HDFC-HDFC Bank: Great Marriage, But...

But there are challenges, observes Tamal Bandyopadhyay.

In Samuel Beckett's classic, Waiting for Godot, two tramps, Vladimir (nicknamed Didi) and Estragon (Gogo), are engaged in a variety of discussions and encounters while waiting for the enigmatic Godot who never shows up.

This theatre of the absurd has prompted people to use the phrase 'waiting for Godot' to describe a situation where they are waiting for something to happen, but which probably never will.

Till April 4, the Indian financial system and the community of investors were mimicking Didi and Gogo, waiting for the merger of the Housing Development Finance Corporation Ltd (HDFC), India's largest mortgage firm, with its offspring, HDFC Bank Ltd, a child of economic liberalisation.

It had been on the cards, forever.

The investors in the bank, India's largest in the private sector both by assets and market value, were always keen that it must sell home loans to complete the suite of retail products, but HDFC had reservations on the duplication of business.

HDFC also justified its reluctance for the merger on the high cost of regulations such as the statutory liquidity ratio (SLR) or the mandatory investment in government bonds by a bank; cash reserve ratio (CRR) or the portion of deposits a bank needs to be keep with the Reserve Bank of India (RBI) on which it doesn't earn any interest; and priority sector lending (PSL).

Forty per cent of a bank's loan must flow into agriculture, small industries, low-cost housing, the weaker section of society, et al.

The cost of regulation has reduced as SLR is now 18 per cent and CRR 4.5 per cent.

Also, the arbitrage between banks and non-banks, including housing finance companies (HFCs), is disappearing fast with the RBI bringing in scale-based regulations.

In the new regime, HDFC has to keep enough liquidity buffer; besides, the asset-classification norms for both banks and non-banks are on a par now.

With the advantages of non-banks disappearing fast, it's better to make HDFC Bank bigger and stronger by merging the parent with it without losing time.

After the merger, which can happen in the next 12 to 15 months, HDFC Bank will have an asset base of Rs 27.09 trillion (going by March 2022 figures; it will be even bigger by that time), almost double the size of ICICI Bank Ltd (Rs 14.11 trillion), the second largest private bank.

Its mortgage book will be Rs 6.21 trillion (minus the corporate loans) -- the largest in the industry. The comparable figure for State Bank of India is Rs 6.05 trillion.

The size is only one of the many advantages for the bank.

Currently, the proportion of corporate and retail loans is 55:45.

After the merger, the portion of the retail book will grow, leading to higher interest income since retail loans typically fetch more interest than corporate loans.

More importantly, 35 per cent of the bank's loans are unsecured now.

As the mortgage book grows, the unsecured portion will go down, lending resilience to its balance sheet, bringing down the credit cost.

It will also increase the size of the average maturity of HDFC Bank's loans.

Currently, it's around 15 months. A mortgage loan, on average, runs for six years.

Following an arrangement with HDFC, the bank had in 2003 started sourcing home loans for the parent.

After due diligence, HDFC disburses the loans and also takes care of collection.

The bank earns a one-time 90 basis points (bps) fee on sanction of each loan plus 20 bps for distribution. One bps is a hundredth of a percentage point.

It has the option of buying back up to 70 per cent of such loans.

If it does so, it needs to pay 75 bps on each loan to HDFC throughout its life.

Through this route, it has built a home loan portfolio of around Rs 83,000 crore.

Now, the pile of retail home loans will rise to Rs 5.15 trillion and since HDFC will be merged with it, the mortgage firm's expertise remains on the table for loan appraisal and servicing.

It's a great marriage. But there are challenges.

To meet 18 per cent SLR and 4.5 per cent CRR requirements on HDFC's liabilities, around Rs 1.15 trillion is required. Part of it is already there.

Since December 2021, a large HFC needs to keep liquidity, investing in government bonds, to meet its next 30 days' money requirement.

This will progressively rise to 100 per cent in the next three years.

HDFC has Rs 45,000 crore worth of such investments.

In addition, it has an investment of around Rs 10,000 crore in liquid instruments, leaving a gap of Rs 60,000 crore. The bank has surplus SLR as well as liquidity to take care of this.

HDFC would also need around Rs 2.3 trillion to meet the PSL requirement on its loans.

It has a Rs 1.2 trillion exposure to affordable housing, which qualifies for PSL.

Besides, the loan assets created by raising long-term bonds (of at least seven years) can be adjusted against the SLR/CRR and PSL.

Still, it will fall short of around Rs 1.1 trillion as HDFC doesn't have any exposure to agriculture and small industries, two essential components of PSL.

As the merger is still quite a while away and the PSL is calculated with a one-year lag effect (it's on the previous year's loan book), HDFC Bank can create part of this; the rest can be bought from other banks.

At 2-2.5 per cent cost, the bank may have to spend around Rs 750 crore annually (post tax) till the PSL target is met.

HDFC has sought the RBI dispensation for meeting the regulatory requirements over the next few years.

In 2002, when ICICI was merged with ICICI Bank, it did not receive any forbearance even though the context of the merger was different -- ICICI was crumbling under huge asset-liability mismatches.

If the RBI sticks to its stance, then growth capital will have to be used to meet regulatory requirements.

To that extent, there won't be instant gratification for the investors.

The list of challenges doesn't end here.

There are certain kinds of loans on the HDFC book that a bank can't carry -- such as loans given against shares and some of the construction loans (used for buying land).

This could be around Rs 25,000 crore now, which, by the time the merger happens, could reduce to Rs 10,000 crore as the loans will get repaid in the normal course. The bank will have to sell off those loans.

Finally, once the merger happens, HDFC Bank will have to up its stake (currently held by the parent) in both the general and life insurance companies.

As on March 31, it holds 49.98 per cent in the general insurance company and 47.81 per cent in the life insurance company.

A non-bank cannot hold 50 per cent in an insurance outfit, but a bank, which already has an insurance company in its fold, can have 50 per cent or more.

But if a bank wants to enter the segment by floating an insurance subsidiary, it is not allowed more than 30 per cent stake.

HDFC Bank may not be asked to bring down the stakes to 30 per cent; instead, it may have to raise it to at least 50 per cent.

HDFC was founded in 1977 on the lines of building societies in the UK and the savings and loans associations of the US.

It has been a one-product institution, which holds 21 per cent in HDFC Bank.

The bank, in turn, holds 100 per cent in another non-bank -- a bit odd in the Indian financial sector architecture.

One way of sorting this out could have been by creating a holding company, but that's far more complicated in terms of tax issues and value creation for the investors.

That's because if both the holding company and the bank or HDFC are listed, the value gets diluted.

HDFC has taken the right step before it was too late.

I hear the bank's new boss, Sashi Jagdishan, took the lead when he found only 2 per cent mortgage penetration among the bank's 70 million customers.

Now the merged entity's nearly 7,000 branches across 3,188 cities and towns will hawk home loans, shaking up the mortgage market and forcing many to redraw their plans.

Tamal Bandyopadhyay is a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd.

Feature Presentation: Rajesh Alva/Rediff.com