Event: HDFC Bank and HDFC Ltd. announced that they have received board approval for amalgamation of HDFC Ltd. with HDFC Bank. Shareholders of HDFC Ltd. will get 42 shares of HDFC Bank for 25 shares of HDFC Ltd. The record date is yet to be announced and the transaction is expected to be completed within ~18 months.

The equity shares held by HDFC Ltd in HDFC Bank will be extinguished as per the scheme. And upon the scheme becoming effective, HDFC Bank will be 100% owned by public shareholders and existing shareholders of HDFC Ltd will own ~41% of HDFC Bank.

Why this makes sense?

Firstly, the merger fulfils the implicit RBI policy of not allowing a bank to be owned by an NBFC/HFC, and having its lending business housed mainly in the bank.

Secondly, in the past when compared to Banks, NBFCs have enjoyed lesser regulations. However, in last 3 years post IL&FS crisis, the norms and regulations have become stricter for NBFCs. For instance, NBFCs would report NPA only if no single instalment is paid in 6 months. And even if a single instalment is paid in 6 months, that account would not be termed as NPA. However, the norms have been changed from 6 months to 3 months recently. Therefore now there is no specific regulatory advantage that a large housing NBFC like HDFC Ltd. would enjoy by remaining an NBFC and not merging with a bank.

Benefits of this merger

• Better Loan Mix: The merger will increase the share of mortgages in HDFC Bank’s loan book. HDFC Bank has not had material portion of home loans and mortgages in its loan book. The default rates for home loans are generally lower which will therefore, improve the overall asset quality. For HDFC Bank, a higher share of the mortgage business (33%) could be margin dilutive, but risk-adjusted margins will still be healthy and also increase the tenor of the loan book.
• Increased Cross-Selling Opportunities: The merger strategically fits HDFC Bank’s product basket. Home loans are long tenor, thus providing the bank opportunities to cross-sell unsecured, lower tenor and profitable credit to the customer during the loan repayment cycle. This will drive up the lifetime value of the customer. Nearly 70% of HDFC Bank’s 6.8 Cr customers do not have housing loans. Thus the merger will provide an opportunity to cross-sell mortgage loans, while HDFC Ltd customers will be offered banking products. HDFC Bank’s cost advantage will make the housing loan business much more competitive amid the rising dominance of banks in the segment.
• Benefits coming from HDFC- HDFCBank will benefit from the expertise of HDFC in the real estate space and its efficient processing of loans which has enabled a favourable cost to income ratio. Also, lower cost of funds will be made available for the mortgage business. The bank will have access to the efficient mortgage origination and loan servicing processes of HDFC Ltd.
• Lower cost of Funds to HDFC Ltd- Thecost of borrowings to the banks is lower than NBFCs. NBFCs have to rely on the wholesale fund raising from banks or markets both of which are relatively costly.  On the other hand banks have CASA which is lowest cost of borrowings. The merger augments the ability to raise big ticket loans especially at such a time when capital investment is picking up.

Challenges in the Merger

• SLR & CRR requirement- The bank is required to follow certain regulatory commitments such as SLR (Statutory Liquidity Ratios) (18% of net demand and time liabilities), CRR (Cash Reserve Ratios) (4% of net demand and time liabilities). The merger will require higher appropriation for SLR and CRR, which would reduce the RoAs (return on assets) because of lower yield on amounts in CRR & SLR.
• Regulatory risk- The merger is subject to regulatory approvals from the RBI, IRDAI, CCI, SEBI and stock exchanges. RBI advocates the holding company structure for non-lending businesses. If the structure is not approved, the companies will have to reconsider the scheme of arrangement.
• Impact on Margins: The merger may lower Net Interest Margin (NIM) due to inculcation of mortgages on HDFC Bank’s loan books. Mortgages generally have a lower default rates and lower margins because of its secured nature. However, the housing cycle in India is poised for an uptick and the growth in housing loans can compensate for the lower NIM.

Short Term Impact on Stock Price

HDFC Ltd. forms ~6% of the MSCI India Index whereas HDFC Bank is not a part of the index. HDFC Ltd. will cease to be a part of the MSCI Index post the merger. Thus, FII may reduce their exposure to HDFC Ltd. steadily. On the other hand, DIIs on aggregate have been under-exposed to HDFC Ltd. as compared to their benchmarks. Thus, they may want to increase their exposure to it. Due to the above reasons, the stock may see some volatility in the medium-term.