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Context

• The Centre announced a mega amalgamation plan, the third in a row, that merged ten public sector banks into four larger entities.
• With these series of mergers, the number of state-owned banks is down to 12 from 27.

Bank Merger

• 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.
• Mergers of banks began in India in the 1960s in order to bail out the weaker banks and protect the customer interests.

Why merger?

• 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.
• 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.
• However the government, after consultations, decided that amalgamation is the “best route” to achieve banking sector scale and to support the target of achieving a $5 trillion economic size for India in five years.

Logic behind the move

• For years, expert committees starting from the M Narasimham Committee have recommended that India should have fewer but bigger and better-managed banks to ensure optimal use of capital, efficiency, wider reach and greater profitability.
• The logic is that rather than having several of its own banks competing for the same pie (in terms of deposits or loans) in the same narrow geographies, leading to each one incurring costs, it would make sense to have large-sized banks.
• It has also been argued that such an entity will then be able to respond better to emerging market trends or shifts and compete more with private banks.
• The proposed big banks would be able to compete globally and improve their operational efficiency once they lower their cost of lending and improve lending.
• But none of India’s banks including the largest, SBI, figures in the list of the top 50 global banks. So that may be a long way away.

Will the move help make banks stronger?

• The banks that have been merged by the government exhibit varying financial strength.
• 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.
• Critics doubt whether the government has any similar incentive to look for synergies that can boost the profits of its banks.
• 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.

How does it help the government?

• For over decades starting from 1992, the government as the biggest shareholder of over 25 banks had to provide capital for them.
• To grow and lend more, the banks often need a higher amount of capital to set aside also for loans that could go bad.
• With the government not willing to lower its equity holdings and with a large slice of the capital being set aside to cover for bad loans, the burden of infusing capital rests on the majority shareholder.
• This means marking a large amount of money almost every year during the last few years in the Budget for capital infusion at many banks at a time when there is a huge demand for social sector.
• By reducing the number of banks to a manageable count, the government hopes that the demands for such capital infusion will be lower progressively with increased efficiencies and with more well capitalised banks.
• It will also help that the government can focus now on fewer banks than in the past.

Pros of the merger

Some of the pros of the mergers are:

• a large capital base would equip the merged entities to disburse a larger number of loans and of higher magnitude,
• operational efficiency will reduce costs,
• the need for recapitalization from the government will reduce, and
• better adoption of technology.

Limitations

The cons of the amalgamation are:

• it would be tough to manage issues pertaining to human resources,
• having only a few large, inter-linked banks can expose the broader economy to enhanced financial risks, and
• the local identity of small banks will be lost, leading to ramifications in the social and cultural space that are often not recognised or understood.

Implications of the merger

Bad Loans

• 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.

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 nationalization 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.

Funding for growth

• 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.
• 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.

Critical opinion on merger

• 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.

More thrust is on RBI

• The RBI keeps monitoring large institutions whose potential failure can impact other institutions or banks and the financial sector, and which could have a contagion effect and erode confidence in other banks.
• A case in point is the recent instance of IL&FS Group, which defaulted on repayments hitting many lenders and investors.
• The creation of more large-sized banks will mean the RBI will have to improve its supervisory and monitoring processes to address increased risks.

 

Conclusion

• The finance minister has quoted that the proposed big banks would be able to compete globally and improve their operational efficiency once they lower their cost of lending and improve lending.
•  But none of India’s banks including the largest, SBI, figures in the list of the top 50 global banks. So that may be a long way away.
• While the announced consolidation of PSU banks is a credit positive as it enables the consolidated entities to meaningfully improve scale of operations and help their competitive position.
• At the same time, there will not be any immediate improvement in their credit metrics as all of them have relatively weak solvency profiles.

 

 

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References

https://www.civilsdaily.com/news/explained-mergers-of-public-sector-banks/

https://www.thehindu.com/business/Industry/how-will-mergers-affect-public-banks/article29363041.ece

https://www.moneycontrol.com/news/business/mergers-acquisitions/digging-deeper-the-big-bank-merger-what-why-and-what-next-4411711.html

https://www.deccanherald.com/specials/sunday-spotlight/the-big-bank-theory-759842.html