ICICI Bank + Bank of Madura = ?

The proposed merger between ICICI Bank and Bank of Madura (BoM) is a remarkable one. The pre--merger market capitalisation of ICICI Bank was roughly Rs.2500 crore while BoM was at roughly Rs.100 crore. BoM is known to have a poor asset portfolio. What will the merged entity be worth?

The key rationale underlying every merger is the question of synergy. Can ICICI Bank's products and technology bring new life to the 263 branches of BoM? Will ICICI Bank (which has 1,700 employees) be able to overcome the 2,600 employees that BoM carries, given that Indian labour law makes it troublesome and expensive to sack workers?

As a benchmark calculation, however, suppose we pretend that there are no synergies, and focus on a purely financial evaluation of the merged entity. This is not easy to do using conventional accounting measures. Instead, arguments based on option pricing theory yield useful insights. These arguments are related to my Business Standard op-ed of last fortnight, and to the working paper, Measuring systemic fragility in Indian banking: Harnessing information from the equity market, by Susan Thomas and myself.

In applying these ideas to ICICI Bank and to BoM, we need to believe that the stock market effectively processes information to produce estimates of the price and volatility of the shares of both these banks. This assumption is suspect, because both securities have poor stock market liquidity. Hence, we should be cautious in interpreting the numbers shown here. There are many other aspects in which this reasoning leans on models, which are innately imperfect depictions of reality. However, these models are powerful tools for understanding the basic factors at work, and they probably convey the broad picture quite effectively.

ICICI Bank. The pre--merger status of ICICI Bank is as follows: it had liabilities of Rs.12,073 crore, equity market capitalisation of Rs.2,466 crore and equity volatility of 0.748. Working through options reasoning, we find that this share price and volatility are consistent with assets worth Rs.13,249 crore with volatility 0.15. Thus, ICICI bank had assets which are 9.7% ahead of liabilities, which is roughly consistent with the spirit of the Basle Accord, and has leverage of 5.37 times.

Bank of Madura. The pre--merger status of Bank of Madura is as follows: it had liabilities of Rs.4,444 crore, equity market capitalisation of Rs.100 crore and equity volatility of 0.69. Working through options reasoning, we may say that the stock market thinks that its assets are worth Rs.4,095 crore with a volatility of 0.02. Hence, BoM is bankrupt (with assets which are Rs.350 crore behind liabilities) and has a leverage of 41 times. If we needed to bring BoM up to a point where its assets were 10% ahead of liabilities, which is broadly consistent with the Basle Accord, this would require an infusion of Rs.800 crore of equity capital.

How do we combine these to think of the merged entity? Assets and liabilities are additive, so the total assets of the merged entity would prove to be roughly Rs.17,345 crore and the liabilities would prove to be Rs.16,517 crore. The merged entity would hence need roughly Rs.800 crore of fresh equity capital in order to come up to a point where assets were atleast 10% ahead of liabilities.

How can we estimate the market capitalisation of the merged entity? The value of equity is the value of a call option on the assets of the merged entity. Pricing the call requires an estimate of the volatility of the merged assets, i.e. it requires a knowledge of the extent to which the assets of the two banks are uncorrelated. We find that using values of the correlation coefficient ranging from 80% to 95%, the volatility of assets of the merged entity proves to be around 0.12. In this case, the valuation of the call option, i.e. an estimate of the market capitalisation of the merged entity, proves to be roughly Rs.2,500 crore.

This number is not far from the pre--merger market capitalisation of ICICI Bank, which was Rs.2,466 crore. Hence, we can say that on purely financial arguments, the merger is roughly neutral to ICICI Bank shareholders if BoM was merged into ICICI Bank for free. Indeed, if banking regulators took their jobs more seriously, they would force the shareholders of BoM to walk into such a merger at a zero share price as a way of reducing the number of bankrupt banks in India by one. Such a forced-merger would be a politically easier alternative for the RBI when compared with closing down BoM.

The shareholders of ICICI Bank have paid a non-zero fee for BoM. This reflects a hope that the products and processes of ICICI Bank will rapidly improve the value of assets of BoM in order to compensate. In addition, the merged entity will have to rapidly raise roughly Rs.800 crore of equity capital to obtain a 10% buffer between assets and liabilities.

Hence, this proposed merger is a godsend for BoM, which was otherwise a bankrupt entity which was headed for closure given the low probability that it would manage to raise Rs.800 crore of equity on a base of Rs.100 crore of market capitalisation. It is useful to observe that BoM probably did not see things in this way, given the willingness of India's banking regulators to interminably tolerate the existence of bankrupt banks. Closure of BoM would normally involve pain for BoM's shareholders and workers; instead both groups will get an extremely pleasant ride if the merger goes through.

The proposed merger is a daunting problem for ICICI Bank. It will need to rapidly find roughly Rs.800 crore in equity. If India's banking regulators were serious about capital adequacy, ICICI Bank should have to pay roughly zero to merge with BoM (it is doing a favour to BoM and to India's banking system); instead ICICI Bank has paid a positive price for BoM. The key question that will be answered in the next two/three years is: Will ICICI Bank's superior knowledge of products and processes revitalise the assets and employees of BoM, and generate shareholder value in the merged entity? ICICI's top management clearly thinks so, and it would be a very happy outcome if this did indeed happen.

The proposed merger is a good thing for India's economy, since the headcount of bankrupt banks will go down by one, and there is a possibility of obtaining higher value added out of the poorly utilised assets and employees of BoM. If the merger goes through, then it will reduce the say of the management team of BoM in India's resource allocation, which is a good thing.

Back up to Ajay Shah's media page