What the HDFC Bank merger really means for investors

capitalmind.in/2022/04/hdfc-bank-merger-impact-explained

Stocks
Deepak Shenoy

Apr 12, 2022

Why bother merging? HDFC and HDFC Bank, the two giants of the Indian financial
industry, are fusing into one. And creating a behemoth bank that will be India’s second-
largest, even if it’s still going only to be half of the mammoth State Bank of India. The new
HDFC Bank, after gobbling up its promoter, HDFC, will have ₹ 18 lakh crore in its mega
balance sheet.

On the day of the merger announcement, both stocks were up 10% on big volumes, but
they are back to pre-merger-announcement levels.

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So we’re going to make our guesses about what the merger means for investors, and we
warn you that they’re all very good guesses disguised as convincing data.

Summary:

Forms the biggest private bank in India

Housing is a good addition but won’t immediately help as people think they’re
the same thing
Why do banks love housing? A summary of how credit to housing is enormously
subsidized by risk weight
MSCI calculations mean HDFC will see huge exits and HDFC Bank will perhaps
not qualify to be part of them
This seems to be a better way to do succession planning at HDFC
Keep calm and carry on.

The merger share ratio is that 25 HDFC shares will be given 42 HDFC Bank shares
when the merger actually happens. (Around two years from now)

HDFC is a housing lender. It lends to you and me, traditionally called “retail”. This is
about 77% of their loans. It also lends money to builders who get to build houses and
other purposes such as Loans against property etc. Mortgages, which are about giving
money to people who primarily use it to buy houses, have three characteristics: They are
long in duration, up to 20 years, and they have a low-interest rate (typically 6.8% to
8%) and a generally low risk of default.

HDFC Bank, on the other hand, has a large number of personal loans (credit card
outstandings, personal loans, loans against deposits etc.). It also has a large number of
auto loans. Here, you can imagine that most loans are short in duration (even auto
loans close in 7 years max), have a higher interest rate, and have a relatively larger

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risk of default. HDFC Bank doesn’t normally lend directly for home loans. It sells loans
for HDFC and its parent and then repurchases some of the loans, which they use for
priority sector lending.

When they merge, the whole thing becomes a larger entity with all this exposure added
up. HDFC Bank has over 12 lakh cr. of lending, and HDFC has about 5 lakh cr.

Company presentation

HDFC Bank is largely retail loans; their mortgages tend to be what they buy from HDFC
itself. HDFC is mostly individual mortgages, but they have about 23%, over ₹ 100,000 cr.
– of lending to corporates, builders and commercial buildings.

HDFC has about 3,000 employees and uses a distribution through HDFC Sales, its
subsidiary, which has 11,000 employees. HDFC Bank, on the other hand, has 134,000
employees, and it’s the larger entity.

So the question that everyone seems to be asking is:

Is this merger going to change the world? Should I buy these stocks now or
forever be cast as a loser who couldn’t see the opportunity?

The answers are no, and what are you smoking.

Potential synergies: Is there something awesome?

We really tried hard to find something incredible in this merger. For the sake of brevity,
let’s say we failed. There are a lot of good things and bad things.

Good things:

HDFC Bank is now going to be able to lend for housing directly. Currently, it does
something ridiculous, like it first sells housing loans of HDFC to its customers and earns a
commission. It does not make any interest income from such loans. Then it goes back to

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HDFC and buys some of those loans, for which it might pay a slight premium. This
merger allows them to directly sell customers home loans that they can earn interest
income, fees (like processing charges) and potential other income such as insurance etc.

The cost of funding will reduce somewhat. HDFC itself has a higher cost of borrowing,
at 5.8%. HDFC Bank is at 3.6% because of all the money you good people leave in your
bank accounts for (mostly) free and all those corporate accounts. Imagine that a merged
entity will get loans at a lower rate, getting a higher “NIM” (Net interest margin). Note,
however, there are other things to consider – that HDFC Bank has to keep part of the
money raised through deposits in SLR and CRR which are very low yielding products.
We’ll talk about this later, but the merged entity will have a lower cost of
borrowing, closer to what HDFC Bank gets now.

All the subsidiaries of HDFC (such as the Mutual Fund AMC, the life insurance
company, the general insurance company, and many others) will now be subsidiaries of
HDFC Bank. This will probably require a go-ahead from various regulators, but it brings
HDFC Bank in line with other large banks like ICICI, Axis and SBI, which own such
subsidiaries. Basically, if you go to a branch, the bankers sell you these products anyhow,
but now the bank will make greater revenues as they will own a part of the subsidiaries’
profits. This may not be good for customers, but it’s positive for shareholders.

One small benefit is lower aggregate capital costs. Housing loans are a special beast,
so they are priced low. Here’s a run-through:

Banks are limited in lending purely by capital. If they have ₹ 100 and they have to
maintain a 15% capital adequacy ratio, they can lend only ₹ 650 or so. (15% of 650 is
₹ 100)
The ₹ 650 is “Risk-weighted assets”. If you lend ₹ 1000 to the government, it needs
no capital (risk weight of zero), so any amount is fine. If you lend for a personal
loan, the risk weight might be 100%. (so you can lend ₹ 650 to personal loans, max)
But if you lend to low-cost housing (less than ₹ 30 lakh loan amount), you have a
risk weight of 35% to 50%. That means you could lend a higher amount (₹ 1300) to
low-cost housing.
In fact, no matter how much the housing loan is if about 1/4th of the amount is paid
by the borrower (loan to value of 75%), then the max-risk-weight is 50%.
This is a huge incentive for banks to lend to housing. If they earn a 2% net interest
margin in housing, it’s equivalent to a 4% NIM in other loans (such as credit cards
etc.)
This allows banks to lend at such a low rate to housing. (Versus credit cards where
the risk weight is 125% and other retail loans where the risk weight is 75%)

HDFC has a similar risk weight structure (the lower risk weights are also translated to
housing finance companies). Still, the merger will result in a bank that has 33% exposure
to housing (versus 11% now). This means that the higher exposure to housing needs
relatively lower capital overall from the bank. The merger will not benefit the capital
ratios, but incremental new housing loans will need lower capital and provide higher
income due to the risk weights.

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Don’t let it startle you if you didn’t understand this whole thing. Lemme put it simply: RBI
loves housing loans and gold and has allowed banks that lend to individuals who buy
those things a much higher return on equity than people who might want to borrow to
build a business. Therefore, HDFC Bank getting more mortgages will, hopefully, help it in
the longer term. In the short term, it will not be helpful.

Bad things:

Regulatory load: HDFC is an NBFC. It doesn’t currently need SLR, CRR or such ratios
– meaning, it needn’t have parked money in low yielding government bonds or for no cost
with the RBI. That allows it to borrow ₹ N and then lend out ₹ N. That’s not the same for a
bank: borrow ₹ N and put 4% of that N in the RBI for no return (CRR). And another 18%
in low yielding government bonds (SLR). This means that post the merger, HDFC Bank
will need an additional ₹ 100,000 cr. (around 22% of the 500,000 cr. they have lent) in
these low yielding avenues. HDFC Bank will, after the merger, have a lower “net
interest margin” (NIM) because housing loans have very low yields, at around 6.8% to
7% anyhow. The current NIMs of 4.1%+ will flatten down to 3.5% or so. Lower NIMs
mean lower margins. This is not good for shareholders, who will undoubtedly pay a lower
price for such a margin compression.

Note: HDFC must have something called a Liquidity Coverage Ratio, which means they
need to keep some portion of whatever debt maturing in the next 30 days in highly liquid
instruments (govt bonds, etc.). That effectively reduces yield since something or the other
will be maturing in the next 30 days, all the time, and so some portion of their borrowing
cannot be used for lending. Note that the LCR for NBFCs is a concept started in 2020 and
slowly increases to the level that banks must keep.

Second, the loan durations go to 20 years for mortgage loans. These loans are currently
linked to an RPLR (the lending rate of HDFC) which is 16% or so, and this will have to
change to the MCLR/Base Rate/Floating rate loans.

Rate Flexibility Gone: Currently, when borrowing rates fall (repo etc.), then all banks
must reduce their lending rates automatically, even to existing customers, typically with a
short lag. However, HDFC isn’t a bank, so it doesn’t really have to reduce these rates. It
maintains a high Retail Prime Lending Rate (RPLR) and offers NEW customers a higher
discount to the RPLR while keeping existing customers at the same rate. This allows them
to attract new customers at lower rates while retaining current customers at high rates.

If existing customers want to change rates to a lower one – because they say come on, why
are you offering lower rates than mine to new customers – then there’s a fee for that
change! HDFC has a page that says this:

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As a bank, it will no longer have this flexibility. Rate changes will apply at regular
resets automatically. That is good for the customers but not-so-good for shareholders.

No major synergy: When you think of Kotak merging with ING Vysya, ING customers
get to be sold the Kotak brand and other products that Kotak has etc. When you think of
HDFC merging with HDFC Bank, the customers are already getting sold each other’s
products. The name is the same, and there’s no advantage to merging the brands (they are
the same brand).

CASA changes: Most of HDFC’s borrowings are from the market (Commercial paper,
Bonds, Masala bonds etc.). These are not cheap – the last set of borrowings from the CP
market show HDFC’s 10-month borrowing costs at 5%+. This will need to be replaced
slowly by the CASA of HDFC Bank, which can take a while. HDFC’s customers may not
have HDFC Bank accounts today and will take years to be moved to a structure where
they maintain their core accounts with the bank.

Comparing the merged bank to the rest

HDFC Bank, pre-merger, is largely an auto and credit card lender. The merger will make
it a mortgage heavy lender.

A Flourish chart
It will also become the second-largest bank by lending size:

A Flourish hierarchy chart

From a low-cost deposit perspective, HDFC’s been the best so far. That will change.

With the best in class ROE today, it will fall to a lower ROE (Return on Equity) after the
merger.

Valuation wise: what happens?

Here’s what they say in the presentation.

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 Company Presentation

HDFC Bank currently gets a price that is 4x book. HDFC itself gets a price that is less than
3x book. HDFC bank gets the higher price because of relatively higher growth in its
business, the higher effective NIMs etc. HDFC will probably slow it down and introduce
layers of risk in the commercial real estate lending business.

Expecting a 3.5x book means a book value of ₹ 446 will lead to a price of ₹ 1560.
The current price (1520) is around that much, so there’s not that much upside. However,
higher profits or a sale of some of their subsidiaries can change the book value in a big
way.

You can’t value the subsidiaries like this company owns 68% of the listed HDFC AMC, so
we should value that. A mutual fund sponsor has to own 40% at least, and we should
expect a minimum of 50% to remain owned. The valuation can only be applied to the
remaining 18%, which will not significantly change a per-share valuation. Similarly, they
need to remain with the insurance business for a long time, and it will likely keep needing
capital, so you can’t just value the shareholding at market value. However, they are
profitable and will help increase the banks’ book value.

The Weird Problem: MSCI Index Will See Big Exits?

There’s a strange issue that isn’t related to fundamentals. It’s about index trackers.
MSCI’s indexes tracking India and Emerging Markets include only HDFC, but not HDFC
bank. That’s because:

MSCI Requires foreign ownership limits (FOL) to have at least 15% room when a
stock is included (i.e. to add new stock, the current owner should allow another 15%
to be bought by foreigners)
HDFC Bank already has 70% FII ownership, with a 74% cap. In fact, the HDFC
holding in HDFC bank is considered part of foreign shareholding.

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 HDFC Bank, therefore, does not have “headroom” in FOL. Therefore it is not part of
MSCI indexes.
HDFC is because it has about 69% ownership and enough headroom.
HDFC will no longer exist as a company after the merger; it will be the bank.
The merged entity as, HDFC Bank, will have only 64% FII shareholding, but it isn’t
enough.
With the FII limit at 74% on banks, the headroom isn’t exactly enough (the technical
upper limit for HDFC bank to qualify is 62.9% FII)

The merged entity will not make it to the MSCI index with the current holding. But it’s
touch and go because this determination will happen when the merger actually happens
(as we’ll see, it can take a long time).

According to HDFC Bank’s conference call, FPIs will own roughly 66%, but that was
before the shareholding pattern was revealed.

There’s another issue: timing. MSCI will move the stock out of its index as soon as
shareholders approve the merger, even if legal or regulatory approvals are pending. So, in
all probability, HDFC will get out of the index before HDFC Bank can even be considered
added, which will only be after the merger.

Why does this matter? Because passive funds will have to exit HDFC if they follow the
index. There is currently a fairly large amount of money in HDFC through passive funds.
Just three – EEM, IEMG and INDA – have more than $1 billion in HDFC, and other
passive funds would probably add more. Having around Rs. 10,000 cr. exit HDFC holding
will not be easily replaced, so the share price is likely to be under pressure.

If for any reason, HDFC Bank will be added eventually after the merger, there’s a similar
upside as well.

Long Time Away: Don’t Hold Your Breath

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The deal has to be approved by regulators first. (SEBI, NSE/BSE, RBI, IRDA, Competition
Commission etc.). This will take around 4-6 months. Specifically, HDFC’s 48%
ownership of HDFC Life Insurance will be a problem because RBI wants banks to own
50%+ or less than 30% of life insurers.

Then they have to file an NCLT application, where the NCLT court will call everyone and
his uncle to state what they think. They’ll take at least a year.

Then the rest of the drama involves actual share transfers.

Note that all debt, warrants, ESOPs etc., will continue and be transitioned over to the
bank later.

Our view: Nothing to see

It’s not a big deal, this merger. It’s not going to change things dramatically, and it has
more downsides on a fundamental basis than upsides. It doesn’t have a valuation kicker.

The merger is more about succession and answering the question: Who after Keki Mistry
and Deepak Parekh? The answer seems to be: Ask HDFC Bank, who will run the show
after the merger.

It’s a good answer. It’s just not so juicy that the bank is any more attractive than now.
Expect the price to book values to moderate, and that growth at this size will slow at some
level.

Disclosure: Small tracking position in either share, owned by the author.

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