Electronic copy available at: http://ssrn.com/abstract=1659634

Assessing the Strategic and Financial Similaritiesof Merged Banks: Evidence from VoluntaryAmalgamations in Indian Banking Sector

Sony Kuriakose and G. S. Gireesh Kumar1

School of Management studies (SOMS), Indira Gandhi National Open University,Maidan Garhi , New Delhi 110068

Email: sonyparackal1@gmail.com , sonyparackal@yahoo.com1Department of Commerce, Nirmala College, Muvattupuzha, Kerala-686 661

E-Mail: gireeshkartha@yahoo.comReceived on 7 June 2010; Accepted on 21 June 2010

AbstractSynergies arising from the increased efficiency, cost savings, economies of

scale etc are the principal factors behind the voluntary amalgamations in the Indianbanking sector. Even though, mergers are the major way to adhere to the regulatoryrequirements and the source of inorganic growth, the strategies adopted by themerging entities have to be critically analysed, because mergers seem to producestrategic and financial growth and also have considerable public policy implications.The merging partner’s strategical similarities and relatedness are very important inthe synergy creation because the relatedness of the strategic variables have asignificant impact on the bank performance. On the basis of existing literature,banks should be similar in some areas and dissimilar in some other areas in order toimprove post merger performance. In this paper we use firm specific data to studythe strategic similarities of bidder and target banks in the voluntary amalgamationsin the Indian banking sector. All relevant strategic and financial variables ofrespective banks are considered to assess their relatedness. It is assumed thatbalance sheet resource allocation is the indicative of the strategic focus of thebanks.

Keywords: Strategic Similarity, Mergers and Acquisitions, BankPerformance, Synergy Creation, Indian Banking Sector.

I IntroductionAfter the economic reforms introduced

by the Government of India in 1991, Indianeconomy have undergone majortransformation and structural changes inall sectors. Mergers and Acquisitions arethe major outcome of the financialtransformation process occurred in theIndian Banking sector. The key driving

force for the merger activity is severecompetition to attain market power andthe creating synergies and cost- revenuebenefits. According to the United StatesFederal Trade Commission reports, thenumber of mergers in 2004 was almostthree times that of 1998 in US (Justin Paul,2005). The same trend is beingexperienced in India also. In 2007, India

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attracted deals worth $68.32 billion, ascompared to $28.16 billion in 2006. Outof this, mergers and acquisitions accountedfor $51.17 billion while remaining in theform of private equity investment.

Banking and financial institutions arethe most significant components of anyfinancial system. From the view ofEmerging Market Economies (EMEs),banking system reflects the financialstability and growth. An overview of thereforms made in the financial sectorwould pinpoint the reasons and context ofmergers and acquisitions happened in theIndian banking sector. This reform phasecan be regarded as the “Second BankingRegulation Period” (B Samal 2001).Despite of the deregulation and all,inorganic growth is the main motive of bankmergers in India. Even though, India’srelatively conservative approach in

banking sector compared to developedeconomies has helped us in restricting theadvancement of recent financialrecession, the recent and past financialcrisis illustrated importance of strongbanking system and its reflection oneconomic growth. Therefore, there is noneed of two opinions that our banks shouldimprove the quality and performance tobecome more effective.

Like all business entities, banks wantto safeguard against risks, as well asexploit available opportunities indicated byexisting and expected trends. M&As inthe banking sector have been on the risein the recent past, both globally and inIndia. The International banking hasshown major turmoil in the past few yearsin terms of mergers and acquisitions.Deregulation in the sector has been themain driver, through three major routes -

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dismantling of interest rate controls,removal of barriers between banks andother financial intermediaries, andlowering of entry barriers. It has lead todisintermediation, investors demandinghigher returns, price competition, reducedmargins, falling spreads and competitionacross geographies forcing banks to lookfor new ways to boost revenues.Consolidation has become a worldwidephenomenon as a significant strategic toolfor this and has, driven by apparentadvantages of scale-economies,geographical diversification, lower coststhrough branch and staff rationalization,cross-border expansion and market shareconcentration. The new Basel II normshave also led banks to consider M&As.

From the financial stability point of view,our banks are far behind the internationalstandards. Our industry has alreadyadopted Basel-II norms which basicallyemphasises the Capital Adequacy ofbanks. A survey conducted by Federationof Indian Chamber of Commerce andIndustry (2005) gives light on India’soperational inefficiency to adhere withcapital requirements prescribed by Basel-II. From the RBI reports, it is revealedthat our banking system needs more than500 billions to implement Basel-II norms.Another important factor which drivesconsolidation is financial serviceconvergence. Financial serviceconvergence focussed on providing allfinancial services such as banking,insurance, investment, stock trading etc tothe customers under one roof, which needshigher size. Higher size also ends in theword ‘consolidation’. In contrast to otherEMEs, our consumption expenditure and

savings rate are well balanced. In additionto this, our savings rate is 37.7 per centand investment rate is 39.1 per cent whichindicates that there is a great chance forinorganic growth. Based on the motivesof merger deals, it can be grouped intothree categories. They are forced merger(Restructuring of a weak bank u/s 45(1)of the Banking Regulation Act, 1949),Voluntary amalgamations (u/s 44A of theBanking Regulation Act 1949), andUniversal Banking Model (Bank-FIs).

The effect of consolidation on themerging banks and on the economy is ahighly debated issue. But what matters isthat whether this business combinationsresult in the creation of the projectedsynergies through cost savings, increasedefficiency and economies of scale.Strategic management literature arguesthat the strategic features of the mergingentities have a significant impact on thepost merger performance. Therefore, theanalysis of strategic relatedness is usefulin evaluating the consequences of bankmergers. In the present paper, we proposean analytical framework to assess thestrategic features of the merged entities.Further an attempt has been made toapply this framework to the voluntarymerger deals in Indian banking.

Section II describes the relatedliterature and section III deals with keystrategic variables and its expected impacton the post merger performance. SectionIV illustrates the research methodologyand sources of data. In section V, wepresent the analysis of variables in termsits strategic similarity and section VIdiscusses the findings and future policy

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implications. Section VII deals with theconclusions and scope for future research.

II. Review of LiteratureThere is wide variety of literature

available regarding the operationalefficiency after merger and the sharemarket performance using eventmethodology. Ravens craft and Scherer(1989) have examined pre-merger (251companies) and post-merger (2732companies) performance for the period

1950-1977 in US. He used cash flow oversales for analysis and found negativeabnormal return in post-merger period.Healy, Pelpu, and Ruback (1992)addressed the issue of long term economicgains due to mergers in US corporatesector. They used cash flow analysis[sales-(cost of goods sold+selling andadministration expenses) + depreciation +goodwill expenses].They found anincrease of 2.8% in operating cash flow.They also found a positive correlation

Figure 1. Reasons and context of bank mergers in India

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between this gain and share pricemovement. Ghosh and Jain (2001), usingthe same methodology, they analysed 315mergers in US and found positiveabnormal return. Further they suggestedthat cash offers are associated with higherperformance.

Cornett and Tehranian (1998) comparedthe pre and post merger performance andfound positive abnormal growth. Sara BMoeller, Federric.P.Schcingemann andRane N .Statz (2005) analysed 12023acquisitions (1980-2001).They observedthat acquiring shareholders lost 12%around acquisition announcement. DirkHackbarth and Erwan Morellec (2008)have developed a framework to analysedynamics of stock returns and firm levelbetas. They concluded that a run-up (run-down) in the beta of bidding firm prior tothe announcement and a drop (rise) inbeta at the time of announcement whenacquiring firm has a higher (lower) pre-announcement beta than its target.

Geoffrey Meeks (1977) explored thegains from merger for a sample of 233transactions in UK (1969-1971). Heanalysed the data by ROA (Return onassets) method and foundunderperformance in 75% deals. JasonKarceski, Steven ongena, and David smith(2005) established the impact on welfareof the borrowers. They took the sampleof Norwegian banks and found 8% declinein the return of targets borrowers andincrease in acquirer’s borrowers. MarinaMartinova, sjoerd Oosting and LucRenneboog (2006) investigated the longterm profitabili ty of companies incontinental Europe or UK. They foundabnormal return for the acquirer. Sharma

and Ho (2002) observed negative returnpost- merger performance from a sampleof 36 Australian companies. Rehman andLimmack (2004) investigated 94 mergersin Malaysia (1998-1992). Using operatingcash flow returns on assets they foundpositive merger gains.

In the post reform period, there hasbeen a sharp increase in the mergeractivity in India. Studies in India are fewand generally on the pre and post mergerperformance. Pawaskar analysed 36mergers (1992-1995) using operating cashflow returns and do not found any increasein profitability. Kumar and Rajib (2007)identified the characteristics of mergingfirms in India based on 227 acquirerand215 targets. Rajesh Chakrabarti(2008) examined both domestic as well asforeign deals, and found that they areassociated with positive announcementresults and in long term it is worse thanpre-merger performance. M.Jayadev andRudrasensarma (2007) analysed thecritical issues of consolidation in the Indianbanking sector from the point view ofshareholders and managers. They foundthat in forced merger, both bidders andtarget’s share price has been reduced. Incase of voluntary merger results aremixed. Manoj Anand and Jagandeep Singh(2008) have studied the impact of mergerannouncement merger announcements onshareholders wealth. They took merger of5 private sector banks in India and foundpositive gain for both bidders and target.

But in the present paper it is not intendedto assess the performance evaluationeither in the operational level or in thestock market but is related to strategicmanagement literature. No study on

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“Impact of strategic features on bankperformance” appears to have been donein Indian banking sector. Levine andAaronovich (1981) and Lubatkin (1983)are introduced the relevance of studyingthe strategical and organisational aspectsof M&As. Ramaswamy (1997) analysedthe impact of strategic similarities on bankperformance in US and found banksexbiting similar features result in betterperformance.

Yener Altunbas, David Margues Ibanez(2004) analysed the impact of strategicsimilarities of bidder and target banks inEuropean banking sector and they founddifferent results for both domestic andcross-boarder mergers. Andreas Behr andFrank Heid (2008) suggested a newmatching strategy to control for theselection bias. From the literature it canbe stated that if other things remainsconstant, the relatedness and similarity willenhance the post merger performance.

III. Key Strategic Variables andtheir Equation Specification

Generally speaking, firms are framingtheir strategies based on the environmentthey are operating and these strategies aredynamic in nature. For instance, in theIndian Life Insurance industry, most of theprivate insurance companies were used topay high commissions to their consultants,but recently they shifted their strategy topromote sales through advertisements.But our banks have more static strategiesthan other advanced economies. Eachbank has its own goals and strategies. Inthe case of merger, the integration of thesefeatures definitely has an impact on thepost merger performance. In this

background, it is attempted to define thekey strategic variables and its expectedeffect on the post merger performance.The merging banks are expected toenhance the profitability and efficiency inthe post merger period. For the selectionof the strategic variables for the study, wehave incorporated the models suggestedby Ramaswamy (1997) and YenerAltunbas and David Marques Ibanez(2004), also given due preference to thefactors which are more relevant in theIndian context. Table 2 gives the strategicvariables, its algorithm and hypothesisrelated to its impact on the post mergerperformance.

IV. Data and Research MethodologyThe study is analytical in nature. The

objective secondary data are extractedfrom various RBI publications, websitesof SEBI, NSE, annual reports of the banksetc. The study includes voluntary mergerdeals took place in Indian banking sector(Table 3). Within the context of bankingindustry, all strategic and financialvariables are taken to assess the similarityand dissimilarity of the merged entities. Itis assumed that balance sheet resourceallocation represents the strategic focusof the bank due to the fact that it showsthe bank’s response to its external andinternal environment.

In addition to the variables mentionedin Table 2, we have considered some otherparameters also for the properconceptualisation and measurement ofstrategic features. Table 4 and Table 5give the list strategic variables used forthe present study.

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Relative size of the target is found bydividing the balance sheet size of targetby balance sheet size of bidder bank. Theunderlying hypothesis on the size ofrelative size of target to the bidder in thecase of domestic merger states thatsmaller the ratio, higher the post mergerperformance. The reason for thisargument is if relative size is small, theintegration is easier and it will enhancecost-cutting measures like sharing oftechnology, elimination of overlappingbranches etc. In the case of diversity ofearnings, if different sources are puttogether, it will increase the profitability

and reduces the risk (diversified sourcesof income). For this purpose, otherrevenues to total income ratio iscalculated and this analysis has a limitedscope unless the sources of income aredisclosed. Cost to income ratio providesan outlook of firms cost controllingstrategies, a lesser ratio indicates firm’sefficiency in cost cutting measures anddissimilarity will harm the performance.In the case of capital structure,dissimilarity will enhance the performanceas the combination of indifferent assetstructures will result in optimum capitalstructure.

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V. Analysis and Discussionsa) Relative Size of the Target

Since all the banking institutions areindulged in providing one-stop facilities toits customers and investors, size andcompetence become vital in marketcoverage and efficiency. There is lot ofambiguity prevailing regarding whichvariable is accounted for marketcoverage. What is the role of number ofbranches in studying the size of the bank?In order to resolve this issue, we analysedboth balance sheet size and number ofbranches. Relative size of target banks isfound by comparing balance sheet size ofboth bidder and target banks. The relativesize of the target is small in all voluntarymergers happened in Indian bankingsector except Centurion bank Vs Bank ofPunjab merger. The relative size is 1.063in this case due to the fact that Bank ofPunjab (4905.18 Crore)) has largerbalance sheet size than Centurion Bank(4611.7 crore). ICICI Bank Vs SangliBank showed the lowest ratio of .009. Inmost of the cases the analysis of numberof branches also gives results in samedirection. However, in ICICI Bank VsBank of Madura merger, ratios regardingbalance sheet size and number ofbranches are contradicting. From theanalysis it may be stated that the mergingbanks are dissimilar in size.

b) Total Cost to Total IncomeWhile addressing the issue of efficiency

of banks, Cost to Income Ratio (CIR) isaccounted for the operating efficiency ofthe banks. Generally, CIR is inverselyrelated to the profitability of the banks anda higher ratio shows the operational

efficiency of the banks. In this regard,both bidders and targets are far below theglobal standard and banks should strive tomaintain CIR below 50 per cent forattaining global competence. For ICICIBank Vs BOM and HDFC Bank Vs CBopmerger, the total cost to total income ratiois similar, but in other cases, target’s coststructure will decrease the post mergerperformance. In Centurion Bank Vs BOPand ICICI Bank Vs Sangli Bank mergersthe ratio is 1.15 and 1.02 respectively fortargets, which indicates they were usingother funds to finance their interest andother expenses. Due to this both banksreported loss of 61.25 crore and 29 crorerespectively in the corresponding financialyear. HDFC Bank Vs Times Bank and CBVs LKB merger showed strongdissimilarity in the cost to income ratio.

c) Financial LeverageAs compared to other industries, banks

and FIs have low geared capital structuredue to the regulatory requirements In orderto understand the financing pattern of themerging entities, we used capital/assetratio. The numerator of the equationincludes reserves and surplus also for thepresent study. As per corporate financeliterature, an optimal capital structure willincrease the EPS and causes shifting ofreturns from bondholders to shareholders.All the merging partners are dissimilar intheir capital-asset ratio except HDFC VsCBop merger. This dissimilarity in the pre-merger period will result in optimum capitalstructure. The target banks are morelevered than bidder banks.

d) Balancing of Loans and Deposits In all mergers, the merging entities are

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similar in this aspect. We calculated loan–deposit ratio to evaluate this aspect. Thesimilarity will enhance the post mergerperformance. If we go through the loan-deposit ratios of merged entities after2005, we can see the impact of “Reportof the committee on banking sectorreforms” (Narasimham M, 1998).In all thecases the ratio is higher than 60% due tothe substantial reduction of CRR exceptin the case of Sangli Bank.

e) Efficiency LevelTo analyse the efficiency of merged

partners we used two vital criteria i.e.,efficiency ratio and return on loan. For theanalysis purpose, efficiency ratio depictsthe relationship between non-interestexpenses with the total income. Return onloan is calculated by dividing the interestincome by total loan amount. Efficiencyratio must be similar and lesser for boththe entities to enhance post-mergerperformance. We can see from the tablethat all banks are similar in this regard.(Table 4). Apart from this in CBop VsLKB merger, the return on loan is sameboth the entities.

f) Liquidity Risk and Asset QualityTo give a proper framework to analyse

the liquidity position of banks, we used twoparameters, loan to book value of assetsratio and capital adequacy ratio of themerging entities. Loan to book value oftotal assets should be optimum. Theremust be a trade-off between them,because if banks maintain lower loan toBV ratio, it would be expensive for thebanks and in the reverse situationincreases the risk propensity. In all thecases, Liquidity ratio is similar. But in the

case of CRAR, we can’t say banks aresimilar or dissimilar. Only CB Vs BOPmerger shows strong dissimilarity inCRAR. In asset quality, all the mergingentities are dissimilar except HDFC VsCBop merger and this will negativelyaffect the post merger performance.Further it is to be noted that CRAR ofSangli Bank is 1.6% in the financial year2005-06.

g) ProfitabilityThe existing literature argues that the

dissimilarity in profitability of mergingentit ies will harm the post mergerperformance. In the Indian context, banksare not similar in this regard, but we cannotsay they are dissimilar in general. OnlyCB Vs BOP shows the strongdissimilarity, because BOP had reporteda loss of 61.24 crore against CB’s profitof 25.11 crore in2005.In addition to thissangli bank also had reported a loss of 29crore against ICICI’s profit of 2540 crorein the financial year 2005-06. In othercases, literally we can say banks aresimilar.

h) Diversity of EarningsThe earnings diversification strategy

indicates the bank’s exposure to thecomponents of revenue other than interestincome. In the modern banking era, theincome from other sources measuresbank’s efficiency to tap financial servicemarket, treasury operations etc. Thehypothesis is that dissimilarity in thesources of revenues of banks will enhancepost merger performance. Except CB VsBOP merger, the quantum of otherrevenues is differing for merging entities.But it is interesting to note that the sources

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of revenue and client mix of mergingentities are different.

VI. Findings and PolicyImplications

This research paper focussed on thestrategic features of merged entities in thebanking sector in the post reform period.The major findings of the research are asfollows:

a) Only private sector banks favourthe voluntary merger wave in theIndian banking sector. Also, publicsector banks are reluctant towards thistype of corporate restructuring.

b) The relative size ratio of bidders andtarget are showing strong dissimilarity,which will enhance the post mergerperformance.

c) Total cost to total income ratio ofmerging partners are different, boundto adversely affect the post mergerperformance and both bidders andtargets are well behind the globalstandards.

d) Target banks are more levered(dissimilarity) than bidder banks, sothe merger leads to attain optimumcapital structure for the bidders.

e) Loan to deposit ratio of mergedentities shows similarity, which willenhance post-merger performance. Inthe case of mergers happened after2005, loan to deposit ratio is higherthan 60 per cent.

f) Liquidity risk is similar in the aspectof loan to total asset ratio, but theCRAR of merging entit ies are

differing except HDFC Vs CBopmerger, and it will harm the post-merger performance.

g) The ratio of other revenues to totalincome shows similarity except inICICI Bank Vs Sangli Bank merger(0.28 and .051). But the client mix ofmerging banks differs, will result inenhanced performance.

h) Asset quality of targets is very poorexcept HDFC Vs CBop merger in2007.

Conclusively, banking system is themajor component and accounted for thefund flow of 80 per cent in Indian financialsystem. Bank mergers show thecontemporary trend and are said to be themain strategy of the banks to facecompetition, growth, and implementationof international standards in the Indiancontext. However, top officials andconsultants have to critically evaluate thestrategic similarity and dissimilarity beforethe deal, because it plays a vital role inthe post merger performance. In mostcases, banks showed dissimilarity. It issuggested that both the merging entitiesshould assess the strategic similarities anddissimilarities before the deal. As a futureresearch, academicians can build a modelfor assessing the impact of these featureson the bank performance and that wouldbe helpful for the bidder banks to selecttheir target banks.

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