Big is beautiful: HDFC-HDFC Bank mega merger sets the stage for financial sector consolidation

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The merger of HDFC with HDFC Bank has been a long time coming, but now that it is finally here, the creation of a financial behemoth deserves a warm welcome. Notwithstanding the accompanying regulatory costs, it is a perfect fit with synergies in the product suite that can be tapped almost immediately. That is the reason investors are not quibbling over the initial expenses and focusing on the long-term benefits. The competitive advantage that the new HDFC Bank will enjoy is truly enviable.

The merger has several broader implications for the banking sector. To begin with, it will result in a sharp rise in competitive intensity given that HDFC Bank will now have a book of close to Rs 18 trillion, which is twice the size of ICICI Bank’s book. One could go to the extent of saying HDFC Bank, with its fairly deep distribution and strong franchise, could even challenge State Bank of India (SBI) though the gap is still large.

One could argue that both HDFC Bank and HDFC were already strong players in their own right but the growth potential of the combined mortgage book—on a cheaper deposit base—will alter the complexion of the profits altogether. What this merger seems to suggest, therefore, is that scale is becoming increasingly important. It was always important, but now it is possibly critical, and unless a lender commands an asset base of a certain level, sustaining profit margins over the long term will be very difficult. It should not be a surprise, therefore, if some of the newer private sector banks decide they should merge with their larger peers. It might not be a bad idea for the regulator to facilitate some of these mergers.

The fact is that attracting cheap deposits, which is key to lending, will become harder, and the smaller banks might simply not have the wherewithal to do so. Offering a higher interest rate to garner deposits can be a sustainable option only in the short run.

It might seem unfair to promoters of these smaller banks, but even as there are a myriad opportunities in the loan market there are as many risks. Withstanding these shocks—like the recent one in the microfinance sector in Assam—requires lenders to have large, well-diversified balance sheets and be well-capitalised. Even a lender of the size of Axis Bank has taken years to clean up its books after the loan losses incurred on infra projects.

Monday’s mega merger announcement also puts the spotlight on the non-banking financial sector that loses out to banks because it doesn’t have access to low-cost current and savings accounts. They are also compelled to be as compliant as banks. Despite this, India has seen some phenomenal success stories in the space—Bajaj Finance, for example. But, it seems almost unfair that Bajaj Finance can’t get a banking licence when in fact it caters to un-served and under-served borrowers to whom banks are unwilling to lend.

Indeed, the HDFC-HDFC Bank merger is an opportunity for the regulator to take a fresh look at country’s banking landscape and invite discussion on it. The nature of the lending business is changing primarily because of rapid digitisation, and there is a need to re-think the size and structure of financial intermediaries. It is a valid argument that the country needs lenders of all hues to be able to able to reach out to and cater for the varying needs of borrowers. Enough competition is also required to ensure that customers don’t get a raw deal. But, it is equally true that India can’t ignore the importance of size, solvency and the cost of loans to the borrower. To be sure, not every merger may be as efficient, but it wouldn’t hurt to initiate some conversations.