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M&As in the Indian Banking Sector

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KEY MESSAGES

M&A in the Indian banking sector is an opportunity


and an imperative

M&A has to be based on a business rationale and


effective execution there is not enough track
record of that in the Indian banking sector

India may have to follow a managed transition


model to ensure a stronger banking sector

IMPERATIVES FOR M&A FOR BANKING IN INDIA

Comments

Fragmentation poses increasing risk in


1

Stability

Returns to
shareholders

Benefits to
customers

Value added
in the sector

the Indian banking sector

While shareholders have had good


returns over the last few years,
valuations are well short of other
markets

Intermediation costs remain high


Access to quality products and
services is restricted to a small part of
the market

The banking sector is a big employer;


large parts of the workforce may be left
without requisite skills if there is not
skill transfer through M&A

1. THERE IS SIGNIFICANT FRAGMENTATION AND INCREASING


POLARISATION IN THE SECTOR. . .
Movement from 2001 to 2004

MARCH 2004

UTI
Bank

P/B
3

Bank
BOB

0
0

5000

Source: Prowess; team analysis

10000

15000

20000

Market capitalisation (Rs crores)

25000

AND VALUE IS MOVING AWAY TO FEWER BANKS

21 listed banks

37 listed banks

Per cent (Year: 1998)

Per cent (Year: 2004)

100%=Rs. 3,710
0.3
Remainin
g banks

37.1
0.6

287 Billion
0.3

100% = Rs. 15,676

Remainin
g banks
Next 15
banks

Top 5
banks

91.9

88.9

36.1

10.5

15.3

Share
of PAT

Share of
market
value

1,114.45 Billion

22.1

41.5

89.4
Next 15
banks

6.0
Share of
assets

37.9

168.57

Top 5
banks

46.9

45.0
36.4

15.3
Share of
asset

18.9
Share
of PAT

Share of
market
value

THE WEAKNESSES OF SMALLER BANKS ARE BEING EXPOSED


LEADING TO MULTIPLE FAILURES
Bank
Global Trust
Bank

Madhavpura
Mercantile Cooperative Bank

South Indian
Co-op Bank

Nedungadi
Bank

Reason for failure

Institutional root-cause

Significant exposure to high-

Absence of strong credit-

risk mid-market corporates


Over-exposure to capital
market operations

risk management systems


and processes
Weak corporate governance

>Rs. 1000 crore unsecured

Weak corporate

loans to 19 customers
High involvement in pay-order
scam

High level of NPAs arising

governance

Weak corporate governance

from extensive lending to


small group of clients

High NPAs from large lending


to small group of clients
High exposure to plantation
industry

Absence of strong creditrisk management systems


and processes

2. INDIAN BANKS HAVE OUTPERFORMED SHARE INDICES IN THE LAST


FIVE YEARS
Total return to shareholders (Indexed to 100 for Jan99)

TRS CAGR
Jan99-Aug04

Per cent
New
Private
Banks

Source: RBI, excludes merger effect of ICICI with ICICI Bank

42.6%

PSU
Banks

30.06%

Banking
Index

27.44%

Old
Private

6.56%

BSE 30
index

9.89%

HOWEVER, VALUATIONS STILL REMAIN LOW RELATIVE TO OTHER


MARKETS
August, 2004
Bank valuation in India

Comparison across countries


P/E

P/B

15.2

Germany

Hong
Kong

2.3

17.7
9.0

1.7

Thailand

8.1

1.5

Korea

6.7
8.5

New private
sector banks

8.0

2.6

2.6

Brazil

India*

P/B*

1.2

14.1

USA

P/E*

1.39*
1.1

*
Weighted average of 37 banks
Source:
Prowess; Bloomberg

Old private
sector banks

Public sector
banks

4.8

3.4

1.5

0.8

3. DESPITE RECENT DECREASES, COST OF INTERMEDIATION


REMAINS HIGH
Real cost of lending*
Per cent

Average leading rate


WPI for all commodities
Real cost of loans to
borrowers

13.00

13.00

13.00

12.00

12.00

11.50

11.00

Real cost of lending, 2003


Per cent

8.10

7.1
5.9

2.36

5.4

4.4

3.7

3.3

3.4

India

1998

*
Source:

1999

2000

2001

2002

Average leading rate less % change in WPI


EIU; CMIE

1.80

2003

2004

UK

US

COMPARISON WITHIN THE INDIAN BANKING SECTOR REVEALS THAT


CONSOLIDATION WILL HELP DRIVE DOWN INTERMEDIATION COSTS
Operating cost/average assets
2.4

Top 5
PSU
Banks

2.52

Next 10

2.86

Remaining

Avg* 2.45

Private
Sector
Banks

Top 5
Remaining

1.59
1.82
Avg* 1.79

Foreign
Banks

Top 5
Remaining

*
Average for 4 years: FY 2000-2003
Source: RBI, McKinsey analysis

2.91
3.03
Avg* 3.01

FURTHER, COMPARISON WITH GLOBAL BANKS INDICATES


THAT FEW INDIAN BANKS HAVE SCALE (1/2)
$ billion, ratio
1997, 2004 data

More details on
next page
2004

~$26bn

1997

Performance: Market-to-Book Ratio

Hang Seng Bank

BCP
~$100bn

~$55bn
Standard
Chartered

MayBank

US Bancorp

Wells Fargo

UniCredito Italiano

Hana Bank
Shinhan

DBS Group
~$35bn
Kookmin

Woori Finance ~$15bn

~$180bn

~$130bn
HSBC

Citigroup 170

Royal Bank of Scotland


BNP Paribas

~$60bn

150

~$95bn

120
110

Deutsche Bank

80
60
40
20
10

70

100

Size: Book Value of Common Equity

*
Market value as of Feb. 16, 2004 and Dec. 31, 1997; book value is as of fiscal year 1997 and for the latest available quarter for 2003
Source:
Bloomberg

FURTHER, COMPARISON WITH GLOBAL BANKS INDICATES


THAT FEW INDIAN BANKS HAVE SCALE (2/2)
$ billion, ratio
1997, 2004 data
7

2004
1997

Performance: Market-to-Book Ratio

6
Hang Seng Bank
~$26bn

5
First Financial***
4

Changwa

Bangkok bank
ICICI
Taishin***

Hua Nan**
~$10bn

25

MayBank

Hana Bank
Sinopac***

~$15bn

Krung

SBI

OCBC
Shinhan Financial Group***

UOB

DBS
Group

~$15bn
20

Kookmin Bank

Woori***

15
10
6
3
1

0
0

Size: Book Value of Common Equity


*
Market value as of Feb. 16, 2004 and Dec. 31, 1997; book value is as of fiscal year 1997 and for the latest available quarter for 2003
**
Fundamentals for 1997 for Shinhan Bank and current for Shinhan Financial Group
***
Fundamentals for 1997 for Woori Bank and current for Woori Finance Holdings
Source:
Bloomberg

10

4. BANKING SECTOR HAS BEEN ONE OF THE KEY EMPLOYERS IN THE


ORGANISED SECTOR
Number of employees, 2001

% of total

Millions
Manufacturing

6.44

Transport storage +
communications

3.12

Financing Insurance,
real estate and
business services

1.65

Agriculture

1.44

23.18%

11.22%

5.94%

5.16%

Construction

1.13

4.09%

Mining

0.95

3.43%

Banking sector
(all SCBs) had a
workforce of 0.93
million as on
31/03/2001, which
is 57% of total
persons employed
in the financial
sector

THERE IS HUGE DISPARITY IN EMPLOYEE METRICS ACROSS BANKS


Employee productivity, 2004
Rs million
1.56

0.8
0.7

Someone in the
system needs to
take on the
pain of reskilling
employees else
there may be a
big issue some
years down the
line

0.6
0.5
Cost***
0.4
per
employee

0.3
0.2
0.1
0
0

50

100

150205

Business* per employee**


*
Source:

Sum of deposits + advances; ** Employees for FY03; *** Personal cost


RBI; IBA

KEY MESSAGES

M&A in the Indian banking sector is an opportunity


and an imperative

M&A has to be based on a business rationale and


effective execution there is not enough track
record of that in the Indian banking sector

India may have to follow a managed transition


model to ensure a stronger banking sector

LEVERS OF VALUE IN M&A


Key source of value for the acquirer

Cost
savings

1 Collections

Ability to maximise the speed and recovery of NPLs

2 Processes

Ability to redesign processes

3 Distribution

Ability to integrate and rationalise branches and other


channels

4 Infrastructure

Ability to combine corporate/regional infrastructure

5 IT

Ability to upgrade overall technology

6 Operations

Ability to quickly centralise operations

Product/
Segments

Ability to upgrade product range and increase cross-sell

Revenue
enhancement

8 Geographies

Ability to ensure geographic growth and synergy

Treasury
improvement

9 Cost of funds

Ability to reduce cost of funds

10 Trading income

Ability to leverage scale and improve trading income

RESEARCH SHOWS THAT IN MOST CASES MERGERS FAIL TO DELIVER


AGAINST THEIR EXPECTATIONS, WHATEVER THE RATIONALE
Poor deal
Unrealistic synergies
Price too high
Competitor reactions

30

70

60-70%
failed

Source:

Good deal poorly implemented


Poor integration management
Failure to address cultural
differences
Customer losses
Poor communication
Poor tracking

McKinsey Corporate Finance Practice; interviews

LOT OF THE MERGERS IN THE RECENT PAST HAVE BEEN


TO BAIL OUT LOW PERFORMING BANKS
Acquirer
Target

Year

Acquirer

Target

2000

HDFC Bank

Times Bank

6 9

Strategic reasons

2001

ICICI Bank

Bank of Madura

12 16

Strategic reasons

2002

Bank of
Baroda

Benares
State Bank

2003

2004

Total assets (after merger) Reasons for merger


Rs 000 crore

negative net worth

High accumulated

Punjab
Nedungadi
National Bank Bank

Oriental Bank Global Trust


of
Bank
Commerce

Target bank with

64

63

73

41

74

48

losses
Net NPAs of Rs.200 crore

Bank failure
Networth wiped out

CURRENT REGULATIONS COULD POSSIBLY IMPEDE MARKETDRIVEN CONSOLIDATION


Recent RBI ownership guidelines. . .

Shareholding in any bank by a single


entity or group of related entities limited
to 10 per cent without prior RBI approval

A private sector bank can hold only 5


percent shares in any other private
sector bank

A foreign bank with presence in India


can hold upto 5 percent shares in any
other private bank

FDI by single entity or group of related


entities cannot exceed 10 percent.
Individual FII investment cannot exceed
10 per cent with the aggregate limit for
all FIIs restricted to 24 per cent (that can
be raised to 49 per cent with the
approval of Board / General Body).

. . . could possible impede


market-driven consolidation
The 5 per cent ceiling proposed
by the RBI is a major disincentive
for foreign banks wanting to buy
a stake in private sector banks. . .
HSBC, which recently lifted a 14.7
per cent stake in UTI Bank, will
have to bring it down to 5 %
The new guidelines could alter
the entire structure and
shareholding patterns of several
private sector banks. . . . This
would force ICICI Bank, for
example, to reduce its 20.44%
stake in Federal Bank and 11.8%
stake in South Indian Bank.

SUMMARY

M&A in the Indian banking sector is an opportunity


and an imperative

M&A has to be based on a business rationale and


effective execution there is not enough track
record of that in the Indian banking sector

India may have to follow a managed transition


model to ensure a stronger banking sector

A CONSCIOUS CHOICE HAS TO BE MADE FOR THE PATH TO


MANAGE CONSOLIDATION IN INDIA
Most appropriate for India

Free market
Key elements of Allow market-driven
restructuring
consolidation
approach
Allow free entry of
foreign banks

Managed
transition

Protectionist

Encourage domestic

Force consolidation

acquisitions by strong
(merger) of local
local banks
banks
Selectively open the
Close/restrict market
banking sector to
access to foreign
foreign competition
players

Impact
Increased dominance
Significant
(based
of 2-3 strong local
consolidation of
on experience of
players through
smaller players
other countries) Near-total replacement acquisitions
of local institutions by Foreign banks begin
to increase presence
foreign banks
Examples

Argentina

Brazil

No significant
strengthening of key
local players
Foreign banks
continue to have
limited opportunities

Malaysia

ISSUES AROUND END-STATE NEED TO BE RESOLVED BEFORE


CONSIDERING A MANAGED TRANSITION

The Designing
World Class
Korean
Retail
the
end-state
Financial Services Company

Define
overall bank
performance
end-state

Define
cost
management
end-state

Define
product
availability
end-state

Define overall market end-state structure

1.DEFINE OVERALL MARKET END-STATE STRUCTURE


FINANCIAL STRUCTURE

Number of players

3-4
broad-based,
global players

Regional/national
players

Micro-market
niche players
Community banks
Credit unions

Defender/small

Reserve the
right to
play/medium

Industry
shaper/large

Strategy/market capitalization (size)

Universal
banks
Non-banks

DEFINE EXPECTED PARTICIPATION LEVELS OF


FOREIGN BANKS
Foreign ownership of banking assets, 1990-2000
Per cent
South
America

Brazil

6
1990
Eastern
Europe

1990

1990

Source:

2000

<1
1990

48
2000

Poland

62
2000

Korea*

23

Hungary

10

Asia

Mexico

3
1990

India

70
2000

Thailand*

33
2000

1990 and 1994 data


**
1994 and 2000 data
BIS; McKinsey knowledge database; press searches

5
1990

12
2000

1990

2003

2008

2. DEFINE OVERALL BANK PERFORMANCE END-STATE


Criteria

Issues

Apply international accounting standards to recognize all


Capital
Capital stability
stability

embedded loan and investment losses and estimate the


real BIS ratio of banks

Banks will need to achieve an industry average ROA > 1


Profitability
Profitability

percent and ROE around the 10~15 percent range


through a greater profitability orientation

Pricing margins for major product groups should move


up

Banks NPL/total loans ratios need to be 1~2 percent

Asset
Asset quality
quality

maximum, which is more in line with the developed world

Apply international accounting standards to identify the


real NPL ratio

Create industry-wide utilities to aid banks

3. DEFINE COST MANAGEMENT END-STATE


Criteria

Issues

Cost efficiency ratio of banks should move to the 30Efficiency


Efficiency

Productivity
Productivity of
of
payment
payment system
system

Branch
Branch structure
structure
for
for retail
retail delivery
delivery

40% percent range in line with more developed


countries in a few years through improving operational
effectiveness

Banks should focus more on electronic payment


system
Create industry-wide utilities to aid banks

Improve branch productivity and realign distribution

Provided through affiliation

DEFINE PRODUCT AVAILABILITY END STATE

Meeting customer needs


Personal
financial
services
(PFS)

Payment

Business
banking

Payment

Banks

Life
insurance

Credit

Provided through subsidiary


Provided through own operations

Retail and
pension fund Non-bank
management trusts

CANADA EXAMPLE
Credit
unions

Asset accumulation

Credit

Corporate finance

Investment

Risk management

Brokerage

Pensions
Insurance

Life
Health
Disability
Property and casualty

No. of players

Source:

4~6 leading
banks, many
foreign
banks
Annual reports; team analysis

120

200+

37

2343

Customer
needs being
met by a
variety of
providers,
including 4-6
major banks
through
several
products
and
channels

IN A MANAGED TRANSITION, IT IS IMPORTANT TO CREATE


SMALL NUMBER OF NEWLY EMERGED LEADING BANKS

Expected
Potential

BASED ON
EXAMPLES OF
OTHER COUNTRIES

Strong
Newly emerged
leading banks
P& A

,
M &A

General
players

Status
quo

Ch
oo

Market
capitalization

se

&

fo
cu

M&A,
P&A
Stand alone
leading banks

M&A, P&A

M&A, P&A

Niche players
Niche banks

Week

Liquidate

Liquidate

Current

Future
Time

Source:

Team analysis

THERE WOULD BE FEWER STRONGER BANKS IN THE END STATE


4.0

3.5

High
performing
banks

3.0

Potential end state?

3-4 large universal

Imputed P/B

2.5

banks (asset size


150,000 crore plus)

2.0

Regional banks
(asset size 70,000
crore)

1.5

Foreign banks
1.0

(asset size 50,000


crore)

Large National
Banks

0.5

Stuck in
the middle

0.0
0
-0.5

10000 unviable
20000
Weak/
banks

30000

40000

50000

60000

Asset size

70000

80000

BANKS IN EACH OF THE CATEGORIES WOULD NEED TO BE ANALYSED


IN DETAIL TO DETERMINE THE ACTUAL PATH
Category
High performing
banks

Weak banks

Imperative

Key issues to resolve

Aggressively increase Should these banks focus on organic growth or


scale (through
acquisitions)

Exit
Get acquired/merge

Are the banks really unviable on a stand alone

Stuck in the
middle

Large national
banks

Merge to form

regional banks
Get acquired by large
national banks/ well
performing banks

growth via acquisitions?


If acquisitions, what are the right candidates?

basis? Do they have a set of product market skills


or management which could turn them around?
If weak, should they be closed or merged with
other banks?
If merged, should they be merged with another
weak bank or a bank of another category?

Do these banks have an opportunity to grow

organically into the large national bank or well


performing bank category?
Which ones could serve as anchors to form
regional banks?
Which ones are suited for acquisition?

Acquire (if necessary) Are these banks truly at a sufficient scale or need
other banks to
increase scale or
obtain access to new
skills

to merge with other large banks to increase scale?


What banks of other categories would make
sensible acquisition candidates?

END OF PRESENTATION