Why Merger Of State-run Banks Is No Panacea For Economy

<div><em>Merger of weak banks with strong has its downside. Is it worth the pain? <strong>Raghu Mohan</strong> explores</em></div><div>&nbsp;</div><div>It’s an idea which has been spoken about in the past, and finance minister Arun Jaitely has thrown up the same again -- that the Centre is not averse to merging weaker state-run banks with stronger ones.</div><div>&nbsp;</div><div>On Wednesday (9 September), Jaitely said that while steps to shore up the financial strength of state-run banks has been done through capitalisation, “After this (measures) if there is a fragile bank, we are looking at consolidation with stronger banks. So it's not that banks don't get a priority. In fact, after inheriting the banks in a fragile situation, we are systematically trying to address each of these problems”.</div><div>&nbsp;</div><div>The reference is to concerns that the weaker among state-run banks may be too fragile to continue to do business in the emerging landscape – that’s even after the steps taken to capitalise them and re-engineer their innards with the “Indradhanush” initiative.</div><div>&nbsp;</div><div><strong>The Triggers Now</strong></div><div>The number one headache for Jaitely and team is the mess as ariticulated S S Mundra, Deputy Governor-RBI (Indian Banking Sector: Emerging Challenges and Way Forward; 5th May 2015). That while the banking system is adequately capitalised, he saw challenges on the horizon (for some of banks). For the system as a whole, capital adequacy has steadily declined; as at end-March 2015, it stood at 12.70 per cent from 13.01 per cent a year earlier. “Our concerns are larger in respect of state-run banks where it has declined further to 11.24 per cent from 11.40 per cent over the last year”, he said.</div><div>&nbsp; &nbsp; &nbsp;&nbsp;</div><div>He went on to add that even the best performing state-run banks have been hesitant to tap the markets to raise their capital levels; that it would be difficult for the weaker to raise resources from the market.</div><div>&nbsp;</div><div>“There is a constraint on the owners insofar as meeting the capital needs of these banks and hence, the underperforming banks are faced with the challenge of looking at newer ways of meeting their capital needs. A singular emphasis on profitability ratios (based on RoA and RoE) perhaps fails to capture other aspects of performance of banks and could perhaps encourage a short term profitability-oriented view by bank management”.</div><div>&nbsp;</div><div>Mundra made it clear that he did wish to get into the merits of this approach, “but from a regulatory stand point, we feel that some of these poorly managed banks could slide below the minimum regulatory threshold of capital if they don’t get their acts together soon enough.. The need of the hour for all banks, and more specifically, in respect of state-run banks, is that capital must be conserved and utilised as efficiently as possible”, Mundra explained.</div><div>&nbsp;</div><div>And given the state of fisc, Jaitely will do well to conserve the Centre’s wallet too; but as to whether it should be done by merging the weak with the strong is a moot point.</div><div>&nbsp;</div><div>But let us step back and look at the historical to get a grip on what we are on.</div><div>&nbsp;</div><div><strong>Blast From The Past</strong></div><div>From the early days of reforms, banking sector consolidation has been detailed in various reports – M Narasimham Committee -I (1991), S H Khan Committee (1997), M Narasimham Committee-II (1998), S S Tarapore Committee on Fuller Capital Account Convertibility (2006), Raghuram G. Rajan Committee (2009) and the Committee on Financial Sector Assessment (CFSA-2009; chairman Rakesh Mohan who was deputy governor-Reserve Bank of India).</div><div>&nbsp;</div><div>In his inaugural address on the annual day of the Competition Commission of India on May 20th 2013, P Chidambaram as finance minister alluded, inter alia, to the need for restructuring of banks through mergers. To quote “ ... some banks, including some public sector banks among the 26 public sector banks that we have, may be better off merging. The need for two or three world-size banks in an economy that is poised to become one among the five largest in the world is rather obvious”.</div><div>&nbsp;</div><div>What should not be missed is Chidambaram’s reasoning for this: that we need globally competitive large banks; it was not to “bailout” weak banks!</div><div>&nbsp;</div><div>Since 1961 till date, there have been as many as 81 bank mergers out here of which 47 took place before the first phase of nationalisation in July 1969. Out of the remaining 34 mergers, in 26 cases, private sector banks were merged with state-run banks; and in the remaining eight cases, both the banks were private sector banks. The spate of mergers before and immediately after nationalisation is not relevant to the times we live.</div><div>&nbsp;</div><div>Let’s come to the post-reform period -- there have been 31 bank mergers. And mergers prior to 1999, (under Section 45 of the Banking Regulation Act, 1949) – and this is the most critical period -- were primarily resorted to in response to the weak financials of the banks being merged. Of this lot, the merger of Global Trust Bank with Oriental Bank of Commerce must find particular mention – that of a basket case new-generation private bank being merged with a state-run bank or of tax payers paying for private loot! Whatever be the colour of capital, the bottomline is there is no reason for a good bank pay to for the sins of a rotten apple.</div><div>&nbsp;</div><div>In the post-1999 period, however, business sense led to voluntary mergers between healthy banks under Section 44A of the Act. The merger of New Bank of India with Punjab National Bank (way back in 1993); and the acquisition of State Bank of Saurashtra (2008) and State Bank of Indore (2010) by the State Bank of India are the only instances of consolidation among state-run banks. All involved pain.</div><div>&nbsp;</div><div><strong>Bank Mergers</strong></div><div>&nbsp;</div><div><span style="color:#ff0000;"><strong>The Pros:</strong></span></div><div>&nbsp;</div><div>• &nbsp; &nbsp; Larger banks may be more efficient and profitable than smaller ones and generate economies of scale and scope. Furthermore, the reorganisation of the merged bank can have a positive impact on its managerial efficiency. The efficiency gains may lead to lower cost of providing services and higher quality as the range of products and services provided by larger banks is supposedly wider than what is offered by smaller banks. Experience in some countries indicates cost efficiency could improve if more efficient banks acquire less efficient ones.</div><div>• &nbsp; &nbsp; Consolidation may facilitate geographical diversification and penetration towards new markets. *</div><div>• &nbsp; &nbsp; Big banks are usually expected to create standardised mass-market financial products. The merging banks may try and extend marketing reach and enhance their customer-base.</div><div>• &nbsp; &nbsp; The common criticism against consolidation is that it will have an adverse effect on supply of credit to small businesses, particularly, those which depend on bank credit, as consolidated big banks would deviate from practising relationship banking. But, there is recent evidence that reduced credit supply by the consolidating banks could be offset by increased credit supply by other incumbent banks in the same local market.</div><div>• &nbsp; &nbsp; The transaction costs and risks associated with financing of small businesses may be high for small banks. Large and consolidated banks can mitigate the costs better and penetrate through lending into these sectors.</div><div>• &nbsp; &nbsp; One of the arguments cited against consolidation is that it may result in rationalization of branch network and retrenchment of staff. However, rationalisation may lead to closure of branches in over banked centers and opening of new branches in under banked centers where staff can be redeployed.</div><div>&nbsp;</div><div><span style="color:#ff0000;"><strong>And the Cons:</strong></span></div><div>• &nbsp; &nbsp; It can result in neglect of local needs leading to reduction in credit supply to some category of borrowers, particularly small firms. The consolidated bank may rather cater to big ticket business, in the process adversely affecting financial inclusion.</div><div>• &nbsp; &nbsp; Not all customers are treated in the same way by the big banks. There is empirical evidence that one consequence of the merger wave in US banking in 1990s has been that loan approvals for racial minorities and low income applicants have fallen and the extent of this decline was more severe for large banks.</div><div>• &nbsp; &nbsp; The consolidating institutions are found to shift their portfolios towards higher risk-return investment.</div><div>• &nbsp; &nbsp; Consolidation could also result in less competition through structure-conductperformance-hypothesis giving fewer choices to the customer and arbitrary pricing of products.</div><div>• &nbsp; &nbsp; Empirical evidence suggests that financial consolidation led to higher concentration in countries such as US and Japan, though they continue to have much more competitive banking systems as compared with other countries. However, in several other countries, the process of consolidation led to decline in banking concentration, reflecting increase in competition.</div><div>&nbsp;</div><div>Source: RBI Discussion Paper on Banking Structure in India -- The Way Forward (2013). Prepared by the Department of Banking Operations and Development; and Department of Economic Policy and Research.</div><div>&nbsp;</div><div>A working group set up by Indian Banks’ Association (IBA;2004) “Consolidation in Indian Banking System: Legal, Regulatory and Other Issues” was of the view that it made sense to &nbsp;bring all banks under the Companies Act so as to ensure that legal dispensation for mergers in banking sector is akin to that of corporate mergers. But it never made a case for a merger between weak and the strong. It can take down both!</div><div>&nbsp;</div><div>&nbsp;</div><div>&nbsp;</div><div>&nbsp;</div><div>&nbsp;</div>