HDFC Bank-HDFC Merger: An Inside Account On Why This Time Was Different

As narrated to BloombergQuint.

The proposed amalgamation of HDFC Ltd. into HDFC Bank Ltd. is a win-win situation for both entities. This proposal has been in the works for many years, and we had discussed it with the regulator when I was with the bank as non-executive chairman. The sticking point at the time was that the Reserve Bank of India was reluctant to provide forbearance on cash reserve ratio, the statutory liquidity ratio, etc. that the bank was looking for. So, the proposed merger couldn't go through. At least from the announcements made on April 4, it appears that HDFC Bank is going to ask the RBI for some regulatory forbearance and give 2-3 years for HDFC assets to be covered by CRR and other requirements. It's likely they have had some discussions with the RBI before making this announcement.

In a broad sense, the idea of the merger is a good one. For HDFC to have all its assets in one basket of only housing and real estate was a very high-risk activity. More so because banks have become very aggressive in mortgage lending, and HDFC was also finding it difficult to match with their cost of funds. HDFC was really looking toward this merger.

Previous Roadblocks

When this proposal came up previously, HDFC Bank was looking to expand its asset and depositor base. A merger like this would have brought HDFC Bank the big-ticket loans. While those may have a lower margin, the operating costs would have been lower because of the longer tenor and the larger size of the loans.

While those aspects would have benefited HDFC Bank, at the time interest rates were much higher than what they are today. Therefore, the burden or drag of the CRR was much higher. The RBI was very reluctant to offer any regulatory forbearance.

We had even made the same proposal as now. That for all new assets the CRR and SLR requirements will be followed. And for existing assets of HDFC that would get merged with the bank, a 3-4-year period could be stipulated for complying with CRR and SLR requirements. The regulator was not willing to consider that.

Today, with interest rates much lower than earlier, the CRR is a much smaller drag. The return on government securities is 6% or more and the cost of funds for the bank is lower. So complying with SLR requirements is no longer an issue. The priority sector lending obligations on the total merged assets was not a problem even then, and less so now, going by the wider definition of PSL.

Even then, HDFC did realise that the problem of competing with banks was becoming increasingly difficult, as its cost of funds was based on bonds, other borrowings, and public deposits at offered higher rates.

In a merged HDFC Bank entity, the previous risk of HDFC's portfolio—that of all eggs in one basket—gets spread much wider. If there are shocks in one sector, the bigger entity can manage the risk more prudently. It has been very clear for a while that this was the way to go, but there were regulatory impediments.

Mega Banks: Opportunities And Risks

The policy push for bigger banks appears to have remained consistent over the last many years. This is evident from the way the government has been carrying out mergers of the public sector banks. The need for bigger banks in the public and private sectors was always felt, and even more so now, with a big bank's ability to withstand shocks in any individual sector. If a small bank has two or three large key NPAs, it can just get blown away.

Larger banks also have a greater capacity to provide infrastructure credit, at much better operating costs than smaller banks. As things stand today, HDFC Bank doesn't have much of a portfolio in infrastructure lending and has focused on short-term consumer loans and other credit of that type, which gave it higher margins of 4-5%. While margins in infrastructure loans are lower, HDFC Bank can lower operating costs with tenor and size of the loans. A bigger bank is also better placed to provide loans in the infrastructure sector, which is a high priority need of the national economy.

Conversely, managing risks in a large financial sector entity is cause for concern because they become too big to fail as their failure can send shocks all across the economy.

The regulators will do anything and everything to ensure that this doesn't happen. For that reason, the RBI placed this big ‘too big to fail' set of banks under a much tighter regulatory regime compared to other banks. So, ICICI Bank, HDFC Bank, and the State Bank of India continue to be identified as ‘Domestic Systemically Important Banks' even before any such merger. Regulators in India have been mindful of these risks and will take care of these aspects very well.

CM Vasudev served as non-executive chairman of HDFC Bank from July 2010 to August 2014. He was previously Secretary, Department of Economic Affairs, Ministry of Finance.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.