How HDFC is Merging with HDFC Bank to Create a Financial Services Giant

HDFC Ltd, in its 45-year history, had not just helped a chunk of the country’s population build dream homes, but also birthed one of the top private lenders of the country. However, the past few years have been tough with the tried-and-tested business model of the country’s largest non-banking finance company (NBFC) facing regulatory headwinds for the first time. Chairman Deepak Parekh, 77, could envisage that the mortgage giant was entering choppy waters. And he was prepared. The patriarch of the HDFC conglomerate, a keen bridge player, kept his cards close to his chest, waiting for the right time to reveal his hand.

On a balmy Monday morning in early April, Parekh finally revealed his hand: a $40-billion merger of HDFC Ltd with its banking subsidiary, HDFC Bank. But this was always on the cards, some said; in fact, talks of a reverse merger of HDFC Ltd with HDFC Bank had been a topic of discussion for over a decade, with the only question being when. As it turns out, when Parekh took the wraps off his move, no one, including the markets, had any clue. Making the announcement, Parekh said the time was right to find a new home. “Our new home is with our family, with our own people, but it’s bigger, better, and significantly more promising,” said the man whose uncle, H.T. Parekh, had set up the mortgage company in the late 1970s. “This merger is a coming together of equals,” said Parekh, who has transformed the group into a financial services powerhouse over the past few decades.

The markets welcomed the news with the shares of HDFC surging some 16 per cent on the BSE in intra-day trade on April 4, while HDFC Bank went up by around 14 per cent. Once the deal is effective, HDFC Bank will be 100 per cent owned by public shareholders, and existing shareholders of HDFC will own 41 per cent of the bank, according to stock exchange filings by the entities. Every HDFC shareholder will get 42 shares of HDFC Bank for 25 shares held. While HDFC brings to the table its domain expertise in real estate and mortgages, HDFC Bank provides scale and distribution with access to low-cost funds. Sashidhar Jagdishan, CEO & MD of HDFC Bank, said the proposed merger ticks all the right boxes in terms of product offerings, leadership in home loans as well as other retail asset products, distribution strength, and a customer base that can be leveraged to cross-sell a complete suite of financial products.

But why did HDFC need a new home? On top of the list are regulatory challenges. Since the failures of large non-banks like IL&FS, Dewan Housing Finance, Reliance Capital and SREI, the Reserve Bank of India (RBI) has been tightening the regulatory framework for NBFCs, narrowing the gap with banking regulations. A year and a half ago, the RBI’s internal working group had also recommended that large NBFCs be converted into banks.

Then, late last year, the regulator introduced the scale-based Revised Regulatory Framework for NBFCs, which directed these entities to maintain a liquidity buffer of high-quality liquid assets to meet any short-term obligations. The RBI has asked NBFCs to maintain liquidity against the next 30 days’ outflows on a rolling basis. Called liquidity coverage ratio (LCR), this was introduced for NBFCs for the first time in December 2021 and is designed to move progressively from the existing 50 per cent to 100 per cent in the next four years.

Earlier, NBFCs had to maintain a statutory liquidity ratio (SLR), which was 13 per cent of public deposits. SLR is a minimum percentage of deposits mobilised from the public that a bank must keep in liquid cash and other government securities. According to NBFC experts, the RBI is introducing cash reserve ratio (CRR or the percentage of a bank’s total deposits that it is required to maintain as liquid cash with the central bank) and SLR via the LCR route as the LCR funds effectively qualify as CRR and SLR.

“If you look at our overall liquidity including LCR [and] SLR on public deposits, we were carrying about Rs 55,000 crore as liquidity buffer as on December 31, 2021. The current requirement of LCR for housing finance companies (HFCs) is 50 per cent and [it will] gradually go up to 100 per cent over the next two years, which may require some higher liquidity requirements,” says an HDFC official who chose to remain anonymous. The total liquidity requirement for HDFC then would go up to Rs 70,000-80,000 crore. Higher liquidity levels mean losing out on the profitable deployment of funds for a short period, which impacts profitability and returns to shareholders.

Then there’s the matter of recognising non-performing assets (NPA). Earlier, NBFCs would classify a loan as an NPA only when it wasn’t serviced for 180 days. But according to the RBI’s new framework, a loan has to be classified as an NPA if it is not serviced for more than 90 days, which puts the norm on a par with that of banks. There’s more. Under banking regulations, if a borrower has crossed the 90-day default period, the account cannot be upgraded to a standard asset till the borrower clears all dues. Earlier, in the case of NBFCs, if a borrower had crossed the 90 days of default and paid some amount to bring the balance down, then the loan account wasn’t treated as an NPA. Not anymore. “This regulatory gap has been plugged,” says a consultant. HDFC, which has implemented the new guidelines, has witnessed a rise in its gross NPAs to 2.32 per cent of total advances in the quarter ending December 2021 as compared to 2 per cent in the previous quarter. “This new norm will not only increase the NPAs and the provisions, but also impact profitability going forward,” says an NBFC player.

The other challenge HDFC faced was the threat of losing its status as an HFC. In February last year, RBI came up with two conditions for HFCs: First, a minimum of 60 per cent of total assets (not loans) should be directed towards providing housing finance. Second, a minimum of 50 per cent of assets should be under housing finance for individuals by March 2024. HDFC’s loan book shows a break-up of 79 per cent loans for housing, 5 per cent for corporate, 9 per cent for construction finance and 7 per cent for lease rentals. But the RBI’s guidelines require HDFC to maintain a minimum of 60 per cent (housing finance) and 50 per cent (individual housing loans) based on the total assets of the HFC, and not on the loan book (where the percentage share is higher). By that yardstick, HDFC currently is at 58 per cent and 54 per cent, respectively. “If you see our loan book and assets on our balance sheet, there is a difference of about Rs 1 lakh crore because of investments in government securities, investments in subsidiaries and mutual funds for liquidity and LCR purposes,” explains the official quoted earlier. In order to meet the new guidelines, the options before HDFC were to increase the size of the housing assets or reduce the total assets on its balance sheet. In the long run, the new guidelines would have restricted future investments in new non-mortgage businesses.

Many experts suggest that the new scale-based regulations for NBFCs—which are primarily in terms of monitoring, inspection and audit—proved to be the last straw for HDFC, which has investments in banking, asset management, insurance and education loans. Under the new framework, the regulatory structure has four layers based on size, activity and perceived risks. HDFC, by virtue of its size, comes under the topmost layer with a regulatory regime closer to banks. The bank-like treatment for a large NBFC like HDFC means enhanced regulatory requirements in terms of governance, inspection, and audit.

“The RBI will continue to tighten the restrictions because of the systemic risk that non-banks pose to the financial system,” says Abizer Diwanji, Head-Financial Services, EY India. If, operation-wise, HDFC is going to be closer to a bank in every respect—from core banking, audit, LCR requirements, governance, etc.—then the mortgage player is just left with CRR, SLR and lending to the priority sector.

Even if HDFC successfully navigated the choppy regulatory waters, the bigger question was, who would steer the ship in the coming decades? HDFC’s top management wasn’t getting any younger. Besides septuagenarian Parekh, both Vice Chairman and CEO Keki Mistry (67) and Managing Director Renu Sud Karnad (69) are nearing retirement age.

“The legacy management of the mortgage lender has already reached a certain age,” says Harendra Kumar, Managing Director, Elara Securities (India). And, going by the new guidelines, there was a probability that, like banks, the tenure of an NBFC’s CEO may be capped in the future, while there could also be an upper age limit for the chairman, CEO and directors. A succession plan needed to be in place. Also, the single-product HDFC was up against banks like the State Bank of India (SBI) and ICICI Bank, which have access to low-cost funds. For the mortgage giant, it was like feeding an elephant with no real advantage of its size under the new regulatory regime. This set the stage for a merger with HDFC Bank.

Regulatory tailwinds are not the only reason for the coming together of HDFC and HDFC Bank. The merger also makes good business sense. Over the past 28 years, the bank has become much larger than its parent, with a balance sheet of Rs 19.38 lakh crore, against HDFC’s Rs 6.23 lakh crore. HDFC Bank’s market cap, too, is more than double that of the mortgage company, while its loan book is at Rs 12.6 lakh crore, against HDFC’s Rs 6.18 lakh crore. The merger will lead to a combined balance sheet of Rs 25.61 lakh crore, narrowing the gap with SBI, the country’s largest lender, which has a balance sheet of Rs 48.21 lakh crore. (See The Making of a Behemoth).

Size has its advantages. A larger balance sheet would enable the combined entity to disburse larger-ticket loans. In addition, non-bank loan businesses ranging from asset management to insurance to education loans will also come under its fold. The structure of the merged entity would be similar to a universal bank like SBI and ICICI Bank. “A larger balance sheet will allow a greater flow of credit into the economy. It will enable underwriting of larger-ticket loans, including infrastructure, which is an urgent need for the country,” said Parekh. The safe and secured mortgage portfolio will become the largest business within the bank, with a 33 per cent share of the loan portfolio. In fact, the merged entity will have the country’s largest mortgage portfolio of Rs 5.46 lakh crore. The low cost of funds, especially current accounts and savings accounts (CASA), and the huge distribution franchise of the bank will be available for the mortgage business. “As of now, 70 per cent of HDFC Ltd and its subsidiaries’ customers do not bank with HDFC Bank, which would provide tremendous cross-sell opportunities to the merged entity,” says Gaurav Jani, Research Analyst at Prabhudas Lilladher. However, S&P Global adds a word of caution. “The efficiency gains will depend on the smooth integration of systems and processes,” it says in its report.

For HDFC, the merger, as Parekh said, is very promising. And here’s why. “It is challenging to raise wholesale resources from the market the moment you attain a certain scale… And it brings in constraints for growth,” explains Elara’s Kumar, adding that it had become uneconomical for HDFC to operate like an NBFC. The merged entity will refinance HDFC’s high-cost funds with low-cost deposits. The bulk of the borrowings of the mortgage giant is from debentures (41 per cent) followed by public deposits (32 per cent). But it is easier said than done. Currently, 40 per cent of HDFC’s borrowings are locked in for over five years.

The prepayment of high-cost or long-tenor borrowings doesn’t make sense, as these are large borrowings that can create asset liability issues. The borrowers also have to agree, which is not a given. This means, according to experts, that all borrowings and liabilities will run through their stated maturities on their contracted terms. On maturity, the borrowings would be either repaid or renewed at the then prevailing rates of interest.

The merged entity will tap the next big opportunity in the rural and semi-urban markets with the mortgage provider’s expertise and the bank’s low-cost funds, leveraging HDFC Bank’s huge network in these areas (more than half its branches are there). It would be easy for the bank to market home-loan products, especially affordable housing loans, to the masses at affordable rates of interest. There will also be cross-selling opportunities. HDFC comes with 445 dedicated offices with trained staff. “The combined entity’s earnings could improve over the next three to five years. The merger will provide the bank with profitable cross-selling opportunities to HDFC Ltd’s large pool of customers, especially for high-yield products such as unsecured loans. It would also generate more fee income from insurance and investment products,” says S&P Global. Incidentally, HDFC has 3,200 people on its rolls, while HDFC Bank has 120,000-plus employees, and it has been reported that all employees would be retained in the merged entity.

In a single stroke, the merger also solves the succession issue. The RBI’s current guidelines do not allow any professional beyond the age of 75 to be on the board of the bank, including the non-executive chairman. So, Parekh, who is 77, won’t join the merged entity. For the MD & CEO, the RBI has a maximum age limit of 70 years. Vice Chairman & CEO Mistry is 67 and the merger will take 16-18 months to complete, which rules him out for an executive post. “They would have probably delayed the merger to complete the term of the senior management team of HDFC Ltd,” says a market expert. Parekh, while announcing the merger, had said that Mistry wasn’t interested in being a “full-time executive” of the merged entity, but would be a director on the board till the time he retires. The onus of steering the merged entity has fallen on 56-year-old Jagdishan, MD & CEO of HDFC Bank. In fact, he will have more than a decade at the helm of the bank, as per the maximum age specified by the RBI.

The merger makes a lot of sense for HDFC and HDFC Bank, but it is not devoid of its share of challenges. “The merger creates a massive organisation. The size is both a strength and a challenge for them. The merged entity is largely a retail lender unlike wholesale lenders, which allow you to write big cheques to grow the book,” says Amit Tandon, Managing Director, Institutional Investor Advisory Services (IiAS). The merger will also have a direct impact on the bank’s CASA ratio, which is expected to fall from 47 per cent to 35 per cent of total deposits. While giving the strategic rationale, Parekh talked about the reduced gap in liquidity requirements between a bank and an NBFC. Over the years, the SLR and CRR requirements for the banking sector have gone down from 27 per cent to 22 per cent (18 per cent SLR and 4 per cent CRR). “The banks also have an option to invest in priority sector lending (PSL) certificates to meet PSL requirements as against direct lending to agriculture and MSME in the past,” said Parekh. However, according to S&P Global, profitability in the short term could be hit due to statutory reserve requirements and PSL regulations. In fact, the merged entity may not underwrite a chunk of the loans to developers that HDFC used to on-board, which could be countered by the addition of below-prime housing customer loans, says Prabhudas Lilladher’s Jani.

But before all that can happen, the proposed merger will have to pass the regulatory test; a sticking point could be the fact that the bank would now hold a stake in HDFC’s life insurance subsidiaries. According to banking regulations, a bank can hold either 30 per cent or below in an insurance subsidiary, or have a stake of 50 per cent and above. HDFC holds 48 per cent in HDFC Life and 51 per cent in non-life insurer HDFC Ergo. It also holds 53 per cent in HDFC Mutual Fund. The RBI proposes creating a non-operative financial holding company (NOFHC) to house non-bank businesses and ring-fence the banks. In the past, the RBI had directed ICICI Bank to reduce its holding to 30 per cent in its general insurance arm, ICICI Lombard. Similarly, Axis Bank was not allowed to own more than 10 per cent of Max Life Insurance.

However, there are options like the RBI allowing HDFC Bank time to reduce its stake to 30 per cent over a longer period of time. Also, the RBI recently allowed holding companies of two small finance banks—Equitas and Ujjivan—to reverse-merge with the respective banks. But these holding companies had no non-banking business. The RBI has also paved the way for IDFC Ltd’s reverse merger with the bank. “They [HDFC Bank] will need NOHFC structure for sure,” says Diwanji of EY India. “The bank has requested the RBI for a phased approach in respect of SLR and CRR, priority sector lending, grandfathering of certain assets and liabilities, and in respect of some subsidiaries,” said Parekh.

People have been waiting with bated breath for over a decade to see this merger happen. Now it’s over to the RBI to bless the union.

@anandadhikari