In a surprise move, the government on Monday made a decision to advise the boards of Bank of Baroda, Vijaya Bank and Dena Bank to consider a three-way amalgamation. Although the amalgamation has not been finalised, as all three banks will have to seek the permission of their respective boards, the approval is a mere formality as a directive of such magnitude cannot be sidestepped. This consolidation move comes on the heels of State Bank of India assimilating the five State Bank Associates along with Bharatiya Mahila Bank into its fold. The SBI merger was a relative success, despite the huge non-performing assets (NPA) overhang and bad asset recognition issues plaguing the banking system. This experience will have provided increased confidence to the government to carry forward further consolidation exercises.

Arguably, this burst of consolidations will be much more straightforward than in the case of the SBI merger, as the bulk of bad asset recognition has been conducted over time. Chances of new skeletons coming out of any of the three banks’ closets are slim, whereas there was an overwhelming air of uncertainty about NPA issues when the SBI merger process was taking place. Of course, there will be an increase in provisioning costs for Vijaya Bank and especially the much weaker Dena Bank to keep up with the stricter accounting norms of Bank of Baroda, but these are just accounting housekeeping issues.

This move also highlights the government’s increasing focus on banking sector reforms. After the three Rs—recognition, recapitalisation and resolution—it was necessary to complement these efforts with reforms to carry forward the transformation process in a holistic manner. Along with consolidation, reforms also entail improving and overhauling governance and HR practices and credit appraisal processes for a long-term solution to the PSU banking malaise. So far, the government has only taken baby steps in solving the massive NPA problem. These lukewarm efforts may come back to bite them when they seek re-election next year. The economy has not exactly been set on fire and the promised acche din are yet to materialise for most people.

It will not be a stretch to say that we’re still dealing with the consequences of the wholesale bank nationalisation decision that took place in 1969. The inefficiencies of PSU banking are there for everyone to see and almost 50 years later, our country’s resources are still being invested in handling the after-effects of that one bad decision. Yet, we are slowly coming full circle and are reversing a situation that should not have been there in the first place. The failures of public sector banking have been a huge drag on our economy and the sooner we revert to the natural order, the better it would be for our economic fortunes.

The natural order in a growing and aspirational country like India would be to have a booming private banking sector along with a limited but focused public sector involvement. While most PSU banks have performed miserably and have guzzled taxpayer’s money just to keep afloat, it would be unfair to paint all PSU banks with the same brush. Banks like SBI, Bank of Baroda, Indian Bank and even Vijaya Bank have been reasonably well-functioning in spite of performing the service motive which is required of them, which burdens their profitability.

India does require five to seven well-managed public sector banks that can bear the mantle of rural banking and inclusive finance which cannot be entrusted upon their more profit-minded private peers. But any number more than single digits is overkill and highly detrimental to public finances. A steady pruning of badly performing public banks like Dena Bank and United Bank will go a long way in correcting the structural defect that we have found ourselves in since 1969.

Some analysts have the contention that the current method of combining strong banks with weaker banks is an incorrect approach to consolidation. They argue that instead of strengthening the weaker banks, it works the other way around. This argument is flawed in multiple respects; a deeper analysis of banking sector trends reflects a different story.

Firstly, in the case of Bank of Baroda absorbing a dud like Dena Bank, the size of Dena Bank’s NPA is so small when compared to the loan book of Bank of Baroda that it will not make a material difference in the overall scheme of things. This is especially the case when a sound bank like Vijaya Bank is also added to the mix. This is borne out of the fact that the overall net NPA of the combined entity will be 5.7 per cent, which is marginally higher than Bank of Baroda’s current 5.4 per cent.

Secondly, the single most important factor to differentiate between a well-performing bank and a bank which is down in the dumps is the bank’s ability to lend prudently and correctly. Eventually, it all boils down to the credit appraisal processes of the bank. When a bank lends to worthy candidates, it not only increases its profitability but also provides a higher bandwidth to its management to take care of other important aspects like strategy, expansion and customer service delivery. This leads to a virtuous cycle of higher growth and higher profits.

On the other hand, when the credit appraisal framework of a bank is faulty, it leads to a spiralling of costs through provisioning and write-offs and derails the whole operations of the bank. The management bandwidth is fixated on issues like monitoring and evaluation of loans, recognition of stressed loans, loan recovery and provisioning for bad debt instead of other more productive actions. This leads to a vicious cycle of lower growth and higher losses. It can be safely assumed in the current amalgamation that Dena’s Bank credit appraisal policies will not be continued in the combined entity.

Thirdly, most mergers or acquisitions fail in one form or the other when the acquiring company ends up overpaying for the acquired asset. In many cases, potential synergies do not match up to the additional premium paid on the valuation front. In the current case, nobody can argue that Bank of Baroda is overpaying for Dena Bank. At the time of the announcement, the price-book value of Dena Bank was a meagre 0.4. Even if we assume that there are more losses to come that will pull down the book value of Dena Bank, Bank of Baroda will end up absorbing Dena Bank at less than cost value. In the overall scheme of things, Bank of Baroda will have to invest time and energy in integrating the combined entity, but it will be richly compensated as the combined entity will have better reach, scale, product diversity and bargaining power than Bank of Baroda would have as a standalone entity.

On the whole, the consolidation efforts are a much-needed step in the right direction and will provide a revitalising boost to the ailing financial system. The efforts were long overdue and will help in strengthening the financial backbone of the country. It is essential that the pace of financial reforms is not reduced and is augmented through other concrete steps. Improving the credit appraisal framework of public sector banks is one such step which will ensure that the bad loan crisis that we are going through right now will not be repeated in future.