Restructuring Indian Banking

That Indian banking today is at cross-roads is an understatement - cross-roads where forced choices to restructure banks have to be made urgently. Nationalisation of 27 major banks since 1969 has placed this strategic dilemma squarely in the lap of the Central Government in post reform India - a task made difficult by divergent views within the political spectrum of the wider role of commercial banks. State owned banks are particularly affected as they control 85per cent of all commercial banking assets today. This is not unique to India. In other emerging markets too such restructuring has proved very difficult. Historically, most developing economies had usually witnessed prominent state ownership of banks in early stages. However, their withdrawal has been progressive and often rapid. Indonesia/Brazil now have only 50per cent of their banking assets under state ownership as against 85 per cent in India, less than 20 per cent in Thailand and nil in Japan and USA. Most emerging economies have learnt the hard

way that economic restructuring towards market orientation entails major risk of bank failures. Dramatic rescue efforts in Argentina cost the Government equivalent of half the annual output (spread over years) whilst it is estimated that Mexicos bank bail out in 94/95 cost over 12 per cent of GDP.

Experience indicates that financial sector reform inherently increases failure probabilities, especially if the state owned the bulk of banks. This is because major structural reforms usually cause unpredictable economic volatility in business/interest rate cycles - which largely bureaucratic bank managements fail to anticipate. Political meddling and weak regulations complete the vicious circle to bank failures.

The Indian nationalised bank bail-out (if one can call the Governments recapitalization efforts in 1994/95) has cost the exchequer over Rs.130 billion to date. With net Non Performing Assets of Indian banks still hovering at 16per cent (vs 4-5per cent norm overseas), the bail-out kitty may need replenishment. Meanwhile, RBI has (post 1992) boldly introduced stronger regulations, transparent and prudential accounting standards, international/BIS capital adequacy norms and set up an independent Board of Bank Supervision for banks. These are necessary but not sufficient conditions for the eventual reform in the banking sector. As the Ministry of Finance is the ultimate owner of state owned banks, it will need to clearly blueprint its restructuring plans and weigh substantial costs of continued status quo. Bank mergers are consequently waiting to happen!

In the current environment where the take-over Code is being finalised by SEBI and everyone realises its importance for effective restructuring of Indian industry, the issue of bank mergers must be debated openly and rationally without the baggage of history, ideology or other extraneous issues so endemic in such debates in India. We must use successful templates used elsewhere to outline our new path to bank restructuring. Of late the task has been made easier with the Minister of Finance, Deputy Governor of the Reserve Bank of India and surprisingly the AIBEA (majority Bank Employee Unions) raising the issue of bank mergers as critical to successful reform. This, as economists would say, is a favourable initial condition.

Rationale for change

The issue of bank mergers was of course outlined in the Narasimhan Committee for Reform of the Banking System in 92/93 which called for creation via mergers of 5/6 global Indian banks and 10/12 regional banks out of the 27 existing state owned banks. This major recommendation was however shelved for political reasons by the previous Government, which initially chose to recapitalize existing banks to maintain depositor confidence.

Why is it that there is a renewed debate for drastic consolidation in banking when the pre-provision operating profits of banks in 1996 have returned to black (except 2) and some of them like State Bank of India, Bank of Baroda, Oriental Bank of Commerce, Dena Bank have successfully raised money from public issues in 95/96? The answer quite clearly lies in the realm of triple future shocks, i.e. need for increased capital, increased competition and phenomenal progress in global information technology and its likely impact in India.

Banks in India have been hitherto protected from domestic or international competition by

lan administered interest rate regime (till 1995) which permitted large guaranteed spreads - one of the highest in the world;

lstrict entry barriers for new domestic bank entrants which includes restrictions on branch expansion;

lrestricting existing foreign banks (who currently have only 6per cent of market share) to few branches and restricting their branching activities;

llack of liberal access to overseas funding (due to strict exchange control restrictions).

This gave a monopoly to large nationalised banks in deposit gathering with little competition or incentive for product innovation or productivity. Branch expansion was based on deposit gathering potential or political direction. This coupled with lack of depth in local money markets prevented emergence of specialised banks/institutions who would largely fund themselves in wholesale markets.

This is all set to change now for three major reasons :

lSecond phase of financial sector deregulation (commencing in 1997) would focus on increased competition as a means to improve the capability of domestic financial institutions to eventually face international competition;

lIndias commitments to WTO will force us to open (albeit gradually) parts of our banking system to foreign entry;

lTechnology in banking has moved rapidly with little regard for national boundaries.

Under this triple onslaught, Indian banks would compulsorily need to restructure and consolidate - lest we want another round of bank bail-outs by 2000 A.D.!

Global experience

In many ways India is similar to developed Commonwealth nations like Canada/ Australia and U.K. where nationwide banking is practised unlike the US which has only lately realised its importance. Nationwide banking provides the critical market size, generates capital for future asset expansion and bring benefits of scale in use of technology - very similar to other major industries which are oligopolistic in nature, with intense competition amongst dominant players.

USA

In the US which is seeing rapid consolidation in banking, the market share of top 5 banks in each of the 9 (census) regions is only 35per cent which offers a greater scope for consolidation to build national franchises. Some spectacular and successful bank mergers in 1995 such as Chase/Chemical Bank (whose market capitalization now stands at over USD 35 bn.) resulted in operating cost savings in branches/staff numbers which turned out much higher than assumed previously. 1997 is likely to see a spate of bank mergers in the US as :

lthe 1996 digestive phase of bank mergers gets over;

lUS banks now have the ability to set up arms length subsidiaries for non bank activities which has increased their attractiveness;

lWell capitalised super regional US banks are trading at PE multiples of 12 with their share price at historic highs which places them at an advantage for a potential acquisition;

lAs loan demand slows down, the challenge is to maintain the technology spend essential for creating increased reach or distribution as against acquisition of new banks for their readymade distribution channels. Bidders would thus pay higher multiples for banks with network in more prosperous areas.

Australia

In Australia bank mergers is very much a hot topic with the new Government having set up the Wallace Commission (similar to Narasimhan Committee) to set out the blueprint for banking in coming years. This includes the issue of local or overseas bank acquisitions. Major Australian banks are currently not allowed to be taken over due to Government regulations via Bank Shareholding Act and Financial Acquisition and Take-Over Act. This could change soon. Already bidding and take-over activity for small regional players has begun. The Government even permitted an outsider like Bank of Scotland a 51per cent stake in a Western Australian Bank. Advance Bank (a strong regional) paid 1.6 x Book value for Bank of South Australia - such ratios clearly value take-over candidates at considerable premiums. Another major reason of increased take-over activity and consolidation in Australia is the level of automation and use of technology in banking - one of the highest in the world. Number of ATMs overtook the number of bank

branches in 1996. In the face of such technological onslaughts, the number of branches is decreasing with the ratio of branches per million inhabitants down to 360 (vs 70 in India).

What is clear is that over the counter banking is being replaced by electronic distribution channels which work out cheaper (especially at large volumes) and are being enthusiastically accepted by consumers, especially those under 35 years of age. Growth of Internet only heralds a new round of branch cuts - at least in developed economies which have seen First Direct (purely a telephone bank) and Internet Bank where branches exist only in cyberspace! The Australian and US examples clearly illustrate the powerful role of technology shaping banking organisations. In contrast delayed and halting mergers between state owned French banks has ultimately proved costlier. Reluctant mergers in response to banking crisis (as in France or Italy) without the opportunity for cost cutting due to political ambivalence has been unsuccessful.

Malaysia

Some enlightened emerging markets are readying themselves for this global phenomenon. Malaysian Government is actively orchestrating mergers of local banks to prepare them for regional competition which is expected after the Government opens its financial sector to ASEAN/APEC banks beyond 2000 A.D. Malaysia with 37 banks serving 20 million people is by the Governments reckoning over banked and splintered despite a savings rate of 38per cent (of GDP) and a buoyant loan demand exceeding 28per cent last year. The strong move by the Government to facilitate bank mergers ahead of international competition is proactive and speaks volumes for their economic management. In addition, restrictions have been put on banks with capital of less than Malaysian Dollars 500 M so as to encourage this process of consolidation.

Indian remedy

Having established an urgent case for bank consolidation/mergers due to environmental pressures as witnessed in other markets, we need to examine this in relation to India. With an 85per cent share of the overall market, the 27 nationalised banks and State Bank of India (itself at 25%+) are prime candidates for restructuring. Recent listing of State Bank of India, Bank of Baroda, Oriental Bank of Commerce and Dena Bank now provide better valuation benchmarks. Whilst the McKinseys advice of merger of State Bank of India and its 7 subsidiaries is eminently sensible (all being largely well run and in need of fresh capital for future growth), the solutions being offered of mergers between larger better run nationalised banks with weaker banks, smack of over simplification. Merging two weak banks is even more dangerous as the combined entity could pose a bigger risks for the entire financial system. Punjab National Bank/New Bank of India merger orchestrated in 1994 was not a great success.

The solution then lies in applying different solutions to different sets of state owned banks - albeit over a defined time frame. However, before considering any moves to consolidate, drastic steps need to be taken to improve operating performance and productivity of these banks by :

Benchmarking staff productivity to Indian best practices levels;

Rationalise loss making branches by freely permitting swaps between banks or closures with agreed staff redundancies via attractive Voluntary Retirement Schemes as permitted under current law;

Rapidly introducing technology, funded via a special Technology Fund through sale of surplus real estate;

Quick workout of major problem loans by a specialised team for recovery, write-offs and quick compromises/settlements so as to reduce the drag of non performing assets on earnings.

Impact of international capital adequacy norms, competition and technology will thereafter drive strategies of both the state owned banks and private sector (including foreign) banks in the coming years in India. 20 Indian banks figured in top 200 in Asia in 1992. By 1996 this had shrunk to 13. Share of Indian banks aggregates in Tier I capital of these top 200 Asian banks has however been static over this 4 year period at 2.7per cent whereas that of Malaysia increased from 2.4per cent to 4.5%, Singapore from 5.2per cent to 8.4per cent and Thailand from 4.2per cent to 6.9%. This indicates growth in core bank capital in Asia largely through consolidation and internal accruals.

The Bangkok Bank has roughly the same asset levels (of USD 42 bn) as SBI but its capital of USD 2.9 bn is twice that of SBI at USD 1.6 Bn. Some powerful Singaporean banks boast of capital adequacy of nearly 20%. Even the largest Indian banks consequently look puny vis-