Professional Documents
Culture Documents
A PROJECT REPOT
ON
Submitted By:
Nipun Trikha (58/2008)
Submitted To:
(Dr.Harish Handa)
JANUARY 2010
1
LAL BAHADUR SHASTRI INSTITUTE OF MANAGEMENT, DELHI
Sector-3, R. K. Puram, Delhi
Dated……………
CERTIFICATE
Certified that NIPUN TRIKHA has successfully completed Project Study entitled
“Consolidation of Indian Banking Sector” under my guidance. It is his original
work, and is fit for evaluation in partial fulfillment for the requirement of the Two
Year (Full-Time) Post Graduate Diploma in Management.
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ACKNOWLEDGEMENT
The satisfaction and joy that accompany the completion of this task is incomplete
without mentioning the people who made it possible. And so, I would like to thank
all those who have supported and guided me to successfully complete this
project.
I would like to acknowledge the support, co-operation, and guidance of all those
who have helped me to complete this project successfully.
I would like to extend my sincere gratitude towards Dr. Harish Handa for helping
me to undertake this project study and providing me the guidance, advice, and
direction that is required to carry out a project, and for helping me with the
intricate details of the project at every step of the way.
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Executive Summary
"Consolidation alone will give banks the muscle, size and scale to act like world-
class banks. We have to think global and act local and seek new markets, new
classes of borrowers. It is heartening to note that the Indian Banks' Association
is working out a strategy for consolidation among banks."
- P. Chidambaram
Consolidation is the buzz word in present banking industry scenario, banking sector is
heading towards a more compact and consolidated shape. This project has been taken to
understand the need of consolidation from Indian bank’s perspective. To find out the “the
management’s perception about the Mergers & Acquisitions among banks and
simultaneously to analyze these activities from investor’s view-point as well.
Consolidation through Merger and Acquisition activity in India—both domestic and cross-
border—has exhibited explosive growth in recent years. Many companies look Merger and
Acquisition as a way of growth. There have been studies which say that M&A activities
add value to shareholders while at the same time there are studies which negate these
results. Along with it there are certain organisational & strategic issues that has to be
taken care of before this sort of consolidatory move
This project has been done with the help of empirical study that was applied on the
historical financial data of the banks which merged in order to analyze investor’s standing
in such consolidatory situations. To understand management’s perception, a survey was
conducted
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Table of content
Serial Content Page
No. No.
Executive Summary 4
1. Introduction
6
2. Literature review
2.1 Methods of Consolidation 22
2.2 Forces encouraging consolidation Introduction 24
2.3 Forces discouraging consolidation Introduction 25
3. Objective 26
4. Methodology 27
8. Annexure 36
Bibliography 38
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CHAPTER 1
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STRUCTURE OF THE BANKING INDUSTRY
According to the RBI definition, commercial banks which conduct the business of banking
in India and which (a) have paid up capital and reserves of an aggregate real and
exchangeable value of not less than Rs 0.5 mn and (b) satisfy the RBI that their affairs
are not being conducted in a manner detrimental to the interest of their depositors, are
eligible for inclusion in the Second Schedule to the Reserve Bank of India Act, 1934, and
when included are known as ‘Scheduled Commercial Banks’. Scheduled Commercial
Banks in India are categorized in five different groups according to their ownership
and/or nature of operation. These bank groups are (i) State Bank of India and its
associates, (ii) Nationalised Banks, (iii) Regional Rural Banks, (iv) Foreign Banks and (v)
Other Indian Scheduled Commercial Banks (in the private sector). All Scheduled Banks
comprise Schedule Commercial and Scheduled Co-operative Banks. Scheduled
Cooperative banks consist of Scheduled State Co-operative Banks and Scheduled Urban
Cooperative Banks
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Banking Industry at a Glance
In the reference period of this publication (FY06), the number of scheduled commercial
banks functioning in India was 222, of which 133 were regional rural banks. There are
71,177 bank XIV offices spread across the country, of which 43 % are located in rural
areas, 22% in semi-urban areas, 18% in urban areas and the rest (17 %) in the
metropolitan areas. The major bank groups (as defined by RBI) functioning during the
reference period of the report are State Bank of India and its seven associate banks, 19
nationalised banks and the IDBI Ltd, 19 Old Private Sector Banks, 8 New Private Sector
Banks and 29 Foreign Banks.
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Table 3: Group Wise: Comparative Average
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Capital To Risk-weighted Assets Ratio (CRAR)
The capital to risk weighted assets ratio (CRAR) is an indicator for assessing soundness
and solvency of banks. Out of 92 scheduled commercial banks, 75 banks could maintain
the CRAR of more than 8 per cent during the year 1995-96, when the prescribed CRAR
was8 per cent. During 1999-2000, 96 banks maintained CRAR of 9 to 10 per cent and
above when the prescribed rate was 9 per cent. In 2004-05,
out of 88 scheduled commercial banks, 78 banks could maintain CRAR of above 10 per
cent and 8 banks between 9 and 10 per cent.
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CHAPTER 2
LITERATURE REVIEW :
CONSOLIDATION OF BANKS
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Methods of consolidation
In general terms, consolidation of the financial services sector involves the resources of
the industry becoming more tightly controlled, either because the number of key firms
are smaller or the rivalry between firms is reduced. Consolidation may result from
combinations of existing firms, growth among leading firms, or industry exit of weaker
institutions. This chapter focuses primarily on the first of these causes. There are several
alternatives for firms combining with each other. Each has its strengths and weaknesses
and may be particularly appropriate in certain situations.
two classes of methods: (1) mergers and acquisitions and (2) joint ventures and strategic
alliances.
The primary methods of consolidation employed by firms are mergers and acquisitions.
With both of these methods, two formerly independent firms become commonly
controlled.
the terms merger and acquisition are used interchangeably to refer to transactions
involving the combination of two independent firms to form one or more commonly
controlled entities. The distinction between a merger and an acquisition i somewhat
vague. A merger is often defined as a transaction where one entity is combined with
another so that at least one initial entity loses its distinct identity. Thus, full integration of
the two firms takes place and control over a single entity can easily be exercised. An
acquisition is often classified as a transaction where one firm purchases a controlling
stake of another firm without combining the assets of the firms involved. Relative to
acquisitions, mergers provide a greater level of control, because there is only one
corporate entity to manage. Acquisitions are most appropriate when there are
operational, geographic or legal reasons to maintain separate corporate structures.
Mergers and acquisitions are also sometimes distinguished by defining mergers as
transactions involving two firms that are of essentially equal size, while acquisitions are
transactions where one party clearly obtains control of another. A partial, or non-
controlling, acquisition is similar to an acquisition of a controlling interest, except that, as
the name implies, the acquiring firm does not establish control. Such deals encourage
cooperation between potential rivals, because they establish a common interest among
the firms. Partial acquisitions may also serve as a first step for firms before engaging in
more complete consolidations of control.
Joint ventures and strategic alliances enable firms to work together without either firm
relinquishing control of its own operations and activities. Strategic alliances are
partnerships between independent firms that involve the creation of tangible or intangible
assets. The level of collaboration is often fairly low and focused on a well-defined set of
activities, services or products. Strategic alliances may be most appropriate for the
exchange of technical information and sophisticated knowledge or when there are legal,
regulatory or cultural constraints making a more thorough collaboration difficult or illegal.
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Moreover, relative to mergers and acquisitions, strategic alliances generally involve
lower formation and dissolution costs. Like partial acquisitions, strategic alliances may
enhance cooperation among firms or serve as a first step towards a merger or
acquisition. A joint venture, which may be viewed as a type of strategic alliance, occurs
when two or more independent firms form and jointly control a different entity, which is
created to pursue a specific objective. This new entity typically draws on the strengths of
each partner. Joint ventures facilitate consolidation, because they enable firms to develop
strong ties. Joint ventures may also serve as a precursor to more comprehensive
consolidation such as mergers.
Mergers and acquisitions in the financial sector are undertaken for a wide variety of
reasons. In any given case, more than one motive may underlie the decision to merge.
Motives may vary with firm characteristics such as size or organisational structure, over
time, across countries, across industry segments, or even across lines of business within
a segment. In the framework used in this chapter, the motives for mergers and
acquisitions are broken down into two basic categories: value-maximising motives and
non-value-maximising motives. In a world characterised by perfect capital markets, all
activities of financial institutions would be motivated by a desire to maximise shareholder
value. In the “real” world, while value maximisation is an important factor underlying
most decisions, other considerations can, and often do, come into play.
Value-maximising motives
The value of a financial institution, like any other firm, is determined by the present
discounted value of expected future profits. Mergers can increase expected future profits
either by reducing expected costs or by increasing expected revenues.
Mergers can lead to reductions in costs for several reasons, including:
• economies of scale (reductions in per-unit cost due to increased scale of operations);
• economies of scope (reductions in per-unit cost due to synergies involved in producing
multiple products within the same firm);
• replacement of inefficient managers with more efficient managers or management
techniques;
• reduction of risk due to geographic or product diversification;
• reduction of tax obligations;
• increased monopsony power allowing firms to purchase inputs at lower prices;
• allowing a firm to become large enough to gain access to capital markets or to receive
a credit rating;
• providing a way for financial firms to enter new geographic or product markets at a
lower cost than that associated with de novo entry.
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increased product diversification allowing firms to offer customers “one-stop shopping”
for a variety of different products;
• increased product or geographic diversification expanding the pool of potential
customers;
• increased size or market share making it easier to attract customers (visibility or
reputation effects);
• increased monopoly power allowing firms to raise prices;
• increased size allowing firms to increase the riskiness of their portfolios.
Non-value-maximising motives
Managers’ actions and decisions are not always consistent with the maximisation of firm
value. In particular, when the identities of owners and managers differ and capital
markets are less than perfect, managers may take actions that further their own personal
goals and are not in the interests of the firm’s owners. For example, managers may
derive satisfaction from controlling a larger organisation or from increasing their own job
security. Thus, they might engage in mergers designed to increase the size of the firm or
reduce firm risk, even if such mergers do not enhance firm value. Managers may acquire
other firms in order to avoid being acquired themselves (defensive acquisitions), even if
being acquired would benefit the firm’s owners. In some cases, managers may care
about the size of their firm relative to competitors, leading them to engage in
consolidation simply because other firms in the industry are doing so.
1. Technological changes
Technology has both direct and indirect effects on the restructuring of financial services.
Direct effects of technology may include:
• Increases in the feasible scale of production of certain products and services (eg. credit
cards and asset management);
• Scale advantages in the production of risk management instruments such as derivative
contracts and other off-balance sheet guarantees; and
• Economies of scale in the provision of services such as custody, cash management,
back office operations and research
2. Deregulation
Governments influence the restructuring process in a number of ways:
• Through effects on market competition and entry conditions (eg placing limits on or
prohibiting cross-border mergers or mergers between banks and other types of service
providers);
• through approval/disapproval decisions for individual merger transactions;
• through limits on the range of permissible activities for service providers;
• through public ownership of institutions; and
• through efforts to minimise the social costs of failures
3. Globalisation
Globalisation is in many respects a by-product of technology and deregulation.
Technological advances have lowered computing costs and telecommunications, while at
the same time greatly expanding capacity, making a global reach economically more
feasible. Deregulation, meanwhile, has opened up many new markets, both in developed
and in transition economies. As a factor encouraging consolidation, globalisation largely
affects institutions providing wholesale services
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CHAPTER 3
OBJECTIVE
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Problem:-
Now with the end of the financial crisis, there shall be resurrection of banks and
financial institutions all over the world. Indian banking industry was the least
affected from this crises because of strong fundamentals and prudent policymakers
and thus it shall be the fastest growing banking sector. This scenario along with
the increased FDI limits in the private banks shall intensify the level of competition
in the banking industry. Though there are 290 banks operating in our country but
still none of them is among the top 50 banks at global level, SBI the largest Indian
bank is ranked 52nd globally with other 5 banks among top 1000 banks. Out of
these 290 banks, 80 banks are catering to only 2% of the industry. As per the
chairman of SBI, “India needs atlest 3 globally reputed banks and 5 banks
equivalent to the size of SBI. This shows the need of consolidation of Indian
banking industry.
objectives
• To understand the present scenario & upcoming trends in Indian banking system.
• To analyze the basic needs for reforms in banking system, and of consolidation
particularly.
• To find out & analyze management’s perception about the consolidation through
Merger & Acquisitions.
• To evaluate some of the recent cases of consolidatory activities in the banking
sector and to analyze them from the customers and investors perspectives.
• To evaluate the pros and cons of consolidation in the banking industry .
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CHAPTER 4
MethodologyAnd
Data Analysis
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Methodology
After doing the literature review and understanding the motives of the merger of banks in
India and benefits achieved there by. It is tried to validate with help of the data if the
benefits of the merger are there in the Indian banking sector .For this study I have
chosen the time period from 1999 to 2006 .The data for 8 significant deals which have
happened during this period has been collected as the time series data. In all the deals
which have been selected between the banks a caution has been taken so that only those
deal are selected for which only 2 banks are involved in the merger. After collection of
data various empirical methods have been applied on the data to validate or refute the
arguments stated in the literature review section and then giving the conclusion on the
basis of the observed results .The data required for the analysis is:
1. Returns of the stock of the banks
2. Expected Rate of return for the stock
3. Cumulative abnormal return
Returns of the stock have been calculated by comparing the closing stock price on the t
day (Day zero) to the closing stock price of the stock on t-1 day. The expected rate of
the return is calculated using the using the capital asset pricing model.
The expected return is calculated as follows:
Expected return = _ + _ * RM
α + β: these are aspects which are related to a individual stock,
RM return of market
α alpha is an intercept of minimum rate of return.
β is a beta which implies the systematic risk of a stock.
α & β are calculated by running a linear regression and then Abnormal returns are
calculated
Abnormal Return = Actual stock – Expected Return on Stock
After a T-TEST is run at confidence level of 95% to verify if there is any significant
change in the CAR calculated. It is this which will indicate the effect of the merger. Also
another test which has been applied to check the financial performance of the banks is
the EVA method .Economic Value Added is a measure of the financial performance of the
banks .EVA method is the invention of the Stern Steward and Co which was launched in
1989.
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How do we calculate the EVA?
EVA is a methodology which links the finance to the competitive strategy framework. It is
also an indicator of the value which is created in the stocks of the company.
EVA = Net operating profit of the company (NOPAT) – (Cost of the capital * Total capital
employed)
This formula will give us a positive or a negative EVA number. Positive EVA number
means that the company is going to create value for its shareholders and negative EVA
number means that it is destroying the value of the shareholder .The concept it is build
upon is that till the time the business does not give out profits which are more that the
cost of the capital till that time business is not profitably and it is making losses. We first
calculate the NOPAT which has been calculated as
• NOPAT = EBIT * (1- tax rate)
• Cost of the capital has been calculated as WACC which is weighted average cost of
capital. This is the weighted sum of the cost of debt and cost of equity.
• Total Capital Employed has been calculated as the total debt and total equity
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Data
This report till now talks about the merger and its benefits in Indian context .To check
how many mergers have been profitable to the banks in India the paper has short listed
8 deals which have happened in the Indian banking sector from the period 1999 to 2006.
The deals which have happened in 2007 have not been included because it would not be
possible to study the effect of merger due to the less number of time periods available
after 2006 .that is post merger years. Also only deals where only two banks have been
involved have been selected.
After selecting the deals we applied two empirical methods on it. To study the short term
impact we applied the t-test and for long term impact we applied EVA (Economic value
added method). T-Test To study the T-Test on the data we selected a time series data of
the closing prices of the stock from 1999 to 2007 and then found the return of these
stocks. We found the intercept and the slope of these stocks and by applying the CAPM
formula we found the expected return on the stocks. Then this expected return was
subtracted from the actual return to arrive at the abnormal return .Over the period of 30
days pre and post merger the abnormal returns where found and t-test was applied on
these abnormal returns .If the value given by the t-test is less than .05 then the
hypothesis which is that the data sets are similar over the period of study is rejected and
we conclude that the significant effect of merger is prevalent.
To study the long term effect of merger another indicator is the EVA. We calculated the
EVA pre merger, in the year of merger and post merger which gives us the idea of the
efficiency of the merger. All the data has been analysed from the acquiring banks
perspective.
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EVA gives us a clear understanding of the values which the banks create over a period of
time .It connects the theories of Finance with the strategy of competitive markets given
by Michael Porter. For the operations of the banks the EVA is used as a common measure
by many banks like Citi Bank, Barclays etc .Many Indian banks also use EVA to calculate
their profits by EVA method like ICICI Bank, HDFC etc which in itself justifies the reason
of using EVA for our methodology for calculating the profits of the banks .Whenever the
benefits of the decisions taken by the banks are more than the cost involved in its
structure, it creates the value for the Bank. Most of the strategies of the banks create
value for the bank over a period of some -time which may be in distant future and thus
when ever profitability of the bank’s merger is to be calculated it should be done through
EVA method. There are two sensitive drives of the value creation in the banks .Firstly
how fast the funds are moved and how much of these funds create further value which is
more than the cost factor of generating these funds which clearly given by the EVA of the
banks Another important thing to be understood in terms of the mergers of the banks is
difference between the projects and strategies. For projects it is best to calculate the NPV
or IRR to check for the feasibility of the projects .For strategies one should check the EVA
and the decision of the merger should be based on the EVA calculated from estimation of
the strategies of the merger.
Limitation of ratios
Many accounting fundaments such as Price Earnings, Return of Equity, Return of Net,
Book Value do not give a clear understanding of the major variables which are the value
drives .These all ratios are prone to window dressing by the mischievous management
.Also these measures use the historical data to arrive at the conclusions .EVA also very
beautifully raises the point of how the shareholders of the bank expect a certain rate of
return for taking the risk of investing in the bank
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Chapter 5
RESULT
Discussion and analysis
25
Discussion and Analysis
26
Centurion Bank and Lord Krishna Bank
The merger between the lord Krishna bank and Centurion bank was more of a RBI driven
merger to safe guard the interests of the depositors .This deal took place finally on 04-
09-2006. As has been talked about in this paper above that many mergers in Indian
banking scenario also happen due to the managed M & A activity by legislature or more
clearly RBI .In this case as well we studies the effect of the merger on returns by t-test
for time period t, t+ 30 and t-30 days where in t stand for the date of the merger. The
value which we get from the t-test is .305 .As the t-test has been done on 95 %
confidence level this accepts the hypothesis that the merger did not show any significant
effect on the bank’s returns. For the significant returns to be shown and to reject the null
hypothesis of t-test we should get the value of .05 or below for the t-test. Also the
cumulative abnormal returns 30 days prior to and post merger did not show any
change .This shows that the within a short period of 30 days the merger did not show
any signs .Also the news of the merger did not create any significant ripples in the
market .To understand the effect of the synergy derived over a long period of time we
applied the EVA test on this merger as well .The EVA for the year before the merger that
is 2005 is 154.61 for the year of the merger it is 421.31 which is a very high value .Even
though the banks spend the money for the merger and the economic value should have
ideally either remained same or marginally increased .But in this case we see a very high
value of EVA .This is contributed due to dual effect .The market had very well accepted
the merger with Lord Krishna bank and this increased the credit worthiness of the
merged entity .But the main factor for such an increase in the EVA was the post merger
gain with the Bank of Punjab which had started to show the effect .This compound effect
really pulled the EVA value high for Centurion bank .The Centurion Bank become the 4th
largest bank after the deals and in the post merger year 2007 its EVA continued to be
good and upwards which is an indication that the merger was successful.
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ICICI Bank and Bank of Madura Limited
This deal too place in the month of December 2000 .At that time ICICI bank did not have
very strong holdings in southern part of India .This deal was done to increase the
presence of ICICI in southern India. ICICI bank paid $70 mn min in share swap to buy
Bank of Madura limited .This deal made ICICI bank 33 percent bigger than HDFC ,its rival
.This deal provided ICICI bank with the synergies that enhanced its brand image
,branches and gave it additional 2.6 million customer and 263 branches in southern
India. The author of this paper checks the short term gains and to gauge the market
reaction using the t-test over short period .The t –test give us a value of .27 which again
accepts our hypothesis that the merger did not show gains over a short period of 30 days
pre and post merger and that the abnormal returns where almost similar .Even though
the value of the t-test is coming out to be .27 which is low and some variation is
abnormal returns can be seen but it is not significant enough in term of merger point of
view. Also the cumulative returns given in the table -3 below shows that the values have
not changed much which is an indication that within short period of 30 days there was no
abnormality of returns pre and post merger. But the gains from the merger were high
over the long period of time.
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31
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Chapter 6
Conclusion
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Conclusion
This paper attempted to provide an analysis of ongoing merger trends in Indian banking
from the view point of two important stakeholders of a banking firm—stock holders and
managers. The trend of consolidation in Indian banking industry bas so far been limited
mainly to restructuring of weak banks and harmonization of banks and financial
institutions. Voluntary mergers demonstrating market dynamics are very few. We
strongly support the view that the Indian financial system requires very large banks to
absorb various risks emanating from operating in domestic and global environments. We
argue that the challenges of free convertibility, Basel-II environment, widening of
financial services activity, and need for large investment banks are the prime drivers of
future consolidation. More voluntary mergers are possible, provided the benefits of
mergers are derived by all the stakeholders of the banks. Currently the forced mergers
may be protecting the interests of depositors but shareholders of both bidder and target
banks are not, necessarily perceived as beneficiaries of the merger. The event study
analysis results, show that both bidder and target banks' market value of equity bas been
reduced on the immediate announcement of mergers. In the case of voluntary mergers,
the results are mixed. Our survey shows that bank managements are strongly in favour
mergers. However, they opine that there are several critical issues, which are to be
bandied carefully to make a merger successful. These are valuation of target bank loan
portfolio, valuation of equity, integration of IT platforms, and issues of human resource
management. Banks are optimistic about realizing the merger gains such as exploration
of new markets and reduction in operating expenses. Based on these results, on the
policy side, we suggest that RBI should activate the Prompt Corrective Mechanism that
helps in identifying the sick banks and advance the timing of the merger to avoid total
collapse of the bank. This will also help the bidder banks to formulate appropriate
strategies, which may mitigate the dilution in market value of equity consequent upon
merger. To ensure the availability of financial services to all segments of the population,
RBI should approve voluntary mergers, conditional upon the disadvantaged segments
being unaffected by the process, and approval should be linked to specific plans offered
by the acquirers to mitigate the extent of financial exclusion. The ongoing consolidation
trends in Indian banking raise some important questions. Is it fair and desirable on the
part of RBI to merge the weak banks with well performing banks, which destroys the
wealth of bidder banks? Being a majority shareholder, the Government of India appears
to be ignoring the interest of minority shareholders. This is a serious concern of corporate
governance. In the case of two forced mergers, viz., GTB with OBC, and Bharat Overseas
Bank with Indian Overseas Bank, the share prices of these two acquired banks have not
shown any significant increase even after a substantial time gap from the merger. In the
post-reform period almost all the public sector banks have improved their performance in
terms of profitability, low NPAs and raised fresh equity from the capital markets at a
good premium. Forced mergers may be detrimental to the further growth of these banks.
Dilution of government ownership may be a prerequisite to improve operational freedom
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and to devise performance linked incentives for public sector employees, which are
essential to tackle the post-merger problems arising out of forced
mergers. Another issue, which is completely ignored, is the impact of consolidation on
customers, especially small borrowers who are dependent on the banking channel. The
other consolidation model, which is simultaneously in progress, is operational
consolidation among banks. The largest public sector bank, State Bank of India is being
operationally integrated with its subsidiaries in providing various banking services. Above
all, we firmly believe that certain corporate governance issues are to be solved on a
priority basis before implementation of merger agenda
35
ANNEXURE
36
37
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