How will mergers affect public sector banks?

What does the rearrangement mean for the banking sector? Is increased credit growth essential for India to achieve the target of becoming a $5-trillion economy?

The story so far: Finance Minister Nirmala Sitharaman recently announced that 10 banks owned by the Government of India will be merged into four larger banks; thus the total number of state-owned banks in the country will have come down from 27 (in 2017) to 12. According to the plan outlined by the government at a press meet late last month, Punjab National Bank will be merged with Oriental Bank of Commerce and United Bank of India; Canara Bank with Syndicate Bank; Union Bank of India with Andhra Bank and Corporation Bank; while Indian Bank will amalgamate with Allahabad Bank. The government also announced an infusion of ₹55,250 crore to help these newly merged banks extend more loans to their customers and meet crucial regulatory norms. Just last year, the government proposed the merger of three banks — Vijaya Bank and Dena Bank with Bank of Baroda — to create a larger bank. Earlier in 2017, State Bank of India, the country’s largest lender, was merged with five of its associate banks.

What is a merger and why are so many state-owned banks being consolidated?

A merger is simply the combining of two business entities to form a larger one but with no explicit change in ownership. This is in contrast to an acquisition where one business entity takes ownership control over another by paying for the ownership privilege in cash, stock, or other means. In the case of state-owned banks that are being merged now, where the government is the majority shareholder, there will be no change in ownership but merely a restructuring of how these banks are organised.

There are various reasons cited by the government for its decision to merge state-owned banks. One of them is that large banks will be able to lend more money and help revive the slowing economy. The government also believes that increased credit growth is essential in order to achieve its target of growing India into a $5-trillion economy in the next few years. It is also of the view that the merger will lead to increased operational efficiency that will help these banks lower their costs, thus enabling them to lower their lending rates.

State-owned banks have been reeling under a bad loan crisis for years now. According to the government, the size of gross non-performing assets of state-owned banks stood at ₹7.9 lakh crore, as of March 31, 2019. Although the government has not projected the present merger as a measure to tackle bad loans, bank mergers in the past have been carried out simply to bail out struggling banks.

Will the move help make banks stronger?

The banks that have been merged by the government exhibit varying financial strength. Banks such as Indian Bank and Punjab National Bank are stronger than the smaller banks that they are being merged with under the plan. Indian Bank, which is considered to be the strongest financially among the 10 banks, for instance, has a net NPA ratio of 3.8%; it is 5.2% for Allahabad Bank So the merger is expected to adversely affect the health of Indian Bank. Not surprisingly, the shares of Indian Bank and other relatively strong banks witnessed a steep fall on the first day of trading (Tuesday) after the announcement of the merger (Friday). It remains to be seen whether the operational benefits that the government believes will come about through the merger will compensate for the deterioration in the financials of the stronger banks.

But if the reaction of investors on Tuesday is anything to go by, it seems quite unlikely that the merger of state-owned banks will create any significant value for shareholders. Private businesses typically merge their operations when they believe that the merged entity will help increase their profits. Critics doubt whether the government has any similar incentive to look for synergies that can boost the profits of its banks. Interestingly, Ms. Sitharaman has assured banks that jobs will not be lost due to the merger. Many see this as a compromise to avoid any trouble from powerful bank employee unions. Given this, it seems unlikely that state-owned banks will be able to become more efficient after the merger by getting rid of redundant labour. More importantly, the merging of healthy banks with weak banks may not really improve the health of the banking system as a whole. In fact, many believe, by diluting the management of strong banks, forced mergers may lead to a significant deterioration in the overall health of the banking system. Last but not least, if the managers of efficient banks are punished for their good performance by being asked to share the burden of weaker banks, many fear that there will be fewer incentives for managers to manage well. This can further negatively affect the long-term performance of state-owned banks.

Will it address the bad loans crisis and help kick-start economic growth?

The merger of banks per se will not lead to a decrease in the absolute size of bad loans in their books. The size of bad loans in bank books can drop only if banks manage to improve the recovery of these loans, or if these loans are written off their balance sheets. The bad loan recovery process remains slow due to the inefficient judicial system in the country and banks have been unwilling to aggressively write off bad loans since that would require recognising greater losses. Mergers do not address these serious structural problems.

The present merger, many believe, also does not address the issue of political interference in the management of state-owned banks that is at the root of the bad loan crisis. The stated purpose of the nationalisation of banks in 1969 was to use bank credit to fund the various development goals of the government. Towards this end, over the years, various state-owned banks have been forced to extend loans under political pressure even though such loans did not always make business sense. This is in contrast to private banks that are allowed to operate simply as pure businesses seeking profits.

In her presentation on Friday, the Finance Minister announced some governance reforms, such as strengthening the power of bank boards, but not many really believe that they will effectively address the fundamental issue of political interference in state-owned banks. Finally, when it comes to funding the growth needs of the economy, large banks may be able to lend more money than smaller banks due to the size of their capital base. Punjab National Bank, for instance, when merged with United Bank of India and Oriental Bank of Commerce will be the second-largest bank in the country carrying out business to the tune of around ₹18 lakh crore. However, some argue that large banks may not really be essential when it comes to funding big-ticket business projects. In the past, several smaller banks have come together to extend large loans. Further, companies themselves might prefer to seek funds from multiple sources. Overall, the infusion of additional capital by the government can temporarily help banks troubled by bad loans to extend loans more confidently without the fear of going bankrupt due to their precarious capital position. But most economic analysts believe that the merger does not really address the root structural causes behind the woes facing state-owned banks in the country.

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