What plagues the Indian banking system? To understand that, we may have to go back a few decades — to the former Federal Reserve chairman Alan Greenspan taking a leisurely bath in a tub. It is then that he thought of the term “irrational exuberance”, when he was writing a speech. It has since come to describe a dangerous optimism that can wreck the financial system, and a wave of that hit the Indian banking system from 2003.
The economy was doing well and banks were happily giving away loans to money-guzzling projects. There were other factors at play as well — borrower companies’ inflating bills, commercial banks lending for infra projects without having the ability to assess the risk competently and political interference (with ministers nudging bankers to give loans to dodgy businessmen). And then hit the 2008 crisis. Repayment was tough and banks resorted to their old trick — evergreening of loans.
When Raghuram Rajan took over in 2013 as the Reserve Bank of India (RBI) governor, public sector banks (PSBs) were saddled with bad loans. He tightened the screws, and PSBs were forced to recognise non-performing assets (NPAs). By 2016-end, the war against NPAs was still in progress, but Rajan had to leave midway, when the Modi-government didn’t give him a second term.
Then, the central government announced its intent to reduce the number of public sector banks in August 2017. Big, they thought, would be better. But as Abhishek Murarka, analyst and VP, IIFL Institutional Equities, says: “Merging several smaller entities with essentially similar problems into one large entity does not solve the problem.” That September, Rajan raised his concern about the consolidation of PSBs without cleaning up their balance sheets. He pointed out that the banks were already weak, and that a merger would simply put an administrative hurdle in their functioning.
But Rajan’s objections seem to have fallen on deaf ears. This August 30, the government announced that 10 PSBs will be merged to four, even while the original banks are struggling with their NPAs — nine out of the 10 have net NPA of more than 5% as on June 2019.
A fragile coalition
The merger of Punjab National Bank (PNB) with Oriental Bank of Commerce (OBC) and United Bank of India will make it the second-biggest public sector bank in the country, with a business of #17.9 trillion. Canara Bank will be amalgamated with Syndicate Bank, while Indian Bank will be paired with Allahabad Bank. The former will become the fourth largest PSB, and the latter will occupy fifth place. Another merger will be between Corporation Bank and Andhra Bank with Union Bank, creating the seventh largest PSB in India.
These four banks will now have large balance sheets, a vast branch network and a wider customer base. But will these mergers address the burgeoning NPAs, shrinking credit growth, deteriorating profitability and poor cadre management? Market experts are not feeling optimistic.
With the auto sector bleeding and fast-moving consumer goods (FMCG) companies going through a rough patch, the economic growth fell to a six-year low of 5% in June. The slowdown in economic activity reflected in a sluggish loan growth. The credit growth of service sector weakened to 15% (YoY) in Q1FY20, compared with 22% growth in Q1FY19. Credit was doled out to NBFCs and construction sector was moderate in June quarter.
In this climate, the announcement of the merger has left analysts and investors baffled. They believe that this consolidation will act as a distraction and slow down the decision-making process; just as Rajan had warned two years ago. The biggest victim of this could be corporate borrowers. “The government should possibly have timed the merger better. Coming in the midst of a growth slowdown, the mergers are likely to be an additional drag on credit growth,” says Abhinesh Vijayaraj, vice president, equity research, Spark Capital Advisors. He adds that the banks will have to restructure their top and mid-management teams, which means big-ticket corporate lending will take a back seat, deepening the slowdown. Ironically, the government announced the mega-merger on the day a weak set of GDP numbers was released.
The mergers may also divert the management and employees’ attention from the bad-loan resolution or recovery process, believes Cyrus Dadabhoy, VP and analyst, institutional equities, Centrum Broking. Banks’ business can get disrupted if employee unions threaten strike. “They could, if they fear that the consolidation could result in fewer branches and job opportunities,” he says.
So, as Rajan asked in September 2017: “Why is this consolidation going to be helpful and not just another distraction which weakens the entire entity?”
Analysts predict that credit issuances will invariably slow down and lead to shrinking of business. Additionally, administrative headaches related to pruning branch network and employees will need to be dealt with over the next several quarters, when the integration comes into effect.
While the idea behind the mergers may be to rationalise costs, the period of transition may actually get tougher for banks that are already in a deep mess. For instance, one imminent worry is of denting profits due to rise in employee expenses. Citing SBI’s decision to offer voluntary retirement scheme to around 4,000 employees post the merger with associate banks, Dadabhoy of Centrum says that there is a cost associated with the consolidation. It will take around 24 months for synergies to play out, including rationalisation of branch network. “Going by recent experiences, consolidation has generally been bad for the stronger acquiring banks in the near term, and the integration period won’t be easy,” he says.
Meanwhile, the overarching issue of bad loans, weak governance and recovery practices will continue to plague these banks. In fact, the NPA problem can become more chronic as new bad loans are unearthed or recognised by the management of anchor banks. “Often, what one bank classifies as an NPA account need not be recognised as one by another bank. But upon merger, such standard assets will have to be recognised as bad, resulting in a bigger NPA number,” says Vijayaraj of Spark Capital.
He warns that investors may end up with lower book value post merger if they have to recognise some standard assets in individual banks as bad loans under the merged entity. That will require further write-offs and provisionings. “From investors’ standpoint, it’s like shooting in the dark,” adds Vijayaraj.
Analysts state that the merged banks are on weak ground when it comes to NPAs, and CET1 (Common Equity Tier-1) levels are not satisfactory too. CET1 is predominantly made up of common stock, which a lender dips into first in the event of a crisis.
Murarka says that banks are consumed by an aspiration to become large entities, which is not good for their profitability. “This focus on size has been at the root of weak underwriting that pays little attention to recovering loans or making profits,” says Murarka. He asserts that the four mergers won’t improve the competence of the state-owned banks.
The only benefit clearly visible is that the mergers will ring-fence the low-cost deposits or CASA (current and savings account) of these banks. “Small and mid-sized PSBs have lost 510 bps (basis points) of CASA market share over FY16-19, and private banks have gained 370 bps over the same period, while large PSBs (ex-SBI) hardly lost 90 bps of market share,” according to a Prabhudas Lilladher report. “As most anchor banks are large or will be larger post merger, private banks’ market share should be restricted,” predicts the report.
The merger may shore up the liability side of these new entities, but the concerns on asset side remain. Banks still have to deal with the rot of bad loans. Net net, the big-bang consolidation promises to hurt in the medium term, with no guarantee of better governance in the long haul.