Roadblocks to banking amalgamations in India

By Jay Parikh and Aastha Khurana, Shardul Amarchand Mangaldas & Co
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The cut-throat competition in India’s banking industry, together with the cocktail of systemic difficulties that the industry faces, present stiff challenges to stabilized and sustained growth. The issues being faced by the banking industry include: (i) sus-tained pressure on asset quality due to continued economic slowdown; (ii) capital inadequacy to support business; (iii) human resource imbalances, specifically at a mid-management level; and (iv) absence of a sound risk management framework.

Jay Parikh
Jay Parikh

To address these issues, the Reserve Bank of India (RBI) has, from time to time, prescribed remedial measures with pan-industry application. A recurring recommendation of the RBI and industry experts is the amalgamation of banks with other banks or non-banking financial companies, or vice versa.

Since the onset of economic reforms in early-1990s, a score of banks, including Bank of Punjab, IDBI Bank and United Western Bank, have been involved in amalgamations. In the past 10 years alone, the industry has seen many bank amalgamations, e.g. Centurion Bank of Punjab with HDFC Bank, State Bank of Indore with State Bank of India, Bank of Rajasthan with ICICI Bank, and ING Vysya Bank with Kotak Mahindra Bank.

Historically, bank amalgamations were primarily a way of bailing out financially weaker banks. However, in the past 20 years, there have also been amalgamations between healthy banks driven by commercial considerations.

Potential benefits

At the outset, it is pertinent to note that in theory, amalgamations in the banking industry may be driven by the objective of leveraging the synergies and complementarities resulting from such amalgamation, which include a rise in expected future profits by either reduction of expected costs or increase of expected revenues, or a combination of both. Further, amalgamations could reduce costs through economies of scale and operations, efficient management, reduction and hedging of risks due to geographic or product diversification, staff rationalization, cross-border expansion, greater access to capital markets, higher credit rating because of increased size, etc., and facilitation of entry into new geographical or product markets at a lower cost than that associated with greenfield expansion.

Even from a tax perspective, bank amalgamations are theoretically a more cost-efficient form of consolidation of entities than business transfers by slump sales or itemized sales. Since the major value of banks is derived from the underlying portfolio, an itemized sale (or even a slump sale) is a far more expensive way to transfer assets.

However, amalgamations are not always preferable either because of commercial or regulatory reasons.

Difficulties

A case in point is M&A involving foreign banks in India – given the RBI’s conservative approach to granting branch licences to foreign banks, it is difficult for foreign banks to carry out mergers or acquisitions in India without extra scrutiny by the RBI. This often results in foreign banks resorting to asset sale transactions, which are extremely difficult to implement and prohibitively costly given the sheer number of assets in a bank’s portfolio.

Aastha Khurana
Aastha Khurana

Another pain point for the banking industry is the scrutiny by the Competition Commission of India (CCI) of all bank M&A transactions except those involving “failing” banks. Though the Finance Ministry had proposed keeping banking sector amalgamations out of the CCI’s purview, the proposal, drafted as an amendment to Banking Regulation Act, 1949, did not find favour with the cabinet.

Further, from a funding perspective, private sector banks (except for wholly owned subsidiaries of a foreign bank) are only eligible for foreign direct investment of up to 49% under the automatic route. Beyond 49%, investors require government approval and even then, they can only invest up to 74%, which includes investments under the portfolio investment scheme. Although there was recently some noise around increasing the cap of 74% to 100%, the RBI has summarily rejected the proposal. Foreign direct investment in public sector banks is even more regulated and is capped at 20% and that too after prior government approval.

Clearly, these restrictions on investment in the banking sector, coupled with caps on voting rights, are significant challenges for Indian banks evaluating options for raising capital.

The newly licensed small banks and payments banks also face some restrictions in M&A activity given that the promoter’s minimum contribution of 40% of paid-up equity capital of such a bank is required to be locked in for a period of five years from the date of commencement of business of the bank.

Bearing the above in mind, it would be prudent for the RBI and the central government to consult each other and take steps to streamline the M&A process and ease foreign investment restrictions for banks in India.

Jay Parikh is a partner and Aastha Khurana is an associate at Shardul Amarchand Mangaldas & Co. The views expressed in this article are those of the authors and do not reflect the position of the firm.

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