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Consolidation (Integration) among Public Sector Banks by R.Gandhi, Dy. Governor of RBI

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Consolidation (Integration) among Public Sector Banks by R.Gandhi, Dy. Governor of RBI

Today Our R. Gandhi Sir, (Deputy Governor of RBI) released a PDF file regarding Consolidation among Public Sector Banks. The letter is as follows below,



"1. At present banking system in India is evolving with a mixture of

bank types serving different segments of the economy. In the last

few years, the system has seen entry of new banks and

emergence of new bank types targeted to serve niche segments of

the society. However, banking system continues to be dominated

by Public Sector Banks (PSBs) which still have more than 70 per

cent market share of the banking system assets. At present there

are 27 PSBs with varying sizes. State Bank of India, the largest

bank, has balance sheet size which is roughly 17 times the size of

smallest public sector bank. Most PSBs follow roughly similar

business models and many of them are also competing with each

other in most market segments they are active in. Further, PSBs

have broadly similar organisational structure and human resource

policies. It has been argued that India has too many PSBs with

similar characteristics and a consolidation among PSBs can result

in reaping rich benefits of economies of scale and scope.

2. The suggestion of consolidation among PSBs has quite old

history. Narasimham Committee Report in 1991 (NC-I),

recommended a three tier banking structure in India through

establishment of three large banks with international presence,

eight to ten national banks and a large number of regional and

local banks. Narasimham Committee Report in 1998 (NC-II) also

reiterated the recommendations on NC-I. Recently, in the budget

speech for 2016-17, Finance Minister mentioned that a roadmap

for consolidation of PSBs would be spelt out. The desirability of

1 Speech delivered by Shri R. Gandhi, Deputy Governor at the MINT South Banking Enclave, Bangalore on April 22, 2016.

Assistance provided by Shri Santosh Pandey is gratefully acknowledged.

consolidation in Indian banking sector is widely felt across the

spectrum.

Current Imperatives

3. There are at present times several congruent factors that

indicate that consolidation in Indian banking scene has its right

time. They are as follows:

4. The need for consolidation is specially felt now, due to the

fact that although India is seventh largest economy in the world in

terms of nominal GDP, there is no Indian bank in the list of 70

large banks in terms of asset size. We can easily see that large

banks reap certain advantages in terms of efficiency, risk

diversification and capacity to finance large projects. The efficiency

gains resulting from lower cost of services and higher quality of

services is too attractive to ignore.

5. It is also felt that a larger bank may be less risky than a

smaller bank as the larger bank will have a more diversified

portfolio resulting in less volatility in its earnings. Consequently, a

large bank may command higher credit rating than a smaller bank.

In a March 2016 report, Fitch rating agency mentioned following:

“More stable banking systems tend to be structured around a

number of large 'pillar' banking groups. These large banks in a

consolidated banking system enjoy scale benefits leading to better

diversification of risks and stronger overall profitability contributing

to higher credit ratings.”

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6. Large banks do benefit from economies of scale in terms of

risk diversification, although this benefit disappears when banks

become excessively large beyond a certain threshold size. This

threshold size has been subject of much debate in the discipline of

finance. However, there is no clear research which may point

towards an optimum size for a bank in a particular country.

Perhaps in future, research will throw light on the optimum size of

banks. However, in the context of India, it is felt that there is ample

room for consolidation in the banking sector, especially among

PSBs without creating issues of moral hazard or too big to fail

concerns. It does appear that the banking system in India is too

fragmented at present. There is evidence, as measured by

Herfindahl-Hirschmann Index (HHI) for Indian banking sector using

square of on-balance sheet market share of all banks in the

system which works out to be 518.53. This indicates that our

banking system is highly fragmented and diffused. In fact there is

evidence which shows that this index has been falling over the

years in India.

7. There are 48 domestic banks (excluding RRBs and LABs)

out of which there are 27 PSBs having a market share of around

70% in terms of asset size. A comparison of performance of larger

PSBs with smaller PSBs does indicate that larger PSBs perform

better. For example, among all PSBs, larger PSBs like SBI and

Bank of Baroda are trading at higher Price to Book Value ratio in

comparison to other smaller PSBs. SBI has been able to maintain

relatively strong capital ratios and appears to be in a better

position to withstand shocks to asset-quality. This indicates that

under Indian conditions, there is lot of scope for banks to grow in

size to become efficient and diversify their risks.

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8. The other important aspect which needs to be considered is

credit demand of a growing economy. As Indian companies

increase their business and become global in nature, their demand

for large scale credit will become higher. Banks also have to grow

in size to meet the higher demand of credit. The banking system

will be required to enhance its capacity to lend to larger companies

and to larger projects. With increase in credit penetration and as

credit to GDP ratio increases from present levels of 50 percent,

PSBs with a market share of over 70 per cent need to contribute

significantly in the process. Without strong PSBs which are

efficient, competitive and well-capitalised, meeting higher demands

of bank credit would be quite challenging in future.

9. Recent proposals on Large Exposure norms which limit

banks’ exposure to a group by 25% of their common equity will

further limit their capacity to fund large credit demands. It is

therefore imperative that some consolidation among PSBs do

happen to support the growth potential of the economy.

10. After the crisis, internationally there has been a significant

tightening of regulatory norms. As mentioned earlier, G-SIBs are

required to maintain higher amount of common equity capital than

other banks. Further, Financial Stability Board has agreed on Total

Loss-Absorbing Capacity (TLAC) standard for G-SIBs. G-SIBs will

be required to meet the TLAC requirement alongside the minimum

regulatory requirements set out in the Basel III framework.

Specifically, they will be required to meet a Minimum TLAC of at

least 16% of the resolution group’s risk-weighted assets (TLAC

RWA Minimum) from 1 January 2019 and at least 18% from 1

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January 2022. These regulatory requirements have compelled

many of these internationally active banks to reframe their

business strategies into downsizing, quitting some businesses and

some jurisdictions. This provides an opportunity for EME banks

who have global ambitions, a ready business and market space. If

we have good large banks, such banks can tap these opportunities

and can become global banks.

11. Thus we can see that right now the time is ripe for

consolidation in the public sector bank space.

Consolidation in Indian banking system in the past

12. There have been two types of bank consolidation in India.

One and most obvious has been voluntary merger of banks driven

by the need for synergy, growth and operational efficiency in

operations. Recent merger of ING Vysya Bank with Kotak

Mahindra Bank is an example of this kind of consolidation. ING

Vysya Bank had a stronger presence in South India while Kotak

had an extended franchise in the West and North India. The

merger created a large financial institution with a pan-India

presence. This kind of voluntary merger driven by synergy and

clear economic logic has been rather common in the private banks

segment. Other examples of this kind of merger may be acquisition

of Bank of Madura in 2001 and Sangli Bank in 2007 by ICICI Bank,

acquisition of Centurion Bank of Punjab by HDFC Bank in 2008,

etc. The Reserve Bank has been given powers under Section 44A

of Banking Regulation Act 1949 to approve such voluntary

mergers. The Reserve Bank has been quite supportive of

voluntary mergers of banks which have the prospect of creating

value for those banks. However, such examples are not many in

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public sector banks sphere. Recent merger of State Bank of

Saurashtra and State Bank of Indore into State Bank of India may

be seen as basically merger among group companies. The only

example of merger of two PSBs is merger of New Bank of India

with Punjab National Bank in 1993. However, this was not a

voluntary merger.

13. The other type of merger of banks has been from the

perspective of resolution of a weak bank. Section 45 of Banking

Regulation Act 1949 empowers the Reserve Bank to make a

scheme of amalgamation of a bank with another bank if it is in the

depositors’ interest or in the interest of overall banking system.

The operation of the weak bank may be kept under moratorium for

a certain period of time to ensure smooth implementation of the

scheme. Many private sector banks have been merged with other

private sector banks or the PSBs under this mechanism. The

merger of Global Trust Bank with Oriental Bank of Commerce in

2004 was an example of this kind of merger. Earlier way back in

1960s, post Palai Central Bank’s failure, there were several such

mergers guided by the Reserve Bank.

14. Since the onset of reforms, there have been about 32

mergers / amalgamations in the banking sector. Prior to 1999,

most of the mergers were driven by resolution of weak banks

under Section 45 of Banking Regulation Act 1949. However, after

1999, there has been increasing trend of voluntary mergers under

Section 44A of Banking Regulation Act 1949. As noted above,

most of these Section 44A mergers were among private sector

banks. PSBs have bypassed this trend despite the fact that there

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might have been ample opportunities of creating value through

strategic mergers and acquisitions among two PSBs.

Some caveats

15. Having said that Consolidation in PSBs is worth considering,

I would hasten to add certain caveats.

16. It is not that a large size is always beneficial for the banking

system and overall economy. The benefit of size is observed up to

a threshold level of size. A size beyond this threshold size may

have negative consequences for the economy. Existence of

excessively large banks may also create significant moral hazard

costs for the entire system. A failure of a very large bank may have

systemic implications and therefore, there is a perception that

large banks may be bailed out during stress periods. This

expectation of government support create the perception of too big

to fail, and this may improve their creditworthiness resulting in

significant funding advantages. This implicit government subsidy

enjoyed by these banks incentivises them to grow even bigger and

makes them use higher leverage and engage in risky market-
based activities. During the recent financial crisis, it was learnt that

problems created by large banks (seen as too big to fail) can only

be addressed by specific regulations targeted to these banks only.

One of the important aspects of the post crisis regulatory reforms

has been formulation of specific regulatory requirements targeted

at larger banks.

17. PSBs as a group have not been performing well during the

last few years. There has been a large increase in Non-Performing

Assets (NPAs). As a part of managing large NPAs, some

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suggestions have been made that perhaps a consolidation of

PSBs can render them more capable of managing such challenges

relatively better. The basic argument is that a large bank will have

been well capitalised, will have deeper expertise to handle large

credits and large NPAs and hence can ride off troughs with relative

ease.

18. It has to be ensured that mergers among two banks should

not be seen as a fix to short term problems as being faced by

certain PSBs. Merger may be useful only if it has strategic vision

driven by synergy and creating value for both the banks. Merger of

a weak bank with a strong bank may make combined entity weak if

the merger process is not handled properly. The problems of

capital shortages and higher NPAs may get transmitted to stronger

bank due to unduly haste or a mechanical merger process.

Consolidation should not be seen from the sole perspective of

creating larger sized banks. While it is agreed that under present

banking structure in India, creating a few large size banks is

desirable, it has to be a well calibrated and cautious process.

Suggested Consolidation Process

19. Ideally, the process has to be initiated by the boards of

individual banks themselves. NC-I had also mentioned that any

move towards restructuring and reducing the number of banks

through mergers and acquisitions should evolve on the basis of

market driven and profitability considerations and with

understanding and support from bank officers and staff. The

committee had emphasized on the voluntary character of the

exercise to avoid the type of problems associated with a top down

approach.

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20. However, as discussed above the examples of two PSBs

coming together voluntarily and planning for merger have not been

seen, although such examples have been quite numerous in

private banking sector. So the question is how to ensure

consolidation among PSBs when PSBs themselves are not coming

forward voluntarily. One way forward may be a nudge from large

shareholder of PSBs i.e. Government of India. As the Honourable

Finance Minister, in his Budget speech of 2016-17 has mentioned,

that a road map in this regard will be announced soon. An

approach in this direction may be constitution of an expert

committee which may thoroughly examine the business of each

PSB, their forward looking business plans and try to find out

opportunities of consolidation based on sound business strategy

and synergy in the operations of concerned banks. The areas of

synergies are to be properly identified encompassing, inter alia,

compatibility of businesses, culture, treasury and IT and locational

advantage. The committee may interact with the boards of banks

on the tentative plans it might be having with respect to individual

banks and try to understand their reactions. Further, interests of all

stakeholders like depositors, borrowers, supervisor, employees,

etc. also need to be balanced. Perhaps, the recently constituted

Banks Board Bureau (BBB) can perform such an advisory role.

21. It also needs to be emphasised that PSBs are listed and their

shares are held by diversified private institutions and individuals

and interests of these minority shareholders need to be protected.

Any plan for merger or acquisition has to be a Board led process in

which all stakeholders have to be involved from beginning.

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22. Further, mergers among PSBs may reduce competition in

certain segments or geographies substantially and may alter

competition between banks and non-banks. As discussed above

HHI of the Indian banking system is about 518 which is very low

and therefore there is room for consolidation. However, as the HHI

scores approach a level of 1800, the competition authorities are

usually alarmed about competition issues. Hence, the aspects

related to competition and consumer protection need to be

evaluated diligently in the context of consolidation.

23. There may also be significant implementation challenges in

the merger of two entities even if it is based on sound business

logic and synergy. Integration of two different organisation cultures

and technological platforms may not be a simple process. The

treatment of legacy issues, closure of redundant branches,

redeployment of human resources and efficient allocation of capital

post-merger are not straight forward decisions. The considerations

related to implementation challenges also need to be adequately

factored in.

Consolidation beyond Mergers

24. Very often, we understand consolidation means mergers and

acquisitions. It need not be so. There is another type of

consolidation viz. consolidation of businesses. This is distinctly

different from consolidation of entities. Under this type of

consolidation, a bank consciously decides to be in particular types

of businesses and sheds or quits certain types of businesses. Why

a bank would decide so? One set of circumstances, as I have

alluded earlier, relates to reaction and readjustment to the new

regulatory structure. The TLAC requirements, the Dodd-Frank Act

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compliance, the Vickers Commission reforms, the Likanen Group

reforms, etc. have forced banks in USA, UK and EU to rethink and

rearrange their businesses. I believe this is also a type of

consolidation.

25. Our PSBs can take a leaf out of this type and can examine

whether every one of them need necessarily be a universal bank

or can each of them choose to be a differentiated bank in its own

area or business of strength. For example, there are a few PSBs

whose major presence, strength and expertise is in agriculture and

rural segment. There are a couple of PSBs whose assets and

reach are predominantly in the SME segment. These PSBs can

choose to be Small Finance Banks. This way they can conserve

capital, do not dissipate their energy in the highly complex and

specialised corporate and project financing business.

26. Similarly, there are a few other PSBs who are effectively

Payments Banks, as they primarily undertake deposit acceptance

business and their loan book has been built only to comply with the

Priority Sector Lending requirements. They even give an

impression that such loan book was built reluctantly. These banks

may better be Payments Banks and undertake that activity in full

vigour and generate value for its stakeholders.

27. Likewise, there may be opportunities for some other PSBs to

be wholesale / infrastructure banks, about which the Reserve Bank

in the recent Monetary Policy Statement expressed its intention to

usher in such differentiated banks in the coming times.

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28. The advantage of being a differentiated bank is that its

capital can be conserved and put to its best use. It can leverage its

core strength, in a focussed manner.

Conclusion

29. Let me conclude by saying that there is tremendous scope

for consolidation among PSBs. Consolidation will bring efficiency

and synergy of operations and will ensure that Indian banking

sector is capable of meeting credit demand of our growing

economy. However, the consolidation needs to be a well-calibrated

process based on sound economic logic. A hasty top-down

approach which does not adequately consider synergies in the

business models and compatibility in the business cultures and

technology platforms of the merging banks may not be sustainable

in the long run. And, finally, consolidation does not mean only

merger of banks; consolidation also means focussing on chosen

businesses only.

30. Thank you very much for your patient attention."

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