Mergers And Acquisition In Banking

In the recent times, there have been numerous reports in the media on the Indian Banking Industr y Repor ts have been on a variety of topics. The topics have been ranging from issues such as user friendliness of Indian banks, preparedness of banks to meet the fast approaching Basel II deadline, increasing foray of Indian banks in the overseas markets targeting inorganic growth. Repor ts from the western markets of increased M&A activity have also aroused a deep sense of keenness in the authors to compare the various aspects of M&A in the Banking sector in India and the international arena. M e r g e r is defined as the combination comparable organizations into one.

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T YPES OF MERGER  ‘H o r i z o n t a l ’ : between enterprises in the same product market and at the same level of the production or distribution cycle.  ‘V e r t i c a l ’: between enterprises that operate at dif ferent levels of the production or distribution cycle.  ‘C o n g l o m e r a t e ’: between enterprises operating in dif ferent markets.  F o r w a r d – Merger of target into the acquirer  R e v e r s e – Merger of acquirer into the target  Tr i a n g u l a r – U s e o f a n S P V f o r u n d e r t a k i n g F o r w a r d o r Reverse merger  D e m e r g e r – Hive-of f of an undertaking into a separate company A c q u i s i t i o n is the take-over of a smaller company by a larger one. Whilst in both cases the two companies merge voluntarily on the basis of a contract, there are also cases of so-called hostile t a k e o v e r, i n w h i c h t h e m e r g e r t a k e s p l a c e s o t h a t t h e l a r g e r company acquires a controlling interest in a weaker bank or other wise wins over the bank’s majority shareholders against the will of the management. While the legal personality of the o r i g i n a l e n t i t i e s u s u a l l y e n d s i n a m e r g e r, i t i s u s u a l l y maintained in the case of an acquisition.

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Multiple reasons force us to believe that M&A in the Indian Banking Sector is an imperative. We list them down below: Stability: Fr a g m e n t a t i o n p o s e s i n c r e a s i n g r i s k i n t h e I n d i a n B a n k i n g S e c t o r. D u r i n g t h e f i n a n c i a l p e r i o d 2 0 01 - 2 0 0 5 , o n l y f o u r b a n k s have been able to cross the market capitalization of Rs. 50 billion included Bank of Baroda, HDFC Bank, ICICI Bank, and State Bank of India. Considerable fragmentation exists in the Banking sector for banks with market capitalization of less than Rs. 50 billion. Moreover the created value is moving away from the top 5 banks thus indicating fragmentation indeed has increased over the period of last five years. Shown below are the deposit shares of the Banks operating in India over the period 2000-2004. Data was drawn from around 45 banks which included state-controlled public sector banks, private sector banks and even foreign banks operating in India. It is obser ved that the share of the top 5 players has eroded and been consumed by the next fif teen players. Considering that the base of total deposits has been consistently increasing, consequently the value in deposits gained by the next 15 banks has been tremendous (see table below).

Ye a r 2 0 0 0 2 0 0 4 Similar trends are obser ved in profit af ter tax, borrowings and interest and non interest incomes of the banks, thereby hinting at increased levels of fragmentation in the top 20 banks. Though this could be the sign of a competitive bank market with healthy banks remaining in the market the goal of globally competent banks would be missed. In other words, while a fragmented Indian banking structure may ver y well be beneficial to the customers (given increased competition due to lower market power of existing players), at the same time this also creates the problem of no player having the critical mass to play the game at the global banking industr y level. This has to be looked at significantly from the state’s long- term strategic per spective.

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Fu r t h e r m o r e , i t i s o b s e r v e d t h a t i n a n i n c r e a s i n g c o m p e t i t i v e arena the smaller fragmented banks with no economies of scale, low capabilities to manage risks and poor market power at times end up taking excessive risks resulting in irreparable loss to their depositors. This also results in af fecting the state and its r e g u l a t o r ’ s i . e . , c e n t r a l b a n k n e g a t i v e l y. Ta k e t h e f o l l o w i n g c a s e s of trouble in the recent past: a . G l o b a l Tr u s t B a n k : S i g n i f i c a n t e x p o s u r e t o h i g h r i s k m i d s i z e corporates and an excessive exposure to capital market operations. b. Madhavpura Mercantile Co-operative Bank: Nineteen customers had unsecured loans of more than Rs. 10 billion . c . S o u t h I n d i a n C o - o p e r a t i v e B a n k : N o n P e r f o r m i n g A s s e t s ( N PA s ) from excessive lending to small group of clients d. Nedungadi Bank: This bank based in Southern part of India had significant exposure to plantation industr y and had weak credit risk management systems and processes. Fu r t h e r r e c e n t c a s e s ( i n 2 0 0 5 - 0 6 ) o f t w o b a n k s i n I n d i a n a m e l y United Western Bank and Sangli Bank became attractive targets for acquisition by private sector banks because of their risk profile. The merger with these larger banks is expected to i m p r o v e t h e a s s e t p r o f i l e , N PA m a n a g e m e n t a n d p r o t e c t t h e depositors at the same time of fer the acquiring private sector banks further reach in terms of branches and customer base.

How Would Consolidation Help Indian Banks? A bigger player can af ford to invest in requisite technology and play globally to take advantage of global oppor tunities Because for going global a bank needs to upgrade its t e c h n o l o g y, M I S , “ s y s t e m s & p r o c e s s e s ” a n d s t r a t e g i e s , . t o c o m p e t e e f f e c t i v e l y a n d “ M & A” c o u l d f a c i l i t a t e t h i s . The confidence of international investors in Indian banks has increased manifold in recent times and this offers our banking sector a good opportunity to restructure itself

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A small analysis of per formance of the bank sector and the equity market benchmark index in India and USA showed the following results:

India United States of America (USA) The above table clearly indicates that the banking portfolio in US is as risky as the composite portfolio which is not the case in India. Though the returns are more in India the risk is also higher as shown by the standard deviation. A report as early as August 1 9 91 r e c o g n i z e d t h e t r e n d i n s h a r e h o l d e r r e t u r n s i n t h e U S a n d hence was one of the reasons for the bank M&A wave in the USA Benefits to the customers: Benefits to customers can be seen in a number of ways. One such way being lowering in the intermediation costs. A 10 year trend i n t h e i n t e r m e d i a t i o n c o s t s a s a p e r c e n t a g e o f To t a l a s s e t s i n Indian Banks shows that the Indian private sector banks have the least intermediation costs as a percentage of total assets (see graph below). During this time frame, a significant decreasing trend can also be obser ved in the Private Sector banks of India in the decade. Being non fragmented they could claim greater ef ficiency and hence lower intermediation costs.

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Adhering to the International CAR norms and Supporting Regulator y Framework: Supporting institutional and regulator y framework in India is vital for domestic banks aspiring for global operations. The Central Bank i.e., the Reser ve Bank of India (RBI) has suitably c hanged the countr y’s regulator y framework from time to time to support Indian financial institutions to withstand the competitive pressures placed on them by increasing globalization. Proper steps have been taken to guide the banking sector to see that the banks pass through this transition phase by and large s u c c e s s f u l l y. W i t h t h e R B I r e g u l a t i n g t h e C a p i t a l t o R i s k Weighted Asset Ratio (CRAR) at 9%, a percent above the Basel II CRAR, going for ward many banks would not be able to meet these requirements and may have to go through restructuring in order t o m e e t t h e r e g u l a t o r y r e q u i r e m e n t s . Fu r t h e r m o r e t h e r e a r e a number of banks in India whose growth is restricted due to unavailability of capital. These banks have a significant depositor base but the market perception does not enable them to raise further funds. Hence such banks also become potential targets of acquisition.

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Average Capital Adequacy Ratio of Banks in India The reforms initiated in the banking sector have now reached a crucial stage. Government’s stake in many Public Sector Banks (PSBs) has gone down and as a consequence other shareholders equity ownership in these PSBs has gone up. This leads to greater responsibility on the bank managements since the level of accountability has increased. Pressures of performance and profitability will keep the PSBs on their toes all the time as the public shareholders expect good financial performance along w i t h g o o d r e t u r n s o n t h e i r e q u i t y. M a n y P S B s h a v e a l r e a d y star ted the exercise of cleaning up of their balance sheets by s h e d d i n g t h e e x c e s s b a g g a g e . T h e Vo l u n t a r y R e t i r e m e n t S c h e m e (VRS) in the recent past in some of the banks was aimed not only at downsizing the manpower but also at cutting down the future staf f costs and increasing the per formance levels of the staf f in the long run. Some of these PSB banks are able to run the show to a cer tain extent by low cost funds that are available thanks to the branch network spread over the length and breadth of the c o u n t r y. M & A a c t i v i t y w i l l f u r t h e r b o o s t t h i s p r o c e s s f o r m a n y other banks that cannot go through this exercise individually and need larger par tners to execute them in terms of processes and resources. Managing Bankruptcy Risks Recent studies have established that if merger and acquisitions in banks if allowed in a controlled manner would significantly r e d u c e t h e b a n k r u p t c y r i s k o f t h e m e r g e d e n t i t y. O b v i o u s l y, mergers would also provide these benefits to banks in India reducing their bankruptcy concerns.

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Bottom Line Growth: Mergers and Acquisitions or Restructuring may also help banks improve in three other areas as listed below: 1. E c o n o m i e s of Scale: An acquirer would capabilities to improve the collections, ser vice distribution, infrastructure and IT of the target bank

have the processes,

2. E c o n o m i e s o f S c o p e : An ability to grow products and segments and an opportunity to cross sell would enhance revenue. This could also result in more geographic growth could also be obtained. 3 . S y n e r g y B e n e f i t s : Tr e a s u r y p e r f o r m a n c e w o u l d b e i m p r o v e d as the cost of funds would reduce (hence, improve spread) as it would have a better credit rating. A bank would also be able to leverage scale and improve its trading income.

Tw o p r i m e r e a s o n s f o r c e u s t o b e l i e v e t h a t M & A i n t h e I n d i a n B a n k i n g S e c t o r i s a n o p p o r t u n i t y. Creation Bank:

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Market

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A recent trend is to promote the concept of a financial super market chain, making available all types of credit and non-fund facilities under one roof under one umbrella organization (or through specialized subsidiaries). An example of such a financial supermarket would be the reverse merger of ICICI and ICICI Bank . ICICI Bank today stands as India’s second largest bank of fering its clients both in India and overseas a product range as varied us retail banking products to e x o t i c i n v e s t m e n t b a n k i n g a n d t r e a s u r y s o l u t i o n s . S i m i l a r l y, I D B I and IDBI Bank treaded the same route. Though one has to state that consolidated accounting and super visor y techniques would have to evolve and appropriate fire walls built to address the risks underlying such large organizations and banking conglomerates. Tec h n ol og ic a l Ex p e r t is e: New entrants in the banking sector are armed with technological exper tise while older players are well equipped with experience in practices. Mergers would thus help both parties gain an exper tise in areas in which they lack . In India, the retail banking market biased towards the urban markets is growing at a C o m p o u n d e d A n n u a l G r o w t h R a t e ( C AG R ) o f a l m o s t 1 8 - 2 0 % w h i l e the rural market is yet to be fully tapped. Keeping in focus the population profile, technology would be a major enabler for banking in the future. A number of state owned banks in India are adopting sophisticated core banking solutions and these are just the larger ones. For smaller banks to adopt technology platforms the expenditure may not be sustainable and hence this may be one more reason for M&A . Growing integration of economies and the markets around the world is making global b a n k i n g a r e a l i t y. T h e s u r g e i n g l o b a l i z a t i o n o f f i n a n c e h a s a l s o gained momentum with the technological advancements which have ef fectively overcome the national borders in the financial ser vices business. Widespread use of internet banking, mobile banking, and other modern technologies (such as SWIFT) has widened frontiers of global banking, and it is now possible to market financial products and services on a global basis. In the coming years globalization would spread fur ther on account of the likely opening up of financial ser vices under W TO. India is one of the signatories of Financial Ser vices A greement ( F S A ) o f 1 9 97. T h i s g i v e s I n d i a ’ s f i n a n c i a l s e c t o r i n c l u d i n g b a n k s an opportunity to expand their business on a quid pro quo basis. An easy way for this is thus to go through adequate reconstruction to acquire the necessar y technology and get an early mover advantage in globalizing the Indian Banks.

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Cross Border M&A in Banks One more reason for M&A which has sprung up in the recent years is Indian Banks seeking international presence. In the last two decades, there has been a jump in the Indian diaspora working abroad. A new recent trend is the increase in the interest of foreign expats to work in India. Both these communities seek banking products in remittances and other cross border retail p r o d u c t s . Fu r t h e r f i r m s a r e l o o k i n g f o r f u n d s o v e r s e a s f o r v a r i o u s purposes ranging from capital expenditure to leveraged M&A financing. Hence, Indian banks are setting up branches and subsidiaries overseas and foreign banks are expanding their operations in India. These bank branches (set up abroad) further target the local population to be profitable and hence target l o c a l a c q u i s i t i o n s . E v i d e n t l y, t h i s r e s u l t s i n a n M & A o p p o r t u n i t y for Foreign Banks to acquire an Indian Bank and also Indian Banks to acquire foreign banks. For example, ICICI Bank has made an acquisition of a bank in Europe in 2006 to establish itself in a geographical area.

The Indian M&A environment is a strongly regulated by the following major pieces of legislation/bodies: − − −

The The The Act,

Companies Act, 1956 Ta k e o v e r s C o d e , 1 9 97 M o n o p o l i e s a n d R e s t r i c t i v e Tr a d e P r a c t i c e s 1969 -9-

− The − The − The − The • • •

Foreign Exchange Management Act, 1999 Foreign Investment Promotion Board (FIPB) Reser ve Bank of India I n c o m e Ta x A c t , 1 9 61

Mergers, amalgamations, de-mergers, acquisitions of business units or divisions, are all governed by The Companies Act for all registered companies Acquisition of shares in listed Indian companies is g o v e r n e d b y T h e Ta k e o v e r C o d e , 1 9 97.

M E R G E R O F S TAT E B A N K O F I N D I A A N D S TAT E B A N K OF SAURASHTRA SBS is the smallest of the seven associates. The other associates a r e S t a t e B a n k o f Tr a v a n c o r e , S t a t e B a n k o f M y s o r e , S t a t e B a n k o f B i k a n e r a n d J a i p u r, S t a t e B a n k o f H y d e r a b a d , S t a t e B a n k o f Indore and State Bank of Patiala. SBS has 460 branches and the merger would help eliminate duplication of branches in the same area. Its net profit rose 45 p e r c e n t t o R s 8 7. 4 c r o r e i n 2 0 0 6 - 07. T h e b a n k h a s p a i d - u p e q u i t y

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c a p i t a l o f R s 31 4 c r o r e . T h e t o t a l d e p o s i t s s t o o d a t R s 1 5 , 8 0 4 crore while total advances were at Rs 11 ,081 crore. The merger would help SBI consolidate its position as the countr y's biggest bank and widen the gap with nearest rival ICICI B a n k . W i t h 9 , 57 9 b r a n c h e s , S B I h a s t o t a l a s s e t s o f R s 5 , 6 6 , 5 6 5 c r o r e a n d p o s t e d a n e t p r o f i t o f R s 4 , 5 41 c r o r e a s o n M a r c h 31 , 2 0 07. I C I C I B a n k h a d a s s e t s o f R s 3 , 4 4 , 6 5 8 c r o r e a n d p o s t e d a net profit of Rs 3,110 crore in 2 0 0 6 - 07. The merger comes at time when the bank has decided to go in for big expansion. The bank is also looking at freeing up capital by setting up a holding company for its life insurance and asset management businesses. SBI’s move to merge its arms could p a v e t h e w a y f o r f u r t h e r c o n s o l i d a t i o n i n t h e i n d u s t r y, w h i c h faces imminent competition from foreign banks from 2009. Merger of State Bank of Saurashtra with SBI would enable it to up-scale in terms of footprint, manpower and other resources. It would also enable it to face competition arising from g l o b a l i z a t i o n o f t h e e c o n o m y, a p a r t f r o m a u g m e n t i n g e f f i c i e n c y and enabling better management of risk. State Bank of Saurashtra is the smallest of its associate banks and operates in regions where SBI does not have a large presence.

Buyer Wells Fargo & Company is a financial holding company and a b a n k h o l d i n g c o m p a n y. I t i s a d i v e r s i f i e d f i n a n c i a l s e r v i c e s c o m p a n y. I t p r o v i d e s r e t a i l , c o m m e r c i a l a n d c o r p o r a t e b a n k i n g ser vices through banking stores located in 23 states: Alaska, Arizona, California, Colorado, Idaho, Illinois, Indiana, Iowa, Michigan, Minnesota, Montana, Nebraska, Nevada, New Mexico, N o r t h D a k o t a , O h i o , O r e g o n , S o u t h D a k o t a , Te x a s , U t a h , Washington, Wisconsin and Wyoming. It provides other financial ser vices through subsidiaries engaged in various businesses, principally wholesale banking, mortgage banking, consumer finance, equipment leasing, agricultural finance, commercial - 11 -

finance, securities brokerage and investment banking, insurance agency and brokerage ser vices, computer and data processing ser vices, trust ser vices, investment advisor y ser vices and venture capital investment. It operates in three segments: Community Banking, Wholesale Banking and Wells Fargo Financial. Ta r g e t Wac hovia Corporation (Wac hovia) is a financial holding company a n d a b a n k h o l d i n g c o m p a n y. I t p r o v i d e s c o m m e r c i a l a n d r e t a i l banking, and trust services through fullservice banking offices in Alabama, Arizona, California, Colorado, Connecticut, Delaware, Florida, Georgia, Illinois, Kansas, Mar yland, Mississippi, Nevada, N e w J e r s e y, N e w Yo r k , N o r t h C a r o l i n a , P e n n s y l v a n i a , S o u t h C a r o l i n a , Te n n e s s e e , Te x a s , V i r g i n i a a n d Wa s h i n g t o n , D . C . I t a l s o provides various other financial ser vices, including mor tgage b a n k i n g , i n v e s t m e n t b a n k i n g , i n v e s t m e n t a d v i s o r y, h o m e e q u i t y lending, asset-based lending, leasing, insurance, international and securities brokerage ser vices, through other subsidiaries. The Company?s retail securities brokerage business is conducted through Wac hovia Securities, LLC, and operates in 49 states. In O c t o b e r 2 0 07 , W a c h o v i a c o m p l e t e d t h e a c q u i s i t i o n o f A . G . E d w a r d s , I n c . I n F e b r u a r y 2 0 07 , t h e C o m p a n y a c q u i r e d a m a j o r i t y interest in European Credit Management Ltd.

Wells Fargo to buy Wachovia for $15.1bn Wells fargo & co the biggest US bank on the west coast, agreed to buy of Wac hov ia corp for about $1 5.1 bn in stoc k , trumping C i t i g r o u p ’ s o f f e r f o r e m b a t t l e d N o r t h C a r o l i n a l e n d e r. T h i s d e a l w o u l d b e e x e c u t e d e n t i r e l y b y We l l s Fa r g o w i t h o u t h e l p of US unlike citigroup’s of fer which relied on financial backing from the Federal Deposit Insurance Corp. R AT E O F R E T U R N W e l l Fa r g o s a i d i t w i l l a c q u i r e a l l o f Wa c h o v i a ’ s b u s i n e s s e s preferred equity and banking deposits. Bank claimed that the acquisition will add to earnings per share by the third year af ter completion and should produce internal rate of return of at least 15 %.

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Buying Wac hov ia is a detour from the strategy was outlined by W e l l s F a r g o . A f t e r a c q u i r i n g W a c h o v i a W e l l s Fa r g o w o u l d h a v e $ 1 . 4 2 t r i l l i o n i n a s s e t s , $ 7 8 7 b i l l i o n i n d e p o s i t s a n d 1 076 1 branches.

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