Should SBI's growth by M&A be curbed? US Fed's too-big-to-fail formula suggests so

Last week, the US Federal Reserve finalised a landmark rule to prohibit any financial company from acquiring another, if the resultant entity’s liabilities exceeded 10 percent of the total liabilities of the financial services system.

The new rule - section 622 of the Dodd-Frank Wall Street Reform and Consumer Protection Act - says once a particular entity reaches the specified concentration limit, that bank cannot acquire control of another entity.

Logically, the new rule intends to shield the US financial system from the foibles of ’too big to fail’ banks, which could then spark a crisis like the one in 2008 following the collapse of lehman Brothers, which triggered a global financial meltdown. That meltdown showed that when banks become too big, they can bring down the whole financial system when they lend or invest imprudently.

Back in India too, the Reserve Bank of India (RBI) is doing the ground work to identify and regulate systemically important financial institutions. In July, it released a framework to identify domestic systemically important banks (D-SIBs) and said four to six banks could come under this category.

The idea is to bring such entities under “differentiated supervisory requirements and higher intensity of supervision”.

Banks having a size beyond 2 percent of gross domestic product (about Rs 2,60,000 crore) will be considered to be part of this category. If one applies this size formula, at least 13 banks will fall under the D-SIB bucket.

These include State Bank of India (SBI), Bank of Baroda, ICICI Bank, Bank of India, Punjab National Bank, Canara Bank, HDFC Bank, Axis Bank, Union Bank, IDBI Bank, Central Bank, Indian Overseas Bank and Syndicate Bank.

To be sure, size alone wouldn’t make these entities D-SIBs. The RBI would also consider their interconnectedness, substitutability and complexity for that.

On the other hand, if one goes by the Fed formula, ie, deposits or liabilities equal to 10 percent of the system, SBI would be the only bank to come under this definition. It would be restricted from adding further liabilities and monitored more closely.

Most other bigger banks will come much below this trigger on a standalone basis, even though any possible merger involving large banks such as Bank Baroda, Bank of India, Punjab National Bank and Canara would result in entities that will have liabilities over the Fed’s threshold.

SBI, which has assets of Rs 18,00,000 crore as in June, 2014, is nowhere among the top lenders in the world. But for India’s Rs 89,00,000 crore banking sector, SBI is T-Rex.

Going by asset size, SBI is nearly thrice as large as the next bank BoB, which has asset size of about Rs 6,50,000 crore. Also, as in June, SBI had a deposit base of Rs 14,00,000 crore, which is about 17.4 percent of the total deposits of the whole industry.

That’s not all. SBI is on course to even grow its liability size by merging its associates with itself. Of the seven associate banks of SBI, two - State Bank of Saurashtra and State Bank of Indore - were merged with the parent in 2008 and 2009 respectively.

According to the government’s stated roadmap, the larger plan is to merge the remaining five subsidiaries with the parent entity. These are State Bank of Bikaner and Jaipur, State Bank of Hyderabad, State Bank of Mysore and State Bank of Patiala.

If one takes the whole SBI group’s liabilities even at this stage, the share of deposits to the total industry stands at a huge 23 percent as in June.

To be sure, there is no rationale in comparing the US banking system with the Indian banking industry. The total assets of US banks are more than 10 times that of Indian banks. Clearly, Indian banks are midgets in comparison to US counterparts.

In global terms, India clearly needs larger banks to compete with the world. Right now, only SBI has the scale and size to be reckoned in the global league.

While SBI, by any definition is a too-big-to-fail bank and this needs close monitoring by the regulator, for all practical purposes it is as good as a sovereign risk. The government has a 59 percent stake in SBI, over 75 percent in 10 other banks and over 80 percent in three. State-run banks control 70 per cent of total assets of the system.

The government cannot let a situation develop where there could be a run on the SBI or any government bank. Even one goes by the key solvency parameters, SBI is on the safer side. The lender has close to 13 percent capital adequacy under Basel-II norms and 12.33 percent under Basel-III.

But, given the size of the SBI compared to its domestic peers, there is an obvious concentration risk that is building up. This is what the RBI would have to monitor. If anything goes wrong with the SBI, it would have repercussions not only for the bank, but the whole financial system.

In a worst case scenario, if a major crisis grips the domestic banking system, a fiscally-constrained government may find it difficult to capitalise the SBI, especially if it keeps growing its book at least as fast as the economy. But governments can always print money. But given its size, an elephant is not easy to feed.

Even now, a rapid growth in bad loans coupled with higher capital requirements under Basel-III norms, will call for additional capital of Rs 2,50,000 crore by 2019. As against this, the government has provided for only Rs 11,200 crore this year for bank recapitalisation.

In August, 2013, former RBI governor D Subbarao had highlighted concerns about ’too-big-to-fail’ banks in India’s financial system. “We don’t need monopolies, instead we need four-five banks of big size, as large banks can become too-big-to-fail, leading to moral hazard problems.” Subbarao said.

There is some merit in controlling the liability growth of SBI for now even as other banks merge to create size and scale to compete with it. In this context, it is worth considering whether SBI should merge more of its subsidiaries with itself or offload them to shore up its own capital.

We have enough evidence to prove that too much of liability concentration on a single bank can be suicidal to any financial system.