The M&A trend in the Indian Banking Industry

ACKNOWLEDGEMENT
The study presented here as my thesis, has been helpful in developing an understanding of the banking sector and the reasons for the current M&A trend. My gratitude goes to the numerous people (friends and fellow colleagues) who helped me in the completion of my report. Last but not least, I would like to thank my institute and all the faculties and my fellow post graduates, who have been a constant source of encouragement.

Table of Content

ACKNOWLEDGEMENT............................................................................................................................ 2 LITERATURE REVIEW............................................................................................................................. 6 INDIAN BANKING SECTOR................................................................................................................. 6 MERGERS AND ACQUISITIONS........................................................................................................... 18 TRANSFORMING INDIAN BANKING.................................................................................................... 29 CONSOLIDATION................................................................................................................................... 31 SWOT ANALYSIS................................................................................................................................... 46 RESEARCH METHODOLOGY ............................................................................................................. 52 ROAD MAP FOR PRESENCE OF FOREIGN BANKS IN INDIA........................................................... 59 FUTURE OF M&A IN INDIAN BANKING INDUSTRY ........................................................................... 62 RECOMMENDATION.............................................................................................................................. 64 CONCLUSION......................................................................................................................................... 65 ANNEXURE ............................................................................................................................................ 69

EXECUTIVE SUMMARY
M&A in the industrial and services sector have brought new life to the style of doing business in todays world. Globalization, technological changes, market deregulation and liberalization have driven the M&A wave across the world. The 1980s often referred to as a decade of merger mania, produced approximately 55000 M&As in the US alone valued at appropriately $1.3 trillion. Continuing the trend, it was about $2.5 trillion in 1999. In consonance with the other sectors, banking the world over, through the 1990s has faced tumultuous times, the consequences of which are visible even today. Consolidation in the US, Japan and Europe gave rise to banking behemoths even while it caused the disappearance of some famous names. One of the most recent visible developments has been the take over of the foreign bank, ANZ Grindlays by the Standard Charted Group.

While Indian manufactures have adopted M&A as their business strategy for growth and have achieved world standards, the Indian Banking Industry has not been moving in tune with Indian businesses and has been slower to respond to the huge growth opportunities in the market. In todays competitive world, banks will have to be competitive in order to face the challenges and leverage the opportunities. Consolidation will provide banks with new capabilities, technologies and products, help to overcome entry barriers, ensure immediate entry into new markets and lower operating costs through consolidation of resources. A few years ago, Citigroup was the only $1 trillion banking organization in the U.S. Now, there are two more- Bank of America and J P Morgan Chase, which have merged with Fleet and Bank One respectively. M&A in Indian Banking is not new and dates back from Imperial Bank of India, which was formed by the amalgamation of the three-presidency banks- The Bank of Bengal, The Bank of Bombay and The Bank of Madras in 1921. Few mergers have taken place thereafter- mainly in the public sector- primarily to protect the interest of the depositors of the weak private banks. The mergers were not far economic considerations and usually distressed mergers i.e. State Bank of India taking over Bank of Cochin and Kashinath Seth Bank; New Bank of India merging with Punjab National Bank. However, the Times Bank mergers with HDFC Bank a few years back and Bank of Madura with ICICI Bank portend a new wave of consolidation in the Indian Banking industry for mutual benefits. The mergers in these cases sought to attain critical size. Liberalization of the Indian Banking industry, since a decade has resulted in entrance of new private players and has let to cut-throat competition in the overwhelmingly public sector industry. Further, with the opening up of the banking sector, which will accelerate with the government seeking to move ahead with neo-liberal reforms, Indian banks will face stiffer competition as large International banks with varied market experience enter the Indian banking arena. The presence of competitive private and foreign banks will subject public sector banks to comparisons with regard to profitability and efficiency, and this would force these banks to change as well. Two important factors that differentiate the profitability 4

of operations of public sector banks vis--vis private sector banks are higher operating expenses and lower income generation. Public sector banks have sought to prune operating expenses through the twin measures of employee rationalization under the voluntary retirement scheme and simultaneous computerization. They also seek to reduce costs by rationalizing the number of branches.

LITERATURE REVIEW

INDIAN BANKING SECTOR

The Indian Banking industry, which is governed by the Banking Regulation Act of India, 1949 can be broadly classified into two major categories: Non-scheduled banks Scheduled banks

Scheduled banks comprise commercial banks and the co-operative banks. In terms of ownership, commercial banks can be further grouped into nationalized banks, the State Bank of India and its group banks, regional rural banks and private sector banks (the old/ new domestic and foreign). These banks have more than 67,000 branches spread across the country. The first phase of financial reforms resulted in the nationalization of 14 major banks in 1969 and resulted in a shift from Class banking to Mass banking. This in turn resulted in a significant growth in the geographical coverage of banks. Every bank had to earmark a minimum percentage of their loan portfolio to sectors identified as priority sectors. The manufacturing sector also grew during the 1970s in protected environs and the banking sector was a critical source. The next wave of reforms saw the nationalization of 6 more commercial banks in 1980. Since then the number of scheduled commercial banks increased four-fold and the number of bank branches increased eight-fold. After the second phase of financial sector reforms and liberalization of the sector in the early nineties, the Public Sector Banks (PSB) s found it extremely difficult to compete with the new private sector banks and the foreign banks. The new private sector banks first made their appearance after the guidelines permitting them were issued in January 1993. The private sector banks due to their late start have access to state-of-the-art

technology, which in turn helps them to save on manpower costs and provide better services. The banking system has witnessed many mergers, big and small, in the past. Between 1969 and 2005, there were 26 mergers. In as many as 22 of them, the transferee bank was a government one. These 22 mergers were essentially at the behest of the government to bail out sick private banks, with a view to safeguard the interest of the depositors and other stakeholders. It is a tribute to the PSBs that they shared the burden of bad banks, with insignificant costs to the economy. The merger of Times Bank with HDFC Bank (2000) Bank of Madura with ICICI Bank (2001) and Bank of Punjab with Centurion Bank (2005), all in the private sector, may be classified as the ones that happened for business considerations. CURRENT SCENARIO The industry is currently in a transition phase. On the one hand, the PSBs, which are the mainstay of the Indian Banking system, are in the process of shedding their flab in terms of excessive manpower, excessive Non Performing Assets (NPAs) and excessive governmental equity, while on the other hand the private sector banks are consolidating themselves through mergers and acquisitions. Squeezed by size and competition, there will be a loss in the business of banks that are small or are uncompetitive, where theres a lot of duplication of products and services without any value-addition to the customer. The set of public sector banks, which account for 75 per cent of banking assets, are ripe for mergers and acquisitions, and hold the key for any meaningful change in the dynamics of the banking sector. Barring SBI, theres not much to distinguish one public sector bank from another. Its common to find 10 public sector banks in an area, all offering an identical banking proposition. PSBs, which currently account for Rs 20,14,880 crores worth of assets are saddled with NPAs (a mind-boggling Rs 14,384 crores in 2006), falling revenues from traditional 7

sources, lack of modern technology and a massive workforce while the new private sector banks are forging ahead and rewriting the traditional banking business model by way of their sheer innovation and service. The PSBs are of course currently working out challenging strategies even as 20 percent of their massive employee strength has dwindled in the wake of the successful Voluntary Retirement Schemes (VRS) schemes. The private players however cannot match the PSBs great reach, great size and access to low cost deposits. Therefore one of the means for them to combat the PSBs has been through the merger and acquisition (M& A) route. Over the last two years, the industry has witnessed several such instances. For instance, HDFC Banks merger with Times Bank, ICICI Banks acquisition of ITC Classic, Anagram Finance and Bank of Madura, OBC and GTB, Bank of Punjab, Centurion Bank and Lord Krishna Bank. The UTI bank- Global Trust Bank merger however opened a pandoras box and brought about the realization that all was not well in the functioning of many of the private sector banks. Private sector Banks have pioneered internet banking, phone banking, anywhere banking, mobile banking, debit cards, Automatic Teller Machines (ATMs) and combined various other services and integrated them into the mainstream banking arena, while the PSBs are still grappling with disgruntled employees in the aftermath of successful VRS schemes. The RBI has mandated a net worth of at least Rs 300 crore for banks. Some of the smaller banks with a lower net worth will be forced to become bigger and find ways to raise more capital. In a short period of time till 2009, it will be difficult for banks to grow organically, hence they are left with no option but to merge. Foreign banks are working on expanding their bases in the country. The Ministry of Finance and Reserve Bank of India have agreed to allow foreign banks to open 20 branches a year as against 12 now. At present, 40 odd foreign banks have over 225 branches in India. At the end of 2004-05, the total assets of foreign banks aggregated US$ 30 billion or 6.9 per cent of the assets of all scheduled commercial banks. They will also be allowed 74 per cent stake in private banks. After 2009, the local subsidiaries of foreign banks will be treated on par with domestic banks. 8

With the economic growth picking up pace and the investment cycle on the way to recovery, the banking sector has witnessed a transformation in its vital role of intermediating between the demand and supply of funds. The revived credit offtake (both from the food and non food segments) and structural reforms have paved the way for a change in the dynamics of the sector itself. Besides gearing up for the compliance with Basel accord, the sector is also looking forward to consolidation and investments on the FDI front. Public sector banks have undergone much restructuring alongside technology implementation. NPAs have been written off against treasury gains in the last few years. Retail lending (especially mortgage financing) has been grabbing a major share of the market in the last 3 years. With better penetration in the semi urban and rural areas the banks garnered a higher proportion of low cost deposits thereby economizing on the cost of funds. Apart from streamlining their processes through technology initiatives such as ATMs, telephone banking, online banking and web based products, banks have also resorted to cross selling of financial products such as credit cards, mutual funds and insurance policies to augment their fee based income. RBI's soft interest rate policy has helped increase the liquidity in the market, and banks have been liquidating their gilt portfolios partially to free resources for lending. Credit off take is expected to be reasonably good both on retail and corporate sides. Following the advice of the government banks have increased lending to agricultural sector, while ensuring good quality lending by informed customer analysis. Currently the banking sector in the country is strongly fragmented and hence with further policy changes taking place in the sector, consolidation is likely to take place at a faster rate. However this is subject to the removal of the ceiling on voting rights will ensure that private sector and foreign banks will be in a much better position to carry out acquisitions in the banking sector. A hike in FDI capital limits in the sector would further go a long way in the process of consolidation. In terms of credit growth, going 9

forward, India's core sector is witnessing a revival of sorts. The manufacturing sector has shown significant improvement in FY05. Hence as corporate growth picks up lending too is likely to see an uptick. Retail credit off-take is expected to remain strong going forward with the housing finance industry, the main contributor to credit off-take from this segment, expected to grow between 20%-25% in the next 3-4 years. Apart from the problem of NPA management, banks now face tougher competition from the international banks and are vulnerable to economic shocks and political instability. At such a juncture, when the urgency of strengthening the capital base can hardly be over-emphasised, the mergers can certainly be expected to give the banks a better competitive and marketing edge. It is true that the Verma Committee has not favourably considered the option of mergers, citing the example of New Bank of India with the Punjab National Bank. Nevertheless, looking to the urgent need to strengthen the weak banks, and the Government's inability to come to their rescue, it appears worthwhile taking a second look at the option. Further, the Committee has only expressed certain reservations in this regard; it has not ruled out the option. There does not appear to be any provision in Indian law for the hostile takeover of a banking company. Banks, as such, can change hands through mutual understanding, accommodation of shareholders and the consent of the boards. Before the process is initiated, however, the first priority for the banks would, obviously, be to clean up their balance sheets tainted with non-performing assets and loans granted on political considerations. Attention must also be paid to evolving more realistic and transparent accounting standards. Given the inevitability of acquisitions and mergers in the emerging scenario, It is desirable that the Government, in consultation with the RBI, formulates a comprehensive approach to this vital issue, keeping in view the trends in international banking and imperatives of competition and growth. But mergers and acquisitions should be left to the banks themselves, and not be mandated by the Government.

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For the experiment to be a success, it is also necessary that an acceptable and scientific methodology is developed by banks and financial institutions to evaluate banking companies -- their strengths and weaknesses, management qualities, administrative practices, level of disclosures and their responsiveness to the market demands, during a takeover or merger. Another ticklish question is how to bring harmony and a sense of identity when two banks with starkly contrasting corporate cultures are merged. There are bound to be problems of corporate culture, values and approach. Integrating work forces is always a tough task, and any incompatibility in the process may result in gross inefficiencies, defeating the very objective of merger. Improving the quality of management is yet another challenge for banks. Modern banking competition is, by and large, a test of the managements' abilities and competence. Banks need to enhance management effectiveness. One way to achieve this is to reduce costs and monitor cost-income ratios. It should, however, be appreciated that there cannot be any blanket solution for all weak banks. Where the restructuring process is likely to result in leaner and more efficient organisations with better and stronger balance sheets, the best alternative may be to go public for recapitalisation. Where this is not possible, the only alternative to closure may perhaps be exploring the possibility of merger, despite the various hiccups inherent in the process. The synergies achieved through M&As could equip banks to face the onslaught of foreign banks better. In the Indian context, the closure of a bank is an extreme step and must be done only as the last resort. The restructuring of weak banks certainly calls for tough and quick decisions, failing which revival may never take place.

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MAJOR BANKS IN INDIA

Table 1 ABN-AMRO Bank Andhra Bank Bank of India Bank of Rajasthan Canara Bank Centurion Bank of Punjab Ltd Citi Bank Dena Bank Dhanalakshmi Bank HSBC Indian Bank ING Vysya Bank Karnataka Bank Oriental Bank of Commerce Scotia Bank State Bank of India (SBI) State Bank of Indore State Bank of Travancore UCO Bank United Bank Of India American Express Bank Allahabad Bank Bank of Maharastra Bank of Ceylon Catholic Syrian Bank China Trust City Union Bank Deutsche Bank Federal Bank ICICI Bank Indian Overseas Bank Jammu & Kashmir Bank Karur Vysya Bank Punjab National Bank South Indian Bank State Bank of Bikaner & Jaipur State Bank of Mysore Syndicate Bank Union Bank of India United Western Bank Abu Dhabi Commercial Bank Bank of Baroda Vijaya Bank BNP Paribas Bank Central Bank of India Commercial Bank Corporation Bank Development Credit Bank HDFC Bank IDBI Bank IndusInd Bank JPMorgan Chase Bank Laxmi Vilas Bank Punjab & Sind Bank Standard Chartered Bank State Bank of Hyderabad State Bank of Saurastra Taib Bank United Bank of India UTI Bank

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INDIAN BANKS LISTED ON STOCK EXCHANGES : 1. Development Credit Bank Limited 2. Yes Bank Limited 3. ING Vysya Bank Limited 4. Vijaya Bank 5. U T I Bank Limited 6. Union Bank Of India 7. Uco Bank 8. Syndicate Bank 9. State Bank Of India 10. State Bank Of Bikaner & Jaipur 11. State Bank Of Mysore 12. State Bank Of Travancore 13. South Indian Bank Limited, The 14. Punjab National Bank 15. Oriental Bank of Commerce Limited 16. Lakshmi Vilas Bank Limited 17. Kotak Mahindra Bank Limited 18. Karnataka Bank Limited, The 19. Karur Vysya Bank Limited, The 20. Jammu & Kashmir Bank Limited 21. Indian Overseas Bank 22. Indbank Merchant Banking Services Limited 23. Indusind Bank Limited 24. Industrial Development Bank of India Limited 25. I D B I Bank Limited 26. I C I C I Bank Limited 27. H D F C Bank Limited 28. Federal Bank Limited 29. Dhanalakshmi Bank Limited 30. Dena Bank 31. Corporation Bank 32. City Union Bank Limited 33. Centurion Bank of Punjab Limited 34. Canara Bank 35. Bank Of India 36. Bank Of Baroda 37. Bank Of Maharashtra 38. Bank Of Rajasthan Limited 39. Andhra Bank 40. Allahabad Bank 41. Indian Bank

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UPCOMING FOREIGN BANKS IN INDIA By 2009 few names will be added in the list of foreign banks in India. This is as an aftermath of the sudden interest shown by Reserve Bank of India paving roadmap for foreign banks in India greater freedom in India. Among them is the world's best private bank by EuroMoney magazine, Switzerland's UBS. The following are the list of foreign banks going to set up business in India:

Royal Bank of Scotland Switzerland's UBS US-based GE Capital Credit Suisse Group Industrial and Commercial Bank of China Sachs holds stakes in Kotak Mahindra arms.

Goldman India.

GE Capital is also having a wide presence in consumer finance through GE Capital

India's GDP is seen growing at a robust pace of around 7% over the next few years, throwing up opportunities for the banking sector to profit from. The credit of banks has risen by over 30% in 2007-08 (Source: www.rbi,org.in) and the growth momentum is expected to continue over the next four to five years. Participation in the growth curve of the Indian economy in the next four years will provide foreign banks a launch pad for greater business expansion when they get more freedom after April 2009. Foreign banks are likely to succeed in their niche markets and be the innovators in terms of technology introduction in the domestic scenario. The outlook for the private sector banks indeed looks to be more promising vis--vis other banks. While their focused operations, lower but more productive employee force etc will stand them good, possible acquisitions of PSU banks will definitely give them the much needed scale of operations and access to lower cost of funds. These banks will continue to be

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the early technology adopters in the industry, thus increasing their efficiencies. Also, they have been amongst the first movers in the lucrative insurance segment. Already, banks such as ICICI Bank and HDFC Bank have forged alliances with Prudential Life and Standard Life respectively. This is one segment that is likely to witness a greater deal of action in the future. In the near term, the low interest rate scenario is likely to affect the spreads of majors. This is likely to result in a greater focus on better assetliability management procedures. Consequently, only banks that strive hard to increase their share of fee-based revenues are likely to do better in the future.

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RESERVE BANK OF INDIA (RBI) The central bank of the country is the Reserve Bank of India (RBI). It was established in April 1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the Hilton Young Commission. The share capital was divided into shares of Rs. 100 each fully paid which was entirely owned by private shareholders in the beginning. The Government held shares of nominal value of Rs. 2,20,000. Reserve Bank of India was nationalized in the year 1949. The general superintendence and direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor and four Deputy Governors, one Government official from the Ministry of Finance, ten nominated Directors by the Government to give representation to important elements in the economic life of the country, and four nominated Directors by the Central Government to represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi. Local Boards consist of five members each Central Government appointed for a term of four years to represent territorial and economic interests and the interests of co-operative and indigenous banks. RBI is the central banking and monetary authority in India. RBI manages the country's money supply and foreign exchange and also serves as a bank for the GoI and for the country's commercial banks. In addition to these traditional central banking roles, RBI undertakes certain developmental and promotional activities. RBI issues guidelines, notifications and circulars on various areas, including exposure standards, income recognition, asset classification, provisioning for non-performing assets, investment valuation and capital adequacy standards for commercial banks, long-term lending institutions and non-banking finance companies, RBI requires these institutions to furnish information relating to their businesses to RBI on a regular basis The Reserve Bank of India Act 1934 was commenced on April 1, 1935. The Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank. The Bank was constituted for the need of following:

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To regulate the issue of bank notes . To maintain reserves with a view to securing monetary stability and To operate the credit and currency system of the country to its advantage.

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MERGERS AND ACQUISITIONS

Underlying Principle for M&A Transactions 2+2=5 Additional Value of Synergy

A "Merger" or "Merger of equals" is often financed by an all stock deal (a stock swap). An all stock deal occurs when all of the owners of the outstanding stock of either company get the same amount (in value) of stock in the new combined company. Merger is a legal process and one or more of the companies lose their identity. An acquisition (of un-equals, one large buying one small) can involve a cash and debt combination, or just cash, or a combination of cash and stock of the purchasing entity, or just stock. The Sears-Kmart acquisition is an example of a cash deal. In addition, the acquisition can take the form of a purchase of the stock or other equity interests of the target entity, or the acquisition of all or substantially of its assets. The phrase Mergers and Acquisitions or M&A refers to the aspect of corporate finance strategy and management dealing with the merging and acquiring of different companies as well as other assets. Usually mergers occur in a friendly setting where executives from the respective companies participate in a due diligence process to ensure a successful combination of all parts. On other occasions, acquisitions can happen through a hostile takeover by purchasing the majority of outstanding shares of a company in the open market. In the United States, business laws vary from state to state whereby some companies have limited protection against hostile takeovers. One form of protection against a hostile takeover is the shareholder rights plan, otherwise known as the "poison pill".

SYNERGY

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Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:

Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also include the former CEO, who typically leaves with a compensation package.

Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies - when placing larger orders; companies have a greater ability to negotiate prices with their suppliers.

Acquiring new technology - To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.

Improved market reach and industry visibility - Companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.

That said, achieving synergy is easier said than done - it is not automatically realized once two companies merge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes a merger does just the opposite. In many cases, one and one add up to less than two.

Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the dealmakers. Where there is no value to be created, the CEO and investment bankers - who have much to gain from a successful M&A deal - will try to create an image of enhanced value. The market, however, eventually sees through this and penalizes the company by assigning it a discounted share price. We'll talk more about why M&A may fail in a later section of this tutorial.

MERGERS STRUCTURE 19

A = Amalgamating Company: Ceases to Exist B = Amalgamated Company B receives all of As assets and liabilities Shareholders of A receive shares in B and maybe other benefits like debentures/shares or cash.

VARIETIES OF MERGERS
From the perspective of business structures, there is a whole host of different mergers. Here are a few types, distinguished by the relationship between the two companies that are merging:

Horizontal merger - Two companies that are in direct competition and share the same product lines and markets. Vertical merger - A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker. Market-extension merger - Two companies that sell the same products in different markets. Product-extension merger - Two companies selling different but related products in the same market. Conglomeration - Two companies that have no common business areas.

There are two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors:

Purchase Mergers - As the name suggests, this kind of merger occurs

when one company purchases another. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable. Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. We will discuss this further in part four of this tutorial.

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Consolidation Mergers - With this merger, a brand new company is

formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.

MERGER PROCESS (source: www.rbi.org.in) Phase- I Draft Scheme Notice to members of Board of both companies Determine swap ratio based on valuation report Board approval of both companies Prior NOCs from secured creditors and shareholders for exemption from meeting: Phase- II Draft Application under s. 391(1) Application to HCs in respective jurisdictions of both companies for sanction / direction to conduct meetings Phase- III Notice of EGM to members with statement of terms of merger, interests of directors and proxy forms: 21 days Advertisement - Notice in 2 newspapers: 21 days Affidavit certifying compliance with HCs directions in respect of notice/ advertisement Meetings of creditors and/ or shareholders: agreed to by majority representing of value present and voting Chairman of meetings to file report within 7 days of meeting Resolutions and Explanatory Statements to be filed with RoC 21

Phase- IV HC to be moved within 7 days of Chairmans Report for second motion petition 10 days notice of hearing of petition in same newspapers Notice to Central Govt. (Regional Director), and OL (if applicable): Submit reports Objections raised in 391 proceedings HC Sanction Certified copy of HC Order to be filed with RoC within 30 days of order

MERGERS HUMAN RESOURCE ISSUES Workmen entitled to retrenchment benefits unless retained in employment on same terms. Adjustments of pay scale need to be resolved. Eg: Global Trust employees were retained on same terms in OBC. Pay packages of former GTB staff could be altered only after 3 years. OBC management had to contend with GTBs complex salary structure.

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MOTIVES BEHIND M&A These motives are considered to add shareholder value: Economies of scale: This refers to the fact that the combined company can often reduce duplicate departments or operations, lowering the costs of the company relative to theoretically the same revenue stream, thus increasing profit. Increased revenue/Increased Market Share: This motive assumes that the company will be absorbing a major competitor and increasing its power (by capturing increased market share) to set prices. Cross Selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker's customers, while the broker can sign up the bank's customers for brokerage accounts. Or, a manufacturer can acquire and sell complementary products. Synergy: Better use of complementary resources. Taxes: A profitable company can buy a loss maker to use the target's tax write-offs. Geographical or other diversification: This is designed to smooth the earnings results of a company, which over the long term smoothes the stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders. These motives are considered to not add shareholder value: Diversification: While this may hedge a company against a downturn in an individual industry it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger.

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Overextension: Tend to make the organization fuzzy and unmanageable. Manager's hubris: Oftentimes the executives of a company will just buy others because doing so is newsworthy and increases the profile of the company. Empire Building: Managers have larger companies to manage and hence more power Manager's Compensation: In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders); although some empirical studies show that compensation is rather linked to profitability and not mere profits of the company.

WHAT DRIVES THE MERGER It is the commercial success of Indian public sector banks, the access of few to this enormous wealth and greedy intention being paid by foreign financial institutions to rich prizes in India that have come together to prompt the central government to urge the mergers of various sets of public sector banks. In order to understand the 'incentive' driving the ministry of finance and various interests pushing it, it is useful to distinguish between activities of banks as seeding cum cultivating agents and banks as harvesters on the one hand, and the activities of modern banks as over-time seekers of interest from customer activities, and their activities as point of-time earners of fees. Bank mergers, like many other types of liberalization, directed at increasing the wealth of rich shareholders has been a tsunami originating in the activities of US financial corporations. Their role has been that of harvester of fruits of other institutions seeding and nurturing activities, and of looking for product lines involving fees for point-oftime services rather than that of customer servicing activities. They generally provide usual banking service only to elite band of up-market customers with whom they have sought to build close relationships.

Many on grounds of economies of scale and of scope advocate bank mergers. Before we look into empirical evidence bearing on that, it should be made clear that there are

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no obvious economies of scale in banking. Banking is not like petroleum refining so that a three-tenth law of relation between volume and surface area will automatically generate productivity gains as size increases. Banking is also not like ordinary production activities, so that an increase in the size of market leads always to better division of labour and hence reduction in cost. Banking is highly differentiated by activities the customers engage in; the different types and degrees of risk they face and strategies open to them to tide over unanticipated shocks. In India and in most other countries, banks come in all shapes and sizes, with different bases of depositors and customers for different types of banks. If US mega banks have succeeded in raising their profitability and hence their shareholder value, which is the altar at which all liberalizers worship, they have done so by excluding 20 %of the population of that rich country from banking services. Moreover, the gains of US banks have been build on the immensely higher burden of consumer debt in that country- a debt that has so far been financed by the loans to that country by the rest of the world: in 2004, the US current account deficit has climbed to 630 billion dollars in 2004(RBI, 2004). There is no other country that can possibly emulate the US banks climb to mega size, even if it were politically desirable to do so. When advocates of bank mergers, as a general policy move and not as a measure to consolidate the gains of two banks or cure the troubles of one bank by bringing in a different and better management style of another bank, use the argument of economies of scale, they really mean economies of exclusion-gains made by denying credit to more venturesome customers or customers who need more attention. Even if profitability of banks may increase by such exercises, the real economy may suffer. Innovations are discouraged, production may decline because of shortage of working and fixed capital, and economic growth declines in context in which jobless growth has been haunting responsible policy planners all over the world.

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MISPLACED OPTIMISM Public sector banks are now in euphoria of mergers and acquisitions, concerned more about size than synergy. Liberalization of the Indian banking sector seems to be entering into a new phase with the Union finance ministries announcement of allowing the foreign banks to own up to 51 per cent of the private sector banks. Low capital base of most of the older private sector banks is a very conspicuous weakness of these banks. A few of them have unsatisfactory levels of capital adequacy ratios and NPA ratios slightly higher than the tolerable level. How far the influx of foreign capital would be able to improve the financial strength and operational efficiency of these banks is a moot question. The rapidly changing banking scenario since the dawn of public sector banking era, saw the foreign banks here attuning themselves to deal with domestic borrowers. They have entered into retail credit in a big way recently. These banks are interested in class banking and not mass banking. They have a profit ratio (ratio of operating profit to total assets) higher than that of Indian banks as a whole. It is 3.79 per cent against 2.87 per cent as on March 2004. It may also be noted that six of them have incurred losses during FY2004. Based on the type of banking business entertained by these foreign banks, it could be observed that they prefer to handle only those advances, where the interest spread is high. There are instances when the blue chip companies financed by them turn red; they have expressed their desire to write-off the amount, than to rehabilitate the ill-fated company. Even now, some of them prefer to walk out of the corporate debt restructuring schemes, than fall in line with other banks to make some sacrifices. Sick units, rightly or wrongly have come to be an inevitable appendix to industrial advances in India. Such units can hardly expect any succour from the foreign banks. When profitability is the measuring rod of efficiency of banks, they cannot be blamed for such an action. Under liberalized banking system, direct lending is an unacceptable proposition. Foreign banks instinctively have a dislike for such lending. In the Indian context, the

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inevitability of directed lending is almost beyond doubt. To comply with the lending priorities stipulated by the regulator, these banks opt for investing in the Rural Infrastructure Development Fund, an amount equivalent to the stipulated amount of credit to be lent to the priority sectors. Given a chance, they would prefer the investment route than the credit route for deploying their funds. Changing scenario foreign banks can enhance their Indian operations through three modes. Firstly, the existing foreign banks would be permitted to open more branches, besides allowing new banks to enter the scene. Secondly, they would be permitted to increase their share in the ownership of Indian banks, acquiring controlling interest. Thirdly, they would be allowed to promote banking subsidiaries to operate in India. These liberalized measures would be indeed a big red carpet welcome to foreign banks. In the changing scenario, foreign banks influx would be confined to metropolitan centers only. Their branches may spread out at the most to some of the major cities and port towns. They cannot be expected to enter into district headquarters. Opening financial super markets in the metros, they would be interested in retail banking, credit card and a string of ATMs. Little interest in rural India... As far as the acquisition of bank ownership is concerned, they are more likely to be interested in banks having greater exposure to urban-based business than to retail lending in rural areas. Some of the private sector banks fulfill this condition, as they have very little business relations with the rural sector. Even if they acquire banks having some rural exposure, it may not be unrealistic to expect them to hive off the rural outfits. The impression that the Indian banks are over-staffed is likely to prompt them to downsize the staff. Computerization would naturally get precedence over retaining an army of staff. Their banking subsidiaries would be invariably highly sophisticated business entities offering world-class services to selected customers. Under WTO regime, when the capital movements across the national borders are un-interrupted, they would play a decisive role in this field. Competing with them would be formidable tasks for the local banks, which may find their share in the foreign exchange business coming under severe pressure.

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As against these impending changes, the public sector banks are now in euphoria of mergers and acquisitions, concerned more about the size than the synergy. The combined strength of the merged banks, measured in terms of enhanced financial resources or extended operational infrastructure should not be the more crucial inducement for merger. The synergy gained through merger should fortify them to be more competitive. It is not possible to estimate as to how quickly the foreign banks would respond to the swagatham orchestra from India. The tunes from the North Block and Mint Street appear to be slightly different in pitch. But then the domestic banks may have to prepare themselves to face the music, sooner or later.

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TRANSFORMING INDIAN BANKING

Recent spate of bank mergers has led to the M&A scene in the Indian banking industry warming up. Mergers and acquisition route is providing a quick step to acquire competitive size and offering banks an opportunity to share markets and reduce cost of product development and delivery. Consolidation in the banking sector is inevitable Mergers of smaller; newer banks would be much easier than the PSU banks, due to legal and social constraints. India is now moving in the direction of fewer but larger mega banks.

While merging banks should keep in mind the inherent strengths and weaknesses of a taken over bank. Fundamental features like Portfolio, NPA levels, capital adequacy, technology levels, staff issues should be closely considered when planning for a merger. Public Sector banks that imbibe new concepts in banking, turn tech savvy, leaner and meaner post VRS and obtain more autonomy by keeping governmental stake to the minimum can succeed in effectively taking on the private sector banks by virtue of their sheer size. Weaker PSU banks are unlikely to survive in the long run. Consequently, they are likely to be either acquired by stronger players or will be forced to look out for other strategies to infuse greater capital and optimize their operations. Foreign banks are likely to succeed in their niche markets and be the innovators in terms of technology introduction in the domestic scenario. The outlook for the private sector banks indeed looks to be more promising vis--vis other banks. While their focused operations, lower but more productive employee force etc will stand them good, possible acquisitions of PSU banks will definitely give them the much needed scale of operations and access to lower cost of funds. These banks will continue to be the early technology adopters in the industry, thus increasing their efficiencies. Also, they have been amongst the first movers in the lucrative insurance segment.

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Already, banks such as ICICI Bank and HDFC Bank have forged alliances with Prudential Life and Standard Life respectively. This is one segment that is likely to witness a greater deal of action in the future. In the near term, the low interest rate scenario is likely to affect the spreads of majors. This is likely to result in a greater focus on better asset-liability management procedures. Consequently, only banks that strive hard to increase their share of fee-based revenues are likely to do better in the future. During the last few years the Indian Banking system has witnessed some very high profile mergers, such as the merger of ICICI Ltd. with its banking arm ICICI Bank, the merger of Global Trust Bank with Oriental Bank of Commerce and more recently, the merger of IDBI with its banking arm IDBI Bank Ltd. The Union Finance Minister, P. Chidambaram gave inkling of the governments stance on mergers in the banking sector when he stated that The Government would encourage consolidation among banks in order to make them globally competitive. The Government will not force consolidation, but if two banks want to consolidate, we would encourage them. We will encourage them if it helps banks grow in size, scale and muscle so that they can compete globally. To facilitate such mergers, a small amendment to the Income-tax Act would be made during the budget session of Parliament next year. Similarly, banks would be encouraged to go to the market to raise resources. The above statement of the Finance Minister has to be understood in the context of the Basel II Accord, which was proposed in June 1999 by the Basel Committee on Banking Supervision. As per the Quantitative Impact Study published by the Basel Committee in May 2003, there would be an increase in capital requirements by 12% for banks in developing countries on implementation of the Basel II Accord. Mergers among banks will be one of the ways to increase market power and thereby increase the revenue generation of banks, which would in turn enable them to access the capital market to raise funds and meet the increased capital requirement.

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CONSOLIDATION
1. BENEFITS

As competition would increase, many banks having bigger size, will command more in the market. A bigger bank would have more staff strength, greater geographical reach, more financial resources, more delegated power and less operational and transactional costs due to economies of scale. A bigger financial conglomeration can easily withstand external assaults more effectively.

Mergers and acquisitions can help banks with complimentary expertise to boost up their combined talents as well as on presenting a vastly improved performance. For instance, a foreign bank with proven merit in treasury operations when merged with a bank with surpluses could generate substantial profits.

The geographical and regional spread would get widened when banks with different strongholds merge. Based on the principles of synergy, the business volume and geographical reach of consolidated entity automatically increases by many folds.

Similarly, the market image and brand name of the consolidated entity will always likely to get a boost in comparison to the individual banks. This will lead to a better market image which in turn translates to better performance expectations by the investors and the analysts, thus finally leading to better valuations in the market. We know, that better market valuations mean better shareholder returns leading to an even better market image. Thus, a reinforcing vicious cycle would set in.

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The larger size, greater geographical penetration and enhanced market image and other synergic factors would inevitably increase the bargaining power of the new bank. In a competitive world where the battle is fierce, a better bargaining power position is always an invaluable asset.

The business in near future is unlikely to remain localized but bound to go global. In view of the saturating environment at domestic front, banks will have to venture overseas without any hesitation. Initial foray into overseas markets are always made through strategic alliances and joint ventures. A merged entity with bigger market size, greater geographical spread, sound financial position, good image, greater resistance etc. would necessarily be successful in the overseas. All these virtues also help in acquiring tenders and bids.

The consolidated entity can serve the end user i.e. the customer in a better way through providing single window service by offering a variety of services like conventional banking, merchant banking, mutual funds, insurance etc. under one umbrella leading to innovation and origin of new hybrid products and services like banc-assurance.

2. RISKS :

There are several risks associated with consolidation and few of them are as follows: When two banks merge into one then there is an inevitable increase in the size of the organization. Big size may not always be better. The size may get too widely and go beyond the control of the management. The increased size may become a drug rather than an asset. Consolidation does not lead to instant results and there is an incubation period before the results arrive. Mergers and acquisitions are sometimes followed by losses and tough intervening periods before the eventual profits pour in. Patience, forbearance and resilience are required in ample measure to make any

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merger a success story. All may not be up to the plan, which explains why there are high rate of failures in mergers. Consolidation mainly comes due to the decision taken at the top. It is a topheavy decision and willingness of the rank and file of both entities may not be forthcoming. This leads to problems of industrial relations, deprivation, depression and de-motivation among the employees. Such a work force can never churn out good results. Therefore, personal management at the highest order with humane touch alone can pave the way. The structure, systems and the procedures followed in two banks may be vastly different, for example, a PSU bank or an old generation bank and that of a technologically superior foreign bank. The erstwhile structures, systems and procedures may not be conducive in the new milieu. A thorough overhauling and systems analysis has to be done to assimilate both the organizations. This is a time consuming process and requires lot of cautions approaches to reduce the frictions. There is a problem of valuation associated with all mergers. The shareholder of existing entities has to be given new shares. Till now a foolproof valuation system for transfer and compensation is yet to emerge. Further, there is also a problem of brand projection. This becomes more complicated when existing brands themselves have a good appeal. The question arises whether the earlier brands should continue to be projected or should they be submerged in favor of a new comprehensive identity. Goodwill is often towards a brand and its sub-merger is usually not taken kindly.

3. IMPORTANT CONSIDERATIONS :

With the international banking scenario being dominated by larger banks, it is important that India too should have a fair number of large banks, which could 33

play a meaningful role in the emerging economies. Among the top twenty banks in the emerging economies, India has only one; whereas China has five banks and Brazil has six banks. The performance of banks in India indicates that certain performance characteristics are not restricted to a particular bank. Therefore, consolidation of banking industry is critical from several aspects. Mainly, the reasons for mergers and acquisitions can include motives for value maximization as well as non-value maximization. The factors inducing mergers and acquisitions usually include technological progress, excess capacity, emerging opportunities, and consolidation of international banking markets and deregulation of geographic, functional and product restrictions. Policy inducements such as the governments incentives that could accrue to the top managers are also other important factors which may determine the pace of consolidation. It is found that in all major economies, banking industry undergoes some sort of restructuring process. The economy which delays this process leads to stagnation. That is why, it is important from the point of view of long term prospects of the economy, the consolidation process should be given prime attention. The major gains perceived from bank consolidation are the ability to withstand the pressures of emerging global competition, to strengthen the performance of the banks, to effectively absorb the new technologies and demand for sophisticated products and services, to arrange funding for major development products in the realm of infrastructure, telecommunication, etc. which require huge financial outlays and to streamline human resources functions and skills in tune with the emerging competitive environment. The international experiences reveal a wide range of processes and practices involving consolidation, their impact on the banking market and the trends in post merger performance of banking institutions. These experiences could provide useful inputs to the banking policy in India.

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An important observation which may be induced from various past mergers that the merger between big and small banks led to greater gains as compared to merger between equals. It is also observed from past experiences that if the merger follows business expansion aided by appropriated technology and diversified product range, it could lead to greater gains for the banking industry as a whole. Similarly, consolidation increases the market power and does not cause any damage to the availability of services to small customers.

Evaluation of banks carried out by individual banks reveal that higher capital adequacy and lower non-performing assets explain to a greater extent the growth, profitability and productivity of banks since increase in capital and steep reduction in non-performing assets cannot be entirely left to the individual banks in the present scenario. Consolidation in the banking industry is of great relevance to the economy.

A diagnostic performance evaluation study would reveal out important aspects of divergence in the performance of the domestic banking institutions. A high degree of variation is found in the performance of various groups of banks. Since, public sector banks account for a large share of banking assets and their lower performance ratio reflect the entire banking industry, it is considered important that suitable consolidation process may be initiated at the earliest, so that, the efficiency gain made by a large number of banks of other groups will be properly reflected which could lead to a positive impact on the image of banking.

Consolidation can also be considered critical from the point of view of quantum of resources required for strengthening the ability of banks in asset creation. It indicates that restructuring in Indian banking may not be viewed from the point of particular group rather it can be evolved across the bank groups.

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Indian banks have the unique character in displaying similar characteristics of performance despite consisting of different size and ownership. This trend further substantiates the scope for consolidation across the bank groups.

4. LEGAL SPECIFICATIONS:

1 a) Any two or more banks doing business in this state may, with the approval of the department in the case of resulting state bank, consolidate or merge into one bank, on terms and conditions lawfully agreed upon by a majority of the board of directors of each proposing to consolidate or merge. b) This section does not permit a bank or a bank holding company located in another state to acquire by consolidation or merger any bank or branch bank in this state. c) A bank organized under the laws of this state may, with the approval of the department in the case of a resulting bank, consolidate or merge with a savings association located in this state and may, upon the consolidation or merger, maintain the branch and savings association.

2) Upon consolidation or merger, the corporate franchise, the corporate life, being and existence, and the corporate rights, powers, duties, privileges, franchises, and obligations, including the rights, powers, duties, privileges, obligations as trustee, executor, administrator, and guardian and every right, power, duty, privilege, and obligation as fiduciary, together with title to every species of property, real, personal, and mixed of consolidating or merging banks, are, without necessity of any instrument of transfer, consolidated or merged and continued in and held , enjoyed ,and assumed by the consolidated or merged bank. The merged bank has the right equal with any other applicant to appointment by the courts to the offices of executor, administrator, guardian, or trustee under any will or other instrument made prior to the consolidation or merger and by which will or instrument the consolidating or merging bank was nominated by the maker to the office.

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3) Upon consolidation or merger, the consolidated or merged bank shall designate and operate one of the prior main banking houses of consolidating or merging banks as its main banking house and the bank may maintain and continue to operate the main banking houses of each of other consolidating or merging banks as a branch bank. 4) Upon consolidation or merger, the resulting bank, including all depository institutions that are affiliates of the resulting bank, may directly or indirectly control more than 22% of the total amount of deposits of insured depository institutions and credit unions located in this state.

5. RBI ROLE IN THE CONSOLIDATION (CURRENT AND EXPECTED)

The RBI is responsible for :

1. Restrictions on Sale of the Equity Shares and Repatriation of Sale Proceeds 2. RTGS Implementation in India 3. Risk Management and Basel II 4. Bank's aggregate capital market exposure has been restricted to 40% of the net worth of the bank on a stand-alone and consolidated basis; consolidated direct capital market exposure has been modified to 20% of the bank's consolidated net worth. 5. RBI has renamed its credit policy as the "Annual Policy" statement, since the statement is more aimed at structural adjustments rather than controlling the credit flow in the economy. Pursuant to the Annual Policy statement for the year 2005- 06, the rate of CRR of scheduled commercial banks has been kept at 5.00% of net demand and time liabilities as on the last Friday of the second preceding fortnight.

India is viewed as one of the biggest growth stories among emerging markets explains only part of the attraction for foreign banks. The country's central bank has outlined the roadmap for foreign players to grow, allowing them to set up branches in rural India and take over weak banks with an investment of up to 74% -- and promises to do more 37

in three more years. Credit off-take has grown 25%-30% annually in recent years, with most of the new action in retail consumer lending, which tends to be happy hunting ground for foreign banks. In its February 2005 roadmap, India's central bank -- the Reserve Bank of India (RBI) said that between March 2005 and 2009, foreign banks that were so far restricted to branch operations could also set up wholly owned subsidiaries. It also said they could buy up to 74% of a private bank, a gray area so far. The guidelines also noted that foreign bank subsidiaries with a minimum capital requirement of Rs. 300 crore ($65 million) would be treated on par with existing branches of foreign banks for branch expansion. However, foreign banks cannot grow unrestrained through local acquisitions; they can buy only weak local banks the regulator identifies. The RBI said the second phase of opening up would commence in April 2009, after "a review of the experience gained and after due consultation with all the stakeholders." Size or the lack of it remains the key to banks' growth aspirations in India. Little wonder then that the announcement of a roadmap of banking reforms was enough to spur a series of investments. Bank of America, a small and subdued player in India, said it would pump $175 million into its Indian operations. Of that amount, $150 million is already in. The Hongkong & Shanghai Banking Corporation (HSBC) brought in $180 million with another $63 million waiting. Citigroup's planned investments this year include $75 million in Citi Financial, a non-bank finance company, or NBFCs, as they are called; that's on top of $50 million it sent that way last year. (NBFCs can perform most banking functions except accept deposits or run savings accounts.) Deutsche Bank, too, invested $91 million in its Indian operations over the past year, of which $50 million went into an NBFC. Barclays invested $50 million. Late entrants like Dutch bank ING have been faster on the acquisition track. ING surprised the markets by acquiring a 45% stake of Bangalore-headquartered Vysya Bank, now known as ING Vysya Bank. HSBC had bought close to a 15% stake in UTI Bank and would have gladly gone on to secure a total of 21% had the banking regulator not stopped it early last year. HSBC has since brought down its stake to 4.99% as the banking regulator does not allow any bank to hold more than 5% of another bank without its clearance. HSBC is also considering setting up its own NBFC, regulatory approvals for which tend to arrive faster than those for a new bank or branch expansion. 38

However, foreign banks like HSBC may not any longer find it easy to float NBFCs. In November 2006, the Reserve Bank of India not only disallowed banks from holding 5% of the equity of any NBFC; it also limited any bank's credit exposure to all NBFCs to 40% of the bank's net worth. Those two measures will effectively frustrate foreign banks' perceived attempts to use NBFCs as de facto branches. Further, the banking regulator also required NBFCs to adhere to capital adequacy norms (these didn't apply to them earlier), restricting the size and structure of their loan portfolio, and a capital adequacy requirement (it didn't apply to NBFCs earlier); it also decided to regulate NBFCs promoted by the parents of foreign banks operating in India on a consolidated basis, and not as independent entities. India's NBFC industry is both large and fragmented enough for the regulator to keep a close watch. There are 436 deposit-taking NBFCs, of which 16 have asset sizes of over Rs. 500 crore ($112.5 million) and account for 49% of the aggregate deposits of the total NBFC sector. Then come another 2,615 non-deposit taking NBFCs, of which 104 have assets worth at least Rs. 100 crore each. Citigroup heads the segment of nondeposit taking NBFCs, followed by GE Capital and its associates. Ten of these 104 NBFCs account for more than 43% of the total assets of this sector; five of these 10 companies are foreign-owned. The banking regulator's new guidelines aim at reining in the huge regulatory arbitrage that the foreign players have been enjoying. As the regulator has indicated that the banking sector would not open up before April 2009, foreign banks have been using the NBFC route to add muscle to their balance sheet and expand their activities. This is possible since under the foreign direct investment norms, any foreign player could set up an NBFC once it is cleared by the foreign investment promotion board and the RBI nod in this case is a mere formality (required only to bring in foreign capital. Citigroup in May 2005 paid $676 million for a 9.3% stake in India's leading mortgage lender Housing Finance Development Corp., taking its total stake in that company to 13%. Others have begun circling. After spending more than a decade as an NBFC doing small retail loans, GE Capital said it wants to buy an Indian bank. Two South African 39

banks, First Rand Bank and Standard Bank are also believed to be eying the country. And not far behind are believed to be UBS of Switzerland and Australia-based Macquarie Bank. Even ANZ, which a few years ago sold its operations in India to Standard Chartered Bank is said to be keen on coming back to India. In the era of globalisation, financial sector conglomorisation and bundling in the provision of financial services, there is a need for further strengthening of the regulatory and supervisory regime to ensure stability of the financial system. The Reserve Bank of India has recognised this need and the fact that it cannot remain insulated from the international developments while crafting these regulatory and supervisory standards. Competition and Consolidation The deregulation in interest rates, grant of functional autonomy to banks in the area of credit, entry of foreign banks and emergence of new private banks has made the banking environment more competitive. While the total share in bank credit continues to be dominated by public sector banks, the share of foreign banks is showing an increasing trend. As announced in the Union Budget for 2002-2003, it has been decided to give an option to foreign banks to either operate as branches of their parent banks or to set up subsidiaries. As per the recent RBI guidelines, the overall ceiling for foreign direct investment in private sector banks has also been enhanced. In the changed scenario, it has now become extremely important for Indian banks to remain competitive for surviving. Universally there is a move towards consolidation and convergence. It has been our contention that the Government and supervisory authorities should only provide a conducive environment for consolidation and convergence through appropriate fiscal and monetary policies supported by a sound regulatory and supervisory framework. Hence, bank consolidation/ merger process should be primarily market driven and such proposals should come voluntarily from the banks themselves depending on the organizational synergy and the market share. Management of NPAs

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Management of NPAs continue to be the foremost challenge of the Indian banking system. In the recent past there has been a conscious and persistent effort through the prescription of strict objective norms for the identification and classification of NPAs. This was also supplemented by the sustained efforts both by the Government and the RBI for setting up the requisite infrastructure as also systems/ procedures for effecting recoveries/ reduction of NPAs. The result has been encouraging. However, realising the rigidities in the legal system, Govt. of India/ RBI have taken several special steps to ensure that legal inadequacies do not thwart the resolve to reduce the NPAs of banks. In addition, banks have been advised to strengthen their credit administration machinery and put in place effective credit risk management systems to reduce the fresh incidence of NPAs. Tightening of Prudential Standards The prudential standards need to be enhanced to fall in line with the international best practices. In this direction, Reserve Bank of India has introduced the 90 days delinquency norm for identification of NPAs with effect from the year ending March 2004 and reduced the timeframe for classification of a sub-standard asset as a doubtful asset from 18 months to 12 months with effect from the year ending March 2005. In some countries, doubtful assets, irrespective of their status i.e. secured or unsecured, are required to be classified as loss assets and fully provided for. However, in India, doubtful assets backed by collateral, are provided for only upto 50% of the outstanding balances, irrespective of the number of years in which the accounts remain in this category. Given the delay in recovery of dues through the legal process, the current provisioning norms followed in India do not entirely cover the latent losses inherent in such advances. The existing provisioning requirements would have to be enhanced in line with the international best practices. The Proposed Basel Capital Accord The Basel Committee recognises that the New Accord is more extensive and complex than the 1988 Accord. The New Accord is more risk sensitive and it contains a range of new options for measuring both credit and operational risks. The New Accord is

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likely to be finalised next year and would be implemented in member jurisdictions in 2006. The adoption of the New Basel Capital Adequacy Framework, relating to assigning capital on a consolidated basis, use of external credit assessments as a means for assigning preferential risk weights, sophisticated techniques for estimating economic capital, etc., may need suitable modifications to adequately reflect the institutional realities and macro-economic factors specific to emerging market economies including India. Recognising these implications, RBI has been impressing on the Basel Committee that some of these proposals may require modification / flexibility to fully reflect the concerns of the emerging market economies. Notwithstanding the above, it is imperative that the banks in India study the proposed Capital adequacy framework, identify their transition path and initiate steps to be fully prepared for adoption of the new standards when introduced. Risk Management Systems In view of the diverse financial and non financial risks confronted by banks in the wake of the financial sector deregulation, the risk management practices of banks have to be upgraded by adopting sophisticated techniques like VaR, Duration and Simulation and adopting internal model-based approaches as also credit risk modelling techniques, at least by top banks. Banks need to evolve an integrated risk management system depending on their size, complexity and the risk appetite. As a step towards enhancing and fine-tuning the existing risk management practices in banks RBI has recently issued the draft guidance notes on credit and market risks. Risk Based Supervision Financial sector supervision is expected to become increasingly risk oriented and concerned more with validation of systems. Bank managements will have to develop internal capital assessment processes in accordance with their risk profile and control environment. These internal processes would then be subjected to review and supervisory intervention if necessary. The emphasis will be on evaluating the quality of risk management and the adequacy of risk containment. The transaction based internal / 42

external audit would have to give way to risk based audit system. As banks are computerising more areas of their operations, they would be required to introduce information system audit also. Corporate Governance An adequate institutional and legal framework is in place in India for effectively implementing a code of sound corporate governance in banks. The statutes have builtin legal provisions that prohibit or strongly limit activities and relationships that diminish the quality of corporate governance in banks. As a major step towards strengthening corporate governance in banks, they have been advised to place before their Board of Directors the Report of the Consultative Group of Directors of banks and FIs (Dr. Ganguly Group) set up to review the supervisory role of Boards of banks. The recommendations include the responsibility of the Board of Directors, role and responsibility of independent and non-executive directors, fit and proper norms for nomination of directors in private sector banks, etc. The banks were advised to adopt and implement the recommendations on the basis of the decision taken by their Board. Transparency and disclosure standards are also important constituents of a sound corporate governance mechanism. Transparency and accounting standards in India have been enhanced to align with international best practices. However, there are many gaps in the disclosures in India vis--vis the international standards, particularly in the areas of risk management strategies and practices, risk parameters, risk concentrations, performance measures, components of capital structure, etc. Hence, the disclosure standards need to be further broad-based in consonance with improvements in the capability of market players to analyse the information objectively. Technology Issues The delivery of products and services need extensive use of information technology necessitating high magnitude of investment. However, with a view to enhance the quality of customer service as also to enhance the quality of control, one of the prime thrust areas for the future would be completion of branch computerisation and

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networking of banks. This would also necessitate putting in place of appropriate legal and security systems.

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BANKS AMALGAMATED SINCE NATIONALISATION

DATE

BANK MERGED WITH

Nov-69Bank of Bihar and State Bank Of India Feb-70 Jul-85 Aug-85 Aug-85 Dec-86 May-88 Feb-90 Feb-90 Feb-90 Aug-90 Sep-93 Jan-96 Apr-97 Apr-97 Jun-99 Dec-99 Feb-00 1-Mar 2-Jun 3-Feb 4-Jun 4-Aug National Bank of Lahore and State Bank Of India Miraj State bank and Union Bank of India Lakshmi commercial bank and Canara Bank Bank of Cochin and State Bank Of India Hindustan Commercial bank and Punjab National bank Traders bank and Bank of Baroda Bank of Tamil Nadu and Indian Overseas Bank Bank of Thanjavur and Indian Bank Karur Central bank and Bank of India Purvanchal Bank and Central bank of India New bank of India and Punjab National bank Kashi nath Seth bank and State Bank Of India Bari Doab bank and Oriental Bank of Commerce Punjab Cooperative and Oriental Bank of Commerce Bareilly Corporation and Bank Of Baroda Sikkim bank and Union bank of India Times Bank and HDFC Bank Bank of Madura and ICICI Bank Benares state bank and Bank of Baroda Nedungadi bank and Punjab national Bank South Gujarat local Area and Bank of Baroda Global Trust Bank and Oriental Bank of Commerce

Oct-89 United Industrial bank and Allahabad Bank

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SWOT ANALYSIS
INDIAN FINANCIAL SERVICES SECTOR We believe liquidity will be the key swing factor in maintaining a stable industry dynamics.

Strengths 1 downturns 2 3 budget

Weaknesses, key challenges deficit, combined with

Proven asset quality resilience in past Continued crowding out effect from govt accelerating private sector credit demands Proven management teams, track Ownership restrictions record Stable industry dynamics Constraints on state-owned banks' micro reforms, including HR, staff cut, branch cut constraints.

4 5

Well-established

regulatory

framework Stable/low NPL formation rates Opportunities Key issues / swing factors Liquidity: Deposit growth sustaining momentum and loan growth moderating to 25% from the current level of 30% Policy risks: Moderation in inflation outlook. Potential for further tightening in the short term. Our economist believes that the risk is less Interest rate outlook: Some headwind from policy rate hike but won't be a shock factor Loan growth: Moderation needed more 46

1.

Improving secular GDP growth prospects.

Establishment of special economic zones likely to promote further industrialization

3.

Years, if not decades, of catch-up economics low per capita income, educated workforce. Rapid financial deepening, i.e. loan

growth as multiple of nominal GDP 5 growth Rising consumer spending, consumer credit business. 6 7 Rising corporate capex, investments M&A optionality

for maintaining industry dynamics Reduction in reserve requirements: Key swing factor for liquidity and hence for sustaining growth momentum

Key risk factors 1. "Running on empty" in terms of liquidity. 2. Tightening in global liquidity may trickle down to India. 3. Potentially hawkish RBI stance on inflation/monetary policy. 4. Potential rise in long bond yields, MTM risk for banks. 5. Potential for valuation pullback, should earnings delivery disappoint expectations.

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PEST ANALYSIS 1. Political Factors Focus on Regulations & High Capital Adequacy Ratio (CAR) for Implementation of Basel II: CAR (Capital adequacy ratio) is a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures. One of the significant reason for merger and acquisition is to increase CAR so that these banks become adequately capitalized by December 2006, when the Base II norms will get implemented. This rise in treasury income and the passing of Securisation act in 2002 enabled banks, specially the new age private banks to shore up their CAR levels to well about the mandated 9%. However, going by the Base-II norms of 12.5% Car, 18 private and public banks are yet to prop up their CAR. For e.g. Mumbai-headquatered Dena bank, which is considering merger with Gujarat based Bank of Baroda had high provisioning for gross non- performing assets (GNPA) of Rs. 1928.26 crore in FY 2001 and Rs.1996.02 crore in FY 2002.It eroded the bank's capital, which declined from 7.73% in FY 2001 to 7.64% in FY 2002. But constant efforts of the bank dipped its gross NPAs to Rs.1484.01 crore and its CAR increased to 9.48% in FY 2004. Dena bank realized that its stated Rs. 200 crore public issue will reduce government stake to 51%, the minimum government need to hold in PSU banks. Since the bank can raise no further capital from primary market, a merger with another bank seems to be a logical option for growth of capital and to become adequately capitalized as per Base-II norms. The merger of Dena bank (asset worth Rs. 21951.55 crore) and Bank of Baroda (Assets Rs. 85108.67 crore) will create India's third largest bank with a combined asset base of Rs.107060.22 crore, next to Punjab National Bank with assets worth Rs. 102373.14 crore. Compared to Dena bank whose GNPAs stand at 1484.01 crore BOB has huge GNPAs of Rs. 3979.86 crore. However, Dena bank CAR stands at a low of 9.4% but BOB is adequately capitalized with a CAR at 13.91% in FY 2004. BOB is not only one sector that Dena Bank is looking at with a current Car of 9.48%. It

48

is also contemplating a merger with OBC, which is adequately capitalized with a CAR at 14.47%. 2. Economic Factors RBI's soft interest rate policy has helped increase the liquidity in the market, and banks have been liquidating their gilt portfolios partially to free resources for lending. Credit off take is expected to be reasonably good both on retail and corporate sides. Following the advice of the government banks have increased lending to agricultural sector, while ensuring good quality lending by informed customer analysis. India's economy is booming. Since 1991, economic growth has averaged about 6%, and in the last two or three years it has grown even fasteraround 8%making India, along with China, among the fastest growing countries in the world. Per capita GNP is still very low but has been rising impressively. The service sector in India accounts for more than 50% of total outputan unusually large share for a developing countryand its growth has been consistently strong. In the industrial sector, growth has been more variable, but it has picked up noticeably in the past two years. The agricultural sector is a major concern to Indian policymakers. It accounts for roughly 20% of India's output and employs 60% of the population. India's business climate is improving, and one concrete sign is that foreign capital is finally flowing inthough not at anything like the scale into Chinaafter a long history of hostility to foreign involvement in the economy. The single most important reason for stronger growth is economic liberalization The notable feature in the Indian Banking Sector is that the levels of the Nonperforming loan have been falling in India and are now in the 4-5% range, and bank capital is adequate. But 2 concerns relating to the health of the banking sector have, however, attracted concern. First, there is concern that aggressive retail loan growth may lead to future asset quality problems. There is no doubt, that India is experiencing a credit boom, but

49

it is also possible that lending standards may be declining, which could lead to higher nonperforming loans in the future. A second concern relates to the banking system's high level of exposure to long-term government bonds. Although government bonds have fallen to less than 30% of the banking system's assetsfrom nearly 40%this level remains high and entails risks as interest rates continue to rise. An important feature of India's banking system is that, as in China, state ownership of banks is high. Overall, state-owned entities account for close to three-fourths of total financial system assets. Another important fact is that the Indian private banks are flourishing. They have adopted relatively stronger risk-management processes, using technology effectively and developing new financial products. 3. Social Factors Banks are reinventing themselves as marketing agencies by selling products like bancassurance, RBI bonds, credit cards, etc. Technology has enabled customers to access information through the phone instead of physically traveling to bank locations for the slightest of queries. Phones and advanced web phones have made it possible for customers to get details of balances, accounts and other transactions without traveling. Banks, who have absorbed CRM systems have been able to achieve transparency in customer interface and have made sure that customers receive offers which match with their needs. Consequently this has resulted in greater income for the bank as CRM 'satisfies customers and immediately builds loyalty'. Services such as money transfers and personal payments online and through the phone are already available. 4. Technological Factors Apart from streamlining their processes through technology initiatives such as ATMs, telephone banking, online banking and web based products, banks have also resorted to 50

cross selling of financial products such as credit cards, mutual funds and insurance policies to augment their fee based income. Banks have joined together in small clusters to share their ATM networks during the year. There are five such ATM network clusters functioning in India. The total number of ATMs installed by the public sector banks stood at 8,219 at March 31, 2004, compared with 5,963 ATMs at March 31, 2003. The payment and settlement system is also being modernised. As described above, RBI is actively pursuing the objective of establishing a Real Time Gross Settlement (RTGS) system, on par with other developed economies. In addition to computerisation of front-office operations, the banks have moved towards back-office centralisation. Banks are also implementing "Core Banking" or "Centralised Banking", which provides connectivity between branches and helps offer a large number of value-added products, benefiting a larger number of customers.

51

RESEARCH METHODOLOGY
& REPORT OF DATA COLLECTION
The research methodology was basically secondary data but a visit was made to the branch of Centurion Bank of Punjab in Chandigarh where discussion was held with the Branch officials who recommended visiting the banks website for all the details.. The data is presented as follows: The merger of Lord Krishna Bank (LKB) into Centurion Bank of Punjab (CBoP) would create Indias ninth largest private sector bank with a balance sheet size of ~Rs150bn. The merger is value accretive for CBoP as it augments its geographical presence by 50% and offers the potential to tap into NRI-related businesses. Going forward, we expect 41% CAGR in CBoPs earnings over FY06-08 on the back of multiple growth drivers (retail, SME and wealth management). Synergistic merger at fair valuations: The proposed merger of LKB with CBoP would augment CBoPs branch network by almost 50% and entrench it in southern states and Delhi. LKB provides a base of Gulf-based NRIs to CBoP, which it can target for deposits, remittances and wealth management. Multiple growth drivers to drive profits: CBoP has traditionally been quite strong in the high-yielding retail segment. The merger of erstwhile BoP and now LKB has endowed CBoP with alternate growth engines like SME lending. Wealth management is another focus area CBoPs emergence among the top five banks in mutual funds and insurance sales proves its capabilities in this area. A significantly cleaned up balance sheet and improving productivity would drive CBoPs profitability. Attractive valuations for a rapidly growing bank: A 27% CAGR is expected in CBoPs balance sheet and 41% CAGR in its earnings over FY06-08. Proposed equity issuance to private equity investors would ensure adequate capitalization for CBoP to sustain its organic growth momentum over the next 2-3 years. Valuations of 2.6x FY07E and 2.3x FY08E adjusted book appear attractive for a rapidly growing private

52

sector bank with excellent management quality. We have valued the bank using the CAP model and maintain our 12-month price target of Rs35. LKB, a bank with Rs26bn balance sheet size and 112 branches across India, is merging into CBoP. Table 2 (Rs Mn) Total Assets Advances Deposits Branches (no) ATMs (no) Bank of Punjab As on June 06 1,24,809 74,524 1,03,721 249 202 LKB As on March 06 25,993 14,209 22,789 112 44 BoP + LKB 1,50,802 88,733 1,26,510 361 246

Table 3 As on FY06 (Rs m) Branches (no.) Employees (no.) Advances Deposits Business Net profit Business / branch Business / employee Net profit / branch Net profit / employee CBoP 242 4,471 65,334 93,996 159,331 878 658.4 35.6 3.6 0.2 CBoP+LKB 354 5,663 79,543 116,785 196,328 915 554.6 34.7 2.6 0.2 BoP 21,939 35,304 251

53

Table 4
Ratio Analysis Year to Mar (Rs m) RoA RoE Tier I Capital adequacy GrossNPA Net NPA

Centurion CBOP CBoP+LKB

FY04 -3.2 -257.6 3.1 14.2 4.4 FY05* -0.4 -9.9 11.8 8.6 3.6 FY06* 0.7 10.1 10.3 4.8 1.5 FY07E 0.9 11.6 14.2 3.2 1 FY08E 1.2 12.4 11.8 2.7 0.7

* FY05 pro forma merged with BoP, FY06 pro forma merged with LKB

CBoP management is quite clear that it is not striving to bring down the cost to income ratio by cutting down on investments. In fact, the bank is investing heavily in technology for various areas such as CRM and risk management. The improvement would come through higher revenue generation from existing branch network and employees. Some of the key business segments contributing to fee income generation are:
Wealth

management: CBoP has made commendable progress in sale of third party

investment products such as mutual funds and insurance. In life insurance, the bank generated premium income of Rs1.12bn in FY06 and Rs96m in general insurance. CBoP has tied up with Aviva Life and ICICI Lombard for life and non-life insurance respectively.
Credit

cards business: CBoP has launched a co-branded credit card in association

with the Art of Living foundation. The card merchant acquisition business is also growing rapidly (~Rs5.5bn worth transaction acquisitions in FY06).
Retail

assets business: Processing fees of 0.25-1.0% are charged to retail asset

customers at the time of sanction of loans.

Core

banking activities: Transaction banking activities, off balance sheet items such

as LC/BG and cash management are other fee income-generating segments. Scope for productivity improvement

54

CBoP+LKB would have 361 branches, which is a sizeable presence. However, there is significant scope for improvement in utilization of the branch network, as branch / employee productivity is still way below that for the peer group.

The first merger of public sector banks Union Bank of India and Bank of India There is another proposed merger between Mumbai-based bank of India and Union bank of India for reasons of branch rationalization. Both banks are headquartered in Mumbai and have extensive branch networks in northern regions and major metros .The merger is likely to entail a massive branch rationalization and shrinkage of branches leading to geographical synergies. The new entity Union & Bank of India will have an asset base of over Rs 1,43,175 crore and will become the second largest commercial bank in the country, overtaking ICICI Bank (Rs 1,25,229 crore), the largest being the State Bank of India (Rs 4,07,815 crore). The merged entity will have 4,582 branches and over 68,000 employees. About 200 branches of the new entity will be closed while 500 new branches will be opened to tap new businesses. This will take the total number of branches to 4,882 and translate into annual savings of Rs 300 crore. Even though Union Bank is currently the stronger of the two banks, it may get merged with Bank of India for technical reasons. Bank of India has 19 branches and three representative offices in four continents with a presence in all major financial centres like London, New York, Paris, Tokyo, Singapore and Hong Kong. Since Union Bank plans to merge with Bank of India, the new entity will not have to seek fresh licences in these countries. Otherwise, it would have been required to surrender all its overseas branch licences. At a later stage, one of the relatively weak banks could get merged with the Union & Bank of India to increase the size of its book to around Rs 200,000 crore.

55

Table 5
Bank of India 2005-06 2678 41808 381.00 1.66 7029 1184 4397 2115 Union Bank 2005-06 2082 25421 436.00 2.66 5864 625 3489 1402 BoI + Union 4760 67229

No. of offices No. of employees Business per employee (in Rs.lakhs) Profit per employee (in Rs.lakhs) Interest Income Other Income Interest Expense Operating Expense

12893 1809 7886 3517

Rising NPAs is another reason for acquisition of banks by stronger banks. Dena Bank can go for any kind of merger only when it succeeds in reducing its NPAs from 7.8% to 5% as NPAs affect the net worth of acquiring bank. Tax concessions also act as a catalyst for a strong bank to acquire a weak bank and ailing bank. OBC acquired GTB in Aug'04 and got a tax benefit of Rs.375 crore on the Rs. 1200 crore net NPAs as there was 40% rebate on Income tax on every 1000 crore write off. Geographically synergies too play an important role. Some banks, which have traditionally focused on consolidating their position of strength in their geographical base, now want to expand their reach. Large PSU banks like Punjab National Bank, Bank Of Baroda, Oriental Bank Of Commerce, corporation Bank and Canara Bank are planning to acquire regional banks to become geographically more strong. Smaller PSU banks with regional presence in western states like Maharashtra and Gujarat and Southern States like Karnataka, Tamil Nadu and Andhra Pradesh will be prime targets for acquisitions by large north-based PSU banks. Besides CAR, (as mentioned above in PEST Analysis) geographical synergy with Delhi based Oriental Bank Of Commerce, which had taken over the Hyderabad based GTB in August2004 and is now going public with a Rs.1200 crore IPO, is another reason for Dena bank to consider a merger with the north-based bank. OBC's 1000 odd branches are particularly strong in north Indian states of Punjab, Uttar Pradesh and Haryana while the southern regions remain largely untapped. 56

OBC acquired crisis- striker GTB in August 2004 and now it is keeping its option open to buy another small banks, preferably one with presence in south India, particularly in Kerala, where it has a miniscule presence. BOB too is also looking to merge with a bank with a strong geographical presence in north eastern and southeastern parts of India. To attain geographical synergy, Banglore-based Vijaya bank is eyeing a northern bank while PNB, head-quartered in Delhi is looking southwards. UBI is strong in east, north and central India and is looking for synergies in the west and south for which it is contemplating to merge with bank of Maharashtra in Mumbai or Indian Overseas Bank in Chennai, Kolkatta based UCO bank is looking for bank with strong presence in south as 1730 branches are primarily in east, north and in the west. Chennai-based Indian bank are targeting banks with major presence in west and north India to consolidate their position in these regions. What are the other merger possibilities? Ideally, the State Bank of India should merge its seven associate banks with itself. A decade ago, McKinsey & Co, the consultancy, suggested just this and that the parent should sell some of the associate banks. This is the right time for State Bank to demonstrate its ability to extract value from its investments in associate banks. That can be done either by merging the associate banks with itself or even selling a few of them. For instance, if State Bank is not willing to merge State Bank of Mysore or State Bank of Indore with itself, it must sell them to Industrial Development Bank of India or any other bank or institution that is willing to buy them. The State Bank has so far sidestepped the merger issue by pointing out that the associate banks are growing faster than itself and so should not merged with it. The point to ponder is: how sustainable is the growth? Not all of them are listed entities and their balance sheets are not under public scrutiny. If the State Bank does not want to merge the associates with itself overnight, it can start with one, say State Bank of Patiala. If the seven State Bank associates get merged with the parent, the combined 57

asset base will be Rs 5,49,257 crore, with 13,638 branches. If the government really wants to create a champion in the financial sector, the merged entity can additionally gobble up one of the three big Indian banks Punjab National Bank, Canara Bank or Bank of Baroda. If that actually happens, it will have an asset base of Rs 6,51,588 crore and a branch network of over 17,000. With this asset base, it will emerge as a formidable force in Asia outside Japan overtaking Development Bank of Singapore and Kookmin Bank of South Korea in terms of asset size.

58

ROAD MAP FOR PRESENCE OF FOREIGN BANKS IN INDIA

The banking sector in India is robust and its standards are broadly in conformity with international standards. In further enhancing its efficiency and stability to the best global standards a two-track and gradualist approach will be adopted. One track is consolidation of the domestic banking system in both public and private sectors. The second track is gradual enhancement of the presence of foreign banks in a synchronised manner. The policy decisions announced on March 5, 2004 on FDI, FII and the presence of foreign banks will be implemented in a phased manner. This will also be synchronised with the two-track approach and will be consistent with Indias commitments to the WTO. In this background, the road map for the implementation of the policy decisions is as follows:

Phase I: (March 2005 to March 2009)

1.1

New banks first time presence Foreign banks wishing to establish presence in India for the first time could either choose to operate through branch presence or set up a 100% wholly owned subsidiary (WOS), following the one-mode presence criterion. (The guidelines are in the Annex).

1.2

Existing banks Branch expansion policy For new and existing foreign banks, it is proposed to go beyond the existing WTO commitment of 12 branches in a year. The number of branches permitted each year has already been higher than the WTO commitments. A more liberal policy for underbanked areas will be followed. Branch licensing procedure will continue to be as per current practice.

vide Press Note No. 2 (2004 Series), Ministry of Commerce and Industry, Department of Industrial Policy and Promotion.

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1.3

Conversion of existing branches to Wholly Owned Subsidiaries In the first phase, foreign banks already operating in India will be allowed to convert their existing branches to WOS while following the one-mode presence criterion. (The guidelines on conversion of existing branches into WOS are in the Annex). The WOS will be treated on par with the existing branches of foreign banks for branch expansion in India. The Reserve Bank may prescribe market access and national treatment limitation consistent with WTO, as also other appropriate limitations to the operations of WOS consistent with international practices and the country's requirements.

1.4

Acquisition of Shareholding in Select Indian Private Sector Banks In order to allow Indian Banks sufficient time to prepare themselves for global competition, initially entry of foreign banks will be permitted only in private sector banks that are identified by RBI for restructuring. In such banks, foreign banks would be allowed to acquire a controlling stake in a phased manner. In considering an application made by a foreign bank, for acquisition of 5 % or more in the private bank, RBI will take into account the standing and reputation of the foreign bank, globally as well as in India, and the desired level and nature of presence of the foreign bank in India. RBI may, if it is satisfied that such investment by the foreign bank concerned will be in the long-term interest of all the stakeholders in the investee bank, permit acquisition of such percentage as it may deem fit. The RBI may also specify, if necessary, that the investor bank shall make a minimum acquisition of 15 per cent or more and may also specify the period of time for such acquisition. The over all limit of 74 per cent will be applicable. Where such acquisition is by a foreign bank already having presence in India, a time bound plan covering a period not exceeding six months to conform to the 'one form of presence' concept will have to be submitted by the foreign bank along with the application for acquisition.

60

Appropriate amending legislation will be proposed to the Banking Regulation Act, 1949, in order to provide that the economic ownership of investors is reflected in the voting rights. Simultaneous amendments will be proposed to provide for regulatory approvals from the RBI.

Phase II: April 2009

2.1

According Full National Treatment to Wholly Owned Subsidiaries of In the second phase, the removal of limitations on the operations of the WOS and treating them on par with domestic banks to the extent appropriate will be designed and implemented after reviewing the experience with Phase I and after due consultations with all stakeholders in the banking sector.

Foreign Banks

2.2

Dilution of Stake in Wholly Owned Subsidiaries In this phase, the WOS of foreign banks on completion of a minimum prescribed period of operation will be allowed to list and dilute their stake so that at least 26 per cent of the paid up capital of the subsidiary is held by resident Indians at all times consistent with para 1(b) of the Press Note 2 of March 5, 2004. The dilution may be either by way of Initial Public Offer or as an offer for Sale.

2.3

Mergers and Acquisition of any Private Sector Bank in India In the second phase, after a review is made with regard to the extent of penetration of foreign investment in Indian banks and functioning of foreign banks, foreign banks may be permitted, subject to regulatory approvals and such conditions as may be prescribed, to enter into merger and acquisition transactions with any private sector bank in India subject to the overall investment limit of 74 percent.

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FUTURE OF M&A IN INDIAN BANKING INDUSTRY

The Road Ahead Indian banks have a long way to go before that reach the size of there international counterparts. Even the biggest Indian bank, State Bank of India, is nowhere on the international scale, with assets in the range of $50 billion. Absence of significant scale benefits and higher implicit costs of several services are perpetuating the poor ranking of Indian banks in the international league tables. Shareholding structure, government regulations and sheer size of the country ensure that the existence of Indian banks is not at stake at this stage, What is at stake is the banking support that is available for Indian economic activity, and thereby the international competitiveness of various sectors. What is also at stake is the scope for the banking industry to earn superior returns through differentiated wider services. Further, it is quite conceivable that with passage of time government holding in banks is progressively divested, regulatory authorities will be unable to hold back the international giants from buying out Indian banks. Even economies with a "domestic mindset", such as France and Germany, have been forced to bow before the international capital market forces.

In the globalization era, PSU banks are not content to spread their reaches in India. They are eyeing overseas banks, too. SBI is keen to acquire a US based bank and is conducting due diligence in five banks. Banks of India is eyeing two Indonesian Bank for a tie-up Mumbai based Union Bank, with an International presence is believed to be toying with the idea of forging an alliance with Bank of India, with an international presence in 12 countries and 22 branches. Consolidation in the banking area seems to be an idea whose time has come. Besides attaining growth consolidation will help PSU banks become robust and attract capital from within and outside country.

62

The impact of consolidation banks structure has been obvious, while its impact on banks performance has been harder to discern, However, recent studies accounting for combined effects of adjustments affecting costs and revenues suggest that mergers have had a positive effect on bank performance. The government favour consolidation to come from mergers between state-owned banks or between a state-owned bank and a private bank top create globally competitive strong entities. Economies of scale, a bigger asset base enabling a bank to take larger, exposure, geographical reach, ability to take advantage of technology and the ease in expanding into related areas such as investment banking are some benefits of mergers.

63

RECOMMENDATION
As per the study and the research conducted by me in order to bring forward the concept of merger and acquisition that is taking place in the banking sector, it comes to notice that the fact that merger and acquisition is the biggest tool in accelerating the growth of the banks in the banking sector whether private or public or foreign. The implications of the mergers for the banking system and the economy are considerable. Banks, post-merger, may emerge stronger with better earning capacity, which would enable them to strengthen their capital base further, from retained earnings. The improvement in capital will enable the banks to take up new and diversified activities, such as financing equity underwriting, distributing investment and insurance products, issuing asset-based securities and providing new delivery channels for their products. Its a win-win situation both for the banks as well as the consumers. In addition I would like to add that the banks will have to adopt best global practices, systems and procedures. The skills of bank staff should be upgraded continuously through training. In this regard, the banks may have to relook at the existing training modules and effect necessary changes, wherever required. Seminars and conferences on all relevant and emerging issues should be encouraged. Banks should also set up Research and Market Intelligence units within the organization, so as to remain innovative, to ensure customer satisfaction and to keep abreast of market developments. Banks will have to interact constantly with the industry bodies, trade associations, farming community, academic / research institutions and initiate studies, pilot projects, etc. for evolving better financial models.

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CONCLUSION
Indian banks have a long way to go before that reach the size of there international counterparts. Even the biggest Indian bank, State Bank of India, is nowhere on the international scale, with assets in the range of $50 billion. Absence of significant scale benefits and higher implicit costs of several services are perpetuating the poor ranking of Indian banks in the international league tables. Shareholding structure, government regulations and sheer size of the country ensure that the existence of Indian banks is not at stake at this stage, What is at stake is the banking support that is available for Indian economic activity, and thereby the international competitiveness of various sectors. What is also at stake is the scope for the banking industry to earn superior returns through differentiated wider services. Further, it is quite conceivable that with passage of time government holding in banks is progressively divested, regulatory authorities will be unable to hold back the international giants from buying out Indian banks. Even economies with a "domestic mindset", such as France and Germany, have been forced to bow before the international capital market forces. In the globalization era, PSU banks are not content to spread their reaches in India. They are eyeing overseas banks, too. SBI is keen to acquire a US based bank and is conducting due diligence in five banks. Banks of India is eyeing two Indonesian Bank for a tie-up Mumbai based Union Bank, with an International presence is believed to be toying with the idea of forging an alliance with Bank of India, with an international presence in 12 countries and 22 branches. Consolidation in the banking area seems to be an idea whose time has come. Besides attaining growth consolidation will help PSU banks become robust and attract capital from within and outside country. The impact of consolidation banks structure has been obvious, while its impact on

65

banks performance has been harder to discern, However, recent studies accounting for combined effects of adjustments affecting costs and revenues suggest that mergers have had a positive effect on bank performance. The government favour consolidation to come from mergers between state-owned banks or between a state-owned bank and a private bank top create globally competitive strong entities. Economies of scale, a bigger asset base enabling a bank to take larger, exposure, geographical reach, ability to take advantage of technology and the ease in expanding into related areas such as investment banking are some benefits of mergers. Broadly, there is a consensus that consolidation is inevitable and next step for evolution. The government must create an enabling situation where the leaders are encouraged to take the lead. Eight to ten big banks will dominate the industry over the next five years or so. Foreign banks are already allowed to play a role in this consolidation game and the regulator must set rules for them in transparent manner without delay. Thus, consolidation is a means of making Indian banking competitive. India with a population of 102 crores cannot be content with just one large bank. At least four or five other public sector banks have to grow in size and reach the level of SBI to become globally competitive. Moreover, the road ahead for foreign banks is also clear from the above scenario: Join the private banks' party with strategic stakes, as they wait for more policy latitude to fire their own growth aspirations. The promise lies in those market segments that now account for small shares. Retail lending represents only about 20% of the Indian banking industry's advances and less than 7% of India's GDP of $775 billion, lower than Thailand (18%), Malaysia (33%) and South Korea (55%). India's demographics with its young, consuming class that represent good opportunities are now high in the sights of the foreign banks. A report from Boston Consulting Group in 2005 on opportunities for foreign banks in India outlined the opportunities. It said 60 million new households should be added to India's bankable segment in three years The report highlighted the fact that only around $35 billion in assets -- less than 6% of GDP -- were being managed "professionally," 66

(meaning the organized banking and financial services industry and excluding the informal sector made up of largely local money lenders). And with more than $180 billion in long term fixed deposits in banks and low penetration in the pension market, the opportunity for sustained double-digit growth is attractive. In addition to this foreign banks have been using the NBFC route to add muscle to their balance sheet and expand their activities (See page 41 and 42). The most dramatic impact of globalization on remote servicing in India of banks backoffice processes. It is noted that the huge improvements in telecommunications and computing technology combined with vast variations in factor costs across the world and tight immigration laws will lead to large shifts in work that doesn't a require customer interface. Further, the beginning of this trend is evident mostly in outsourcing of voice-based services. This is a tide that cannot be turned back and will lead to huge improvements in the efficiency of the financial services industry's operations -- both in cost and quality -and lead to a further integration of the global financial industry.

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BIBLIOGRAPHY
www.hinduonnet.com www.123eng.com www.google.com www.epw.org.in www.ilo.org/public www.rbi.org.in www.iba.org
www.thehindubusinessline.com

Report from Copal Partners Report from SSKI Research www.centurionbop.co.in Journals o Economic Times o Times of India

Banks Visited : o ICICI

o Centurion Bank of Punjab

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ANNEXURE
Roadmap for Presence of Foreign Banks in India The guidelines for setting up of WOS by foreign banks and conversion of existing branches of foreign banks into WOS are given hereunder: Eligibility of the parent bank 1. Foreign banks applying to the RBI for setting up a WOS in India must satisfy RBI that they are subject to adequate prudential supervision in their home country. In considering the standard of supervision exercised by the home country regulator, the RBI will have regard to the Basel standards. 2. The setting up of a wholly-owned banking subsidiary in India should have the approval of the home country regulator. 3. Other factors (but not limited to) that will be taken into account while considering the application are given below: i. ii. iii. iv. v. vi. Economic and political relations between India and the country of incorporation of the foreign bank Financial soundness of the foreign bank Ownership pattern of the foreign bank International and home country ranking of the foreign bank Rating of the foreign bank by international rating agencies International presence of the foreign bank

Capital

The minimum start-up capital requirement for a WOS would be Rs. 3 billion and the WOS shall be required to maintain a capital adequacy ratio of 10

69

per cent or as may be prescribed from time to time on a continuous basis, from the commencement of its operations. 5 The parent foreign bank will continue to hold 100 per cent equity in the Indian subsidiary for a minimum prescribed period of operation. Corporate Governance

6. The composition of the Board of directors should meet the following requirements: Not less than 50 per cent of the directors should be Indian nationals resident in India. Not less than 50 per cent of the Directors should be non-executive directors A minimum of one-third of the directors should be totally independent of the management of the subsidiary in India, its parent or associates. The directors shall conform to the Fit and Proper criteria as laid down in RBIs extant guidelines dated June 25, 2004. RBIs approval for the directors may be obtained as per the procedure adopted in the case of the erstwhile Local Advisory Boards of foreign bank branches. 7. Accounting, Prudential Norms and other requirements

i.

The WOS will be subject to the licensing requirements and conditions,

broadly consistent with those for new private sector banks ii. The WOS will be treated on par with the existing branches of foreign banks

for branch expansion. The Reserve Bank may also prescribe market access and national treatment limitation consistent with WTO as also other appropriate limitations to the operations of WOS, consistent with international practices and the countrys requirements. iii. The banking subsidiary will be governed by the provisions of the

Companies Act, 1956, Banking Regulation Act, 1949, Reserve Bank of India Act, 70

1934, other relevant statutes and the directives, prudential regulations and other guidelines/instructions issued by RBI and other regulators from time to time. 8. Conversion of existing branches into a WOS

All the above requirements prescribed for setting up a WOS will be applicable to existing foreign bank branches converting into a WOS. In addition they would have to satisfy the following requirements.

Supervisory Comfort

Permission for conversion of existing branches of a foreign bank into a WOS will inter alia be guided by the manner in which the affairs of the branches of the bank are conducted, compliance with the statutory and other prudential requirements and the over all supervisory comfort of the Reserve Bank.

Capital Requirements

The minimum net worth of the WOS on conversion would not be less than Rs. 3 billion and the WOS will be required to maintain a minimum capital adequacy ratio of 10 per cent of the risk weighted assets or as may be prescribed from time to time on a continuous basis. While reckoning the minimum net worth the local available capital including remittable surplus retained in India, as assessed by the RBI, will qualify. Reserve Bank will cause an inspection/ audit to assess the financial position of the branches operating in India and arrive at the aggregate net worth of the branches. RBIs assessment of the net worth will be final.

9. Acquisition of holding in select private sector banks

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Foreign banks may apply to the Reserve Bank for making investment in private sector banks that are identified by RBI for restructuring. Reserve Bank will examine the application with regard to the eligibility criteria prescribed for foreign banks to set up a WOS vide paragraphs 1 to 4 above as well as their track record in restructuring banks. While permitting foreign banks to acquire stake in the identified private sector banks, RBI may undertake enhanced due diligence on the major shareholders to determine their Fit and Proper status. Reserve Bank may also prescribe additional conditions in this regard as may be considered appropriate. 10. Application procedure Applications for setting up of wholly-owned banking subsidiaries by foreign banks including conversion of existing branches should be made to the Chief General Manager-in-Charge, Department of Banking Operations and Development, Reserve Bank of India, World Trade Centre, Cuffe Parade, Colaba, Mumbai 400 005. The prescribed application form will be placed on the RBI's web site.

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