M

1
MAs in the Indian Banking Sector
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KEY MESSAGES

• MA in the Indian banking sector is an
  opportunity and an imperative
• MA has to be based on a business rationale and
  effective execution there is not enough track
  record of that in the Indian banking sector
• India may have to follow a managed transition
  model to ensure a stronger banking sector

3
IMPERATIVES FOR MA FOR BANKING IN INDIA
Stability
1

• While shareholders have had good returns over the
  last few years, valuations are well short of
  other markets

Returns to shareholders
2

• Intermediation costs remain high
• Access to quality products and services is
  restricted to a small part of the market

Benefits to customers
3

• The banking sector is a big employer large parts
  of the workforce may be left without requisite
  skills if there is not skill transfer through MA

Value added in the sector
4
4
1. THERE IS SIGNIFICANT FRAGMENTATION AND
INCREASING POLARISATION IN THE SECTOR. . .
Movement from 2001 to 2004
MARCH 2004
Market capitalisation (Rs crores)
Source Prowess team analysis
5
AND VALUE IS MOVING AWAY TO FEWER BANKS
6
THE WEAKNESSES OF SMALLER BANKS ARE BEING EXPOSED
LEADING TO MULTIPLE FAILURES
Bank
Reason for failure
Institutional root-cause
Global Trust Bank

• Significant exposure to high-risk mid-market
  corporates
• Over-exposure to capital market operations

• Absence of strong credit-risk management systems
  and processes
• Weak corporate governance

• Rs. 1000 crore unsecured loans to 19 customers
• High involvement in pay-order scam

• Weak corporate governance

Madhavpura Mercantile Co-operative Bank
South Indian Co-op Bank

• High level of NPAs arising from extensive lending
  to small group of clients

• Weak corporate governance

• High NPAs from large lending to small group of
  clients
• High exposure to plantation industry

• Absence of strong credit-risk management systems
  and processes

Nedungadi Bank
7
2. INDIAN BANKS HAVE OUTPERFORMED SHARE INDICES
IN THE LAST FIVE YEARS
Total return to shareholders (Indexed to 100 for
Jan99) Per cent
TRS CAGR Jan99-Aug04
42.6
New Private Banks
30.06
PSU Banks
Banking Index
27.44
6.56
Old Private
9.89
BSE 30 index
Source RBI, excludes merger effect of ICICI with
ICICI Bank
8
HOWEVER, VALUATIONS STILL REMAIN LOW RELATIVE TO
OTHER MARKETS
August, 2004
Comparison across countries
Bank valuation in India
P/E
P/B
P/E
P/B
Germany
New private sector banks
USA
HongKong
Old private sector banks
Brazil
Thailand
India
Public sector banks
Korea
Weighted average of 37 banks
Source Prowess Bloomberg
9
3. DESPITE RECENT DECREASES, COST OF
INTERMEDIATION REMAINS HIGH
Real cost of lending
Per cent
Average leading rate
WPI for all commodities
Real cost of loans to borrowers
Real cost of lending, 2003
Per cent
India
UK
US
1998
1999
2000
2001
2002
2003
2004
Average leading rate less change in
WPI Source EIU CMIE
10
COMPARISON WITHIN THE INDIAN BANKING SECTOR
REVEALS THAT CONSOLIDATION WILL HELP DRIVE DOWN
INTERMEDIATION COSTS
Operating cost/average assets
PSUBanks
Top 5
Next 10
Remaining
Avg 2.45
PrivateSectorBanks
Top 5
Remaining
Avg 1.79
ForeignBanks
Top 5
Remaining
Avg 3.01
Average for 4 years FY 2000-2003 Source RBI,
McKinsey analysis
11
FURTHER, COMPARISON WITH GLOBAL BANKS INDICATES
THAT FEW INDIAN BANKS HAVE SCALE (1/2)
billion, ratio 1997, 2004 data
More details on next page
2004 1997
26bn
Hang Seng Bank
BCP
100bn
55bn
180bn
Performance Market-to-Book Ratio
130bn
Standard Chartered
US Bancorp
Wells Fargo
HSBC
MayBank
170
Citigroup
UniCredito Italiano
Royal Bank of Scotland
150
BNP Paribas
Hana Bank
DBS Group
95bn
120
35bn
Kookmin
110
Shinhan
Deutsche Bank
60bn
80
15bn
Woori Finance
60
40
20
10
70 100
Size Book Value of Common Equity
Market value as of Feb. 16, 2004 and Dec. 31,
1997 book value is as of fiscal year 1997 and
for the latest available quarter for
2003 Source Bloomberg
12
FURTHER, COMPARISON WITH GLOBAL BANKS INDICATES
THAT FEW INDIAN BANKS HAVE SCALE (2/2)
billion, ratio 1997, 2004 data
7
2004 1997
6
Hang Seng Bank
5
First Financial
Changwa
4
Performance Market-to-Book Ratio
Hua Nan
Bangkok bank
3
10bn
15bn
ICICI
Taishin
25
MayBank
15bn
DBS Group
UOB
OCBC
20
2
Hana Bank
Sinopac
Shinhan Financial Group
15
Krung
Kookmin Bank
SBI
Woori
1
10
6
3
1
0
0
5
10
Size Book Value of Common Equity
Market value as of Feb. 16, 2004 and Dec. 31,
1997 book value is as of fiscal year 1997 and
for the latest available quarter for
2003 Fundamentals for 1997 for Shinhan Bank
and current for Shinhan Financial
Group Fundamentals for 1997 for Woori Bank
and current for Woori Finance Holdings Source B
loomberg
13
4. BANKING SECTOR HAS BEEN ONE OF THE KEY
EMPLOYERS IN THE ORGANISED SECTOR
of total
23.18
Manufacturing
Transport storage communications
11.22
Banking sector (all SCBs) had a workforce of 0.93
million as on 31/03/2001, which is 57 of total
persons employed in the financial sector
Financing Insurance, real estate and business
services
5.94
Agriculture
4.09
Construction
3.43
Mining
14
THERE IS HUGE DISPARITY IN EMPLOYEE METRICS
ACROSS BANKS
Employee productivity, 2004 Rs million
1.56
Someone in the system needs to take on the pain
of re-skilling employees else there may be a big
issue some years down the line
Cost per employee
205
Business per employee
Sum of deposits advances Employees for
FY03 Personal cost Source RBI IBA
15
KEY MESSAGES

• MA in the Indian banking sector is an
  opportunity and an imperative
• MA has to be based on a business rationale and
  effective execution there is not enough track
  record of that in the Indian banking sector
• India may have to follow a managed transition
  model to ensure a stronger banking sector

16
LEVERS OF VALUE IN MA
Key source of value for the acquirer
Collections
Cost savings

• Ability to maximise the speed and recovery of NPLs

1
Processes

• Ability to redesign processes

2

• Ability to integrate and rationalise branches and
  other channels

Distribution
3
Infrastructure
4

• Ability to combine corporate/regional
  infrastructure

IT

• Ability to upgrade overall technology

5
Operations
6

• Ability to quickly centralise operations

Revenue enhance-ment
Product/Segments

• Ability to upgrade product range and increase
  cross-sell

7
Geographies

• Ability to ensure geographic growth and synergy

8
Treasury improve-ment
Cost of funds

• Ability to reduce cost of funds

9
Trading income

• Ability to leverage scale and improve trading
  income

10
17
RESEARCH SHOWS THAT IN MOST CASES MERGERS FAIL TO
DELIVER AGAINST THEIR EXPECTATIONS, WHATEVER THE
RATIONALE

• Poor deal
• Unrealistic synergies
• Price too high
• Competitor reactions

• Good deal poorly implemented
• Poor integration management
• Failure to address cultural differences
• Customer losses
• Poor communication
• Poor tracking

60-70failed
Source McKinsey Corporate Finance Practice
interviews
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LOT OF THE MERGERS IN THE RECENT PAST HAVE BEEN
TO BAIL OUT LOW PERFORMING BANKS
Acquirer
Target
Year
Acquirer
Target
Total assets (after merger)
Reasons for merger
Rs 000 crore
2000
HDFC Bank
Times Bank

• Strategic reasons

9
2001
ICICI Bank
Bank of Madura

• Strategic reasons

16
2002
Bank of Baroda
Benares State Bank

• Target bank with negative net worth

64

• High accumulated losses
• Net NPAs of Rs.200 crore

2003
Punjab National Bank
Nedungadi Bank
74
2004
Oriental Bank of Commerce
Global Trust Bank

• Bank failure
• Networth wiped out

48
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CURRENT REGULATIONS COULD POSSIBLY IMPEDE
MARKET-DRIVEN CONSOLIDATION
. . . could possible impede market-driven
consolidation
Recent RBI ownership guidelines. . .

• Shareholding in any bank by a single entity or
  group of related entities limited to 10 per cent
  without prior RBI approval
• A private sector bank can hold only 5 percent
  shares in any other private sector bank
• A foreign bank with presence in India can hold
  upto 5 percent shares in any other private bank
• FDI by single entity or group of related entities
  cannot exceed 10 percent. Individual FII
  investment cannot exceed 10 per cent with the
  aggregate limit for all FIIs restricted to 24 per
  cent (that can be raised to 49 per cent with the
  approval of Board / General Body).

The 5 per cent ceiling proposed by the RBI is a
major disincentive for foreign banks wanting to
buy a stake in private sector banks. . . HSBC,
which recently lifted a 14.7 per cent stake in
UTI Bank, will have to bring it down to 5
The new guidelines could alter the entire
structure and shareholding patterns of several
private sector banks. . . . This would force
ICICI Bank, for example, to reduce its 20.44
stake in Federal Bank and 11.8 stake in South
Indian Bank.
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SUMMARY

• MA in the Indian banking sector is an
  opportunity and an imperative
• MA has to be based on a business rationale and
  effective execution there is not enough track
  record of that in the Indian banking sector
• India may have to follow a managed transition
  model to ensure a stronger banking sector

21
A CONSCIOUS CHOICE HAS TO BE MADE FOR THE PATH TO
MANAGE CONSOLIDATION IN INDIA
Managed transition
Free market
Key elements of restructuring approach Impact
(based on experience of other countries)

• Allow market-driven consolidation
• Allow free entry of foreign banks
• Significant consolidation of smaller players
• Near-total replacement of local institutions by
  foreign banks

• Encourage domestic acquisitions by strong local
  banks
• Selectively open the banking sector to foreign
  competition
• Increased dominance of 2-3 strong local players
  through acquisitions
• Foreign banks begin to increase presence

Examples

• Argentina

• Brazil

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ISSUES AROUND END-STATE NEED TO BE RESOLVED
BEFORE CONSIDERING A MANAGED TRANSITION
The World Class Korean Retail Financial Services
Company
Designing the end-state
2
3
4
Defineoverall bankperformanceend-state
Definecost management end-state
Defineproduct availability end-state
1
Define overall market end-state structure
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1.DEFINE OVERALL MARKET END-STATE STRUCTURE
FINANCIAL STRUCTURE
3-4broad-based,global players

• Universal banks
• Non-banks

Regional/national players
Number of players

• Micro-market
• niche players
• Community banks
• Credit unions

Defender/small
Reserve the right to play/medium
Industry shaper/large
Strategy/market capitalization (size)
24
DEFINE EXPECTED PARTICIPATION LEVELS OF FOREIGN
BANKS
Foreign ownership of banking assets, 1990-2000
Per cent
Brazil
Mexico
South America
1990
2000
1990
2000
Hungary
Poland
India
?
1990
2003
2008
1990
2000
1990
2000
Korea
Thailand
1990
2000
1990
2000
1990 and 1994 data 1994 and 2000
data Source BIS McKinsey knowledge database
press searches
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2. DEFINE OVERALL BANK PERFORMANCE END-STATE
Criteria
Issues
Capital stability

• Apply international accounting standards to
  recognize all embedded loan and investment losses
  and estimate the real BIS ratio of banks

Profitability

• Banks will need to achieve an industry average
  ROA 1 percent and ROE around the 1015 percent
  range through a greater profitability orientation
• Pricing margins for major product groups should
  move up

Asset quality

• Banks NPL/total loans ratios need to be 12
  percent maximum, which is more in line with the
  developed world
• Apply international accounting standards to
  identify the real NPL ratio
• Create industry-wide utilities to aid banks

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3. DEFINE COST MANAGEMENT END-STATE
Criteria
Issues

• Cost efficiency ratio of banks should move to the
  30-40 percent range in line with more developed
  countries in a few years through improving
  operational effectiveness

Efficiency

Productivity of payment system

• Banks should focus more on electronic payment
  system
• Create industry-wide utilities to aid banks

Branch structure for retail delivery

• Improve branch productivity and realign
  distribution

27
DEFINE PRODUCT AVAILABILITY END STATE
Provided through affiliation Provided through
subsidiary Provided through own operations
CANADA EXAMPLE
Retail and pension fund management
Life insurance
Non-bank trusts
Credit unions
Meeting customer needs
Banks
Personal financial services (PFS)
Payment

Credit
Asset accumulation
Customer needs being met by a variety of
providers, including 4-6 major banks through
several products and channels


Business banking
Payment
Credit

Corporate finance





Investment

Risk management

Brokerage


Pensions
Insurance
Life
Health
Disability
Property and casualty
46 leading banks, many foreign banks
No. of players
120
200
37
2343
Source Annual reports team analysis
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IN A MANAGED TRANSITION, IT IS IMPORTANT TO
CREATE SMALL NUMBER OF NEWLY EMERGED LEADING BANKS
Expected Potential
BASED ON EXAMPLES OF OTHER COUNTRIES
Strong
Market capitalization
Week
Current
Future
Time
Source Team analysis
29
THERE WOULD BE FEWER STRONGER BANKS IN THE END
STATE
High performing banks
Imputed P/B
Large National Banks
Stuck in the middle
Weak/ unviable banks
Asset size
30
BANKS IN EACH OF THE CATEGORIES WOULD NEED TO BE
ANALYSED IN DETAIL TO DETERMINE THE ACTUAL PATH
Category
Imperative
Key issues to resolve

• Aggressively increase scale (through acquisitions)

• Should these banks focus on organic growth or
  growth via acquisitions?
• If acquisitions, what are the right candidates?

High performing banks

• Exit
• Get acquired/merge

• Are the banks really unviable on a stand alone
  basis? Do they have a set of product market
  skills or management which could turn them
  around?
• If weak, should they be closed or merged with
  other banks?
• If merged, should they be merged with another
  weak bank or a bank of another category?

Weak banks

• Merge to form regional banks
• Get acquired by large national banks/ well
  performing banks

• Do these banks have an opportunity to grow
  organically into the large national bank or well
  performing bank category?
• Which ones could serve as anchors to form
  regional banks?
• Which ones are suited for acquisition?

Stuck in the middle

• Acquire (if necessary) other banks to increase
  scale or obtain access to new skills

• Are these banks truly at a sufficient scale or
  need to merge with other large banks to increase
  scale?
• What banks of other categories would make
  sensible acquisition candidates?

Large national banks
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END OF PRESENTATION