mergers and acquisition in banking

In the recent t imes there have been numerous reports in the media on the Indian Banking Industry Reports have been on a var iety of topics The topics have been ranging f rom issues such as user f r iendl iness of Indian banks preparedness of banks to meet the fast approaching Basel I I deadl ine increas ing foray of Indian banks in the overseas markets target ing inorganic growth Reports f rom the western markets of increased MampA act iv i ty have a lso aroused a deep sense of keenness in the authors to compare the var ious aspects of MampA in the Banking sector in India and the internat ional arena

Merger i s def ined as the combinat ion of two re lat ive ly comparable organizat ions into one

TYPES OF MERGER

lsquoHorizontal rsquo between enterpr ises in the same product market and at the same level of the product ion or d istr ibut ion cyc le

lsquoVertical rsquo between enterpr ises that operate at d i f ferent levels of the product ion or d istr ibut ion cyc le

lsquoConglomerate rsquo between enterpr ises operat ing in d i f ferent markets

Forward ndash Merger of target into the acquirer Reverse ndash Merger of acquirer into the target Tr iangular ndash Use of an SPV for undertaking Forward

or Reverse merger Demerge r ndash Hive-of f of an undertaking into a

separate company

Acquisit ion i s the take-over of a smal ler company by a larger one Whi lst in both cases the two companies merge voluntar i ly on the bas is of a contract there are a lso cases of so-ca l led host i le takeover in which the merger takes p lace so that the larger company acquires a contro l l ing interest in a weaker bank or otherwise wins over the bankrsquos major i ty shareholders against the wi l l o f the management Whi le the legal personal i ty of the or ig inal ent i t ies usual ly ends in a merger i t i s usual ly mainta ined in the case of an acquis i t ion

- 1 -

MampA in the Indian Banking Sector as an Imperative

Mult ip le reasons force us to bel ieve that MampA in the Indian Banking Sector is an imperat ive We l is t them down below

Stabil ity

Fragmentat ion poses increas ing r isk in the Indian Banking Sector Dur ing the f inancia l per iod 2001-2005 only four banks have been able to cross the market capi ta l izat ion of Rs 50 b i l l ion inc luded Bank of Baroda HDFC Bank IC ICI Bank and State Bank of India Considerable f ragmentat ion exists in the Banking sector for banks with market capi ta l izat ion of less than Rs 50 b i l l ion Moreover the created value is moving away f rom the top 5 banks thus indicat ing f ragmentat ion indeed has increased over the per iod of last f ive years Shown below are the deposi t shares of the Banks operat ing in India over the per iod 2000-2004 Data was drawn from around 45 banks which inc luded state-contro l led publ ic sector banks pr ivate sector banks and even fore ign banks operat ing in India I t i s observed that the share of the top 5 p layers has eroded and been consumed by the next f i f teen p layers Consider ing that the base of tota l deposi ts has been consistent ly increas ing consequent ly the value in deposi ts gained by the next 15 banks has been tremendous (see table below)

Year 2000 2004Simi lar t rends are observed in prof i t a f ter tax borrowings and interest and non interest incomes of the banks thereby h int ing at increased levels of

- 2 -

f ragmentat ion in the top 20 banks Though th is could be the s ign of a compet i t ive bank market with heal thy banks remain ing in the market the goal of g lobal ly competent banks would be missed In other words whi le a f ragmented Indian banking structure may very wel l be benef ic ia l to the customers (g iven increased compet i t ion due to lower market power of ex ist ing p layers) at the same t ime th is a lso creates the problem of no p layer having the cr i t ica l mass to p lay the game at the g lobal banking industry level Th is has to be looked at s igni f icant ly f rom the statersquos long-term strategic perspect ive Furthermore i t i s observed that in an increas ing compet i t ive arena the smal ler f ragmented banks with no economies of sca le low capabi l i t ies to manage r isks and poor market power at t imes end up tak ing excess ive r isks resul t ing in i r reparable loss to thei r deposi tors This a lso resul ts in af fect ing the state and i ts regulator rsquos i e centra l bank negat ively Take the fo l lowing cases of t rouble in the recent past

a Global Trust Bank S igni f icant exposure to h igh r isk mid s ize corporates and an excess ive exposure to capi ta l market operat ions

b Madhavpura Mercant i le Co-operat ive Bank Nineteen customers had unsecured loans ofmore than Rs 10 b i l l ionc South Indian Co-operat ive Bank Non Performing Assets (NPAs) f rom excess ive lending tosmal l group of c l ients

d Nedungadi Bank This bank based in Southern part of India had s igni f icant exposure toplantat ion industry and had weak credi t r isk management systems and processes

Further recent cases ( in 2005-06) of two banks in India namely United Western Bank and Sangl i Bank became attract ive targets for acquis i t ion by pr ivate sector banks because of thei r r isk prof i le The merger with these larger banks is expected to improve the asset prof i le NPA management and protect the deposi tors at the same t ime of fer the acquir ing pr ivate sector banks further reach in terms of branches and customer base

- 3 -

How Would Consolidation Help Indian Banks

A bigger p layer can af ford to invest in requis i te technologyand p lay g lobal ly to take advantage of g lobal opportuni t ies

1048709 Because for going g lobal a bank needs to upgrade i tstechnology MIS ldquosystems amp processesrdquo and strategies to compete ef fect ive ly and ldquoM amp Ardquo could fac i l i tate th is

1048709 The conf idence of internat ional investors in Indian bankshas increased mani fo ld in recent t imes and th is of fers ourbanking sector a good opportuni ty to restructure i tse l f

Returns and Risks to Shareholders

A smal l analys is of performance of the bank sector and the equity market benchmark index in India and USA showed the fo l lowing resul ts

India United States of America (USA)The above table c lear ly indicates that the banking port fo l io in US is as r isky as the composi te port fo l io which is not the case in India Though the returns are more in India the r isk is a lso h igher as shown by the standard deviat ion A report as ear ly as August 1991 recognized the trend in shareholder returns in the US and hence was one of the reasons for the bank MampA wave in the USA Benef i ts to the customers

Benef i ts to customers can be seen in a number of ways One such way being lower ing in the intermediat ion costs A 10 year t rend in the intermediat ion costs as a percentage of Tota l assets in Indian Banks shows that

- 4 -

the Indian pr ivate sector banks have the least intermediat ion costs as a percentage of tota l assets (see graph below) Dur ing th is t ime f rame a s igni f icant decreas ing trend can a lso be observed in the Pr ivate Sector banks of India in the decade Being non f ragmented they could c la im greater ef f ic iency and hence lower intermediat ion costs

Adhering to the International CAR norms and Supporting Regulatory Framework

Support ing inst i tut ional and regulatory f ramework in India is v i ta l for domest ic banks aspir ing for g lobal operat ions The Centra l Bank i e the Reserve Bank of India (RBI) has su i tably changed the countryrsquos regulatory f ramework f rom t ime to t ime to support Indian f inancia l inst i tut ions to withstand the compet i t ive pressures p laced on them by increas ing g lobal izat ion Proper steps have been taken to guide the banking sector to see that the banks pass through th is t rans i t ion phase by and large successfu l ly With the RBI regulat ing the Capita l to R isk-Weighted Asset Rat io (CRAR) at 9 a percent above the

- 5 -

Basel I I CRAR going forward many banks would not be able to meet these requirements and may have to go through restructur ing in order to meet the regulatory requirements Furthermore there are a number of banks in India whose growth is restr icted due to unavai labi l i ty of capi ta l These banks have a s igni f icant deposi tor base but the market percept ion does not enable them to ra ise further funds Hence such banks a lso become potent ia l targets of acquis i t ion

Average Capital Adequacy Ratio of Banks in India

The reforms in i t iated in the banking sector have now reached a cruc ia l s tage Governmentrsquos stake in many Publ ic Sector Banks (PSBs) has gone down and as a consequence other shareholders equi ty ownership in these PSBs has gone up This leads to greater responsib i l i ty on the bank managements s ince the level of accountabi l i ty has increased Pressures of performance and prof i tabi l i ty wi l l keep the PSBs on their toes a l l the t ime as the publ ic shareholders expect good f inancia l performance a long with good returns on their equi ty Many PSBs have a l ready started the exerc ise of c leaning up of thei r ba lance sheets by shedding the excess baggage The Voluntary Ret i rement Scheme (VRS) in the recent past in some of the banks was a imed not only at downsiz ing the manpower but a lso at cutt ing down the future staf f costs and increas ing the performance levels of the staf f in the long run Some of these PSB banks are able to run the show to a certa in extent by low cost funds that are avai lable thanks to the branch network spread over the length and breadth of the country MampA act iv i ty wi l l further boost th is process for many other banks that cannot go through th is exerc ise indiv idual ly and need larger partners to execute them in terms of processes and resources

Managing Bankruptcy Risks

- 6 -

Recent studies have establ ished that i f merger and acquis i t ions in banks i f a l lowed in a contro l led manner would s igni f icant ly reduce the bankruptcy r isk of the merged ent i ty Obvious ly mergers would a lso provide these benef i ts to banks in India reducing their bankruptcy concerns

Bottom Line Growth

Mergers and Acquis i t ions or Restructur ing may a lso help banks improve in three other areas as l i s ted below

1 Economies of Scale An acquirer would have the capabi l i t ies to improve the co l lect ions serv ice processes d istr ibut ion in frastructure and IT of the target bank

2 Economies of Scope An abi l i ty to grow products and segments and an opportuni ty to cross se l l would enhance revenue This could a lso resul t in more geographic growth could a lso beobtained

3 Synergy Benefits Treasury performance would be improved as the cost of funds would reduce (hence improve spread) as i t would have a better credi t rat ing A bank would a lso be able to leverage scale and improve i ts t rading income

- 7 -

MampA in the Indian Banking Sector as an Opportunity

Two pr ime reasons force us to bel ieve that MampA in the Indian Banking Sector is an opportuni ty

Creation of a Financial Super Market or a Universal Bank

A recent t rend is to promote the concept of a f inancia l super market chain making avai lable a l l types of credi t and non-fund fac i l i t ies under one roof under one umbrel la organizat ion (or through specia l ized subsid iar ies) An example of such a f inancia l supermarket would be the reverse merger of IC ICI and ICICI Bank IC ICI Bank today stands as Indiarsquos second largest bank of fer ing i ts c l ients both in India and overseas a product range as var ied us reta i l banking products to exot ic investment banking and treasury so lut ions S imi lar ly IDBI and IDBI Bank treaded the same route Though one has to state that consol idated account ing and superv isory techniques would have to evolve and appropr iate f i re wal ls bui l t to address the r isks under ly ing such large organizat ions and banking conglomerates

- 8 -

Technological Expertise

New entrants in the banking sector are armed with technologica l expert ise whi le o lder p layers are wel l equipped with exper ience in pract ices Mergers would thus help both part ies gain an expert ise in areas in which they lack In India the reta i l banking market b iased towards the urban markets is growing at a Compounded Annual Growth Rate (CAGR) of a lmost 18-20 whi le the rura l market is yet to be fu l ly tapped Keeping in focus the populat ion prof i le technology would be a major enabler for banking in the future A number of state owned banks in India are adopt ing sophist icated core banking so lut ions and these are just the larger ones For smal ler banks to adopt technology p lat forms the expenditure may not be susta inable and hence th is may be one more reason for MampA Growing integrat ion of economies and the markets around the wor ld is making g lobal banking a real i ty The surge in g lobal izat ion of f inance has a lso gained momentum with the technologica l advancements which have ef fect ive ly overcome the nat ional borders in the f inancia l serv ices bus iness Widespread use of internet banking mobi le banking and other modern technologies (such as SWIFT) has widened f ront iers of g lobal banking and i t i s now poss ib le to market f inancia l products and serv ices on a g lobal bas is In the coming years g lobal izat ion would spread further on account of the l ike ly opening up of f inancia l serv ices under WTO India is one of the s ignator ies of F inancia l Serv ices Agreement (FSA) of1997 This g ives Indiarsquos f inancia l sector inc luding banks an opportuni ty to expand their bus iness on a quid pro quo bas is An easy way for th is is thus to go through adequate reconstruct ion to acquire the necessary technology and get an ear ly mover advantage in g lobal iz ing the Indian Banks

Cross Border MampA in Banks

One more reason for MampA which has sprung up in the recent years is Indian Banks seeking internat ional presence In the last two decades there has been a jump in the Indian d iaspora work ing abroad A new recent t rend is the increase in the interest of fore ign expats to work in India Both these communit ies seek banking products in remittances and other cross border reta i l

- 9 -

products Further f i rms are looking for funds overseas for var ious purposes ranging f rom capi ta l expenditure to leveraged MampA f inancing Hence Indian banks are sett ing up branches and subsid iar ies overseas and fore ign banks are expanding their operat ions in India These bank branches (set up abroad) further target the local populat ion to be prof i table and hence target local acquis i t ions Ev ident ly th is resul ts in an MampA opportuni ty for Fore ign Banks to acquire an Indian Bank and a lso Indian Banks to acquire fore ign banks For example IC ICI Bank has made an acquis i t ion of a bank in Europe in 2006 to establ ish i tse l f in a geographica l area

REGULATIONS OF MERGER AND ACQUISITION IN INDIA

The Indian MampA environment is a strongly regulated by the fo l lowing major p ieces of leg is lat ionbodies

The Companies Act 1956 The Takeovers Code 1997 The Monopol ies and Restr ict ive Trade

Pract ices Act 1969 The Foreign Exchange Management Act

1999 The Foreign Investment Promot ion Board

(F IPB)

- 10 -

The Reserve Bank of India The Income Tax Act 1961

bull Mergers amalgamat ions de-mergers acquis i t ions of bus iness uni ts or d iv is ions are a l l governed by The Companies Act for a l l registered companies

bullbull Acquis i t ion of shares in l i s ted Indian companies

is governed by The Takeover Code 1997

MERGER OF STATE BANK OF INDIA AND STATE BANK OF SAURASHTRA

SBS is the smal lest of the seven associates The other associates are State Bank of Travancore State Bank of Mysore State Bank of B ikaner and Ja ipur State Bank of Hyderabad State Bank of Indore and State Bank of Pat ia la

SBS has 460 branches and the merger would help e l iminate dupl icat ion of branches in the same area I ts

- 11 -

net prof i t rose 45 per cent to Rs 874 crore in 2006-07 The bank has paid-up equity capi ta l of Rs 314 crore The tota l deposi ts stood at Rs 15804 crore whi le tota l advances were at Rs 11081 crore

The merger would help SBI consol idate i ts pos i t ion as the country s b iggest bank and widen the gap with nearest r iva l IC ICI Bank With 9579 branches SBI has tota l assets of Rs 566565 crore and posted a net prof i t o f Rs 4541 crore as on March 31 2007 IC ICI Bank had assets of Rs 344658 crore and posted a net prof i t o f Rs 3110 crore in 2006-07

The merger comes at t ime when the bank has decided to go in for b ig expansion The bank is a lso looking at f reeing up capi ta l by sett ing up a hold ing company for i ts l i fe insurance and asset management bus inesses SBI rsquos move to merge i ts arms could pave the way for further consol idat ion in the industry which faces imminent compet i t ion f rom fore ign banks f rom 2009

Merger of State Bank of Saurashtra with SBI would enable i t to up-scale in terms of footpr int manpower and other resources I t would a lso enable i t to face compet i t ion ar is ing f rom global izat ion of the economy apart f rom augment ing ef f ic iency and enabl ing better management of r isk State Bank of Saurashtra is the smal lest of i ts assoc iate banks and operates in regions where SBI does not have a large presence

ACQUISITION OF WACHOVIA BY WELLS FARGO

Buyer

Wel ls Fargo amp Company is a f inancia l ho ld ing company and a bank hold ing company I t i s a d ivers i f ied f inancia l

- 12 -

serv ices company I t provides reta i l commercia l and corporate banking serv ices through banking stores located in 23 states A laska Ar izona Cal i forn ia Colorado Idaho I l l ino is Ind iana IowaMichigan Minnesota Montana Nebraska Nevada New Mexico North Dakota Ohio Oregon South Dakota Texas Utah Washington Wisconsin and Wyoming I t provides other f inancia l serv ices through subsid iar ies engaged in var ious bus inesses pr inc ipal ly wholesale banking mortgage banking consumer f inance equipment leas ing agr icu l tura l f inance commercia l f inance secur i t ies brokerage and investment banking insurance agency and brokerage serv ices computer and data process ing serv ices t rust serv ices investment advisory serv ices and venture capi ta l investment I t operates in three segments Community Banking Wholesale Banking and Wel ls Fargo F inancia l

Target

Wachovia Corporat ion (Wachovia) is a f inancia l ho ld ing company and a bank hold ing company I t provides commercia l and reta i l banking and trust serv ices through fu l lserv ice banking of f ices in A labama Ar izona Cal i forn ia Colorado Connect icut Delaware F lor ida Georgia I l l ino is Kansas Mary land Miss iss ippi Nevada New Jersey New York North Caro l ina Pennsylvania South Caro l ina Tennessee Texas V i rg in ia and Washington DC I t a lso provides var ious other f inancia l serv ices inc luding mortgage banking investment banking investment advisory home equity lending asset-based lending leas ing insurance internat ional and secur i t ies brokerage serv ices through other subs id iar ies The Companys reta i l secur i t ies brokerage bus iness is conducted through Wachovia Secur i t ies LLC and operates in 49 states In October 2007 Wachovia completed the acquis i t ion of AG Edwards Inc In February 2007 the Company acquired a major i ty interest in European Credi tManagement Ltd

Wells Fargo to buy Wachovia for $151bn

- 13 -

Wel ls fargo amp co the b iggest US bank on the west coast agreed to buy of Wachovia corp for about $151 bn in stock t rumping Ci t igrouprsquos of fer for embatt led North Caro l ina lender

This deal would be executed ent i re ly by Wel ls Fargo without help of US unl ike c i t igrouprsquos of fer which re l ied on f inancia l backing f rom the Federal Deposi t Insurance Corp

RATE OF RETURN

Wel l Fargo sa id i t wi l l acquire a l l o f Wachoviarsquos bus inesses preferred equity and banking deposi ts Bank c la imed that the acquis i t ion wi l l add to earnings per share by the th i rd year af ter complet ion and should produce internal rate of return of at least 15 Buying Wachovia is a detour f rom the strategy was out l ined by Wel ls Fargo After acquir ing Wachovia Wel ls Fargo would have $142 tr i l l ion in assets $787 b i l l ion in deposi ts and 10761 branches

- 14 -







Mult ip le reasons force us to bel ieve that MampA in the Indian Banking Sector is an imperat ive We l is t them down below

Stabil ity

Fragmentat ion poses increas ing r isk in the Indian Banking Sector Dur ing the f inancia l per iod 2001-2005 only four banks have been able to cross the market capi ta l izat ion of Rs 50 b i l l ion inc luded Bank of Baroda HDFC Bank IC ICI Bank and State Bank of India Considerable f ragmentat ion exists in the Banking sector for banks with market capi ta l izat ion of less than Rs 50 b i l l ion Moreover the created value is moving away f rom the top 5 banks thus indicat ing f ragmentat ion indeed has increased over the per iod of last f ive years Shown below are the deposi t shares of the Banks operat ing in India over the per iod 2000-2004 Data was drawn from around 45 banks which inc luded state-contro l led publ ic sector banks pr ivate sector banks and even fore ign banks operat ing in India I t i s observed that the share of the top 5 p layers has eroded and been consumed by the next f i f teen p layers Consider ing that the base of tota l deposi ts has been consistent ly increas ing consequent ly the value in deposi ts gained by the next 15 banks has been tremendous (see table below)

Year 2000 2004Simi lar t rends are observed in prof i t a f ter tax borrowings and interest and non interest incomes of the banks thereby h int ing at increased levels of

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Bottom Line Growth





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(F IPB)

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Buyer


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RATE OF RETURN


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Bottom Line Growth





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(F IPB)

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Buyer


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Target



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RATE OF RETURN


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Bottom Line Growth





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(F IPB)

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Buyer


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Target



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RATE OF RETURN


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Bottom Line Growth





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(F IPB)

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Buyer


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Target



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RATE OF RETURN


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Bottom Line Growth





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(F IPB)

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Buyer


- 12 -


Target



- 13 -



RATE OF RETURN


- 14 -







Bottom Line Growth





- 7 -





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(F IPB)

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- 11 -






Buyer


- 12 -


Target



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RATE OF RETURN


- 14 -










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- 9 -







(F IPB)

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Buyer


- 12 -


Target



- 13 -



RATE OF RETURN


- 14 -










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(F IPB)

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Buyer


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Target



- 13 -



RATE OF RETURN


- 14 -












(F IPB)

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Buyer


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Target



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RATE OF RETURN


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- 11 -






Buyer


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Target



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RATE OF RETURN


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Buyer


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Target



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RATE OF RETURN


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Target



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RATE OF RETURN


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RATE OF RETURN


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mergers and acquisition in banking

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