Bharat Financial-IndusInd Bank merger: Near-term hitches, structural risks may play the spoilsport

Bharat Financial Inclusion (erstwhile SKS Microfinance) has entered into an exclusivity agreement with IndusInd Bank to explore merger possibilities. On the face of it, the dominant market position of BFIL amongst microfinance institutions (MFIs) and the possibility of leveraging BFIL’s large customer base to garner deposits, among other strategic reasons, appear a good deal for IndusInd Bank.

However, near-term integration costs aside, the merger, if any, presents long-term challenges and risks that could weigh on IndusInd Bank’s earnings to a large extent.

While BFIL is the largest MFI in terms of gross loan portfolio (Janalakshmi Financial Services which was the largest MFI, recently received final licence to set up a small finance bank), growth challenges that have emerged post- demonetisation within the MFI industry is a cause for worry. BFIL’s gross loan portfolio stood at ₹9,631 crore as of the June 2017 quarter, a growth of 14 per cent year-on-year. In the same quarter last year, BFIL had registered 76 per cent YoY growth.

Post demonetisation, cash crunch and rising defaults have impacted growth for MFIs. Until FY16, loans for MFIs were clocking a growth of over 50 per cent annually.

BFIL’s loan growth (annual) between FY13 and FY16 stood at 56 per cent, which has moderated significantly post demonetisation. While the sector is slowly limping back to normalcy, it may not return back to the high growth of 50 per cent levels any time soon. Many of the MFIs that have transitioned to small finance banks have been trying to diversify away from MFI lending, given the risks within the portfolio.

Aside from slowdown in disbursements, collections too have taken a knock post demonetisation. Collection efficiencies which were close to 100 per cent pre-demonetisation, fell to 80-90 per cent between November 2016 and January 2017, driven by steeper slowdown in certain markets such as Uttar Pradesh and Maharashtra.

For BFIL, gross collection had slipped to 91-92 per cent in the two months immediately after demonetisation. This has inched back to 99.5 per cent in July. The company recognises more than 8 weeks overdue loans as NPAs (against RBI’s 90-day norms). In the June quarter, GNPA stood at 6 per cent of loans. While the company has been conservative on provisioning and the management has stated that it has taken much of the hit in the June quarter itself, returning to pre-demonetisation levels of GNPAs looks unlikely.

Acquiring an MFI business, when the sector is facing headwinds could weigh on IndusInd Bank’s earnings.

One of the biggest arguments in favour of the merger, could be the leveraging of BFIL’s large customer base for deposits. But mobilising deposits from existing MFI customers will be a tall task, given the weak savings pattern within this segment. Other MFI players transitioning into small finance bank such as Bandhan have faced similar challenges.

Also, IndusInd Bank has been growing its loan book by 25-30 per cent over the last couple of quarters. Hence, its deposit base will only be able to fund its own growth. IndusInd Bank’s loan book stood at ₹1,16,407 crore as of June quarter.

Incremental cost savings could thus accrue if IndusInd Bank is able to raise lower-cost bulk deposits to replace BFIL’s current borrowings. The marginal cost of borrowing for BFIL stood at 8.9 per cent as of June quarter.

Taking into account the cost to comply with cash reserve (CRR) and statutory liquidity (SLR) requirements, margin gains could be about 80-90 basis points. However, with leading MFIs transitioning into small finance banks, such cost savings are unlikely to offer competitive advantage. Instead, increasing competition could add pressure on margins, eating into some of these gains. BFIL has among the lowest lending rates (19.75 per cent) among MFIs.

Above all, valuation could make or break the deal. According to reports, Kotak Mahindra Bank and IDFC Bank have acquired microfinance businesses at 1.9-2.0 times trailing book to value. After the rally in recent months, BFIL trades at 4.5 times one-year forward book, making it an expensive acquisition; though contours of the deal and the swap ratio are awaited.