Why merger of United Bank with another bank makes no sense

Vivek Kaul
Nothing works like the formula. And the formula to rescue a bank which is in trouble is to merge it with another bank. Reports in the media seem to suggest that there might be plans to merge the troubled United Bank of India with the Union Bank of India.
In fact, on February 24, 2014, the share price of United Bank jumped by 13.75% on this possibility, in the early morning trade. It finally closed the day 6% higher at Rs 25.8 , from its closing price on February 21, 2014.
As has been reported before, the United Bank of India is in major trouble. For the period of three months ending December 2013, the bank reported a loss of Rs 1,238 crore. This, after it had provided Rs 1,858 crore against bad loans.
During the period, the bank’s gross non performing assets (NPA) increased by a whopping 36% to Rs 8,545.5 crore. This amounted to nearly 10.8% of the total loans given out by the bank. In fact, in December the Reserve Bank of India(RBI) had asked United Bank not to give a loan of greater than Rs 10 crore to any single borrower.
A recent report in the Mint newspaper points out that the bank has issued an internal directive not to make any fresh loans, unless they are backed by the mortgage of fixed deposits.
In this scenario it is not surprising that there is speculation of the bank being merged with the Union Bank of India. Having said that, the United Bank has denied any such possibilities.
But given the past record of the government merging a bank in trouble with another bank, the merger of the United Bank with the Union Bank(or any other public sector bank) is a possibility that remains. The troubled Global Trust Bank was merged with the state run Oriental Bank of Commerce in 2004. In 2002, the Benares State Bank was merged with the Bank of Baroda. Before this, in 1988, the Hindustan Commercial Bank was merged with the Punjab National Bank. The Punjab National Bank also came to the rescue of Nedungadi Bank in 2003.
So there is a clear trend of a failing bank being merged with an existing bank. In the examples given above, all the failing banks were private sector banks and they were taken over by public sector banks. The United Bank of India is a public sector bank in which the government has a stake of 88%.
This makes it even more likely that the government will try and do everything to save the bank. The total assets of the United Bank as on March 31, 2013, amounted to Rs 1,14,615 crore. The Union Bank is around 2.7 times bigger and has total assets of Rs 3,12,912 crore.
If the banks had been merged on March 31, 2013, the total assets of the new bank would amount to around Rs 4,27,527 crore. The assets of the United Bank would form around 26.8% of the merged entity. Given this, the erstwhile United Bank would form a significant part of the merged entity.
Hence, with nearly 10.8% of its total loans being classified as gross non performing assets, it is possible that the bad loans of United Bank may dramatically pull down the performance of the merged entity.
Let’s take the case of Oriental Bank of Commerce. In August 2004, the Global Trust Bank, which had run into trouble due to bad lending, was merged with the Oriental Bank of Commerce. For the year ending March 31, 2004, the Oriental Bank of Commerce had reported a profit of Rs 686 crore.
The merger destablized Oriental Bank of Commerce and the net profit fell to Rs 557 crore for the year ending March 31, 2006 and took a few years to recover.
A similar thing will happen with the Union Bank of India, if the United Bank is merged into it. Also, it is worth pointing out that most public sector banks are already in trouble, given the mounting amount of bad loans on their books.
As the latest RBI Financial Stability Report points out “Among the bank-groups, the public sector banks continue to have distinctly higher stressed advances at 12.3 per cent of total advances, of which restructured standard advances were around 7.4 per cent.”
So, merging United Bank with Union Bank or any other public sector bank for that matter means destablizing the Union Bank as well and in the process creating more trouble for the entire banking sector.
It will also bring to the fore the issue of “moral hazard”. Before we get into discussing this, it is important to understand what moral hazard means. As Alan S Blinder writes in
After the Music Stopped “The central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains ( and incur costs) to avoid it. Here are some common non financial examples: …people who are well insured against fire may not install expensive sprinkler systems; people driving cars with more safety devices may drive less carefully.”
Given this, insurance companies must take into account the fact that insurance may induce people to take on more risk. “In financial applications, moral hazard concerns arise whenever some third party—often the government—intervenes to insure against or lessen the consequences of, the risk of loss,” writes Blinder.
In fact, the American economy is a great example of all that can go wrong because of moral hazard. Since the 1980s, scores of financial institutions in trouble have been rescued by the government. The signal this sends out to the participants in the financial system is that they can take on more and more risk, and if something does not work out well, the government will come to their rescue.
This is precisely what happened in the United States, where banks took on more and more risk, confident of the fact that if something went wrong, the American government would come to the rescue.
If the United Bank is merged with the Union Bank (or any other public sector bank), this is the signal that will be sent out. Hence, it is important the United Bank not be rescued by the government.
This does not mean that the bank should be allowed to fail. The government needs to protect the depositors of the bank.
As has been suggested before here the government should look to sell the bank to any private businessman for Re 1, who can then run it. Also, India currently has 21 public sector banks, and one less public sector bank will really not make much of a difference to the overall financial system.
The article originally appeared on www.FirstBiz.com on February 25, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why believing that real estate prices will never fall is a stupid idea

India-Real-Estate-MarketVivek Kaul

In a piece I wrote yesterday I said that banks in India play an important role in ensuring that real estate prices do not fall. The main point was that loans given by banks to commercial real estate, between November 2012 and November 2013, has grown at a much faster rate than their overall lending.
This has happened in an environment where real estate companies have a lot of unsold homes(or what is referred to as inventory in technical terms). The number of new projects being launched by real estate companies has also fallen significantly.
Hence, fresh loans given by banks has helped real estate companies pay off their old loans. And this has ensured that they haven’t had to cut prices in order to sell their unsold inventory. If bank loans to commercial real estate hadn’t grown as fast as it has, then
the real estate companies would have had to sell off their existing inventory to repay their bank loans. And in order to do that they would have to cut prices.
In response to this piece several readers said that real estate prices never fall. Still others agreed that there is a real estate bubble in India but that bubble would never burst (whatever that meant). And this is not the first time I have received such responses.
So what is it that leads people to believe that real estate prices never fall? People have seen real estate prices only go up over the last 10 years. A home that was bought for Rs 25 lakh is now worth Rs 2 crore. Hence, there is a firm belief that real estate prices can only keep going up.
In fact such confidence was observed even during the American real estate bubble that ran from the late 1990s to late 2006.
As Alan S. Blinder writes in
After the Music Stopped “A survey of San Francisco homebuyers… found that the average price increase expected over the next decade was 14 percent per annum…The Economist reported a survey of Los Angeles homebuyers who expected gains of 22 percent per annum over the same time span.”
At an average price increase of 14% per year, a home that cost $500,000 in 2005 would have cost $1.85 million by 2015. At 22% it would have cost $3.65 million.
If we apply this in an Indian context we get some fairly interesting numbers. A three bedroom apartment near the Sector 12 metro station in Dwarka, a sub-city of Delhi, went for around Rs 25 lakh nearly 10 years back.
Now it costs around Rs 2 crore. If prices rise at 14% per year it will cost Rs 7.4 crore in 10 year’s time. At 22% it will cost Rs 14.6 crore. If prices rise at the same rate as they have in the last ten years, then the home would cost around Rs 16 crore. And these are huge numbers that we are talking about here. This small calculation tells us how ridiculous it is to assume that real estate prices will continue to go up at the same rate as they have in the past.
We all know what happened in the United States. The real estate bubble peaked in 2006. Prices started to fall after the last. For the last 16 months real estate prices as measured by the
20 City S&P/ Case- Shiller Home Price Index, have been rising. But they are still 20.7% below their 2006 peak.
A similar thing is playing out in the Indian context as well, wherein people are extrapolating the price rise of the last 10 years over the future. They are “anchored” into the price rise that real estate has seen over the last 10 years and this has led them to believe that prices will continue to rise forever.
What they forget is that real estate prices fell dramatically between 1997 and 2003. As
Manish Bhandari of Vallum Capital writes in a report titled The End game of speculation in Indian Real Estate has begun “The previous deleveraging cycle in year 1997-2003 witnessed price correction by more than 50% in Mumbai Metro Region (MMR) property.” Yes, you read it write, prices fell by 50% in Mumbai, the last place you expect prices to fall, given that the city is surrounded by the sea on three sides and can grow only in one direction.
Other than the price rise, another reason behind the belief that real estate prices will continue to go up is the fact that there is only so much land going around. In fact, this reason has been offered for more than 100 years.
George A. Akerlof and Robert J. Shiller point out in Animal Spirits “In a computer search of old newspapers, we found a newspaper articles from 1887—published during the real estate boom in some U.S. cities including New York—which used the idea to justify the boom amid a rising chorus of skeptics: “With the increase in population, the demand for land increases. As land cannot be stretched within a given area, only two ways remain to meet demands. One way is to build high in the air; the other is to raise price of land…Because it it perfectly plain to everyone that land must always be valuable, this form of investment has become permanently strong and popular.”
The point I am trying to make here is that the ‘limited land’ argument to justify high real estate prices is as old as land being bought and sold. Nevertheless, in most cases there is enough land going around. This is reflected in the American context in the fact that real estate prices have barely risen over the last 100 years, once they are adjusted for inflation.
As Akerlof and Shiller write “Moreover, real home prices in the United States rose only by 24% from 1900 to 2000, or 0.2% per year. Apparently land hasn’t been the constraint on home construction. So home prices have had negligible real appreciation from the source.”
What about India? While land maybe an issue in a city like Mumbai, it clearly is not much of an issue anywhere else. There is enough land going around.
Economist Ajay Shah
did some number crunching in a May 2013 column in The Economic Times. He showed that there is enough land to house India’s huge population. As he wrote “A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
Also, it is worth pointing out here that real estate prices have fallen dramatically even in countries like Japan where land unlike the United States is scarce. “
Urban land prices have recently fallen in Japan (where land is every bit as scarce as it is in other countries). In fact they fell 68% in real terms in major Japanese cities from 1991 to 2006,” write Akerlof and Shiller. And the property prices in Japan are still lower than they were in the 1980s.
The moral of the story is that just because something has continued to happen till now, does not mean that it will continue to happen in the future as well. There are many fundamental reasons behind why the Indian real estate bubble is unsustainable (
I made some of them in yesterday’s piece).
Let me make a few more here. Indian real estate has now become totally unaffordable. As Bhandari writes “
The current real estate price represents affordability of very few, while average users have to sell their twenty years of future earnings to afford a house.”
The employment situation remains extremely grim. In a report titled
Hire and Lower – Slowdown compounds India’s job-creation challenge,Crisil estimates that “employment outside agriculture will increase by only 38 million between 2011-12 and 2018-19 compared with 52 million between 2004-05 and 2011-12.” This in an environment where “India’s working age population would have swelled by over 85 million. Of these, 51 million would be seeking employment.”
With fewer non agriculture jobs being created a direct implication would be that incomes will not continue to grow at the same pace as they have in the past. And that in turn will mean a lower amount of money waiting to get into real estate. There are other economic indicators also which clearly show that the Indian economy has slowed down considerably than in comparison to the past. And the real estate sector will have to adjust to this reality.
Bhandari believes that the scenario that played out during the period 1997 ad 2003 will play out again, very soon. As he points out “
One of the most important proponents of fall in the property prices is likely to start from the deleveraging cycle, by the Indian banking sector, which is running a multi decade investment to deposit ratio (108%). The reversal of easy business cycle, scarcity of capital, tight monetary cycle in domestic and international market will force scheduled commercial banks to deleverage their balance sheet over the next three to four years. One can observe the same scenario, witnessed in 1997-2003, when deleveraging by the Indian Banking Sector was accompanied by deleveraging corporates that had accumulated huge debts on their books during good times. This augurs a difficult time for the Real Estate Industry.”
ven with all these reasons it is difficult to predict when the Indian real estate bubble will start running out of steam. But that does not mean that real estate prices will never fall in India. It may happen this year. Or in 2015. Or the year after that.
But in the end, all bubbles burst. It is just a matter of time. As Blinder aptly puts it “Anyway, one thing we
do know about speculative bubbles—whether in houses, stocks, or anything else—is that they eventually burst.” And what that tells us is that days of earning huge returns from Indian real estate are more or less over.
The article originally appeared on www.firstpost.com on January 8, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek)