Historical Indian Banking M&A Motivations: Political or Economic?

by Tehreem Husain (The Express Tribune)

Over the past few decades rapid strides of financial globalization of capital markets, technological advancement and financial innovation gave rise to an environment supporting large M&A activity arose globally (Smith & Walter, 2002). Market driven business mergers has been an integral part of the commercial and financial history of advanced economies but has only gained recent momentum in the case of emerging markets (Gourlay, Ravishankar & Jones, 2006). This blog delves into an important historical episode of banking merger, perhaps the first ever, in British India where the Presidency banks of Bengal, Bombay and Madras merged into the Imperial Bank of India in 1921. It aims to determine the motivations behind the merger episode which set foundations for a central banking institution in British India.

Banking Merger Episode in British India

In recent times, the financial industry has been witness to major restructuring which amongst other causative factors includes episodes of M&A activity. Merger episodes are not just a recent phenomenon and have existed throughout history. Before discussing the specific merger episode in British India, it is illustrative to shed light on the business of banking in India. Formalized banking commenced in British India with the English agency houses in Calcutta and Bombay which served as bankers to the English East India Company. Up till 1876, the Presidency banks of Bengal, Bombay and Madras established in 1800, 1840 and 1843 respectively, were ‘quasi-public institutions’ managing government balances and being responsible for note circulation. From 1876, they became purely private concerns but still maintained close contact with the government (Rau, 1922).

They provided support to the government during the Great War but towards the end of the Great War, the directors of the Presidency Banks entered into negotiations amongst themselves and later with the government of India for their merger. A Government of India Finance Department Note No.230 of 1919 presented to Edwin Montagu, Secretary of State for India presented a proposal for the amalgamation of the Presidency Banks quoting an increase in capital, increase in branches and improvements in the future management of the rupee debt of India as key advantages from the merger. The Presidency Banks were merged into the Imperial Bank of India in 1921.

 Merger Motivations

 It is important to delve into some of the factors that led to the merger of the Presidency Banks. Historically and more so in today’s dynamic economy, financial corporations and otherwise have undergone restructuring their businesses in order to remain competitive. Norley (2008) defined restructuring as reorganizing the legal, ownership, operational or other structures of a company for the purpose of making it more profitable and better organized for its needs. This restructuring entails activities ranging from mergers and acquisitions to divestitures and spin-offs to reorganization under the protection of national bankruptcy laws (DePamphilis, 2017). In the context of M&A a merger represents the absorption of one company by another whereas an acquisition is the purchase of some portion of one company by another. Mergers occur due to various reasons. Firstly, they generate synergies between the acquirer and the target, which increases the value of the firm (Hitt et al, 2001). Mergers allows firms to capture synergies and improve efficiencies in order to survive economic contractions (Tarsalewska, 2015). Increasing market share, achieving economies of scale and scope, increasing profits and diversification of risk are other motivations behind mergers (Ntuli, 2017).

One other important motivation for merger is due to considerations of economic efficiency (Lin, 2013). Achieving economic efficiency is also a key motivation behind merger motivations in public sector organizations. Mergers can eliminate duplicated responsibilities, utilize synergies and obtain more resource efficiency (Grossman et al., 2012).

It is with this background in mind that the recognized international rating system ‘CAMELS’ was used on the Presidency Banks and the Imperial Bank of India to make sense of whether the inherent financial performance of the banks led to their merger. Individual balance sheets and profit and loss accounts for the three Presidency Banks and the Imperial Bank of India were used for the analysis. Dissecting the ‘CAMELS’ acronym, reveals that the system rates financial institutions based on their capital adequacy, asset quality, management, earnings, liquidity and sensitivity. Working with limited data, financial indicators over a two-decade period from Dec 1910 to Dec 1930 are analysed to make sense of how banks performed on each of these metrics. This approach is not exhaustive but is indicative nonetheless.

Analysing the financial performance of the Presidency banks and the Imperial Bank of India during the time period reveals the following.

• To determine capital adequacy, the capital to assets ratio was used. In the post-merger episode, the Imperial bank of India witnessed an average capital to assets of 10.7 percent relative to an average of 5.5 percent for the Presidency Banks. This exhibits that through merger, Imperial Bank of India was well capitalized and capital adequacy ratio was improved. Post financial crisis of 2007, the Basel Committee of Banking Supervision has also introduced the leverage ratio to judge capital adequacy. The deposits to equity ratio was used as an indicator to determine the amount of leverage that is used to finance the banks’ assets. The Imperial Bank of India has exhibited a relatively stable leverage position since its inception marking an average of 15.1 percent. This is in contrast to the Bank of Bombay which faced high leverage during the Great War reaching almost 31 percent in December 1917. Keeping all other factors constant, higher leverage ratios indicate higher bank riskiness.
• In order to judge of asset quality, the investment to total assets ratio is used which focuses on the proportion of total assets that are being invested by banks to protect itself from the risk of non-performing assets (Paul, 2017). Data shows that the merger resulted in an improvement in asset quality based on this indicator. The Imperial Bank of India performed significantly well in comparison to the Presidency Banks. It maintained an average of almost 20 percent from its inception till 1930, compared to an average of 15.5 percent of all three Presidency banks.
• In terms of profitability, the return on assets and return on equity have been calculated. The ratios measure how profitable are the banks relative to their assets and the net income returned as a percentage of shareholders equity respectively. Both ratios exhibit great fluctuation and variability for the Imperial Bank of India but were on the upward trend for the Presidency Banks. A case in point is the return on equity which stood at an average of 13.4 percent for the Presidency banks compared to 10.1 percent for the Imperial Bank of India. This indicates that the merger did not create additional revenues that could accrue to shareholders as increased equity.
• In measuring liquidity, the deposits to assets ratio is used. Data shows that through the Presidency banks faced issues on the liquidity front. The ratio, remained within the recommended band of 80 to 90 percent for the Imperial Bank of India whilst touching 78 percent for the Bank of Bengal in December 1919. This shows that the merger resulted in an improved liquidity position for the Imperial Bank of India.

This blog attempts to analyse the merger episode using modern CAMELS indicators. Some of the financial indicators employed have presented a persuasive case for merger as the Bank of Bombay and Madras did not exhibit sound financial fundamentals during the early part of the twentieth century. There was also substantial evidence that the Presidency banks should be merged due to administrative reasons. The financial crisis in British India during 1913-18 were attributed partly due to the exigencies imposed by the Great War and the absence of a financial regulatory body as discussed here. Future research can explore these questions in greater detail.

The merger led to greater ‘financialization’ of British India as the Imperial Bank of India pursued a vigorous policy of opening new branches, specifically in areas where banking facilities did not exist. This can be evidenced from the fact that from 70 branches in 1920, the bank had 202 branches by 1928 (Singh, 1965).

The above discussion primarily employs technical reasons to argue a case for the merger of the Presidency Banks. It would also be quite instructive to explore the political climate at the formation of the Imperial Bank of India and the incentives of the governments both in Britain and in India in doing so.