can support higher credit growth at lower cost of lending and 3) raise resources from the market rather than relying on the government for capital infusion. There is also a general perception that smaller state banks have much weaker risk assessment systems and are more susceptible to corruption and frauds which is why they need to merge with large banks. The mergers have been based not on geographic considerations but on the consideration that banks with similar technology platforms need to be merged to ensure smooth technological integration post-merger. The mergers will be accompanied by governance and other reforms to strengthen the structure of state banks. These reforms include making managements accountable to boards, changing board structure, strengthening the succession process and giving longer tenures to the top brass.  To strengthen the merged entities, recapitalization funds have been allocated to them. Of the proposed recap of Rs700bn, Rs550bn has been allocated to specific banks. Of the total of Rs550bn, Rs99.5bn is for standalone state banks, Rs383bn is for the newly announced mergers and Rs70bn is for BoB.

Merger details: The government has proposed four big mergers: 1) The merger of PNB, OBC and United Bank 2) The merger of Canara and Syndicate Bank 3) The merger of Union, Andhra and Corporation Bank and 4) The merger of Indian and Allahabad Bank. In September 2018, the government had announced the merger of BoB, Vijaya and Dena which has now been implemented and in 2017, SBI’s subsidiary banks were merged into SBI. From a total of 27 banks in 2017, the number reduced to 20 in 2017 post SBI merger and to 18 in 2018 post BoB+Dena+Vijaya merger. That number would now reduce to 12 post the newly announced mergers. The state banks involved in the recently announced mergers account for 25% of the lending market share of Indian banks.

Our view – Mergers will be negative for earnings and dilutive: Going by the examples of BoB and SBI, we believe merger synergies take a long time to realize. Executing mergers is a tough task due to branch overlaps, migrating clients to a single data base, non-alignment of provisioning policies and difference in cultures. Taking BoB’s example, a year after the merger (merger was announced in September 2018), 1) the improvement in RoA is small (from 0.3% to 0.5%), 2) the capital base has eroded with CET-1 dropping to 8.5% from 9.3%, 3) domestic loan growth has fallen from 20% to 5%, 4) the net NPA / net worth ratio has not reduced dramatically, falling from 50% to 40% 5) while the BVPS has fallen from INR 167 to INR 159 due to higher provisioning at Dena and Vijaya. So the merger has not yet added value. We believe the new mergers will also be negative in the short to medium term due to higher loan provisions and slower loan growth during the consolidation phase. Also, the key consideration in the mergers has been compatibility of technology which is not amongst the most important / synergistic criteria for a merger. More importantly, given the huge correction in stock prices of state banks, the capital infusion by the government would be highly dilutive (for example for Union the dilution in BVPS post capital infusion is 40% while post-merger and post capital it is even higher at 47%). The new mergers will be negative for all banks involved but more so for Indian Bank as the asset quality of Allahabad is weaker than Indian and Union where dilution is high. The government wants state banks of scale so that they can access capital from the markets rather than rely on government infusion. If the government reduces capital allocation to state banks from FY21 that would be an added negative. We reiterate our negative view on state banks and continue to prefer private over state banks despite the valuation gap. Within state owned banks we prefer SBI to the others. BoB will continue to suffer from the overhang of a likely CEO change.