International Research Journal of Finance and Economics ISSN 1450-2887 Issue 37 (2010) EuroJournals Publishing, Inc. 2010 http://www.eurojournals.com/finance.

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Market Based Mergers in Indian Banking Institutions

K. Ravichandran Assistant Professor of Finance, College of Business Administration King Saud University, Saudi Arabia E-mail: varshal2@yahoo.com Fauzias Mat-Nor Professor of Finance and Dean, Graduate School of Business Universiti Kebangsan Malaysia E-mail: Fauzias@ukm.my Rasidah Mohd-Said Associate Professor of Finance, Graduate School of Business Universiti Kebangsan Malaysia E-mail: rasidah@ukm.my Abstract This paper analyses the efficiency and performance using CRAMELtype variables, before and after the merger for the selected public and private banks which are initiated by the market forces. The results suggest that the mergers did not seem to enhance the productive efficiency of the banks as they do not indicate any significant difference. The financial performance suggests that the banks are becoming more focused on their retail activities (intermediation) and the main reasons for their merger is to scale up their operations. However it is found that the Total Advances to Deposits and the profitability are the two main parameters which are to be considered since they are very much affected by mergers. Also the profitability of the firm is significantly affected giving a negative impact on the returns. Keywords: Bank Mergers, Efficiency, Performance, CRAMEL-type variables.

1. Introduction
The banking sector of India is considered as a booming sector and the soundness of the banking system has been vital for the development of the countrys economy. Having its economy grown by over 9% for the last three years has made India regarded as the next economic power house. Various challenges and problems faced by the Indian banking sector and the economy have made mergers and acquisitions activity not an unknown phenomenon in Indian banking industry. Historically, mergers and acquisitions activity started way back in 1920 when the Imperial Bank of India was born when three presidency banks (Bank of Bengal, Bank of Bombay and Bank of Madras) were reorganized to form a single banking entity, which was subsequently known as State Bank of India. Several M&A activities among banking institutions were later reported during this preindependence

period. In 1949, the Banking Regulation Act which empowered the Reserve Bank of India (RBI), Indias central bank, to regulate and control banking institutions in India was enacted. International Research Journal of Finance and Economics - Issue 37 (2010) 31 This enactment has provided a sigh of relief to investors and improved depositors confidence in Indian banking system. In 1960s, several private banks were found to be operating on a very low capital. As a result, several banks have failed and this has led to loss of confidence of the public towards the banking system as a whole. To restore confidence in the banking system and thus to avoid losses to depositors, 45 banks were pushed into mergers. Most of these mergers were between failed private banks and public sector banks. Since 1980 the consolidation fever started in both commercial and rural banks. There were about 196 rural banks in 1989 that were consolidated into 103 by merging themselves into commercial banks. In 2000, about 17 urban co-operative banks were merged with the state owned commercial banks. Since about 75% of the Indian banking system consists of public sector banks, more consolidations began to take place in the late 2000. Indian banking institutions began facing competition when the regulators started to allow foreign banks to enter the local banking market. At the same time, private banks began to increase in number. With strong support from their parents, foreign banks in India have set the trend of services and performance in Indian banking institutions. Feeling this pressure, many private banks began to merge with foreign banks for reasons such as building up their financial strength, capturing larger portion of the growing retail business and securing better regional presence. This paper seeks to analyze the efficiency of banks that have gone through merger process as a result of market forces. A comprehensive study is undertaken to investigate the performance of those banks three years before the merger took place and three years after the completion of the said merger. For this research we have considered three private banks and four nationalized banks to have a comprehensive framework of entire banking industry. After considering various measures, we adopted CRAMEL (Capital Adequacy, Resources Raising Ability, Asset Quality, Management Quality, Earnings Quality, Liquidity) model to assess efficiency and performance of the Indian banking institutions. We also applied the Factor Analysis using Kaiser Normalization method to find out the parameters that we should look for before and after merger.

2. Literature Review

Government policy can be the one of the major forces in banking consolidation. In 1997, as a result of the Asian financial crisis, the governments of the region have promoted consolidation of the banking system on the ground that this would contribute to the stabilization on the banking system of the region (Berger et al (1999)). Besides this guided merger, consolidation due to market driven has also increased. According to Amel (2002), between 1990 and 2001, more than 8000 bank consolidations has occurred globally. It has been argued that the rationale for consolidation of banking institutions through mergers and acquisitions is to improve cost and revenue efficiency that will in turn improve profitability, safety and soundness of these institutions (Berger, Hunter and Timme (1993)). Ahmad Ismail, Ian Davidson & Regina Frank (2009) concentrates on European banks and investigates post-merger operating performance and found that industry-adjusted mean cash flow return did not significantly change after merger but stayed positive. Also find that low profitability levels, conservative credit policies and good cost-efficiency status before merger are the main determinants of industry-adjusted cash flow returns and provide the source for improving these returns after merger. Anthony (2008) investigates the effect of acquisition activity on the efficiency and total factor productivity of Greek banks. Results show that total factor productivity for merger banks for the period after merging can be attributed to an increase in technical inefficiency and the disappearance of economies of scale, while technical change remained unchanged compared to the pre-merging level. Elena Carletti, Philipp Hartmann & Giancarlo Spagnolo (2007) modelled the impact of bank mergers on loan competition, reserve holdings, and aggregate liquidity. The merger also affects loan market competition, which in turn modifies the distribution of bank sizes and aggregate liquidity needs. Mergers among large banks tend to increase aggregate liquidity needs and thus the public provision of liquidity through monetary operations of the central bank. 32 International Research Journal of Finance and Economics - Issue 37 (2010) George E Halkos & Dimitrios (2004) applied non-parametric analytic technique (data envelopment analysis, DEA) in measuring the performance of the Greek banking sector. He proved that data envelopment analysis can be used as either an alternative or complement to ratio analysis for the evaluation of an organization's performance. Marc J Epstein. (2005) studied on merger failures and

concludes that mergers and acquisitions (M&A) are failed strategies. However, analysis of the causes of failure has often been shallow and the measures of success weak. Morris Knapp, Alan Gart & Mukesh Chaudhry (2006) research study examines the tendency for serial correlation in bank holding company profitability, finding significant evidence of reversion to the industry mean in profitability. The paper then considers the impact of mean reversion on the evaluation of post-merger performance of bank holding companies. The research concludes that when an adjustment is made for the mean reversion, post-merger results significantly exceed those of the industry in the first 5 years after the merger. Ping-wen Lin (2002) findings proves that there is a negative correlation and statistical significance exist between cost inefficiency index and bank mergers; meaning banks engaging in mergers tend to improve cost efficiency. However, the data envelopment analysis empirical analysis found that bank mergers did not improve significantly cost efficiency of banks. In another study, he found that (1) generally, bank mergers tend to upgrade the technical efficiency, allocative efficiency, and cost efficiency of banks; however a yearly decline was noted in allocative efficiency and cost efficiency. (2) In terms of technical efficiency and allocative efficiency improvement, the effect of bank mergers was significant; however, in terms of cost efficiency improvement, the effect was insignificant. Robert DeYoung (1997) estimated pre- and post-merger X-inefficiency in 348 mergers approved by the OCC in 1987/1988. Efficiency improved in only a small majority of mergers, and these gains were unrelated to the acquiring bank's efficiency advantage over its target. Efficiency gains were concentrated in mergers where acquiring banks made frequent acquisitions, suggesting the presence of experience effects. SU WU (2008) examines the efficiency consequences of bank mergers and acquisitions of Australian four majors banks. The empirical results demonstrate that for the time being mergers among the four major banks may result in much poorer efficiency performance in the merging banks and the banking sector. Suchismita Mishra, Arun, Gordon and Manfred Peterson (2005) study examined the contribution of the acquired banks in only the non conglomerate types of mergers (i.e., banks with banks), and finds overwhelmingly statistically significant evidence that non conglomerate types of mergers definitely reduce the total as well as the unsystematic risk while having no statistically

significant effect on systematic risk. Ya-Hui Peng & Kehluh Wang (2004) study addresses on the cost efficiency, economies of scale and scope of the Taiwanese banking industry, specifically focusing on how bank mergers affect cost efficiency. Study reveals that bank merger activity is positively related to cost efficiency. Mergers can enhance cost efficiency, even though the number of bank employees does not decline. The banks involved in mergers are generally small were established after the banking sector was deregulated.

3. Data and Methodology

Since 2000, only seven bank mergers were identified and are considered for the study. The data used in this study is gathered from the annual reports of all the seven banks for the period 2000 to 2007.The data was divided into pre- and post-merger according to each individual banks completed merger date for the descriptive equality test analysis. If a merger was completed before the middle of the year, that year is considered as the starting period of the post merger analysis. On the other hand, if it was completed after the middle of the year, then that year is considered as pre-merger period. Finally, analysis was carried out on a three year pre-merger period and a three year post-merger period. The analysis is divided into two parts; namely, Regression analysis and Factor analysis using Kaiser Normalization method where the datas are converted in to ratios. The study used CRAMEL International Research Journal of Finance and Economics - Issue 37 (2010) 33 model for further analysis. An entity specific analysis of the risk profile is done through qualitative cum quantitative approach following a structured methodology called the "CRAMEL" model. Based on the rating criteria, relative strengths and weakness of each entity in comparison to its peer group are evaluated. The CRAMEL model consists of the following: Capital Adequacy Resource raising ability Asset Quality Management and systems evaluation Earning Potential Liquidity / Asset Liability Management By performing tests on mean differences for the CRAMEL variables it can be determined whether there are significant differences in the average values of those variables during the premerger and post-merger periods. Based on the CRISIL (Credit Rating Information Services of India Limited) methodology, the following variables are taken into consideration: Capital Adequacy : Debt- Equity, Advances to Total Assets, Capital buffer Ratio

Resources : Cost efficiency (CE), Cost/Total Asset Asset Quality : Gross NPA /Net advances, Loans/ Deposits Management Quality : Operating rev. / Turnover per share, Total Advances / deposits Earnings Quality : Earnings per share, Interest Earning Ratio, Price Earning Ratio, Return on Total Assets (%), Profit Margin (%), Return on Shareholders Funds (%) Liquidity : Current Ratio, Solvency Ratio (%), Liquid Asset / Deposits, Liquid Asset / Total Advances An examination of the impact of the CRAMEL model variables is done by data reduction using Factor analysis. By performing Regression analysis and t tests on the CRAMEL variables it can be determined whether there are significant relationship of those variables during the post-merger periods. Detailed description of the variables will be provided in the following section when the empirical findings are discussed. An examination of the impact of the CRAMEL type variables is done by data reduction using factor analysis. Empirical Findings Regression Analysis on Pre- Merger CRAMEL Variables The results of the regression analysis conducted on Pre- Merger CRAMEL type variables (Table1) infers that, out of 16 variables considered for the study only five variables such as cost buffer ratio, Advances to Total Assets, Profit margin, solvency ratio, current ratio, were found to be highly significant, which is evident from (table no.1) the t test. Also from the analysis of variance (ANOVA) conducted on those significant variables infers that there is a significant relationship between those variables.

India Banking 2010

Towards a High-performing Sector

India Banking 2010

The last decade has seen many positive developments in the Indian banking sector. The policy makers, which comprise the Reserve Bank of India (RBI), Ministry of Finance and related government and financial sector regulatory entities, have made several notable efforts to improve regulation in the sector. The sector now compares favourably with banking sectors in the

region on metrics like growth, profitability and non-performing assets (NPAs). A few banks have established an outstanding track record of innovation, growth and value creation. This is reflected in their market valuation. However, improved regulations, innovation, growth and value creation in the sector remain limited to a small part of it. The cost of banking intermediation in India is higher and bank penetration is far lower than in other markets. Indias banking industry must strengthen itself significantly if it has to support the modern and vibrant economy which India aspires to be. While the onus for this change lies mainly with bank managements, an enabling policy and regulatory framework will also be critical to their success. The failure to respond to changing market realities has stunted the development of the financial sector in many developing countries. A weak banking structure has been unable to fuel continued growth, which has harmed the long-term health of their economies. In this white paper, we emphasise the need to act both decisively and quickly to build an enabling, rather than a limiting, banking sector in India.

GOOD PERFORMANCE, QUESTIONABLE HEALTH

Indian banks have compared favourably on growth, asset quality and profitability with other regional banks over the last few years. The banking index has grown at a compounded annual rate of over 51 per cent since April 2001 as compared to a 27 per cent growth in the market index for the same period. Policy makers have made some notable changes in policy and regulation to help strengthen the sector. These changes include strengthening prudential norms, enhancing the payments system and integrating regulations between commercial and co-operative banks. However, the cost of intermediation remains high and bank penetration is limited to only a few customer segments and geographies. While bank lending has been a significant driver of GDP growth and employment, periodic instances of the failure of some weak banks have often threatened the stability of the system. Structural weaknesses such as a fragmented industry structure, restrictions on capital availability and deployment, lack of institutional support infrastructure,

restrictive labour laws, weak corporate governance and ineffective regulations beyond Scheduled Commercial Banks (SCBs), unless
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Executive Summary
addressed, could seriously weaken the health of the sector. Further, the inability of bank managements (with some notable exceptions) to improve capital allocation, increase the productivity of their service platforms and improve the performance ethic in their organisations could seriously affect future performance.

OPPORTUNITIES AND CHALLENGES FOR PLAYERS

The bar for what it means to be a successful player in the sector has been raised. Four challenges must be addressed before success can be achieved. First, the market is seeing discontinuous growth driven by new products and services that include opportunities in credit cards, consumer finance and wealth management on the retail side, and in fee-based income and investment banking on the wholesale banking side. These require new skills in sales & marketing, credit and operations. Second, banks will no longer enjoy windfall treasury gains that the decade-long secular decline in interest rates provided. This will expose the weaker banks. Third, with increased interest in India, competition from foreign banks will only intensify. Fourth, given the demographic shifts resulting from changes in age profile and household income, consumers will increasingly demand enhanced institutional capabilities and service levels from banks.

ONE OF THREE SCENARIOS WILL PLAY OUT BY 2010

The interplay between policy and regulatory interventions and management strategies will determine the performance of Indian banking over the next few years. Legislative actions will shape the regulatory stance through six key elements: industry structure and sector consolidation; freedom to deploy capital; regulatory coverage; corporate governance; labour reforms and human capital development; and support for creating industry utilities and service bureaus. Management success will be determined on three fronts: fundamentally upgrading organisational

capability to stay in tune with the changing market; adopting value-creating M&A as an avenue for growth; and continually innovating to develop new business models to access untapped opportunities. Through these scenarios, we paint a picture of the events and outcomes that will be the consequence of the actions of policy makers and bank managements. These actions will have dramatically different outcomes; the costs of inaction or insufficient action will be high. Specifically, at one extreme, the sector could account for over 7.7 per cent of GDP with over Rs.. 7,500 billion in market cap, while at the other it could account for just 3.3 per cent of GDP with a market cap of Rs. 2,400 billion. Banking sector intermediation, as measured by total loans as a percentage of GDP, could grow marginally from its current levels of ~30 per cent to ~45 per cent or grow significantly to over 100 per cent of GDP. In all of this, the sector could generate employment to the tune of 1.5 million compared to 0.9 million today. Availability of capital would be a key factor the banking sector will require as much as Rs. 600 billion (US$ 14 billion) in capital to fund growth in advances, non-performing loan (NPL) write offs and investments in IT and human capital upgradation to reach the high-performing scenario. Three scenarios can be defined to characterise these outcomes: High performance: In this scenario, policy makers intervene only to the extent required to ensure system stability and protection of consumer interests, leaving managements free to drive far-reaching changes. Changes in regulations and bank capabilities reduce intermediation costs leading to increased growth, innovation and productivity. Banking becomes an even greater driver of GDP growth and employ4

ment and large sections of the population gain access to quality banking products. Management is able to overhaul bank organisational structures, focus on industry consolidation and transform the banks into industry shapers. In this scenario we witness consolidation within public sector banks (PSBs) and within private sector banks. Foreign banks begin to be active in M&A, buying out some old private and newer private banks. Some M&A activity also

begins to take place between private and public sector banks. As a result, foreign and new private banks grow at rates of 50 per cent, while PSBs improve their growth rate to 15 per cent. The share of the private sector banks (including through mergers with PSBs) increases to 35 per cent and that of foreign banks increases to 20 per cent of total sector assets. The share of banking sector value add in GDP increases to over 7.7 per cent, from current levels of 2.5 per cent. Funding this dramatic growth will require as much as Rs. 600 billion in capital over the next few years. Evolution: Policy makers adopt a pro-market stance but are cautious in liberalising the industry. As a result of this, some constraints still exist. Processes to create highly efficient organisations have been initiated but most banks are still not best-in-class operators. Thus, while the sector emerges as an important driver of the economy and wealth in 2010, it has still not come of age in comparison to developed markets. Significant changes are still required in policy and regulation and in capability-building measures, especially by public sector and old private sector banks. In this scenario, M&A activity is driven primarily by new private banks, which take over some old private banks and also merge among themselves. As a result, growth of these banks increases to 35 per cent. Foreign banks also grow faster at 30 per cent due to a relaxation of some regulations. The share of private sector banks increases to 30 per cent of total sector assets, from current levels of 18 per cent, while that of foreign banks increases to over 12 per cent of total assets. The share of banking sector value add to GDP increases to over 4.7 per cent. Stagnation: In this scenario, policy makers intervene to set restrictive conditions and management is unable to execute the changes needed to enhance returns to shareholders and provide quality products and services to customers. As a result, growth and productivity levels are low and the banking sector is unable to support a fast-growing economy. This scenario sees limited consolidation in the sector and most banks remain sub-scale. New private sector banks continue on their growth

trajectory of 25 per cent. There is a slowdown in PSB and old private sector bank growth. The share of foreign banks remains at 7 per cent of total assets. Banking sector value add, meanwhile, is only 3.3 per cent of GDP.

NEED TO CREATE A MARKET-DRIVEN BANKING SECTOR WITH ADEQUATE FOCUS ON SOCIAL DEVELOPMENT
The term policy makers used in this document, as mentioned earlier, refers to the Ministry of Finance and the RBI and includes the other relevant government and regulatory entities for the banking sector. We believe a co-ordinated effort between the various entities is required to enable positive action. This will spur on the performance of the sector. The policy makers need to make co-ordinated efforts on six fronts: Help shape a superior industry structure in a phased manner through managed consolidation and by enabling capital availability. This
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would create 3-4 global sized banks controlling 35-45 per cent of the market in India; 6-8 national banks controlling 20-25 per cent of the market; 4-6 foreign banks with 15-20 per cent share in the market, and the rest being specialist players (geographical or product/ segment focused). Focus strongly on social development by moving away from universal directed norms to an explicit incentive-driven framework by introducing credit guarantees and market subsidies to encourage leading public sector, private and foreign players to leverage technology to innovate and profitably provide banking services to lower income and rural markets. Create a unified regulator, distinct from the central bank of the country, in a phased manner to overcome supervisory difficulties and reduce compliance costs. Improve corporate governance primarily by increasing board independence and accountability. Accelerate the creation of world class supporting infrastructure (e.g., payments, asset reconstruction companies (ARCs), credit bureaus, back-office utilities) to help the banking sector focus on core activities. Enable labour reforms, focusing on enriching human capital, to help public sector and old private banks become competitive.

NEED FOR DECISIVE ACTION BY BANK MANAGEMENTS

Management imperatives will differ by bank. However, there will be common themes across classes of banks: PSBs need to fundamentally strengthen institutional skill levels especially in sales and marketing, service operations, risk management and the overall organisational performance ethic. The last, i.e., strengthening human capital will be the single biggest challenge. Old private sector banks also have the need to fundamentally strengthen skill levels. However, even more imperative is their need to examine their participation in the Indian banking sector and their ability to remain independent in the light of the discontinuities in the sector. New private banks could reach the next level of their growth in the Indian banking sector by continuing to innovate and develop differentiated business models to profitably serve segments like the rural/low income and affluent/ HNI segments; actively adopting acquisitions as a means to grow and reaching the next level of performance in their service platforms. Attracting, developing and retaining more leadership capacity would be key to achieving this and would pose the biggest challenge. Foreign banks committed to making a play in India will need to adopt alternative approaches to win the race for the customer and build a value-creating customer franchise in advance of regulations potentially opening up post 2009. At the same time, they should stay in the game for potential acquisition opportunities as and when they appear in the near term. Maintaining a fundamentally long-term value-creation mindset will be their greatest challenge. The extent to which Indian policy makers and bank managements develop and execute such a clear and complementary agenda to tackle emerging discontinuities will lay the foundations for a high-performing sector in 2010.
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