The Banking Sector with consolidation imminent thanks to proposed reforms on Basel-II and need for enhanced capital requirements to meet regulatory needs in India.
In particular, generic research questions are pursued-
(1) What is the present landscape for Merger and Acquisition Trend on risk arbitrage activities in the Indian Financial markets specific to Banks & FI’s..
(2) What is the current trend and effect of the Indian financial regulatory mechanism on risk arbitrage(M&A Arbitrage) ?
Returns associated with risk arbitrage are more pronouncedly decreased in down/severely depreciating stock market and business conditions especially when there is possibility of deal failure but remain rather uncorrelated with market returns when the market is flat and appreciating.
There has also been a growing trend in Indian financial market regulatory mechanism toreduce systemic risk, eliminate legal uncertainty and control regulatory and to have a
closer look on derivatives trading, over the counter derivatives including P-Notes which could be potentially used for fraud or manipulation. The current focus of the financial regulatory mechanism is to curb illegal trading in risk arbitrage activities through limits on trading volume and control of regulatory arbitrage opportunities which should continue into the future.
Acknowledgements
I would like to thank my team of analysts at Altos who have been patient enough with my tantrums,mood swings and have contributed considerably.
My sincere thanks are due to Raj Venkatraman New York a M& A arbitrageur, guru for his guidance and valuable suggestions.
Disclosures:
Investments & Exposure to Banks and Financial Institution
Proprietary Position : No
Family and Friends : Yes
Clients : No
Other Conflicts : Maybe
Introduction
With the global financial services scenario having changed in the recent past, there is a growing trend of mergers and acquisitions which has taken place recently in numerous financial institutions specifically in India .
INDIAN BANKING stands at the threshold of a mega change in the next five years. Many new situations as compared to the present scenario are predicted to emerge. However, participants and analysts in the industry too see the opportunities and failures in distinctively different ways. While the core area of discussion in the recent reports published on the industry relates to consolidation and foreign direct investment, "Social Banking,'' an area of concern, has got short shrift.
Standard & Poor's, which compares Indian and Chinese banking, prescribes risk management as a thrust area for the former. McKinsey, however, suggests different goals (and ways of achieving them) to different sets of bankers — public sector, old private, new private and foreign — while visualizing different scenarios of Indian banking five years from now. The Independent Commission of Bank Officers analyses, in detail, the issues that had hampered the Indian banking system in the past and argues how the Government's recent proposals — foreign direct investment (FDI) and consolidation of public sector banks — will not ensure systemic transparency and efficiency as projected.
One has to see these reports in the light of the United Progressive Alliance (UPA) Government's priorities in the rural and agrarian sector, and the future growth of the economy as well as employment generation. These reports also focus on the emerging scenario in April 2009, when the second phase of the "Road Map for Foreign Banks' Presence in India" begins. In the second phase, the removal of limitations on the operations of the wholly owned subsidiaries and the treating of foreign banks on a par with domestic banks to the extent appropriate will be implemented after reviewing the experience with phase one (March 2005 to March 2009), and after due consultations with all stakeholders in the banking sector. While rating the country's top 20 banks (most of them are public sector banks), Standard & Poor's narrates the key challenges in the system, with priority given to "the need for banking sector consolidation.'' It expects that "rationalisation will ultimately occur among the Indian public sector banks, albeit at a moderate pace.'' At the same time, consolidation could occur between foreign banks and private sector banks, "although any sharp increase in such activity is only expected after March 2009,'' as per the guidelines for the Road Map for the presence of foreign banks.
The banking sector reforms undertaken in India from 1992 onwards were basically aimed at ensuring the safety and soundness of financial institutions and at the same time at making the banking system strong, efficient, functionally diverse and competitive. The reforms included measures for arresting the decline in productivity, efficiency and profitability of the banking sector. Furthermore, it was recognized that the Indian banking system should be in tune with international standards of capital adequacy,
prudential regulations, and accounting and disclosure standards. Financial soundness and consistent supervisory practices, as evident in our level of compliance with the Basel Committees Core Principles for Effective Banking Supervision, have made our banking system resilient to global shocks.
Potential scenarios
In an interesting futuristic study, McKinsey uncovers "three potential scenarios'' that could emerge in the banking sector by 2010 (after the entry of a large number of foreign players), based on the interplay between policy and regulatory interventions and management strategies. The first is a "high performing'' scenario, where policy makers intervene only to the extent required to ensure system stability and protection of consumers' interest, and bank managements step up the drive for far-reaching change.
In the second, "evolving'' scenario, policy makers adopt a pro-market stance but are cautious on pushing reform. The share of the banking sector value added would be 4.7 per cent of GDP. And in the third scenario — stagnating — policy makers intervene to set restrictive conditions and management is unable to execute changes to deliver value to shareholders or customers. Here, the share of the banking sector value added would be only 3.3 per cent of GDP.
The evidence from many emerging market economies, particularly Latin America, shows that a greater reliance on banking FDI has given rise to conditions of: stalled overall growth in credit with domestic banks also reducing loan exposure; far greater financial instability during episodes of shock to the domestic economy; and uncertainty and slow economic growth due to foreign banks acting as conduits for transmission of contagion and strategic decisions from parent banks onto developing markets. "It is to be noted that these consequences are but an expression of the loss of economic sovereignty. We can choose to ignore these lessons only at our own peril,'' states the Independent Commission of Bank Officers.
Consolidation of banks
On consolidation of banks, especially public sector banks, the Commission says that "while the gains from consolidation are expected along greater economies of scale and scope available to bigger banks, the evidence does not support an automatic association between large size and profitability.
On the other hand, bigger banks tend to rely much more on arm's length transactions and standardised balance sheets and loan accounts, on fee based income that seek to avert credit and interest risk, and on trading risk at the securities market. These tendencies give rise to the phenomenon of financial exclusion (whereby a large segment of the population remains unbanked) at the same time that it engenders financial fragility via a greater exposure to financial markets.''
Today, the overall level of non-performing loans (NPLs) in the entire financial system is around Rs. 1,20,000 crore. Of this, around Rs. 50,000 crore are NPLs on account of the corporate sector, the rest accounted for by the rural and cooperative sector. The cooperative sector is not ruined by the rural poor, but by politicians and other manipulators. What India needs is a proper banking structure to ensure that these funds reach the end user.
The Author believes that at current juncture due to the above stated factors the opportunities in the area of Risk Arbitrage or what is commonly reffered to as M&A Arbitrage in the Indian Banking & FI sector are phenomenal.
In Risk Arbitrage, large excess returns have been documented in literature i.e. in previous studies(in the US in 1990’s) .
Two reasons can be attributed to this-
a) Transaction Costs and other practical limitations prevent investors from realizing these
extraordinary returns.
b) Risk arbitrageurs receive a risk premium to compensate for the risk of deal failure. The
risk arbitrage premium is defined as the spread between the current market price and the price to be paid for the shares in the deal at the time of the tender offer announcement. Another possible explanation for the extraordinary returns to risk as documented in previous studies is that they simply reflect the compensation for bearing
extraordinary risk. The paper by Mitchell, Mark and Todd Pulvino (2001) attempts to understand the effect of stock market and business conditions as well as the M&A trend on risk arbitrage in US financial markets confirms that returns associated with risk arbitrage are said to expect more of a downturn in down stock market and business conditions especially when there is possibility of deal failure.
However under the Present Indian Context it is totally different.
Domestic mergers The Narrow RBI Approach.
Under the Banking Regulation Act, banking companies cannot merge without the approval of the Reserve Bank of India. The government and the Reserve Bank do not play a proactive role in either encouraging or discouraging mergers. It is our endeavour that the government and the RBI should only provide the enabling environment through an appropriate fiscal, regulatory and supervisory framework for the consolidation and convergence of financial institutions, at the same time ensuring that a few large institutions do not create an oligopolistic structure in the market. Mergers should be
based on the need to attain a meaningful balance sheet size and market share in the face of heightened competition and driven by synergies and locational and business-specific complementarities.
While there is no regulatory deterrence to bank mergers, their incidence has not been significant and hence no problems have occurred in India. Mergers of banks help to reduce the gestation period for launching/promoting new places of business,
strengthen product portfolios, minimise duplication, gain competitive advantage, etc. They are also recognized as a good strategy for enhancing efficiency.
Ideally, mergers under the present context according to the RBI ought to be aimed at
exploiting synergies, reducing overlap in operations, right-sizing and redeploying surplus staff either by retraining, alternate employment or voluntary retirement, etc.
As banks are leveraged and the credibility of the top management has tremendous supervisory implications, we prefer consensual mergers to hostile takeovers. The takeover codes should, therefore, reflect the supervisory concerns.
Issues in banks mergers with non-banks (NBFC’S)
The RBI endeavor’s to preserve the integrity and identity of banks. The activities that the banks and their subsidiaries can undertake are restrictive, to ensure that the interests of existing and future depositors are fully protected. Banks are also not allowed to undertake trading in commodities(and since yours truly began his career as a Comodity broker I am consistent on my role as a RBI basher) .
In pursuit of these objectives, the merger of a bank with a non-bank is generally not favored.
However, the merger of a non-bank financial company with a bank is allowed subject to the prior approval of the Reserve Bank of India and compliance with all the regulatory and supervisory standards applicable to banks. The issues that may arise in such mergers would be the bank’s ability to comply with statutory and regulatory requirements in respect of liabilities and assets taken over by it from the non-bank.
Mechanism for preserving competition
There is no separate agency/mechanism for preserving competition in the banking sector. Promoting competition is, however, one of the key objectives of the new proposed financial sector reforms.
The entry of new private sector and foreign banks and introduction of new products and technology and operational freedom to banks have ensured a competitive environment in the financial market.
Impact of consolidation
Since the consolidation process has not gone very far in India, its impact has not been significant.Mergers of certain foreign banks at the global level have also not affected the Indian market, as their market share is currently very low. However, the deregulation process has brought in more competition in the banking sector, resulting in delivery of innovative financial products at competitiverates. The consolidation of banks may not significantly affect the functioning of various segments of the financial markets. In a liberalised environment, the mere size of the bank may not be an enabling condition for distorting the pricing mechanisms or liquidity in the market. The presence of large banks
would result in more competition and narrowing spreads.
Role of banks and development finance institutions (DFIs)
India being a geographically vast country with its rural population constituting almost 70% of the total, the role of regional rural banks remains important. The banking sector, characterised by the presence of internationally active banks, national-level banks and regional rural banks, is likely to be preserved to cater to the needs of a varied customer base. Consequent to liberalisation and financial sector reforms, there has been some blurring of distinction between the activities of banks and DFIs. In
particular, the traditional distinction between commercial banking and investment banking has tended to narrow somewhat. Banks have been moving into certain areas which were the exclusive domain of the DFIs, eg project finance and investment banking. DFIs have recently been given the option to convert themselves into universal banks with the RBI’s approval.
To this end, a DFI would need to prepare a transition path in order to comply fully with the statutory and regulatory requirements applicable to banks
Research Purpose and Contribution
This paper analyses risk arbitrage in Indian financial markets specific to the Banking and Financial services sector. An attempt has been made to the paper by studying the Indian financial regulatory mechanism and its related impact on risk arbitrage in terms of controlling trading limits as well as illegal trading.
Questions that are pursued include,
(1) What are the effects of financial market and business conditions as well as the Merger and Acquisition Trend on risk arbitrage activities in the Indian Banking and financial services space ?
(2) What is the effect of the Indian financial regulatory mechanism on risk arbitrage?
(3) The Dichotomy that exists in the current regulatory structure where by “slaves” who have two masters become free – Especially in the Indian context where Banks are regulated by the Reserve bank of India and as listed entities regulated by the SEBI and its prescribed take over code of conduct.
The first signigicant M& A arbitrage opportunity was observed in the HDFC Bank, Times Bank Merger in the year 1998.
There have been swings on subsequent deals, like that of The OBC –GTB deal and the lastest Centurion Bank –Bank of Punjab deal.
Definitions
Risk Arbitrage otherwise called as merger arbitrage, refers to an investment strategy whereby an attempt is made to profit from what is known as an arbitrage spread.
A Takeover in the modern day business world refers to one company (the acquirer) purchasing another company (the target).
An Overview
Risk Arbitrage otherwise called as merger arbitrage, refers to an investment strategy whereby an attempt is made to profit from what is known as an arbitrage spread. After the announcement of a merger or acquisition, the stock of the target company is typically traded at a discount to the stock of the acquired company.
In fact the difference in the price of stock between that of the target company and the acquiring company is known as the arbitrage spread.
In the event of the merger being successful the arbitrageur incurs a profit based on the arbitrage spread. However in the event of a merger failure the risk arbitrageur incurs loss , which is usually much more than the profits he would have earned, had the merger been successful.
Institutional Background of mergers in the US
With the global financial services scenario having changed in the recent past, there is a growing trend of mergers and acquisitions which has taken place recently in numerous financial institutions. This has been particularly observed in the U.S.A where takeover activity has been most observed in the 1990s.
There was an encouragement for merger activity, due to the removal of geographical restrictions for banks and thrifts under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Also observed was the removal of preferential tax treatment of bad debt reserves under a special provision of the Small Business Jobs Protection Act of 1996 eliminated previous impediments for thrift to bank conversions and mergers. Another significant change observed during that time was the Gramm-Leach-Bliley Act (Financial Modernization Act) of 1999 that permitted the creation of Financial Holding Companies which could practice all functions ‘financial in nature’ under one umbrella removed further deterrents to bank/thrift mergers.
What we are seeing in the Indian Context is an adaptation of the best practices of the above with a new Jargon of Shri Kamath Chief of ICICI “ The Universal Banking”
Limited Arbitrage in Mergers and Acquisition
Firstly arbitrage is limited to the extent of buying the acquiring firms shares, with a direct
purchase and an indirect purchase. While the direct purchase would involve buying the shares from the acquiring firm, an indirect purchase would involve buying the target firm’s shares and waiting for the deal to come through, during which the target firm’s shares are exchanged for the acquirer’s shares.
Both the above methods of transacting in shares have identical payoffs if the
merger deal comes through. The arbitrageur also faces an inherent fundamental risk, that of deal failure which could lead to exorbitant losses. The phenomenon of deal failure can be described as any risk arbitrage deal where the arbitrageur loses money.
Nature of Risk Arbitrage
While understanding the nature of risk arbitrage, it is important to know that it can be categorized into two –
a) Pre-emptive Arbitrage-In this kind of arbitrage opportunity, the arbitrageur buys the
shares of the acquired company well in advance. This kind of arbitrage is quite speculative and depends on the success of the merger. In the event of the merger being carried out, the arbitrageur does benefit from the price paid and the tender offer of the share. Pre-emptive arbitrage is guided by instinct and predictions made by the arbitrageur who attempts to forecast potential mergers and acquisitions in the coming weeks and months.
b) Post-Tender Arbitrage-As far as post-tender arbitrage is concerned the acquiring
company makes a tender offer about shares and the arbitrage profit is determined by the price differential between the offer price of the share and the selling price of the share on a particular day, post merger. For example say BIHAR BANK(fictious bank) is planning to acquire UTTAR PRADESH BANK in the near future. BIHAR BANK makes a predictable tender offer of the stock of UTTAR PRADES for Rs. 25;
however the common stock of UTTAR PRADESH BANK sells for Rs. 27 in the market. In such a case the arbitrageur seeks to make a profit from the Rs. 2 differential.
The process of post-tender arbitrage is very dynamic wherein the investment is held for a very short time with very high potential for profits.
Risks associated with risk arbitrage
The main risk associated with risk arbitrage is that of deal failure, otherwise called the completionrisk. If at some stage the management of either company decides not to go through with the deal, then the benefits of arbitrage accruing to the transaction of shares may not materialise. Some shareholders may wish to insure this risk by selling of their shares. As a result of this selling pressure, the price of the target firm can fall below its efficient market price and lead to a market inefficiency thereby resulting in abnormal profits. Arbitrage is also limited to the extent of supply of capital which is a prerequisite for its smooth functioning; it has been observed that the lender typically requires 105-110 % of the short position as collateral.
Calculating Annual Return for Risk Arbitrage
The formula for calculating the returns for risk arbitrage, in other words the potential arbitrage
commitment, was invested by Benjamin Graham in the book Security Analysis (1951).
Indicated Annual Return = [GC-L (100%-C)] /YP (Rockwood, Richard M (2001))
G=Expected gain in points in the event of success.
L=Expected loss in points in the event of failure.
C=Expected change of success as a percentage.
Y=Expected time of holding of shares, in years
P=Current Price of the security
Risk Arbitrage in Bank &FI Takeovers
In the modern day business world a takeover refers to one company (the acquirer) purchasing another company (the target). Though takeovers resemble mergers they are different in the sense that while a merger leads to the formation of a new company, a takeover does not. Corporate takeovers are common in USA and the United Kingdom. However they are a rare occurrence in Germany because of the dual board structure, in Japan because of kereitsu or the interlocking sets of ownerships in the corporate structure and in China because a majority of the publicly listed companies are owned by the state.
Under the present Indian context especially in the Banking and financial services sector it is far more complicated and are backed by various legislations of the Parliament.
Takeovers are of the following kinds-
a) Friendly Takeover-A friendly takeover involves the straight buyout of a company and is observed frequently. In such a takeover the shareholders are the recipients of cash or a number of shares which is contractually agreed upon in advance.
b) Hostile Takeover-In a hostile takeover one company agrees to buy out another company regardless of the consent of the company or otherwise. The mode of conducting a hostile takeover is through publicly traded shares. The rationale behind this mode of performing a hostile takeover is that the acquiring company is actually required to bypass the board the directors and purchase shares from other sources. The process of carrying out a hostile takeover through publicly traded shares is rather difficult unless the shares of the company are otherwise widely available and can be easily purchased.
c) Reverse Takeover-A reverse takeover can take place through either a smaller firm taking over a larger firm, a private company taking over a public company by bypassing a majority of security regulations. This cannot be ruled out in the later economic landscape of corporate India.
Rationale behind takeovers
A variety of reasons can be attributed to why one Bank would like to acquire another
Bank .
One reason is profitability, the target company in such a case may be reasonably priced
and so the acquiring company may make a decision that within a certain time period purchasing that company would be a profitable move.
Takeovers can also be strategic in the sense that the acquiring Bank has motives other than profit to purchase another Bank. In such a case the company that is to be acquired could be quite profitable on its own but may harbour other capabilities that could be beneficial to the acquiring firm. For example a target Bank may
have a well developed distribution network,best practices or information technology capabilities which could lead to an acquiring Bank wishing to takeover it. The acquiring Bank as a result of this takeover will be able to benefit strategically from the capabilities of that Bank apart from earning a profit. An acquiring Bank may decide to takeover another bank as it enables the company to enter into a new market. In some cases in order to eliminate competition, one bank may decide to acquire another and also to be able to defend itself against another competitor. It has very often been the case that very large companies enter into takeovers for the purpose of boosting their reported revenues without much care for the profit involved and the company’s profitability does stand a chance of being affected if there are large costs involved.
There is a premium involved if the target company is financially healthy which may not always be the case. Following a takeover the stock price of the target company may rise forcing down the price of the acquiring company Takeovers and the legal system
In the US takeovers are governed by the Williams Act, which was enacted in July 1968. (Gomes, Armando, 2001)Takeovers are also governed by corporate laws and the state jurisdiction. The purpose of the Williams Act is to enable shareholders of a company to have fair and full disclosure to information and sufficient time to be able to act upon information. US Takeover rules are contained in the in Section 14(d)(1) of the Securities Exchange Act of 1934 and Securities and Exchange Commission (SEC) Rules 14D and 14E.
Indian Scenario SEBI’s guide lines on take over.(refer appendix A 4)
Risk Arbitrage in Takeovers: An overview
Arbitrageurs are strategically important in the market for corporate control. Following a tender offer there is often a drastic rise in risk arbitrageur activity. Risk arbitrageurs take long positions in a target stock with the notion that the takeover will go through. Based on the cooperative Nash bargaining game, the idea that blocking of shares may be relevant for pricing of takeovers wasfirst developed by Bergström, Clas, Peter Högfeldt, and Kenneth Högholm (1993).These arbitrageurs are often hedged by taking short positions in the acquirers stock. Factors contributing to a rise in risk arbitrage activity include the emergence of Ivan Boesky(a prominent arbitrageur on Wallstreet who had been involved in an Insiders Trading Scandal) and an increase in the number of corporate takeover deals contributing to its visibility. Due to the large volume of new arbitrage capital in recent times there is a rise in the narrowing of spreads and the increase in
share price following a takeover announcement which has on an average reduced profit margins in this activity. Despite the odds that prevail, risk arbitrageurs continue to make profits and are considered as important players in the success of a takeover. Usually in an arbitrage deal the number of risk arbitrageurs contributes to 30-40% of the stock and they are considered an important element in the very many deals that are happening.
Rationale behind Risk Arbitrage in Takeovers
Risk arbitrageurs enjoy an information advantage which arises from their choice to enter the field of risk arbitrage. (Larcker, D. and T. Lys,(1987)) If the presence of risk arbitrageurs increases the likeliness of a takeover occurring, then one risk arbitrageur buying shares is relevant for the entire value of shares. Risk arbitrageurs expend a large effort in understanding how other risk arbitrageurs would behave. The number of arbitrageurs who decide to take positions, the number of shares that they will purchase and the price of shares are often determined in equilibrium of an endogenous kind. The value of shares in a takeover does depend on the probability of a takeover occurring. Share value should be higher in the event of there being a larger number of risk arbitrageurs in the market. The informational advantage that a risk arbitrageur enjoys enables and makes him willing to pay a price high enough to persuade smaller shareholders to sell their shares. In most cases the risk arbitrageurs do not have any initial private information. The private 14 information that they enjoy arises endogenously when they start buying shares. However arbitrageurs have to be controlled to ensure that they don’t compete away their rent.
Conclusion
1. With consolidation in Banking and FI imminent in India , a tremendous opportunity in the area of Risk arbitrage(M&A arbitrage) largely remains untapped.
2. Players who have exposure to sophisticated risk management tools and systems (barra et all) and best practices that are currently being used in the developed financial markets for assessing Risk Arbitrage opportunities have a significant competitive advantage over the local Indian players.
3. Market driven reforms will make Indian regulators to strive to reduce the cost associated with “regulatory arbitrage” opportunities.
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