The composite index hosting public sector bank shares on the National Stock Exchange (NSE) has lost 7% of its value. It is a clear signal that investors don’t like the government’s first attempt at bank consolidation. On Monday, the government announced that it would merge Bank of Baroda (Bank of Baroda), Vijaya Bank and Dena Bank to form the third largest lender in India.

While it is evident that Bank of Baroda shareholders stand to lose the most, Dena Bank investors will have everything to gain from the transaction. After all, Dena Bank has a colossal toxic loan pile and a capital canvas full of holes. It does not lend anymore and has been under intensive care of the Reserve Bank of India (RBI) for more than four months. The merger is rightly seen as a bailout for Dena Bank.

Investors in Bank of Baroda and Vijaya Bank have lost 14% and 12% in market value, respectively, after the announcement on Monday, while Dena Bank investors gained 14%.

One way the government can right some of the wrongs is by arriving at a fair share swap ratio. Analysts believe that the recent surge in Dena Bank’s share price has made it one of the most expensive stocks among PSU banks relative to its net worth and other unpleasant metrics.

Indeed, before the bank merger was announced, Dena Bank’s stock was pricing in a fair bit of the pain in its numbers. It traded at a 33% discount to its book value as on June 2018, while Bank of Baroda was trading at a 20% discount. Based on their book values as of June, every share of Bank of Baroda was worth 8.5 shares of Dena Bank.

Since then, because of the divergent movement in the stocks, every share of Bank of Baroda is now worth only 6.4 shares of Dena Bank. Because shares of Bank of Baroda and Vijaya Bank have moved more or less in tandem, nothing much has changed in their swap equation.

But if the government were to use current prices as a benchmark, or rather if the markets are reading the government’s mind correctly, it would mean that there would be a 20% haircut on account of Bank of Baroda’s bad loans, while no such depreciation would be imposed on Dena Bank’s value. Needless to say, this is bizarre, considering that the latter has a far worse bad loan problem.

As pointed out earlier, the government should correct the anomaly when it announces the swap ratio—the pre-announcement ratio of 1:8.5 seems more appropriate, considering Dena Bank’s financial metrics.

Else, it would be akin to Bank of Baroda’s investors being ready to accept the consequences of the bad assets on their books, while at the same time giving a pass for Dena Bank’s toxic pile.

If the swap ratio favours Dena Bank, the government will stand to gain the most, given its 80% stake in the bank. In Bank of Baroda, it has a lower stake of about 64%. But this will clearly be a myopic view, since the overall loss in the government’s portfolio is huge, as is evident from the fall in the CNX PSU Bank index.

Hopefully, Dena Bank’s largest shareholder can view things in a realistic light.

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