India needs bigger banks

Recently some articles have challenged the need for consolidation in the Indian state-owned banking sector. They argue that the global experience with mergers has been poor and the majority of mergers have destroyed shareholder value.

In the Indian context they believe that post-merger integration problems will be accentuated because of the muted autonomy public sector banks enjoy, and suggest that the integration would be unlikely to lead to many synergies. Globally, while many mergers have not created shareholder value, every large player operating today has grown through acquisition.

In fact, every large bank in the world is big because it has acquired repeatedly and integrated well. Today, these banking titans dominate the financial services landscape. Thus, it seems an opportune time to debate the way forward for Indian banking.

A review of the international banking scenario over the past decade reveals that consolidation has been a dominant feature of the banking sector in most countries. In fact most countries have higher levels of concentration in their banking industry than India.

The largest banks in terms of asset size are now over a trillion dollars and some like Citi, JP Morgan Chase, HSBC and Bank of America have a market capitalisation of over $150 billion. The US had one of the most fragmented systems because of stringent regulations preventing consolidation but over the past decade the market share of top five banks has risen to about 45 per cent today from about 26 per cent in the 1990s (see chart).

Asia has seen much greater government activism in consolidation. In Malaysia, Singapore, Taiwan, Thailand, Indonesia and South Korea, the governments have supported consolidation. They are keen to build national champions that can at least obtain regional size.

Malaysia has reduced the number of banks from 55 to 10, Taiwan aims to bring down the number of state banks from 12 to six this year, and Singapore government guided the system down to three players with DBS being supported to become a regional leader. Similar initiatives are in place in Indonesia, South Korea and Japan.

Australia has always had greater concentration and the four big Chinese banks are over $400 billion in assets size. The market capitalisation of the entire Indian banking sector is about $40-45 billion, which would make the entire banking sector rank after the 30 largest banks in the world.

Citi, HSBC, Santander and DBS have spent between $8 billion to $25 billion in the past three to four years on acquisitions. I don't argue that small banks can't be strong performers; in fact, we find no correlation between size and profitability, only that small banks, because of their small market capitalisation, typically cannot fend off a predator that is large and eager.

Thus, all our banks are vulnerable. The risk is especially galling given that the rapid growth in the Indian banking sector is making it one of the most attractive banking markets in the world. Would it not be wrong in the circumstances to bet the survival of the domestic industry on the crutches of a protective regulatory framework for all time to come?

Given that the Reserve Bank of India (RBI) has indicated that the sector will open up in 2009, it would be foolish not to anticipate foreign governments putting their weight to press the case of their banks to enter and acquire our dwarf-like domestic champions.

Many argue that consolidation will lead to poorer customer service because branches will be rationalised to enforce efficiencies. Others argue that because of banks' inability to reduce staff, there will be no synergies on cost but increased complexity in operations, which will lead to poorer service and higher cost.

The Indian banking market is growing at about 17 per cent annually and yet does not reach out to many people --  that will require people and more distribution points. The current overstaffing of PSBs is independent of this.

If we agree that there is rapid growth in the sector, that PSBs are currently doing little on street marketing, together with the fact that the average age of bank employees is high (close to 48), in the next five years this situation will change without any forced attrition.

Services should improve because people will be available to serve customers and as no premium (for state owned mergers) will be paid, the cost should actually reduce on account of sourcing synergies especially in IT. All this does not take into account the improvements in revenue that should arise due to improved density of branch coverage in specific localities.

It is true mergers will be difficult to execute, but we cannot avoid consolidation just because the process is tough. It is not so much the complexity of the exercise that is a deterrent, but the reduction in the number of positions of general secretary of employee unions and chairman and managing directors of banks that creates greater opposition.

The industry today is in better shape than before to undertake consolidation and the government should start to create the nucleus of regional champions from among the current players. India desperately needs bigger banks and a less fragmented banking structure. The need to move fast is paramount.