Fitch Ratings: India's HDFC bank-NBFI merger to shake-up sector dynamics

12 Apr 2022 , 12:32 PM

Fitch Ratings-Mumbai/Singapore-12 April 2022: The recently announced merger between India’s second-largest bank, HDFC Bank, and its shareholder HDFC Limited, India’s largest housing finance company, may have long-term implications for the nation’s banking and non-bank financial institution (NBFI) sectors, says Fitch Ratings.

The proposed merger could redefine the competitive landscape for banks, and increase the prominence of M&A among banks seeking to close market-share gap with the merged HDFC Bank. It could also influence the evolution of the NBFI sector, particularly for large entities that have nurtured banking ambitions amid tightening sector regulations.

Indian banks intermediate roughly 60% of system credit, but face stiff competition as the market is fragmented and products are fairly homogenous. Three rounds of state bank mergers since 2017 have led to some consolidation but with limited impact on pricing power.

Fitch believes that the proposed merger of the HDFC entities and the recently announced acquisition of Citibank India’s consumer business by Axis Bank Limited (BB+/Negative) could encourage banks to turn to M&A. Large NBFIs could be acquisition targets, given their higher-margin products, large pools of priority-sector customers and loans, and potential cross-selling opportunities. However, the regulatory attitude towards such acquisitions will be an important factor in their success.

The combined HDFC entity will have an asset base of USD340 billion, nearly half the size of the largest bank, State Bank of India (BBB-/Negative), and double its nearest competitor, ICICI Bank (BB+/Negative). It will account for nearly 14% of system loans and 9% of system deposits, — a roughly 300bp jump in loan market share and about 100bp for deposits from the standalone HDFC Bank. The all-stock merger will take between 12-18 months to complete, subject to regulatory approvals.

Fitch believes both entities stand to gain from the deal. HDFC Bank will gain about 500 new branches, improve its operating efficiency as HDFC Limited’s cost/income ratio is 10% versus the bank’s 36%, and diversify its loan book, as the bulk of the loans will be mortgages. HDFC Limited will benefit from greater liquidity and a gradual shift to lower-cost deposits to support a more competitive offering in the large-ticket housing space. It will also be able to expand in affordable-housing financing, underpinned by the combined distribution network.

The harmonisation of NBFI regulations with that of banks over the past few years may have played a role in the merger decision. Tighter regulations amid some high-profile NBFI defaults should ensure stronger risk and governance standards and narrow the regulatory arbitrage between NBFIs and banks. However, the trend will continue to drive greater costs, which will weigh on profitability. Higher capital requirements, stricter norms for non-performing loans and the introduction of a liquidity coverage ratio, risk-based internal audits and core financial-service solutions, imply further increases in the cost of doing business for NBFIs.

The Reserve Bank of India previously raised the idea of converting large systemically important NBFIs into banks, but this was not made policy. This merger could serve as a template for entities keen to explore this route. Large corporate-backed NBFIs, particularly ones with commoditised product segments (such as consumer and housing finance) that face tough competition from banks, may find that the franchise and funding benefits from a bank merger may offset the costs. However, the central bank has been wary of allowing greater corporate ownership of banks due to the risk of conflict of interest.

Non-banks that are either small or in niche non-urban segments may find a bank merger or conversion less attractive. Many still serve market segments and customers with legitimate but informal income sources, which may not meet the documentation requirements of a bank.