The Hindu Business Line : Banking by collaboration

The recent coming together in a strategic alliance of three mid-size public sector banks presages a consolidation phase in Indian banking, and endorses the fact that size does matter.

TREND-SETTING ALLIANCE... (L to R) Mr K. C. Chakrabarty, CMD, Indian Bank, Mr K. N. Prithviraj, CMD, Oriental Bank of Commerce and Mr B. Sambamurthy, CMD, Corporation Bank. — Shashi Ashiwal

Size matters. That is probably why three mid-size public sector banks — Indian Bank, Corporation Bank and Oriental Bank of Commerce — have entered into a `strategic alliance', which could herald a consolidation phase in Indian banking. The alliance, intended to help the banks leverage their combined balance-sheet strength and share the benefits of economies of scale, is reflective of the dynamics at play in the Indian banking space today.

Sweeping changes in the banking environment offers tremendous opportunities for those who can decipher the underlying trends, adapt quickly and develop a clear vision of the future success model. Managing risks and ensuring commensurate capital are core issues in the strategic business positioning initiative of banks in the Basel era. Given the business compulsions and the growing pressure on capital availability of banks, it is a moot question if Basel II implementation will be instrumental in triggering consolidation in banks.

Basel approach

Since advances in technology, telecommunications and markets have changed the way banks assess and manage their risks, the three-pillar approach of Basel II is designed to provide incentives `to advance the state-of-the-art in risk management across the industry.' It incentivises banks to review their business strategies and underlying risks with a view to achieving efficiency of capital utilisation.

The Basel concept of `economic capital' enables banks to determine capital adequacy based on the amount of risk that an individual transaction contributes to the bank's portfolio of risk. Once banks can attribute risks to a potential transaction, product, or process, they can allocate economic capital to it, define an expected return on it, consider how best to price it, decide how to manage the risk and, thus, take a call on whether to enter a transaction or engage in a particular business activity.

In the long run, Basel implementation will be instrumental in helping banks better understand their customers, markets, demands, and processes while improving operational efficiencies by streamlining business processes and making them more effective.

Centred on credit risk

The capital structure of banks is centred on credit risk in line with Basel I. Market and operational risks, contingent liabilities and possible credit growth have not been duly considered for estimating the capital cushion. In the current growth phase of the Indian economy, banks require additional capital to support business expansion, given the rapid increase in their risk-weighted assets. In the WTO era, domestic banks preparing for competition will look to build their size and strength by first shoring up their capital base.

Other possible determinants of the capital structure include the diversity and varying size of bank balance-sheets, regulatory requirements, level of non-performing assets and the recourse available for capital infusion. Obviously, the capital requirement will increase for banks holding low-quality assets vis-a-vis those with high quality assets, a balanced portfolio and effective risk management systems.

Given the trend of technology absorption by Indian banks, it can safely be said that there will be an increasing convergence in the technology platform of individual outfit.

However, in a market of thinning spreads, absorption of technology would necessitate a corresponding sharp rise in business volumes to even sustain the cost of technology. Achieving critical mass (size), either through organic or inorganic growth, will become the key issue.

Focus on size

Consolidation in the industry would, therefore, become a matter of natural business compulsion; spare capacities available within banks would prompt banks to explore the takeover route. Moreover, to sustain business growth, each bank would not only try to become capital-efficient but also simultaneously work out strategies to augment their individual capital base.

Given that the Government would have little leeway in pumping additional capital, banks would hardly have any option but to merge with banks/institutions having surplus capital or with those with the ability to raise capital from the market.

The strategic factors for existing banks competing with private and international players would be the size, quality of service and low cost finance by achieving `critical mass'. In contrast to the earlier experience of mergers being initiated by the regulator to protect the interest of depositors of weak banks, the trend of market-led mergers between private banks and private banks with public sector banks may gain momentum. Consolidation may also take place through strategic alliances or partnerships covering specific areas of business such as SME lending, credit-cards and insurance.

Competitive edge

Size is rightly regarded as a great competitive advantage for banks to respond to the emerging global opportunities. It enables lending banks develop better quality asset book through proper portfolio management strategies. Significant infrastructure cost, essential to meeting the demand for a wide range of retail products in today's customer-driven banking environment, can be better managed by large banks. Basel II will require increased capital commitment from all banks, as well as increased transparency and accountability to both regulators and the market. Consolidation, therefore, seems to be a logical outcome for building the required financial muscle. Larger efficient institutions created through this process would be better placed to raise capital at better valuations than smaller banks.

Stakeholders would benefit due to reduced intermediation costs and consolidation is also likely to benefit employees in the banking system since it would lead to re-training and re-skilling of the work force. It is well known that the major economic forces driving mega mergers are economies of scale and scope, that is, reduction in the per unit cost due to increase in the scale of operations and due to synergies in producing multiple products within the same firm.

Risk diversification

There is potential for risk diversification with geographic expansion providing diversification benefits to a bank not only by reducing its portfolio risk on the asset side, but also by lowering its funding risk on the liability side. As larger entities can obtain better credit rating and have better access to the capital market, this may translate into increased market share.

It is hypothesised that implementation of Basel II may result in a consolidation in the banking sector as a natural corollary. It needs to be emphasised, however, that consolidation should maximise synergies in terms of regional balance, network of branches, human resource culture and asset commonality, ensuring that legacy issues are not overlooked.

Besides benefiting the merging entities in terms of revenue growth, lower costs and improved return on assets, the consolidation process should promote the safety and stability of the financial system and encourage financial inclusion.

Key drivers

It is apparent, therefore, that competition, consolidation and convergence are the key drivers of the banking sector in India today. Basel II implementation is likely to accelerate the emerging trends of consolidation to overcome capital constraint, streamline risk management, maximise return on capital, better use technology for efficiency gains, for more robust risk-based pricing and closer alignment with international best practices. The OIC (Oriental-Indian-Corporation) alliance appears to be a step in this direction, aimed as it is at collaboration in such areas as sharing IT, treasury resources and making a foray into international capital markets, insurance and other financial services.

Future success of banks will depend upon a rigorously defined strategic focus, strengthening operating capabilities, and finding a way to grow profitably, either by extending geographical coverage, expanding product/market coverage, going for mergers or acquisitions, or a combination of these.

(The authors are, respectively, a senior official with the RBI, and a Director, National Institute of Bank Management, Pune. The views are personal.)

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