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Sanjiv Shankaran

Mr. Keki Mistry (above), and Mr Aditya Puri (below), Managing Directors, HDFC and HDFC Bank... Too early to shake hands.

HOUSING Development Finance Corporation (HDFC) finds itself caught in speculation about another large merger in the financial sector, with its associate company, HDFC Bank. The respective managements have denied the possibility, but the rumours refuse to die. Therefore, another look at the issue is necessary to arrive at a conclusion on investment in HDFC's equity shares.

Background

HDFC Bank was promoted by HDFC in the mid-1990s. Since then, HDFC's stake in the company has declined to about 24.47 per cent (March 2002). Since inception, HDFC Bank has grown fast to edge ahead of HDFC. By March 2002, HDFC Bank had pumped Rs 23,787 crore in its business against HDFC's Rs 21,459 crore.

The growth in both the entities have not come at the expense of profitability. For instance, HDFC's and HDFC Bank's profitability from operations in April-September 2002 was 26 per cent and 27 per cent respectively; impressive vis-à-vis the other industries.

HDFC Bank has laid emphasis on growing its retail business (with individuals for car loans, etc.), so much so that this segment comprised 43 per cent of total business in 2002 against 39 per cent business from corporates — the usual mainstay of banks.

HDFC's housing loan business has an overwhelming retail orientation; about 75 per cent of outstanding loans are to individuals.

Thus, at some point, there is the possibility of the two entities having to compete with each other for the same piece of business. It does not happen now because of agreements — written and otherwise — that prevent competition.

In this backdrop, the immediate trigger for the merger appears to be the rich potential for the housing loan business.

HDFC, the market leader, has grown its housing loan disbursement by about 31 per cent over the last four years. Banks have renewed focus on housing finance business, thereby, making one wonder if HDFC Bank is losing opportunities by staying away.

More so, when the retail business is the dominant activity for HDFC Bank.

Case against a merger

HDFC is the market leader in housing finance, and despite new competition, it is unlikely to be displaced from that position. Competition, among other factors, has played a role in bringing down lending rates, and thinning interest spread (the difference between interest paid out on borrowings and interest earned on loans).

In this environment, banks that have access to the least expensive funds, are at an advantage.

Even in this situation, HDFC has managed to grow its profitability from operations over the last couple of years because of the tight rein on cost, and its ability to use its top-rung credit standing to significantly reduce its cost of funds.

Deposits comprise about 45 per cent of HDFC's capital deployed in business. These deposits have a statutory liquidity ratio (SLR) requirement (specified investment mandated by the regulator to ensure safety) of 12.5 per cent.

Banks, on the other hand, have a much higher SLR requirement. Therefore, in its current form, HDFC is able to get more out of its deposits by having greater freedom to deploy the money. Seen in the light of its operational flexibility, HDFC may not be eager to merge.

HDFC Bank's retail business spread is 3-7 per cent. Against this, HDFC's spread is 1.8-2 per cent. Even if a bank, in housing finance business, were to work on a higher spread because of a lower cost of funds, auto loans may be more lucrative.

Even assuming a lower risk in housing finance, other branches of retail finance may be more lucrative as long as there are growth opportunities.

Housing loans are also long-term in nature (about 10-15 years against 3-5 years for other retail finance options).

Banks usually work on a shorter duration of borrowing and lending. Therefore, once again, housing finance may not be attractive if there is scope in other areas.

A problem of the financial sector is the multiplicity of regulators with varying requirements. Therefore, SLR requirements for banks and housing finance companies vary. It is much the same in the case of other regulatory requirements, thereby, making it bothersome to house the entire gamut of financial activities under one roof.

Should status quo change?

The entities concerned deny it, and the reasons to let status quo remain are powerful. Yet, it appears difficult to believe that HDFC Bank and HDFC will not consider a merger some time in the future. It may be purposeless to bother guessing when, but there are other factors at play that suggest that it may happen.

Boundaries between different areas in financial services have disappeared rapidly in the last decade. The trend may continue in fits and starts. Therefore, factors such as multiple regulators and varying requirements may eventually cease to matter. That day, however, may not happen soon.

Credibility matters in financial services. Surely, the success of HDFC Bank and the mutual fund business owes a lot to the credibility of the parent.

The group's credibility provides an advantage in exploiting opportunities when linkages between different areas of financial services increase. As boundaries disappear, HDFC Bank and HDFC are likely to head towards a merger.

Investment outlook

For the moment, it may be prudent to focus only on factors that are of immediate concern. HDFC is the market leader in the housing finance market. The company has earned a reputation for being competitive and credible.

In its core business, it is difficult to see HDFC being more profitable. The company's return on equity shareholders' funds is around 23 per cent. With the advent of competition, it is difficult to see HDFC expanding its return further.

The businesses that have the potential to expand HDFC's returns are its new forays such as insurance and Information technology enabled services. Insurance, both life and non-life, are likely to be the most capital-intensive of the new forays, and also have a long gestation period.

In this context, it is difficult to see a potentially-lucrative business such as insurance helping HDFC nudge its return upwards in the immediate future. In the light of above, it may be prudent to avoid an investment in HDFC for now.

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