By R Jagannathan
The child, runs an old proverb, is the father of the man. In the corporate world, it holds goods for at least one child and one father - HDFC Bank and HDFC respectively.
HDFC fathered its bank nearly 20 years ago, and willy-nilly agreed to lend the offspring its much-coveted name. But today, if the name belongs more to one of them, it is the bank rather than the pioneer housing finance company. The bank's market value exceeds that of the parent by a substantial 25 percent (Rs 1.63 lakh crore to Rs 1.28 lakh crore). In reality, it would be even more since the value of HDFC includes the value of its shareholding in the bank.
Hence, the issue that keeps cropping up repeatedly in stock market circles is this: when will the child take over the man? When will HDFC, a relic of the era when banks did not lend for housing, do a reverse merger with its bank.
The answer comes from journalist Tamal Bandyopadhyay's book on HDFC Bank, titled Bank for the Buck. HDFC CEO and Managing Director Keki Mistry has this answer: "We have a Rs 1.67 trillion (Rs 1.67 lakh crore) balance-sheet. If we were to merge with the bank, we would need a huge reserve requirement. That's the biggest issue."
In short, even the father tacitly agrees that the only thing holding back a merger is the regulatory requirement. The Reserve Bank of India (RBI) mandates that banks have to keep aside a certain percentage of their liabilities (a.k.a. deposits) as cash reserve ratio (CRR, 4.25 percent now) and another 23 percent as SLR (statutory liquidity ratio) - something that housing finance companies don't have to bottle up needlessly.
Mistry sets a clear rider to the merger: "If the regulator excuses us from these pre-emptions for five years or allows us to maintain SLR and CRR on incremental deposits and not on the existing balance-sheet, it would make tremendous sense for both HDFC and the bank."
In plain terms, the answer seems to be no. But the point is that the housing finance company is an anachronism in an era where funds are available with the bank at low cost, but the loans are being made more through the parent. HDFC Bank originates the loan and books a fee, and the parent takes it over and gets a lower return minus the fee.
This business model is convenient, but not sensible in the long term. As we noted in Firstpost some time ago, "the problem in the HDFC-HDFC Bank relationship is that it is the opposite of what it should be. When banks want to grow housing finance in a big way, they set up a subsidiary. In HDFC's case, it is the housing finance company (HFC) that set up the bank."
Thanks to aggressive competition from banks, HDFC's incremental spreads on loans have fallen by 80-100 basis points (0.8-1 percent), says a research note from Ambit. The logic of merging with the bank is thus growing stronger - at least on paper.
Put another way, HDFC, despite its strong housing finance franchise, is likely to lose the war in the long term to banks. It remains strong now because the public sector banks are still not providing it mega competition, and the bank which can do so - HDFC Bank - is a non-competitor.
Some years back, ICICI Bank and State Bank started aggressively expanding into housing loans, and HDFC got dethroned from its No 1 status.
While the issue of a sudden increase in CRR and SLR liabilities will depress profits at the bank (which will be the surviving entity), it cannot be avoided. The Reserve Bank did not show any kind of regulatory forbearance for ICICI Bank when it merged its parent ICICI with the Bank. ICICI then took over another private sector bank, the Bank of Madura, to speed up the process.
According to Ambit, thanks to high current valuations of HDFC (four times book value) any merger will depress share values.
But longer-term value creation depends on biting the bullet.