DOLAT CAPITAL

Consolidation in Indian Banking

India Research

Bachelors Party!!!
Analysts: Darpin Shah / Mayur Vani Tel : +91-22-4096 9742 / 4096 9721 E-mail: darpin@dolatcapital.com / mayurvani@dolatcapital.com

May 2007

DOLAT CAPITAL Consolidation - need of the hour!!!!

The increased compliance requirements with the onset of Basel II have started a global spiral of consolidation. Indian banking sector too is expected to witness its own share of similar activites. A proactive regulator has already played its part in terms of laying a formal roadmap and guidelines to enable this migration. Indian Banks are preparing themselves for necessary re-alignmnets/ makeovers in the interim. The valuation matrices are soon expected to be weighed by the probabilities of individual bank participating in this activity. The cues from current deal premia in the regional consolidation experiences provide additional opportunities of value unlocking on eventual action...

Executive Summary
Consolidation - A Global Phenomenon Banking sector consolidation is not just an Indian phenomenon but a Global reality on the back of Basel II implementations. As India integrates itself with the world the increased adherence to global compliance standards will become a major tool for sustenance. Indian Banking Character- Unlike globaly, the Indian Banking system is characterized by large number of small banks participating in a large market. The top 5 banks cover around 45% of Assets in India, while globally they cover 75-95% assest. We feel that size will soon emerge as a strategic compulsion to remain competitive in the emerging opportunities from the Indian economic renaissance. Barring sparse instances, consolidation in Indian Banking industry till date has been undertaken primarily as an external compulsion than internal strategic initiative. Asian Experience - The Asian region (Malaysia, Taiwan, Singapore, Indonesia, South Korea and Japan), particularly after the 1997 South East Asian Crisis, has witnessed its own share of consolidation in the recent past. Further, recent M&A activity in the region has witnessed deal executions at 40%+ premia of prevailing valuations. The Indian Banking Industry is governed by a regulator with pedigree of taking proactive measures that facilitate integration of Indian Banking sector with emerging global trend. To facilitate timely entry of relevant global players in the banking space, RBI has set its roadmap for consolidation in two phases
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Phase I (2005-2009) focused on enabling Indian Banks to become more competitive Phase II (post-2009) providing competitive entry opportunities (Open branches and take over private banks) to foreign banks.

As we move closer to the 2009 deadline both domestic as well as cross-border M&A activity is expected to gather further pace. We also expect some of the futuristic bank managements to take complementary overseas bets during this period. We also expect the activity to heighten further (post-2009) given the strategic opportunity for the Global banks to participate in the Indian pie.

Valuations
Till the actual action Valuation segmentation a natural transition Till 2009 - the strategic complements in business, contemporariness of the bank, and its relevance/ ability/willingness to participate in the activity, would start reflecting in valuation thereby sharpening the valuation differentials further. At the Action a decisive strategic premium Adjusted for better growth opportunity, better regulatory compliances, adequate penetration of target assets and contemporary technology complements we expect the stakes to change hands at premia of 40-50% of the then prevalent multiples.

How does one play this

We expect SBI to be the natural beneficiary (among the PSB segment) and a direct play given clarity on the end and means of its M&A related initiatives and preparedness. The new-age private banks with their wide/decent spread of network, diverse product offerings, and better technology and customer base offer the best participation in this space for foreign banks. In this scenario, our top picks are ICICI Bank, Kotak Mahindra Bank, Centurion Bank of Punjab and YES Bank.
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Indian Banking system Fragmented structure
The Indian Banking System is well diversified and also has extensive banking network, both in rural as well as urban areas. The Indian Banking system is classified in three types i.e. Schedule Commercial Banks (SCB), Regional Rural Banks (RRB) and Cooperative Banks and Special purpose rural Banks. Commercial Banks are further divided into Schedule and non Schedule Commercial Banks. However, in India these Banks are classified as Public sector Banks, Private Banks (Old Private sector Banks New Private sector Banks) and Foreign Banks. (Refer Annexure I ) Further, Indian Banking system is fragmented with top 5 banks covering around 45% of Assets, where-as world wide top 5 banks cover around 75-95% of the Assets. The Indian Banking system is characterized by large number of small banks rather than a few banks participating in a large market. Public Sector Banks (PSB) are still dominant in the business profiles of Indian banks, with around 28 of them controlling around 74% and 72% of the Total Deposits and Total Advances respectively. The Private Sector Banks (a dominant phenomenon post economic reforms) represent around 21% market share each in Total Deposits and Advances. On the other hand, Foreign Banks (so far restricted in terms of local aggression for the limited scope offered by law), have mere 5.6% and 7.1% share in the Total Deposits and Advances respectively. Market share in Indian Banking
90 80 70 60 (%) (%) 50 40 30 20 10 0 Public Sector Banks
Source: RBI, Dolat Research

FY1999 82.0 82.0

Deposits Advances

80 70 60 50 40 30

FY2006 73.8 72.1

Deposits Advances

20.6 20.8 5.6 7.1

14.0

17.0 4.0 1.0

20 10 0

Private Sector

Foreign Banks

Public Sector Banks

Private Sector

Foreign Banks

Size - minnows on Global scale

The size and structure of Banking system depends on stage of economic evolution, risk appetite of the economy for growth and its financial market structure. Being a late participant in the global growth Indian banks are in their early stage of growth and thus are minnows, as compared to the global peers on the critical parameters of Business size and geographical reach. Only 22 of Indian Banks figure among the top 1,000 banks in the world. State Bank of India (SBI), the largest bank of India is around one-tenth the size of Citigroup, the world largest Bank on the Tier I basis. Further, SBI has around 90-100mn customers and an Asset Base of $155bn; where as Bank of America has customer base of around 30mn and the Asset Base of more than trillion dollars. In Asia, Indias SBI is the only local bank that had made it to the top 25 list. In comparison Chinas 4th largest bank is 2.5 times that of SBI. Also, the 5th largest Bank in China is probably larger than the top five banks in Indian on the Total Asset front on aggregate basis.

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Tabel 1: -Banks in Different Categories
$Bn (March 2006) World Citigroup HSBC Holdings Bank of America JP Morgan Chase Mitsubishi UFJ Financial group Asia China Construction Bank Corp. Industrial & Commercial Bank of China Bank of China National Australia Bank Kookmin Bank India SBI ICICI Bank PNB BoB Canara Bank Source: Industry 8 4 2 2 2 155 56 33 23 30 1.9 0.7 0.5 0.3 0.3 0.89 1.23 1.09 0.79 1.16 36 32 31 17 12 568 800 587 299 181 7.0 7.0 7.0 5.0 3.0 1.21 0.92 1.14 1.67 1.78 79 74 74 73 64 1,494 1,502 1,292 1,199 1,509 29.0 21.0 25.0 12.0 13.0 1.97 1.40 1.95 1.02 0.85 Tier I Capital Assets Profits RoA (%)

Further, the statistics for Bank Credit to GDP (x), clearly indicates that India is still an under-banked country. Banks Credit / GDP (x)
Bank Credit / GDP (x) 249

156 133 113 76 25 35 47 77 94 113

167

Thailand

China

UK

Brazil

Singapore

Hong Kong

Korea

Source: Industry, Dolat Research

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Malaysia

Taiwan

Russia

India

USA

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Asian Experience
In Asian region, Malaysia had reduced the number of banks from 55 to 10; while, Taiwan aims to bring down the number of state banks from 12 to 6 (FY2004). Singapore government has also guided the banking system to lower the number of Banks to mere 3 players with DBS being supported to become a regional leader. Similar initiatives have been undertaken in Indonesia, South Korea and Japan particularly after the 1997 South East Asian Crisis.

Consolidation A Global phenomenon

Banking sector consolidation is not just an Indian phenomenon it is a Global Reality. As India integrates with the world the increased adherence to global compliance standards makes Capital Adequacy (to participate in growth both in India as well as outside) a major tool for sustenance. Basel II is an attempt to bring semblance into the global banking environment to respond to the emerging challenges in terms of risk management to address increased money-ness of all assets globally and would remain key driver of global M&A activity (Table 2). With the regulator sounding an early alert on preparing for this eventuality Indian Banking sector can not remain aloof to the emerging trends on Consolidation and M&As. Table 2: - Basel II impacts on M&A
M&A Factors Capital release Basel II impacts Acquires capital through IRB compliance to help fund purchase Unsophisticated banks facing increase in capital requirements under standardised approach could be acquired Portfolio mixes Targets identification Regional focus for expansion National barriers Source: Mercer Oliver Wyman (2003) Business Lines profitability shifts prompt shake-outs. Retails Banks benefit from increased balance sheet flexibility Enhanced disclosure on risk and capital positions aids screening of targets and due diligence Regulatory capital changes will differ by country/ region, yielding a concentration of possible targets Basel II and IAS reduce international regulatory and accounting differences

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Indian Banking Sector - Consolidation roadmap
The Banking sector reforms in India were initiated in 1992, with a core focus on ensuring the safety and soundness of financial institutions and at the same time making the banking system strong, efficient, functionally diverse and competitive. The reforms included measures for arresting the decline in productivity, efficiency and profitability of the Banking sector. The idea was to prepare a robust financial structure that enables the economy to operate in an open world environment. All the key parameters like Capital Adequacy, prudential regulations, and accounting and disclosure standards have been subjected to compliance of international standards since. Today, the level of compliance of the sector with the Basel Committees Core Principles for Effective Banking Supervision, has refined financial soundness and consistent supervisory practices of the Indian Banking system and made it resilient to absorb/respond global shocks. While these initiatives on banking reforms have created a robust banking structure it has also created a peculiar environment by creation of multiple similar entities small in size competing to create their sizeable identity over the next few years. While base business growth remains favorable for each constituent in the current economic environment size of business (balance sheet) would remain a strategic compulsion to remain competitive in emerging opportunities from the Indian economic renaissance. This makes mergers & acquisitions (both local as well as cross border) to form critical components of the evolution of the Indian financial sector.

The main objectives for consolidation are typically

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Migration towards Universal Banking Model Gain Size Balance Sheet/ Geographic Presence Increase Market Share Assets/ Liabilities Acquire Skills/ Processes New Opportunities Diversification Business Diversification, Risk Management To tap opportunities beyond regulatory restrictions

The major gains perceived from bank consolidation are the ability to withstand the pressures of emerging global competition, to strengthen the performance of the banks, to effectively absorb the new technologies and demand for sophisticated products and services, to arrange funding for major development products in the realm of infrastructure and telecom, etc which require huge financials outlays and to streamline human resources functions and skills in tune with the emerging competitive environment. Banking Industry vision 2010 a vision document of Indian Banks Association (IBA) has also highlighted consolidation and M&A activity as an immediate agenda driven mainly by expectations of shareholders. It sets a vision to deliver 4-5 world class Indian banks by the year 2010. It also envisions a roadmap where Indian Banking system would witness emergence of a few national banks of global scale and a number of regional players. RBI has also on its part defined a clear roadmap recently to enable, facilitate and also regulate developments that make consolidation an executable reality. The roadmap is split in two phases
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Phase I (2005-2009) focused on enabling Indian Banks to become more competitive (Refer Annexure II) Phase II (post-2009) providing competitive entry opportunities to foreign banks (Refer Annexure III)

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Phase I (Pre-2009) We expect following scenarios to evolve under these regulation during this phase. The existing banks will get categorized in following six groups
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Revitalized Banking Entities Banks like Indian Bank/ IDBI (which have been at the receipt of Govt funding/ largesse in the form rupee recapitalization/ favorable regulatory exemptions in the past) would be allocated / acquire other banks to become strong with wider reach. Public Sector Banks - with large domestic presence (Tier I banks like SBI, PNB, Canara, BoB, BoI, Central, etc.) that want to acquire bank with an overseas presence to become global entities. The Tier II banks (like Dena, Vijaya, BoM, Andhra, etc.) in this segment might re-align to any of the bigger umbrella from among the first layer. Large Private Sector Banks with contemporary management practices and high growth ambitions (ICICI Bank, Kotak Mahindra Bank, HDFC Bank, UTI Bank) Niche New-Age Private Sector Banks headed by aggressive CEOs, who have been leading ex-bankers (CBoP, Yes Bank, DCB, etc.) and are driven by ambition to create a sizeable banking entity (through organic as well as inorganic growth) Niche Old Private Sector Banks boutique regional presence with decent growth focus (Federal, South India, Karur Vysya, Karnataka) to align for strategic partnership options with a larger national player (foreign or domestic) Small Banks Banks, which find organic growth restrictions with size and capital and would need to align with larger banks to remain viable (Dhanalakshmi, City Union, etc). These are definite potential targets.

SBI offers maximum clarity on the structure and method of its evolution through this face to emerge as a larger participant in the system. Phase II (post 2009) RBI has highlighted following key regulatory changes for operative principals for Foreign banks operating in India post 2009
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According Full National Treatment of Wholly Owned Subsidiaries (WOS) of Foreign Banks Dilution of Stake in WOS Merger and Acquisition of any Private Sector Banks

Foreign Banks entry - Increased services and healthy competition Foreign Banks full-fledged entry is expected to transform the business of Indian banking in many ways, which would be reflected in terms of greater breadth of products, depth in delivery channels and efficiency in operations. With better technology and expertise in offering specialised banking products such as derivatives, advisory services, trade finance, etc, the entry of foreign banks can enhance healthy competition and has a positive spillover effect on the domestic banks. The impact of the entry of Foreign Banks on domestic Banks is likely to depend on various factors such as the structure, strength and competitiveness of domestic Banks, the share of foreign banks, and the regulatory/supervisory framework. We foresee following scenarios to emerge ScenarioI - BUY SBI for clarity on means and end Scenario II Consolidation of Private Sector Banks Scenario III Region Centric Private Banks strategic partners

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ScenarioI - BUY SBI for clarity on means and end SBI Clearly stands as a best bet amongst the PSBs (on consolidation theme) on the back of the emerging clarity towards the consolidation/ merger with its seven banking subsidiaries (3 listed and 4 unlisted). Benefits for SBI and Group: - Currently, the subsidiaries together form the 2nd largest banking entity on consolidated bases. The merger of these Banks with SBI would propel SBI to a newer orbit in terms of business, Balance Sheet to play the larger turf globally. Other PSBs Play for Value Consolidation amongst the Public Sector Banks (PSB) - Governments mercy As the name suggests Public Sector Banks bear a legacy of being owned by government and barring a few stray occasions, deliver similar pattern of performance, delivery, operations and brand equity. The likes of BoB, PNB, etc have displayed wherewithal and strategic vision to embrace changing competitive realities. Barring these, there is not much to separate one from the other particularly on account of culture, vision, customer orientation (!), and operational efficiency. The gaps are narrower, as we move to the Tier II Public Sector Banks. Therefore in this segment is critical from several aspects, which include motives of value maximizations as well non-value maximization. Policy measures such as governments incentives that could accrue to the top managers are also important factors, which may determine the pace of consolidation. The Government has kept the forum open for the Nationalized Banks towards Consolidation. However, due to the lack of initiatives from respective banks and also due to issues related to cultural mis-match, technology implementation and also various other factors like human resource optimiz ation, over-lapping of branches; consolidation remains an unclear vision for the Indian PSBs. The proposed merger of Canara Bank and Dena bank has already sounded the bugle for the consolidation exercise. We expect the momentum to only build from hereon. The obvious participants would be banks which need a definite capital infusion, having GoI holding at threshold limit (51%) and on stand-alone find themselves in a non-distinctive market position. However, there remains a possible outside trigger of substantial re-rating in this space if and when GoI decides to reduce its controlling stake to 33% from the current 51% levels. (Refer Annexure IV) We feel the value unlocking from consolidation opportunity in this segment is limited on account of lack of clarity on the roadmap and higher complexities (in terms of internal realignments within PSB units) and hence should be explored from Value perspective as against consolidation perspective. We like PNB, IOB, BoB and Andhra Bank in this space on pure valuation basis. (Refer Annexure V) Scenario II Consolidation of Private Sector Banks Smaller Private Banks:- Amongst the Indian Private Sector Banks, the weaker and small banks are definite candidates for the consolidation on account of lower Networth and inability to face competition. (City Union Bank, Dhanalakshmi etc). However, the desire being on the sellers side to raise capital and also to support the regulatory norms, we expect limited upside to happen in this segment of private banks. New Private Sector Banks: - Post reforms in 1992, the new age private banks (ICICI Bank, Kotak Mahindra Bank, HDFC Bank, YES Bank, CBoP etc) has captured a substantial share in the Indian Banking system. Further, these banks have also built strong / decent franchise, products and services to cater the entire needs of customer. These Banks are expected to takeover / merger some of the weak and smaller banks along with some cross border acquisitions to enhance their core competency. Private sector banks are expected to witness a spate of mergers, acquisitions, and open offers post 2009 from global banks seeking complementary India Strategy. India had its own-share of M&A over the last decade (Refer Table 3, Annexure VI) Scenario III Region Centric Private Banks strategic partners When the name of the game to increase footprint we feel there exists a niche space for the Old Regional Private Sector banks to join the party. Given their existing strong presence in their respective region and a legacy of relationships with subsequent brand equity they are natural targets. The banks however have compulsive strategic reasons that restrict them from a complete sell-out (issues like retaining identity, maintaining culture, and dispersed shareholding).
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We feel that there exists very limited possibility to ride these banks from a sell out perspective. However they do possess a strategic relevance as channel partners/ strategic allies which allow them to ride on their current channel strength and improve fee based incomes through partnerships (non-core business income for foreign banks). We expect this to be the natural transgression given their pedigree on technology, product offerings and market aggression. This could see the emergence of niche alliances in differential functional areas and business segments such as housing, credit cards, mutual fund, insurance etc. Table 3: -M&A activity in India
Banks HDFC Bank and Times Bank Particulars Emerged as largest Private Bank in India Customer Base :- 650,000 Branch Network:- 107 Balance Sheet size:- Rs 9000cr Advantages from Infrastructure and also employee work culture Increased reach to 360 branches with BOMds 263 branches especially in Southern region. Largest customer base of 2.7mn ( 1.2mn of BOMd), thus enabling ICICI Bank to offer its banking and finanical services and also cross sell products and services of ICICI group BOMd also had better technology. BOMd had an attractive business per employee of Rs.202lakh. Asset Base of over Rs 160bn. Cultural Integration tough task for ICICI Bank. Merged Entity to become 2nd largest Bank in India with Total Assets of about Rs 950bn, 396 branches and Extension counter of ICICI Bank / 140 reatil finance offices of ICICI To leverage on its large capital base, comprehensive suite of products and services. It had extensive corporate and retail customer relationships, strong technology-enabled distribution architecture, strong brand franchise and vast talent pool The strong corporate and retail relations to further help of fee based income and also other financial products The merger has helped OBC to widen its branch network by 104 branches. GTB had a strong foothold in the Southern region where OBC had only 59 branches. With this merger OBC also got ready access to around 1mn customers of GTB, with a high concentration of HNI customers having a propensity for saving. GTBs thrust on retail had given it wider access in the area of non-interest income OBC was relatively slow in its technology implementation plans. But, GTB being a private sector bank had a strong existing IT platform with a centralized banking infrastructure in place. The merger facilitated OBC in stepping up its technology drive. Centurion Bank had a strong Advances Portfolio where as Bank of Punjab had a strong CASA Deposits. Centurion Bank had strong foothold in West and South while Bank of Punjab had presence in North (highest CASA Deposit in the region) given a better senergy. Strong nation wide franchise of 240 branches and extension counters and 386 ATMs. The merged Entity to have Assets worth Rs 800bn, thus having size and strength to be comparable to big players. Merged entity to be 7th largest bank based on assets. Profitability to improve after the merger, as IDBI banks portfolio of assets and liabilities also earn better. 95 branches, 302 ATMs and nearly 1mn customers of IDBI bank will help IDBI to raise finances for its development finance activities. It would also enable IDBI to reduce its cost of borrowing and lend infrastructure projects at a lower rate IDBI Public sector undertaking and IDBI Bank new age private sector bank - integration problems, legacy corporate culture ICICI Bank paid higher valuation for the merger of Sangli Bank. ICICI Bank got direct access to existing 198 branch network of Sangli Bank (ICICI Bank did not receive new branch license for two quarters). Sangli Banks 50% of the branches are located in the rural and semi urban area (Rural Business - next growth driver for ICICI Bank). On the Business front, Sangli Bank added mere 2% to ICICI Banks Total Business.

ICICI Bank and Bank of Madura (BOMd)

Problem ICICI Bank and ICICI Ltd

OBC and GTB

Centurion Bank and Bank of Punjab

IDBI and IDBI Ltd

Problem ICICI Bank & Sangli Bank

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Banks IDBI & UWB Particulars IDBI paid a decent value to acquire UWB. IDBI branch network reached to 425 branches with the acquisition of UWBs 195 branches (70% of the branches in the urban areas). The strong branch network is expected to benefit IDBI to garner higher Retail Credit and also Low Cost Deposits (CASA) Portfolio. CBoP continued its inorganic growth strategy and paid fair value to acquire LKB. LKBs 112 branches and 44 ATMs extends around 50% geographic reach to CBoP, especially in Kerla. LKB also increases CBoP Balance Sheet size by around 20%, thus making it the 9th largest Private Sector Bank in India.

CBoP& Lord Krishna Bank (LKB)

Source : Dolat Research

Foreign Banks with global strategy to look for opportunityAlthough post 2009, the foreign banks will be allowed to set up new branches and also to acquire Indian Private Banks, only few foreign Banks having global presence strategy are expected to aggressively take advantage of the reforms. Foreign Banks having global presence strategy are expected to react in a different way depending on the level of presence in India. These Banks are expected to have two options to spread their reach, expand business, customer base viz.
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Open newer branches and expand rapidly into newer areas, Buy out any Private Bank and expand on the ready made branches, customers and business.

For details of Foreign Banks Exposure in India (Refer Anexure VII) If the foreign Banks opt to buy out private sector banks they would seek
Radar Chart for The Prospective Acquirer
Retail - Credit

Brand

Retail - CASA

Mgmt Style - Grow th/Safe

Technology

Mgmt Style - Risk/Agrresive

Pricing Policy

Corporate Relations
Source : Dolat Research

Products Innovation

External View Consumer Beheviour Potential Brand Price Policy Service Customer Contact Core Products & Services Sales Channel 16 May, 2007

Internal View Degree of Integration of Channels Degree of Decentralisation Competence source & Impacts Management Policy Process & Structures Responsibilities Range of Products & Services Openness 10

AND

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Presence and Non Presence of Foreign Banks in India what they look for...
Foreign Banks

Having Presence Small size Tier II Banks Decent Branch netw rok Technology Estabilshed products Banks CBoP YES Bank Indusind Bank DCB

Not Having Presence Larger size Banks Strong Netw ork Superior Techonolgy Estabilished products Strong Retail Presence Banks ICICI Bank Kotak Bank HDFC Bank UTI

Regional Banks Federal Bank KTK SIB KVB

Source: Dolat Research

In this scenario the following Banks come into play

Banks ICICI Bank Particulars ICICI Bank is the largest Private sector Bank and 2nd largest bank in the country The Bank has largest retail assets base Universal Bank i.e. offering gamut of financial products and services Kotak Mahindra Bank Kotaks commercial banking business, to grow at much higher pace then industry given its small base. The Bank continues to focus on High Interest Margin business and expected to continue. Kotak, with its market leadership in broking and capital markets, appears to be one of the best listed plays on this theme. Universal Bank i.e. offering gamut of financial products and services. HDFC Bank HDFC Bank is 2nd largest private sector bank. Consistent 30% earnings growth. Higher efficiency and high return ratios. Best NPAs in the industry. UTI Bank UTI Bank is one of fastest growing tech savvy bank Strong retail presence Superior return ratios CBoP CBoP is the fast growing new generation bank. Strategic mix helping the bank to have highest margin in industry. Aggressive organic as well as inorganic growth strategy. YES Bank New generation Bank with unique Banking strategy (knowledge banking). Strong Management Team. Growing at around 80% in Business. Further expected to continue the growth momentum for next couple of years. DCB Source: Banks; Dolat Research The new generation bank with the strong turn-around Story (Both Balance Sheet as well as Earnings). Strong Promoter group.

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Global Banks M&A Scenario- Developing Countries
l

ABN Amro Bank acquired 93.4% in Prime Commercial Bank (PCB) of Pakistan at PKR 13.8bn or Eur 172mn (PKR 54/ share). The acquisition made ABN as 2nd largest Foreign Bank in Pakistan and one of the top 10 banks in the country with Total Assets of PKR 124bn and around 80 branches. PCB had Total Assets of PKR 52bn or EUR 654mn, Deposits to the tune of PKR 41bn or EUR 508mn. Further PCB had 69branches and was the 19th largest bank in the Country. PCB was valued at 4x its Book Value and represented around 42% premium over PCBs average share price over last one year. Standard Charted Bank (Pakistan) acquired 80.9% stake in Union Bank Limited (Pakistan) for $ 413mn. Union Bank was eight largest Bank in Pakistan by market share, had around 65 branches, 37ATMs and 4 lac retail customers. Banks Total Assets were $ 2009mn, Advances $1201mn and Net Assets $91mn. Union Bank was valued at 17.1x FY2005 earnings and 5.6x FY2006 Net Asset Value (Book Value) Citigroup to buy Taiwans Bank of Overseas Chinese (BOOC) for T$14.1bn ($ 426mn) or T$11.8/share. The acquisition will boost Citigroups Taiwan-based assets to $22.8bn, making it the 13th largest bank on the island. In the first three quarters of last year, BOOC posted a net loss of T$510 million

Strategic Relavance of India for Global Bank Emerging economy in terms of spending, saving, investments and growth India is the 2nd fastest growing emerging Economy and also the fastest growing economies in the terms of spending, saving, investments and growth. Important peg of the future growth pie The strong corporate capex pipeline, growing retail business with increased spending power, along with Infrastructure projects, makes Banking Credit growth to remain healthy above global averages. This makes India presence strategically crucial for every global financial conglomerate. Regulatory environment poised to complement the opportunity The Apex Bank i.e. RBI has set norms for the Foreign Banks, where-in these Banks cannot expand their reach extensively during the Phase I (March 2005-2009). Subsequently, the Foreign Banks are missing the crucial current growth momentum in the Indian Banking system. Further RBI to its credentials has enough history in terms of agility to respond to the emerging global business standards in banking ahead of global timelines. Enough Available Options The well-dispersed diversified Indian Banking System provides large complementary offerings (options/ alternatives) to the Foreign Banks depending in terms of the presence, need and business strategy.

How Much??? - Beauty lies in the eyes of beholder; Valuation in those of buyers!!!
The valuations for the eventual transactions would be driven by the ultimate strategic premia that the buyers would be keen to pay for gaining access/ control in the Indian banking space.

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Table 5: -Global M&A activity - Premiums paid
Sr no 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Acquire Bank H&CB Overseas Union Bank DBS Bank Hong Kong Taipei Bank Chohung Bank Chohung Bank Chohung Bank Ufj Holdings inc Bank Nisp Pt Prudential Bank Equitable PCI Bank Bank Buana Indonesia Farners Bank of China Momji Holdings Inc Southern Bank Berhad Average Centurion Bank ICICI Bank HDFC Bank IDBI Average Combined Average Source : Bloomberg Target Bank kookim Bank United Overseas Bank Ltd DBS Group Holdings Ltd Fubon Financial Holding Co Shinhan Financial Group Ltd Shinhan Financial Group Ltd Shinhan Financial Group Ltd Mitsubishi UFJ Financial Overseas Chinese Banking Corp Bank of Philippine Islands Banco De Oro Universal Bank United Overseas Bank Ltd Taiwan Cooperative Bank Yamaguchi Bank Ltd Bumiputra Commerce Hldgs Bank of Punjab Bank of Madhura Times Bank United Western Bank Deal Premium 0.2% 26.8% 61.4% 46.0% 7.0% 22.1% 5.2% 35.8% 5.1% 95.6% 15.2% 0.9% 5.3% -28.2% 6.8% 20.3% 4.6% 100.0% 8.1% 21.0% 33.4% 27%

Challenges in Consolidation Some of the major concerns or issues for the Consolidation in the Indian Banking could be:
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Adaptation of Technology or technology platforms. Culture, working environment (Labor problems). Change in Government / Government Guidelines.

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What Does This Mean To Bank Valuations???
Till the actual action Valuation Segmentation a natural transition As we move closer to the 2009 deadline both domestic as well as cross-border M&A activity is expected to gather further pace. We also expect some of the futuristic bank managements to take complementary overseas bets during this period. We expect the momentum to also build in terms of valuation differentials with a further sharpening during this period towards the likely beneficiaries, vis--vis the ones where the chances for M&A/ consolidation are lower. At the Action a decisive strategic premium Adjusted for better growth opportunity, better regulatory compliances, adequate penetration of target assets and contemporary technology complements we expect the stakes to change hands at premia of 40-50% of the prevalent multiples.

How does one play this

We expect the M&A activity to gain momentum sooner and heighten further as we approach the eventual 2009 deadline. During this period, the strategic complements in business, contemporariness of the bank, and its relevance/ ability/ willingness to participate in the activity, would start reflecting in valuation thereby sharpening the valuation differentials further. We expect SBI to be the natural beneficiary (among the PSB segment) and a direct play given clarity on the end and means of its M&A related initiatives and preparedness. In its peer-set - value would remain a dominant investment theme along with a possible outside trigger of substantial re-rating in this space if and when GoI decides to reduce its controlling stake to 33% from the current 51% levels. The new-age private banks with their wide/decent spread of network, diverse product offerings, and better technology and customer base offer the best participation in this space. In this scenario, our top picks are ICICI Bank, Kotak Mahindra Bank, Centurion Bank of Punjab and YES Bank.

Private Banks Valuation

Banks Rs bn CBoP Federal Bank HDFC Bank ICICI Bank Karnataka Bank Kotak Mahinrda Bank South Indian Bank UTI Bank YES Bank Banks Rs bn CBoP Federal Bank HDFC Bank ICICI Bank Karnataka Bank Kotak Mahinrda Bank South Indian Bank UTI Bank YES Bank CMP as on 16/05/2007 CMP (Rs) 40 267 1,034 919 175 552 106 541 164 FY07E 5.9 6.9 36.8 66.1 4.1 9.7 3.5 15.7 1.7 NII FY08E 7.9 8.2 46.6 88.0 4.7 13.6 4.3 21.6 3.7 P/E (x) FY08E 40.8 7.3 21.6 20.1 9.2 21.7 6.5 18.8 29.6 FY09E 10.0 9.8 58.4 113.5 5.3 17.9 5.3 26.8 6.1 FY07E 4.6 3.2 4.6 2.4 2.6 4.7 3.1 2.9 2.5 NIM (%) FY08E 4.5 3.2 4.4 2.4 2.6 4.6 3.1 3.0 3.0 P/BV (x) FY08E 4.0 1.3 4.2 3.0 1.5 4.2 0.9 3.6 4.2 Net Profit FY09E FY07E FY08E FY09E 4.5 3.3 4.3 2.5 2.6 4.5 3.2 3.0 3.1 1.4 2.6 11.5 33.0 2.0 5.9 1.0 6.6 0.9 1.7 3.1 15.0 40.7 2.3 8.0 1.2 8.1 1.7 2.6 3.8 19.5 51.2 2.6 10.5 1.6 10.4 2.7 FY07E EPS (Rs) FY08E FY09E 1.0 36.7 47.8 45.8 18.9 25.4 16.4 28.7 5.5 1.4 43.9 62.4 57.5 21.7 33.3 22.2 36.8 7.9

0.8 30.5 36.6 35.0 16.5 18.6 13.6 23.4 3.5

FY07E 52.3 8.8 28.3 26.3 10.6 29.7 7.8 23.1 46.9

FY09E 27.8 6.1 16.6 16.0 8.0 16.6 4.8 14.7 20.7

FY07E 4.4 1.6 4.9 3.4 1.7 5.8 1.0 4.4 6.6

P/ABV (x) FY09E FY07E FY08E FY09E 3.5 1.1 3.4 2.6 1.3 3.5 0.8 3.0 3.1 4.7 1.6 5.1 3.7 1.8 6.0 1.2 4.8 6.6 4.2 1.4 4.3 3.2 1.6 4.3 1.0 3.9 4.2 3.6 1.1 3.5 2.8 1.4 3.6 0.8 3.1 3.1

FY07E

RoANW (%) FY08E FY09E 10.3 19.6 20.9 15.8 17.2 22.8 15.1 21.1 18.2 13.4 19.8 22.7 17.5 17.4 23.1 17.9 22.2 17.9

10.7 19.2 19.3 13.4 16.9 22.1 14.1 20.8 15.2

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Annexure I

Structure of Indian Banking system

Scheduled banks in India

Scheduled commercial banks

Scheduled co-operative banks

Public sector bank

Private sector bank

Foreign sector bank

Regional rural bank

Scheduled urban co-operative banks

Scheduled state co-operative banks

Old Private sector bank

New Private sector bank

Nationalised bank

State Bank & its Associates

Source : Banknet India

Annexure II RBIs Roadmap for foreign banks in India The banking sector in India is robust and its standards are broadly in conformity with international standards. In further enhancing its efficiency and stability to the best global standards a two- track and gradualist approach will be adopted. One track is consolidation of the domestic banking system in both public and private sectors. The second track is gradual enhancement of the presence of foreign banks in a synchronized manner. Implementation of the policy decisions is as follows: Phase1: (March 2005 to March 2009) 1. New Banks First time presence Foreign banks wishing to establish presence in India for the first time could either choose to operate through branch presence or set up a 100% wholly owned subsidiary (WOS), following the one-mode presence criterion. 2. Existing banks- Branch expansion policy For new and existing foreign banks, it is proposed to go beyond the existing WTO commitment of 12 branches in a year. The number of branches permitted each year has already been higher than the WTO commitments. A more liberal policy for under-banked areas will be followed. 3. Conversion of existing branches to wholly owned subsidiaries In the first phase, foreign banks already operating in India will be allowed to convert their existing branches to WOS while following the one-made presence criterion The WOS will be treated on par with the existing branches of foreign banks for branch expansion in India.

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4. Acquisition of Shareholding in select Indian Private Sector Banks In order to allow Indian banks sufficient time to prepare themselves for global competition, initially entry of foreign banks will be permitted only if private sector banks that are identified by RBI for restructuring. In such banks, foreign banks would be allowed to acquire a controlling stake in a phased manner. In considering an application made by foreign bank, for acquisition of 5% or more in the private bank, RBI will take into account the standing and the reputation of the foreign bank, globally as well as in India, and the desired level and the nature of presence of the foreign bank in India. RBI may, if it is satisfied that such investment by the foreign bank concerned will be in the long term interest of all the stakeholders in the invested bank, permit acquisition of such percentage as it may deem fit. The RBI may also specify, if necessary, that investor bank shall make a minimum acquisition of 15% or more and may also specify the time frame for such acquisition. The over all limit of 74% will be applicable. Where such acquisition is by a foreign bank already having a presence in India, a time bound plan covering a period not exceeding six months to conform to the one form of presence concept will have to be submitted by the foreign bank along with the application for acquisition. Annexure III Phase II: April 2009 1. According Full National Treatment to WSO of foreign Banks In the second phase removal of limitations on the operations of the WOS and treating them on par with domestic banks to the extent appropriate will be designed and implemented after reviewing the experience with phase 1 and after due consultations with all stakeholders in the banking sector. 2. Dilution of stake in WSO In this phase, the WOS of foreign banks on completion of a minimum prescribed period of operation will be allowed to list and dilute their stake so that at least 26% stake of the paid up capital of the subsidiary is held by resident Indians at all times. The dilution may be either way of IPO or as an offer to sale. 3. M&A of any Private Sector Bank in India In the second phase, after a review is made with regard to the extent of penetration of foreign investment in Indian banks and functioning of foreign banks, foreign banks may be permitted, subject to regulatory approvals and such conditions as may be prescribed, to enter into M&A transactions with any private sector bank in India subject to the overall investment limit of 74%. Annexure IV: - Government holding in the PSB and CAR(%)
Bank Allahabad Bank Andhra Bank Bank of Baroda Bank of India Bank of Mah. Canara Bank Corporation Bank Dena Bank IDBI Indian Bank Indian Overseas Oriental Bank Punjab National Bank State Bank of India* Syndicate Bank UCO Bank Union Bank of India Vijaya Bank *- RBI Holding Government holding 55.23 51.55 53.81 69.47 76.77 73.17 57.17 51.19 52.71 80.00 61.23 51.09 57.80 59.73* 66.47 74.98 55.43 53.87 CAR (%) 12.52 11.33 11.80 11.85 12.06 13.50 12.76 11.52 13.73 14.14 13.27 12.51 12.90 12.34 11.74 11.56 12.80 11.21

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P/E (x) FY07E 4.9 8.3 9.8 9.0 6.9 8.7 11.0 6.4 11.0 14.9 6.0 7.3 6.2 5.4 102.6 117.4 135.3 1.2 1.0 0.9 1.4 5.1 4.5 64.9 77.5 92.2 1.3 1.1 0.9 1.4 13.0 11.2 596.1 678.8 776.8 2.2 1.9 1.7 2.6 2.2 1.1 1.2 9.1 6.6 340.2 392.9 468.9 1.6 1.4 1.2 1.7 1.4 5.2 4.3 76.1 98.1 125.1 1.6 1.2 0.9 1.7 1.2 1.0 1.2 1.9 0.9 1.0 8.8 7.4 94.8 103.5 113.9 1.1 1.0 0.9 1.2 1.0 0.9 7.4 6.4 264.0 298.4 339.3 1.2 1.1 0.9 1.3 1.1 1.0 6.1 5.3 201.6 232.6 268.2 1.2 1.0 0.9 1.4 1.1 1.0 18.9 14.9 9.9 27.6 15.9 15.4 23.0 17.4 7.4 6.3 121.7 145.7 174.6 1.7 1.4 1.2 1.9 1.5 1.3 17.4 7.8 6.3 235.2 262.8 298.4 1.2 1.0 0.9 1.2 1.1 1.0 12.5 14.3 16.8 18.3 15.5 11.4 26.2 16.7 15.6 22.4 18.0 7.2 6.1 66.5 74.6 84.6 1.4 1.2 1.1 1.4 1.3 1.1 17.6 18.0 3.6 3.0 100.2 118.2 140.2 0.8 0.7 0.6 0.9 0.7 0.6 18.5 21.1 FY08E FY09E FY07E FY08E FY09E FY07E FY08E FY09E FY07E FY08E FY09E FY07E FY08E FY09E 21.1 18.8 15.7 18.6 18.2 15.6 12.5 24.8 19.6 15.8 21.7 18.1 B.V. (Rs) P/BV (x) P/ABV (x) RoANW (x)

Annexure V: - Public Banks Valuation

Banks

CMP

EPS(Rs)

(Rs) FY07E

FY08E FY09E

Allahbad Bank

83

16.8

23.0

27.3

Andhra Bank

92

11.1

12.7

15.0

Bank of Baroda

276

28.1

35.5

44.0

Bank of India

207

23.0

28.0

32.8

Canara Bank

243

35.5

39.8

45.6

Corporation Bank

321

37.1

43.5

49.9

IDBI

100

9.1

11.3

13.6

IOB

118

18.5

22.8

27.6

PNB

557

50.7

61.1

84.5

SBI*

1,284

86.3

99.2

115.1

Syndicate Bank

82

13.7

16.0

18.4

Union Bank

122

16.7

19.8

22.9

CMP as on 16/05/2007

* Standalone

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Annexure VI: - Valuation table for the recent mergers and acquisitions
Particulars Price Paid (Rs mn) Branches Price / Branch (Rs mn) Networth Net NPAs Effective Price Total Business Total Business / Branch (Rs mn) Effective Price / Branch (Rs mn) Total Business / Effective Price Equity (Rs mn) BV (Rs) Price / Share P/BV (x) Adj BV (Rs) P/ABV (x) Total Business as on 31st March 2006 Effective Price = Price Paid -Networth + NPA Source:- Banks, Dolat Capital Sangli Bank 3,000.0 198 15.2 250.0 200.0 2,950.0 28,920.0 146.1 14.9 9.80 31.9 78.4 940.4 12.0 15.7 60.0 LKB 3,400.0 112 30.4 1,631.0 676.6 2,445.6 36,997.4 330.3 21.8 15.13 944.5 17.3 36.0 2.1 10.1 3.6 UWB 1,500.0 230 6.5 791.5 2,273.0 2,981.5 104,860.0 455.9 13.0 35.17 537.7 14.7 27.9 1.9 (27.6) (1.0)

Annexure VII : Foreign Banks in India

FY2006 (Rs mn) Capital Deposits Advances Total Assets Networth PAT RoA (%) RoAA (%) RoNW (%) RoANW (%) Source: RBI, C-line, Dolat Research Citi Bank 5,013.6 279,117.4 244,552.8 454,592.5 41,955.5 7,055.5 1.55 1.78 16.82 19.2 Bank of America 6,571.0 21,062.1 33,690.7 59,927.2 15,742.3 1,437.0 2.40 2.50 9.13 9.6 HSBC 13,677.5 249,551.1 168,122.9 374,730.6 39,254.1 5,149.2 1.37 1.58 13.12 14.1 ABN Amro 1,690.2 118,637.7 150,732.2 235,437.9 15,885.9 2,416.8 1.03 1.24 15.21 16.5 Deutsche 7,126.8 43,799.0 25,817.8 120,502.8 13,113.2 1,259.3 1.05 1.10 9.60 9.9 Stan Chart 5,282.0 284,598.1 240,767.3 481,824.0 45616.12 9,048.5 1.88 2.12 19.84 23.2

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Annexure VIII: - Valuing an Acquisition
Component Valuation Guidelines Value the combined firm with synergy built in. This may include A higher growth rate in revenues: Growth synergy Higher Margins, because of economies of scale Synergy Lower Taxes, because of tax benefits: Tax synergy Lower cost of debt: Financing synergy Higher debt ratio because of lower risk: Debt capacity Subtract the value of the target firm (with control premium) + Value of the bidding firm (pre- acquisition). This is the value of the synergy. Should You pay? Which firm is indispensable for the synergy? If It is the target, you should be willing to pay up to the synergy. If it is the bidder, you should not.

Value the company as if optimally managed. This will usually mean that investment, financing and dividend policy will be altered: Investment Policy: Higher returns on projects and divesting Control Premium unproductive projects. Financing Policy: Move to be a better financing structure Dividend Policy : Return unsused cash Practically, 1. Look at industry averages for optimal ( if lazy) 2. Do a full fledged corporate financial analysis

If motive is control or in a stand alone valuation, this is the maximum you should pay

Status quo Valuation

Value the company as is, with existing inputs for investments, financing and dividend policy.

If motive is undervaluation, this is the maximum you should pay

Source: Damodaran on valuation

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The ratings are based on the absolute upside of our target price from the current price. Upside > 25 % 15% - 25% 0% - 15% <0% Ratings Buy Accumulate Reduce Sell

Team Research
research@dolatcapital.com Sanjeev Patkar sanjeev@dolatcapital.com Mehul Mehta mmehta@dolatcapital.com Darpin Shah darpin@dolatcapital.com Kapil Yadav kapil@dolatcapital.com Ritesh Poladia ritesh@dolatcapital.com Navin Matta navin@dolatcapital.com Nadeem Parkar nadeem@dolatcapital.com Ankit Babel ankitbabel@dolatcapital.com

Sector / Tel No.

Team Sales
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Tel No.

Head of Research, Strategy 91-22- 4096 9732 FMCG, Power, Engineering 91-22-: 4096 9743 Banking, Finance & Insurance 91-22- 4096 9743 Hotel, Shipping 91-22- 4096 9742 Media, Entertainment 91-22- 4096 9742 Auto, Auto Anciliary 91-22- 4096 9741 Logistics 91-22- 4096 9741 Textile, Power 91-22- 4096 9724

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91-22- 4096 9796 91-22- 4096 9734

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91-22- 4096 9797 91-22- 4096 9707 91-22- 4096 9705 91-22- 4096 9727 91-22- 4096 9718

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Quantitative Research
Aalap Shah aalapshah@dolatcapital.com derivativesinfo@dolatcapital.com Sachin Mulay sachin@dolatcapital.com Derivatives 91-22- 4096 9733 Technical Analyst 91-22- 4096 9720

91-22- 4096 9745 91-22- 4096 9746

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This report contains a compilation of publicly available information, internally developed data and other sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated are accurate and the opinion given are fair and reasonable, we do not take any responsibility for inaccuracy or omission of any information and will not be liable for any loss or damage of any kind suffered by use of or reliance placed upon this information. For Pvt. Circulation & Research Purpose only.

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