HDFC Bank-HDFC merger: euphoria is misplaced

After the initial spurt in stock prices after the announcement of the merger of the HDFC duo, prices have fallen back. There is a better appreciation of the realities.

Yes, the merger was required, more so by HDFC because of the obvious difficulties in sustaining earnings growth. But that doesn't mean that the new entity is going to produce fabulous returns. The chances are that returns of the merged entity will be lower than that of either entity before the merger. 

The issues are:

• The statutory requirements that will apply to the liabilities of HDFC
  
•  The difficulty in cross-selling deposits to HDFC customers
•  The managerial challenges of merger, including managing a more complex entity than before
• The problems with growing earnings on a larger base
• The prospect that the competitive landscape will have changed by 2025 when the presumed benefits of the merger will start kicking in

I elaborate in my article in Bloomberg Quint.

For those who can't access it, here it is:

HDFC Bank-HDFC merger signals goodbye to the halcyon days

T T Ram Mohan

HDFC Bank reported a return on assets (RoA) of 2.3 per cent last quarter and earnings growth of over 18 per cent. These are numbers that should make analysts and investors salivate- internationally, even an RoA of 1.25 per cent is considered very good.

Yet, the price to book value ratio of HDFC Bank was just 2.3 before the recently announced merger with HDFC, way below the multiples that the bank commanded at lower returns. The stock has underperformed the index over the past year.

Why so? Clearly, investors did not think that HDFC Bank could sustain high earnings growth.  

One reason surely was the bank’s low exposure to home loans: these constitute only 11 per cent of HDFC Bank’s portfolio.  A reasonable share of home loans in the overall portfolio of a private bank would be 25 per cent. Post the merger, management expects home loans will constitute 33 per cent of the overall book.

Right since the bank’s inception, not being able to have adequate home loans in its book has been an issue for HDFC Bank. The bank had the distribution capability but could not have its own home loan book because that would mean competing with its parent.  This did not matter much in the initial years because there was enough scope to grow through other products.

A few years down the road, HDFC Bank entered into an arrangement whereby the bank would sell HDFC’s home loans for a fee. It would also have the right to acquire 70 per cent of the home loans it had distributed as mortgage-backed securities. These securities would have the yield of home loans minus a servicing charge for HDFC. This gave the bank a product with a decent margin. But it wasn’t quite the same thing as being able to finance home loans on its own.

Analysts could see this clearly. So they would keep asking Aditya Puri, the former CEO of HDFC Bank, when the bank would do the obvious thing, namely, merging with HDFC. If memory serves correctly, Mr Puri had to tell analysts that that was the one question he didn’t want to hear any more! Mr Puri told analysts that the merger would happen when the timing was right.

The timing was never right in Mr Puri’s time because there was no way that Mr Puri would settle for a position that was less than that of the CEO. It would have been difficult for the parent’s top brass to settle for less either. There is little doubt, therefore, that the personality issue came in the way of the logical thing for HDFC Bank, namely, merger. The argument that interest rates have declined, so the cost for HDFC of complying with statutory liquidity ratio requirements is less onerous is correct. But high interest rates were not the principal hurdle to the merger.

Now, Mr Puri is no longer at the helm at HDFC Bank. Keki Mistry, Vice Chairman of HDFC Renu Karnad, Managing Director are both in their late sixties. There is no difficulty in their making way for the relatively youthful CEO of HDFC Bank, Sashi Jagadishan.

Without its own home loans, growth in recent years at HDFC Bank has come from MSMEs and the unsecured book. These are high-yield products but risky. Home loans have a lower yield but serve the purpose of lowering overall portfolio risk. Investors would prefer a bank whose growth was driven by the latter.

For HDFC, the parent, there was no problem in sustaining growth in the loan book because the potential for home loan growth remains huge in India’s under-penetrated market. The problem was being able to sustain its current margins in the face of tighter regulations.

Non-banking finance companies (NBFCs) have the disadvantage of not having access to low cost savings and current accounts. They had advantages. A big one was not being encumbered by the liquidity and priority sector obligations that banks face.   This is what is called ‘regulatory arbitrage’.

In October 2021, the RBI moved towards bringing regulatory norms for the larger NBFCs broadly in line with those for banks. In particular, the liquidity requirements for larger NBFCs were made the same as for banks with effect from 2025. The RBI’s intent is clear: the larger NBFCs must convert into banks.

The larger the NBFC, the greater its dependence on bank borrowings. Large NBFCs are thus a source of systemic risk. Better, then, that they submit themselves to the tighter regulation that applies to banks. There was no way that HDFC could have kept growing without considerable pressure on its margins. The answer was to access the low-cost funds available to HDFC Bank.

Mergers are touted as great strategic coups. Markets fall for this line and respond by boosting the stock prices of the two entities involved after  a merger  announcement. This has happened with the HDFC Bank- HDFC merger. For that reason, CEOs love mergers.

The prosaic truth is that mergers are confessions of failure: the failure to grow earnings on an organic basis. As our analysis shows, the HDFC Bank- HDFC merger is no exception.

Mergers are expected to reward investors through synergies and cost savings.  Alas, a large proportion of mergers- in some sectors and economies, the majority- fail, that is they failed to enhance the combined shareholder value of the two erstwhile entities. That is because the supposed benefits are overwhelmed by the complexity of the  larger entity. Every merger thus represents the triumph of hope over experience- every CEO hopes that his adventure will belong to the successful minority.

What of the HDFC Bank-HDFC merger? The two entities belong to the same family. HDFC’s employees are a small fraction of that of the bank but there is still the task of integrating the senior management of HDFC and resolving issues of who reports to whom.

Analysts talk of the benefits of scale. But these economies kick in at a much lower scale than that of the behemoth that will be created in the present merger. Beyond a certain scale, there is little to be gained.

Then, there is the potential for cross-sell. HDFC Bank can certainly push home loans in a bigger way to its customer base than before. Selling deposits of HDFC Bank to HDFC’s customer base is a more challenging proposition. HDFC’s customers would have their own banking relationships and switching from one bank to another is not easy. Had it been easy, HDFC could have  sold the bank’s deposit products all these years and collected a fee from the bank.

The merger is to be completed in 2024. The presumed benefits will happen in the years thereafter. The banking landscape then is unlikely to be the same. The newly consolidated public sector banks will have got to their acts together by then and may pose stiffer competition on both the liabilities and the asset side. Some of the NBFCs promoted by industrial houses may get the nod to convert into banks. Who knows what other changes are in store? The gains of the merger are thus subject to considerable uncertainty.

What is certain is the negative impact, post-merger, of the SLR and priority lending requirements against HDFC’s deposits. The returns of the enlarged HDFC Bank will fall as a result.  It Is not clear whether the RBI will allow HDFC Bank to directly hold the numerous subsidiaries of the merged entity. If the RBI insists on a holding company structure, that again will impose costs and returns will fall.

In sum, the merger is the answer to slower earnings growth faced by the two entities. We will have a giant that can be expected to do better than either entity would have done sans the merger. However, it is unlikely that the glorious past of either entity can be recaptured on a much larger base.  It does appear that the halcyon days of the HDFC duo  are over.

(Disclosure: The author is on the board of directors of IndusInd Bank Ltd. ttrammohan28@gmail.com)