The HDFC-HDFC Bank Merger Explained

The Indian capital markets are hitting one record after another in terms of mergers and acquisitions.

Be it Tata’s acquisition of Air India, Sony’s merger with Zee or Adani’s purchase of SB Energy, equities are on a dance and markets are on a cash-ride. In fact, our minds are still afresh with the alliance between PVR-INOX declared just last week.

But the latest new merger to hit the streets is the one between HDFC Ltd and HDFC Bank. Unlike a merger in the movie exhibition business, this one screams significance for the markets and the economy on a whole new level (#bigleagues).

While the deal is a marriage within the HDFC fraternity itself, it has immense importance for the Indian banking and financial sectors. Not only will this lead to creating the second-most valuable company in the country, but it will also become the biggest M&A in the history of Indian markets.

The announcement came as a joy to the investors of both entities. Needless to say, the joint entity will become a formidable player in the financial sector. It is also a signal that the fervent calls for consolidation in the banking sector are now underway and here to stay.

Here’s a deep dive into the deal points of the merger and its significance in the long run.

The Merging Identities

HDFC Ltd or Housing Development Finance Corporation is India’s largest housing finance company which has approximately ₹5.26trn ($69.7bn) worth assets under management. HDFC Bank, on the other hand, is India’s largest private sector bank (by assets) and has a market cap of ₹4.44trn ($58.8bn). Combined, these two entities will give birth to a behemoth, commanding a market cap of roughly ₹8.35trn ($110.6bn).

Just to give you some reference, that’s more than the market cap of companies like Volkswagen, General Electric, Airbus etc. and also more than the combined market cap of Ford, Adidas and Credit Suisse.

HDFC Ltd. is also the holding company of HDFC Bank along with that of HDFC Life, HDFC General Insurance, HDFC Mutual Fund, HDFC Credila and HDFC Venture Capital. Which means that post-merger, all these companies will become the direct subsidiaries of HDFC Bank.

How Will the Deal Go Through?

The scheme essentially involves merging the bank and the holding company and issuing the bank’s shares to the company’s shareholders in return — a share swap arrangement.

Shareholders of HDFC Ltd will receive 42 shares of HDFC Bank for every 25 shares of HDFC Ltd. HDFC Ltd’s 21% shareholding in the bank will be extinguished and HDFC Bank will be 100% owned by public shareholders. Plus, the existing shareholders of HDFC Ltd. will own 42% of HDFC Bank.

Bottom line: HDFC Bank will be a full-fledged publicly-held company.

What Are the Benefits?

The first and the most important benefit will be the inflow of foreign investments. The equity restructuring opens up close to 7% headroom for FPIs (Foreign Portfolio Investors) in HDFC Bank. The combined foreign ownership will account for 65–67% of the merged company.

Second, a fat big balance sheet. HDFC Bank currently has a largely retail-focused operation but post-merger, it will have access to a $237bn-large balance sheet that will enable it to dabble in other sectors (like infrastructure etc.) in a much bigger way. It could underwrite bigger-ticket loans and expand its loan book by almost 40%. The share of retail assets in the bank’s portfolio could increase as well.

Third, bigger cross-selling avenues. Almost 70% of HDFC Ltd customers don’t bank with HDFC Bank. The merger would, therefore, give the bank a long-elusive opportunity to cross-sell products to a larger customer base by offering the customers a full suite of products and services to choose from. It will also help the entity leverage its distribution network across urban, semi-urban and rural areas.

One must also remember that close to 80% of HDFC Bank customers don’t have mortgages. Mortgages barely make up 11% of its loan book even though mortgages are secured loans and carry less risk weight when calculating the bank’s prudential ratios and this low-penetration is expected to be rectified.

What are the Costs?

This is the flip side which lies in every merger in the form of challenges to the cultural synergy and systems transition. Although the management of the HDFC Ltd insist that employees would be transferred to the banks at all levels, there are uncertainties surrounding the exact dynamics of such transfers. For instance, whether they would get ESOPs, how would their roles change inside the new entity etc.

Then there is the issue of technology transfer which is unlikely to be a soft-sailing considering the bank’s numerous glitches in the recent past, something which drew the Reserve Bank of India’s ire multiple times.

From a financial standpoint too, there are flip sides involved in the cost structure of setting up the new entity. The most obvious one being the mandate for banks to set aside a portion of their liabilities in the non-interest-bearing cash reserve ratio and the compulsory investments in Government securities. Bigger the loan book, bigger is the obligation to adhere to these mandates.

Larger Impact on the Banking Ecosystem

This is not the first time a bank and its holding company have merged together (cite: ICICI and ICICI Bank, circa 2001). Talks for the HDFC merger, however, were ongoing for some time and it’s remarkable how it was finalised in less than 18 months after the bank’s founding CEO Aditya Puri retired and S. Jagdishan stepped in.

If you’re wondering as to WHY NOW, then the answer could be reflected in the current macro level indicators. Post the IL&FS fiasco, the Indian regulatory environment has grown warier of the slippery arbitrage between banks and Non-Banking Financial Companies (NBFCs). So, turning a large-run NBFC (like HDFC Ltd) into a scheduled commercial bank (like HDFC Bank) is favourable for the current regulatory culture.

There is also a funding advantage to the merger. While HDFC Ltd has been an outperformer in managing its spreads across interest rate cycles, its cost of borrowings stood at 7.2% (as of Q2FY21). Even though that’s the best among NBFCs, HDFC Bank, in comparison, has its cost of borrowings at around 5%. Tapering this scale would be quite beneficial from a retail banking standpoint.

HDFC Ltd, by virtue of being a wholesale-backed financier, is also prone to more volatility in interest rates and liquidity. So, a merged enterprise with a bank would have a more sustainable profile for the entity.

Having said that, there are still some questions that need to be addressed before the merger takes effect. For one thing, the financial overhang will be profound as HDFC Bank will have an SLR/CRR asset requirement of around ₹70,000–80,000cr ($9.2–10.6bn) and will thus need an incremental ₹90,000cr ($11.9bn) agriculture portfolio to meet the Priority Sector Lending norms.

Similarly, ownership over the insurance business could be a pain. At present, banks can own more than 50% stake in an insurance company (HDFC owns 48% in HDFC Life). But if the merged entity ends up owning a bigger share then it might have to pare its stake over the next 15–18 months.

All said and done, the merger will bring considerable synergy in a sector that is undergoing a renaissance to integrate with the changing climate of modern-day financial markets. This also cements an ongoing (and state-supported) trend of merging entities to create fewer but bigger institutions. Let’s see how investors and customers adapt to this new and changing structure after the dust settles on this merger.

(Originally published April 5th 2022 in the TRANSFIN E-O-D Newsletter)