Photo: Mint
Photo: Mint

Opinion | Reckless lending rewarded with merger

The problem of non-performing assets requires more than synergy gains from mergers as in the case of Dena Bank

Imagine this: your bank makes lousy loans, runs a very unprofitable business, and even under-reports some of its losses to the regulators. And one fine morning you wake up to bag a hefty sum of 576 crore for being the owner of this bank. No, this is not a fantasy. You are the shareholders of Dena Bank. Congratulations for owning a reckless lender.

The proposed merger of Dena Bank and Vijaya Bank with Bank of Baroda is essentially a reward for reckless lending: a transfer of wealth from (relatively) stronger banks to the weaker one while making everyone collectively worse off. Within three days of the merger announcement, Bank of Baroda’s shareholders ended up losing 5,000 crore in share value: a staggering loss of 14%. Vijaya Bank’s shareholders did not fare any better either: they lost 860 crore in market value during the same time period (a loss of 11%).

Thus, Dena Bank’s shareholders pocketed a value gain of 576 crore at the expense of a combined value loss of over 5,000 crore for the shareholders of three banks put together. In fact, not only is there a combined value loss for these three banks, the entire banking sector is experiencing large losses since the announcement of this deal. This is a classic example of creating bigger problems for solving a smaller one.

More fundamentally, the move does not directly address the core problems faced by the Indian banking sector: poor lending decision, poor loan collection practices, and poor corporate governance. Instead, it exacerbates the moral hazard problem that comes with any government bailout that does not impose any real cost on the shareholders and managers of bad banks for their poor decisions.

Just think about the message this deal sends to the market: shareholders of a well-governed bank end up paying for the poor lending decisions of a very inefficient bank. Why should a bank in future then have any incentive to make prudent lending decisions in the first place?

Mergers and acquisitions have been popular corporate restructuring tools around the world, but empirical evidence on how much value they create is very mixed. In fact, there is ample evidence of value destruction in a variety of merger deals spanning several industries and countries. Academic research suggests that “managerial agency problem" is one of the key explanations of this finding.

The basic idea goes something like this: managers are too focussed on immediate growth and short-term results. They, therefore, acquire other firms for short-run gains even if it does not create value in the long-run. The oft-cited rationale behind almost every deal is some form of “synergy gains", either on the operational side of the business or on the financial side. But more often than not, such synergy gains do not materialize — either the synergy forecasts are too lofty to begin with, or the integration costs end up outweighing any potential synergy gains.

The proposed merger of Bank of Baroda with Dena Bank and Vijaya Bank is no different. The argument for a merger is rooted in the hope that combining a bad bank with a good one can improve the overall management of the non-performing assets of the bad bank, improve corporate governance and risk-management practices across the board, and thus improve overall value in the long run. More magically, in the short-run, the objective is to make Dena Bank’s non-performing asset (NPA) problems simply go away. This then, hopefully, also takes care of the problem of infusion of additional equity required to keep the bank compliant with capital regulations.

This argument coincides with the above-mentioned academic findings: there is a clear, immediate short-term gain here, but the long-run benefits are, at best, uncertain. Stock valuations reflect this concern. It is extremely difficult to change the culture at thousands of branches of the acquired bank. It is even more difficult to change managerial practices of thousands of employees that come from three different backgrounds. Integration costs, especially when it relates to culture and governance, have often proved to be a big bottleneck in mergers, and this deal now faces the same concerns.

At the very core of this deal, the moral hazard problem is the biggest concern. In any prudent corporate restructuring deal, the reckless bank’s shareholders and managers must pay for their bad decisions. We see just the reverse here: these shareholders seem to be getting rewarded. Additionally, the initial proposal from the government states that employees will keep the best benefits available for their grade anywhere in the three banks. Consequently, there seems to be no accountability for the poor lending decisions of the past either for the shareholders or for the managers of the weak bank.

But not all is lost yet. What can be done now? A properly designed stock swap ratio can still impose some cost on the shareholders of Dena Bank. Similarly, limits on executive compensation of the employees of the weak bank, especially on its decision-making authorities, can impose some costs on those who made the poor lending decisions in the first place.

It seems clear that the government is trying to use this deal as a template to solve the banking sector’s NPA problem: it is vital that they get the economics of the first deal right.

Amiyatosh Purnanandam is a professor of finance at the University of Michigan.

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