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Suresh Krishnamurthy

Mr M. Damodaran, CMD, IDBI - Grand entry into the commercial banking arena _ A. Roy Chowdhury .

FORTUNES of IDBI Bank's shareholders is at the crossroads. This fast growing new bank will now not be allowed to realise its potential as a stand-alone bank.

Consequently, their hopes of the bank growing at 100 per cent for a few more years and commanding valuation similar to at least that of UTI Bank's are now gone up in smoke. But viewed from another angle, it may be argued that the value of their holdings need not remain shackled due to uncertainty any longer.

There is reason to hope for a better future too. IDBI's financials are now on the mend. There may be a few more mergers round the corner that would crown IDBI with the status of the second largest bank in the country. Along with such mergers, if the retail banking business, represented by IDBI Bank, is scaled up, a large value-creating, profitable banking behemoth will emerge out of this process.

Financials on the mend

The merger and the infusion of Rs 9,000 crore by the Government is set to transform the decayed Rs 50,000 crore advances portfolio of IDBI with about 10 per cent bad loans, to a portfolio with virtually zero bad loans.

IDBI will also get a reasonably large network of branches and customers to embark on the process of reducing its cost of deposits. IDBI will also now have the opportunity to expand the proportion of high-yielding retail assets in its advances portfolio.

Both high yielding retail assets and low-cost deposits would respectively account only for about 10 per cent of the combined entity's balance-sheet.

The scope for expansion is, thus, immense. The spreads (difference between the rate at which funds are lent and that at which they are borrowed) are, thus, set to expand from the present mere 1.8 per cent to a higher number closer to 3 per cent.

An expansion in spreads by about half a per cent would add about Rs 250 crore to the profits. The combined entity's profits are now about Rs 400 crore and such a spread expansion will add handsomely to the bottomline.

IDBI would also be hoping to cut down on the provision for bad loans. This now accounts for about Rs 1,500 crore. Even if this is halved, and spreads expand by half a per cent,the return on networth of the bank will expand about 15 per cent from 5 per cent now. The bank's profitability will then be more comparable to that of its peers.

A challenging road

That, however, is the optimistic picture. The path to achieving spread expansion and halving provision for bad loans may prove challenging. First, at the core of the expectations is the belief that within the merged entity, IDBI Bank, representing the retail business, will be scaled up, while IDBI, representing development finance dimensions, will be toned down. This may be tough to achieve for two reasons.

One, it is believed that under the umbrella of IDBI, the employees of IDBI Bank will find it difficult to motivate themselves. Many talented people have already left and more may follow. It is, however, rather naïve to assume that working in a public sector bank would be tough.

Some of their employees are doing rather well in the present competitive environment. Still, integrating the employee base of IDBI Bank with that of IDBI may pose problems for other reasons. In banking, employees of IDBI Bank are the experienced lot. They may have to be given a large role, post-merger. Achieving the transformation without ruffling feathers may remain a challenge.

Managing change for employees may, however, prove easy compared to the challenge of fulfilling the development-banking mandate. Will Parliamentary and Government supervisors keep quiet if more than 60 per cent of fresh disbursement in credit is to the retail sector?

Or, if IDBI manages to lend 50 per cent of fresh credit for development banking purposes, will the stock market take kindly to it given the high associated risks? IDBI may find itself in a piquant situation.

These may, however, cease to be a challenge for IDBI, if industrial growth rises rapidly. In such a situation, let alone IDBI, every other bank will be vying to lend to the industry. It is early days to tell if these challenges will be value-detracting. Still, discounting the price for the associated risks appears prudent.

Scrutinising value

IDBI's present book value is now in excess of Rs 100 per share. That, however, is without reckoning the value of bad loans in the portfolio. If we adjust for bad loans, the book value drops to Rs 21. The transfer of Rs 9,000 crore of bad loans in exchange for government bonds is set to increase the book value. It is, however, inappropriate to add the entire Rs 9,000 crore to IDBI's net worth.

This is because these government bonds will not earn anything and it may take even 20 years for IDBI to get back this amount. The value of this sum to IDBI may be closer to Rs 3,000 crore. Considering IDBI's finances, even this amount will lead to a sharp expansion in its book value. In addition, this merger too will prove value-enhancing for IDBI. The swap ratio is likely to be between 3:4 and 1:1.

A more favourable ratio for IDBI Bank shareholders is virtually ruled out, considering that the Government needs to maintain a 51 per cent stake in the merged entity, according to the newly-enacted law governing IDBI.

In this context, the stock of IDBI is under-valued at about Rs 68. The extent of gains from the present price is, however, linked to IDBI scaling up its retail business. The stock could double from present levels if spreads expand and provisions are halved.

Gains, however, would be much more modest if development banking imperatives constrain profitability. These expectations, however, do not factor in a merger with another public sector bank or even IFCI. That would introduce further complications into the equation.

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