Bank mergers: A win-win situation

D. Sampathkumar

THREE bank mergers in the space of less than one year ought to signal a wave of consolidation in the banking industry.

In February 2000 came the announcement of Times Bank tying the nuptial knot with the HDFC Bank. This was followed last month, by the one involving the ICICI Bank and the Bank of Madura. And now, comes the announcement that the Global Trust Bank and the UTI Bank too will come together under a common umbrella.

The positive impact that recent bank mergers are likely to have on the capital adequacy ratio of the composite entity that comes into existence, post-merger, has been commented about in analyses that followed these announcements. But within the context of capital adequacy ratio, one aspect has gone largely unnoticed. Such mergers additionally have the potential to capture the market value of underlying shares of the merging entities in measuring the level of capital adequacy of the bank. Under the existing norms for banking companies, the merging banks would have had to have in place as `net own funds', a minimum of 9 per cent of the total value of risk-weighted assets in their portfolio. Own funds, in this context, is the sum of the paid-up capital contributed from time to time by its shareholders, the accumulated profits and other surpluses belonging to them.

The net-owned funds (paid-up capital and reserves) is measured only in terms of the historical cost at which these are recorded in the books and not in terms of the market capitalisation. The fact that the underlying shares which make up the shareholders' funds are worth a great deal more in the market place, is of little avail to the banking enterprise while arguing its case on capital adequacy, before the banking regulator.

Should the net-owned funds be inadequate to the current size of the asset portfolio, the situation necessarily gives rise to the need for increasing the paid-up capital base of the bank. The development has an adverse impact on the per share earnings. In other words, the leveraging potential of the existing capital base, when measured in terms of market capitalisation, would not be tapped to its fullest potential.

Now, a merger between two such banking entities with unequal market strength neatly sidesteps this difficulty. When a merger is consummated between two entities, the market price of the underlying shares is an important criterion, often the sole criterion, in deciding on the exchange ratio. If the ratio of price-to-book value of the merging entities is different the acquisition by the entity with a stronger price-to-book ratio results in fewer shares being offered to the shareholders of the amalgamating company.

Consequently, an amalgamation surplus results in the balance sheet of the composite entity that comes into existence after the merger. And the capital base of the post-merger entity gets a boost by an identical margin. For example, if the amalgamating bank brings in net assets of Rs 100 and the acquiring bank issues shares for a value of Rs 75, the resultant difference gets accounted in the books of the amalgamated entity as `reserves'.

This is bound to happen if the acquiring bank's share commands a higher premium in the market, relative to its book value, than the target bank. The acquiring bank would then be offering fewer shares for the assets of the bank being taken over. Thus the market value of the shares of an acquiring bank indirectly gets incorporated in the computation of the capital adequacy ratio, post-merger.

Though there are not many banks with a market capitalisation exceeding the book value, for the few that do -- HDFC Bank is one that readily comes to one's mind in this context -- takeovers present an added opportunity for enhancing shareholder value. The merger is equally advantageous to the shareholders of the bank being taken over.

The book value of their shares may be a great deal higher than the current market value. But that is small consolation for someone who wishes to exit from the stock for whatever reason, at a given moment of time. The investor in this case, is unlikely to get a price higher than the going market price, no matter how high the book value may be. A merger with a bank whose shares are quoting at a premium to the current book value offers an opportunity to cash in on some of that excess value (to the market price, that is) when the existing shares are exchanged for the shares of the acquiring bank.

The acquiring bank is in the position of a strategic investor of the shares of the amalgamating company. Such an investor is in a position to offer a premium to the current market value if he sees synergies in the acquisition, should they exist, something the casual investor in the market is unlikely to do. This is important as, without the perception among the shareholders of both the banks that the deal offers a win-win situation, a merger or amalgamation is unlikely to take place.

The opportunity for a bank with a strong market capitalisation for enhancing shareholder value may present its own logic for mergers to take place. But there are other synergies as well. For a nation with a relatively weak banking habit among its citizens, there are far too many banking companies jostling for a share of the economic pie.

The country has 27 public sector banks, including the State Bank of India and its associates. Then there are 34 private banks of varying sizes. Supplementing all this is the presence of as many as 45 foreign banks. All these banks have to contend with a citizens' penchant for keeping a cash hoard. Even today, close to 20 per cent of the money supply in the economy is held by the public in the form of currency.

This is more or less on a par with the quantum of cash hoarded in 1989-90 by the public. All this suggests that there cannot be space for all the players to operate with a modicum of viability. Viewed thus, the spate of mergers that have hit the market in recent times may well be the forerunners of many more to follow.