Bank mergers in India have often been viewed as shotgun marriages: A strong bank takes over a weaker institution — usually one that is about to go belly-up — at the behest of the country’s central banker, the Reserve Bank of India (RBI). Sometimes the deal doesn’t make sense, but regulators force it through. “The merger of banks in India is typically driven by regulatory factors,” says Robin Roy, associate director, financial services, PricewaterhouseCoopers (PwC). But, in a socialistic environment, depositors — and employee jobs — need to be protected. Populism wins over pragmatism.

It was a surprise, then, when a merger was announced in February between HDFC Bank and Centurion Bank of Punjab (CBoP). “Both banks are healthy,” says Aditya Puri, managing director of HDFC Bank. “It is a merger of strength.” Adds Prakash P. Mallya, chairman and managing director of the public sector Vijaya Bank: “I see the merger of two strong banks as a very healthy trend.”

Consider the two institutions that are coming together. HDFC Bank was incorporated in August 1994; Centurion in June of the same year. Both are new generation private sector banks licensed by the RBI in the post-liberalization phase.

HDFC Bank has an asset size of Rs. 131,439 crore ($33 billion) as of the third quarter of 2007-08, 1,100 branches and 21,477 employees. CBoP’s equivalent figures are Rs. 25,404 crore ($6.3 billion), 390 branches and 7,500 employees. HDFC Bank has better asset quality with net non-performing loans at 0.4% (with 2.5% provisioning) against 1.7% (1.5%) for CBoP. The latter, however, has a higher share of retail (60%) in its total loan portfolio than HDFC Bank (51%). “It is not quite a merger of equals or a large bank completely swallowing a smaller one,” according to a report by Macquarie Research, the Australia-headquartered provider of investment and financial services.

Both banks have been through mergers before. HDFC Bank took over the ailing Times Bank (launched by media powerhouse Bennett, Coleman & Co) in February 2000. CBoP had started life as Centurion Bank. It merged with the north India-based Bank of Punjab in June 2005 and also the Kochi (south India)-based Lord Krishna Bank in August 2007. These mergers were, of course, orchestrated by the RBI.

Macquarie notes that since the cultures of the two banks are already mixed because of past mergers, that should make integration easier. The HDFC Bank management, the report adds, “is among the best in India”. Puri himself sees no integration problems. “It should take us about the same time as we needed to integrate Times Bank,” he says. “Times Bank, as a percentage of our balance sheet, was much larger; we were smaller then. It was 35% to 40% of our size.” CBoP adds about 20% in terms of balance sheet.

Executives of HDFC Bank and CBoP believe the two institutions are a good fit in geographic terms. The Bank of Punjab was strong in the north and Lord Krishna Bank in the south. The Mumbai-based HDFC Bank has concentrated on the north and west. As a result, the combined entity will have a pan-India presence.

The biggest plus of the merger is the number of branches it will add to HDFC Bank. The RBI has been very stingy about letting banks open new branches. Going by the rate at which HDFC Bank has been allowed to expand its network in the past, this merger telescopes two-and-a-half years in one fell swoop.

Valuation is another critical issue. “HDFC Bank is paying around one-third for CBoP branches, relative to the value it is getting for its own branches,” says Punit Srivastava, a banking analyst with Enam Securities. “If HDFC Bank manages to leverage these branches, it should have a long-term positive impact on the business and profitability of the merged entity.”

On the other side of the coin are the standard technology and people issues. CBoP has a workers’ union inherited from Lord Krishna Bank; HDFC Bank has always worked in a union-free environment. “In any merger, integration is primarily at three levels — people, processes and technology,” says Roy of PwC. “In the HDFC-CBoP merger, there are more positives than negatives. Their management styles are similar. They both understand consumer and retail banking. Both have been on a technology platform from day one, so there are no data-related legacy issues. Clear-cut synergies exist, and one expects that change-management issues will be addressed comprehensively. This merger is on the right track.”

“The challenge could be that CBoP is more about low-cost operations and distributes more low-cost products while HDFC’s products are more universal and sophisticated and higher up the value chain,” continues Roy. “How well the CBoP team gels with HDFC products could be an area of challenge.”

Step Back?

While the merger, at least at first glance, seems to be good for the institutions themselves, some observers wonder whether it is good for India’s banking industry. “India is under-banked,” says Rajesh Chakrabarti, assistant professor of finance, at the Indian School of Business (ISB), Hyderabad. “But the banking sector in the country is rather fragmented. Generally speaking, consolidation leading to cost efficiency may not be a bad idea. The cost of doing business in the banking sector is high. The cost of intermediation is 5% in India and, compared to international levels, it is at the high end. So, if one can bring down administrative costs through mergers, that does help.”

“Also, many permits and licenses are linked to the total size of the bank,” continues Chakrabarti. “So, size matters in this business. Mergers would typically [happen] because of benefits arising out of synergies — cost savings, wider reach, etc. The one big challenge in any merger is that of integration. It is not so much a disadvantage as a challenge that needs to be tackled.

“Yes, we could do with more private sector Indian banks. Competition is always good. Today, the new private sector Indian banks are as good, if not better, than the foreign banks in terms of efficiencies and levels of service.”

Roy of PwC agrees that the banking industry needs to expand rather than consolidate. “We need many more banks, especially in the rural and semi-urban areas; more than 50% of the population does not have banking accounts,” he says. “But for banks to sustain their business model they require high capital and good networks. They also need to manage their costs and therefore need to scale up. Mergers bring in economies of scale and therefore are important.” Rana Kapoor, managing director and chief executive officer of Yes Bank, another new generation private sector bank, notes: “They (HDFC Bank and CBoP) will get greater economies of scale and retail lending will get a big boost.”

Mallya of Vijaya Bank, however, doesn’t agree with these views. “India is no longer an under-banked country,” he says. “With technology in place, banking is available virtually everywhere.” But he believes in mergers. “In this sector, size is of paramount importance,” he explains. “It helps in economies of scale and in strengthening the capital base of the banks. Having a large number of banks can in fact be unwieldy.” Adds Puri: “India does not need more banks. In fact, we should see consolidation ahead. Weaker banks will have to merge.”

Overseas Growth

HDFC Bank is going abroad. It has acquired a license for a branch in Bahrain, which will be launched soon. That’s where CBoP may be able to pull its weight. The bank already has a presence in Canada. Chairman of CBoP, Rana Talwar, who is joining the new HDFC Bank board, has considerable international experience. The new entity hopes to leverage this.

Puri is clear that this is not where the quest for size comes in. “Yes, we are going abroad,” he says. “But we have something very specific in mind. We are not about to challenge the Citigroups of the world. We want to provide a global range of products for non-resident Indians (NRIs), and we want to participate in trade (India specific export-import related) finance. We are not talking about becoming a big bank abroad at this point of time.”

If the Tatas can take over Corus Steel and leapfrog to the world’s fifth largest steel producer, why shouldn’t HDFC Bank or ICICI Bank harbor similar ambitions? “There are two reasons,” explains Puri. “First, the scale is different.” Tata Steel may have been smaller than Corus, but it was not a cat looking at a queen. On the other hand, even India’s largest bank — the State Bank of India (SBI) — disappears from the radar screen when compared with the world’s largest banks. It makes it to the Top 100, but just about. The others are far down the pecking order.

Secondly, says Puri, “we have a huge domestic market. Does it make sense to go abroad to markets that are over-banked?”

Expansion hawks in India warn that the country may miss out on growth opportunities if banks prefer growing in the local markets rather than expanding overseas. They argue that China and countries in West Asia have been buying up stakes in Western financial powerhouses. The Abu Dhabi Investment Authority and the Kuwait Investment Authority have picked up stakes in Citigroup, while China’s sovereign wealth fund has bought part of Morgan Stanley.

Puri agrees that India should get into the act. “Yes, China is buying stakes,” he says. “But that is through sovereign funds, not by the Chinese banks. We should also do the same — set up a sovereign fund.” Indian foreign exchange reserves have been billowing and the government has looked at setting up such a fund. But opposition from the Left parties, who support the current government in Parliament, has held up progress on this front.

Some observers claim that unless Indian bankers act soon, financial assets in the U.S. and elsewhere will not be available at bargain-basement prices as they are now. But, in the meantime, the banking industry is not losing any sleep. “The Indian economy is growing at 8% plus,” says Puri. “The banking sector is growing at 22%.” Life for Indian bankers has moved into the fast lane.

It could get even more exciting. “By 2009, the banking sector will open up and more foreign banks will come in,” says Chakrabarti of ISB. He believes they are not really needed. “They will not be filling any void or bringing any value addition.” Echoes Mallya of Vijaya Bank: “We do not need more foreign banks or private sector banks.”

Chakrabarti is also critical of countries that preach competition but are fiercely protective of their own markets. Foreign banks should be allowed in on a reciprocal basis only, he says.

Restricting Foreign Banks

The RBI, which is equally protective of the Indian banking industry, has already sounded a note of warning to the foreign banks who expect easier entry and takeover norms by 2009. Under World Trade Organization commitments, licenses may be denied to new foreign banks if the share of this category in total banking assets in the country exceeds 15%.

At the Bankers’ Conference 2007 in Mumbai in November last year, RBI deputy governor Vittal Leeladhar said that two large Indian banks should actually be considered foreign banks as the foreign shareholding in them was close to 74%. He didn’t mention names, but the only two institutions that match the description are ICICI Bank, the country’s second largest bank, and HDFC Bank. If these banks are clubbed with other foreign banks, they control more than 15% of the system. “These banks, together with foreign banks, have a combined market share in the country in the deposits, advances and off-balance-sheet business of 17.46%, 18.65% and 76.63%, respectively,” Leeladhar said. The implication is that the RBI can continue to block the entry of foreign banks if it wishes. As for private sector banks, the RBI has been reluctant to grant new licenses.

According to banking sector analysts, the new private sector banks will be prime targets when foreign banks are allowed to launch predatory forays. But Kapoor of Yes Bank, which is viewed as one of the most attractive buys, denies that it will be up for sale. “There are several investors who have shown keen interest in picking up a stake. And we need money to grow,” he says. “A strategic investor will look at a stake of 20% to 40% in the bank, but we are looking at [selling] not more than 4.9%.”

An emerging consensus suggests that more bank mergers may be inevitable. Giant SBI has already announced that it is working on a plan to merge some of its seven associate banks — the wholly-owned State Bank of Hyderabad, State Bank of Patiala and State Bank of Saurashtra; and State Bank of Bikaner & Jaipur, State Bank of Mysore, State Bank of Travancore and State Bank of Indore (in which its stake ranges from 75% to 98%). That plan has, however, run into opposition from politicians and unions who fear job losses.

But the HDFC Bank-CBoP merger — the biggest buyout in the nation’s financial industry — shows that you can’t stop the inevitable forever. As India prepares for competitive times, more banks will combine for competitive advantage rather than because regulators order them to merge.