Favourable terms

Lower cost of funds will help HDFC Bank after merger

The merger of the HDFC “twins” looks set to go ahead after the Reserve Bank of India (RBI) clarified some ambiguities, and offered a degree of relief to the merged entity, calming investors. The merger is now said to be scheduled for July this year. HDFC Bank is the largest private-sector bank in India, and it is one of the most highly valued ones. Its parent, HDFC, is the pre-eminent mortgage financier. The group subsidiaries include a listed and highly valued life insurance arm, a listed asset management company, an unlisted brokerage, and an unlisted general insurance firm, besides other subsidiaries. The financial logic for the merger arises from the fact that borrowing costs for non-banking financial companies (NBFCs) such as HDFC are significantly higher than those for banks. The merged entity would be a bank, enabling it to lower the cost of funding.

On the flip side, banks, unlike NBFCs, have to offer credit to the priority sector, and priority-sector lending (PSL) is low-yield and relatively high-risk. PSL exposure is mandated to the tune of 40 per cent of adjusted net bank credit. The merger could have immediately led to a massive expansion in PSL obligations if HDFC’s entire outstanding loan portfolio was taken into account. The RBI has instead allowed PSL to be ramped up gradually, with one-third of HDFC’s outstanding loans to be taken into account for PSL lending for the first year from the effective date of merger. The remaining two-thirds will be taken into account over the next two fiscal years. This gives the merged entity three years to meet PSL obligations — one assessment suggests that this relief alone will add 2 per cent to net profits in the first year.

A second big clarification is on the treatment of subsidiaries. The RBI has clarified that shareholdings and investments in subsidiaries and associates of HDFC will be allowed to continue as investments of the merged HDFC Bank. The regulator has also permitted HDFC Bank and HDFC to increase joint shareholding to over 50 per cent in HDFC Life Insurance Company, and in the unlisted JV, HDFC ERGO General Insurance Company. The group gets two years from the effective date of merger to reduce its shareholding to 10 per cent in the unlisted HDFC Credila Financial Services. Hence the merger will not affect control of subsidiaries and this has a positive impact on valuations of the merged entity and the subsidiaries since it obviates enforced selling. However, the central bank has declined to offer relief on mandatory banking reserve requirements such as the cash reserve ratio, statutory liquidity ratio, and liquidity coverage ratio. Those will kick in from the effective date of merger at the enhanced level.

The merged entity will dominate the key mortgage segment. HDFC has over Rs 5.25 trillion worth of housing finance exposure, which is more than twice that of the next largest housing finance company, LIC Housing Finance. HDFC Bank’s own housing loan exposure is roughly 11 per cent of its Rs 16-trillion loan book. Both entities receive high valuations at the stock market as do their listed group companies. In addition to high market share and strong growth rates, they have very low default rates compared to their peers in banking and housing finance. The lower cost of funding after the merger, and the easing of regulatory requirements, should ensure the merged entity is also valued at a premium.