The PSU Bank Nifty index moved up 2.1% on Wednesday on news that the Union Cabinet has moved another step towards the merger of some of the state-owned banks. Bank consolidation has been on the cards for a long time, but the latest move will give it a push.

The Cabinet has given its in-principle approval to PSU bank mergers and a panel of ministers led by the finance minister will decide on the candidates and the scheme to create 10-15 large public sector banks by merging some of the state-owned lenders. Then the boards of the banks will have to initiate the consolidation process.

Ostensibly, the decision to go in for a merger lies with the individual bank boards. But the government is the largest shareholder and everybody knows it calls the shots.

A merger between a healthy bank and a zombie one risks dragging down the merged entity into the ranks of the Undead

Why is consolidation necessary? The accompanying chart shows that most of public sector banks have gross non-performing assets (NPAs) in excess of their net worth. They are generating no shareholder value. As independent expert Ashwin Parekh succinctly put it, “It is not a question of efficiency but that of survival."

With their net worth eroded, several PSU banks are in no position to lend. They are the walking dead of Indian banking. Unless something is done, these zombie banks will infect the entire economy. The decision to merge some of them is the government’s way of showing that something is being done.

Mergers, claim its votaries, will prevent erosion of capital and help banks meet higher requirements under Basel-III norms. More importantly, the government will be spared from spending money to recapitalise the banks—it will instead reach into the pockets of the better-off banks for the purpose.

Will the mergers lead to a healthy, vibrant state-owned banking sector? Sometimes mergers can be effective, but it will take time and expertise, luxuries state-owned banks lack. The costs will be front-loaded and the benefits will come later, if they come at all. Investors in some of the zombie banks will of course rejoice—a merger is a lifeline for them. But for the better-run banks, mergers with weak banks are a disaster. A merger between a healthy bank and a zombie one risks dragging down the merged entity into the ranks of the Undead.

Most public sector banks have exposure to the same set of stressed assets. A merger increases the concentration risk as the merged entity will end up holding a larger exposure to stressed sectors.

What the government risks creating through merging loss-making banks is the birth of a large loss-making entity. But that is just one set of problems.

It simply isn’t true that bigger banks are better. The Indian market itself has seen several smaller private banks that have a higher valuation than their larger peers.

On paper, PSU bank mergers are supposed to create the highest value for shareholders and increase efficiencies. But consider the facts on the ground: in India, even well-managed private sector banks have struggled to digest their acquisitions. Recently, State Bank of India (SBI) saw its fresh slippages soar in the quarter ended 30 June simply because its staff and those of its associates were preoccupied with rationalizing processes after the merger. As more and more man hours are involved in making sense of new systems, existing problems get ignored. This is something the banks cannot afford as the bad loan problem is akin to a ticking time bomb.

Also, since public sector lenders cannot fire excess staff, voluntary retirement benefits would punch a hole into their earnings in the short-term. Plus, which bank now has the money for a VRS? Add to that the problems with technology mismatches and, even more importantly, the very different cultures of two organizations.

Investors will soon realize that, for the state-owned banks, mergers and consolidation will amount to little more than putting lipstick on a pig.

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