The Reserve bank of India (RBI) is embarking on a paradigm change in the model that regulates the financial ecosystem in India particularly the investment banking sector. The main idea is obvious: removing a limit on domestic banks that are allowed to engage in M & A debt financing, RBI tries to increase the efficiency of the market, stimulating competition, and promoting the development of the corporations, especially the small and medium-sized enterprises (SMEs). The move to revise the policy is a major milestone that is changing the accessibility of capital to strategic acquisitions and is likely to bring about a significant surge in merger and acquisition (M&A) transactions.
The Current Landscape
Investment banking is a very essential facilitative role in corporations and is involved in mergers and acquisition, financing of IPOs, debt syndication and also restructuring of a business. One of the main activities is M&A where the bankers are required to carry out valuation, due diligence, deal structure negotiations (cash deal or equity deal), and overall planning of the entire transaction.
In the past, acquiring a company by a corporation was either financed by internal capital or debt (borrowing). Although M&A debt financing is of global origin dates back to 1955 (McCallum Industries, US), in India, it was ruthlessly curtailed after a certain crisis. This was a great blow in 2005 when the car company of Daewoo got a loan of 3400 crores, failed to repay, and the company retrieved only 380 crores.
This was a setback that made RBI bar Indian banks, such as HDFC, ICICI, Axis Bank, and SBI, from funding M&A deals based on debt. As a result, over the last almost twenty years, this highly profitable and strategically-important branch of lending has been monopolized by Multi-National Corporation (MNC) Indian banks, including Citi, HSBC, JP Morgan and Goldman Sachs.
The result of such a ban was a more inefficient domestic market. The RBI realised that its position despite its risk-averse approach was not in line with its fundamental principle of being a regulator rather than a prohibitor. The necessity to offer choices and to enhance the competitiveness has now made the regulatory body to overturn its limiting policy.
Core Analysis and Argument Development
The key decision is to enable Indian banks to fund M&A deals. This step goes in tandem with other major liberalisations: the Loans Against Shares (LAS) cap, which was 20 Lakh, has been increased four times to 1 Crore and even the IPO funding limits have been removed.
The Banking Opportunity: High Risk, High Reward
Opportunities:
Net Interest Margin (NIM) Growth: M & A debt financing is essentially classified as a high-risk loan. The risk profile of this kind of loans is very high; hence, they have a high interest rate that directly raises the Net Interest Margin of the bank. This boost has already been foreseen in the market early and there has been a movement of 3-5 percent in the market immediately after the news.
Increased Lending Book: The opportunity that banks can take part in M&A financing would greatly enlarge their lending books, which would have previously been lost to MNC banks. Corporates frequently maintain current and savings accounts in Indian banks, but used to be compelled to obtain M&A debt in the international institutions, which deprived domestic lenders the opportunity.
Improved Competitiveness: The measure is clearly geared towards the competitiveness of Indian banks in the rest of the world and domestically.
Risks and Regulatory Adjustments
Collateral and Share Price Volatility: The risk of lending to M&A is high due to the character of the collateral. The bank usually possesses the shares of the newly acquired company as collateral unlike the traditional assets that the bank owns. When the price of the share decreases by a large margin (i.e. a stock purchased at 400 is dropped to 170), the bank has to deal with the risk of the borrower defaulting since the price of the collateral will not be enough to wind the loan.
Capital Adequacy Norms: The Capital Adequacy Requirements to banks which have been involved in M&A financing will likely rise because of the risky nature of such loans. This will require banks to raise their funding needs and possibly offer greater credit support to RBI to counter defaults, as personal loans require greater reserves than mortgages.
Corporate Acceleration and SME Jackpot
The reforms serve as an effective motivating factor for mergers and acquirings to be a mainstream activity in the Indian corporate world. According to the sources, once funding opportunities are made easily accessible, such as accessibility of car loans in these times, it is natural to motivate corporations in order to make deals.
The direct beneficiaries will be smaller companies that are commonly referred to as SMEs, small-cap, or micro-cap corporations (e.g., companies with valuation of between 200 crores and 5000 crores). To such smaller companies, the prices of using the best advisory firms worldwide (such as PwC whose fees would eat their entire M&A budget of a 20-50 crore acquisition) were prohibitive. The smaller M&A transactions will be promoted by the liberalisation of debt access using domestic banks that are already the main partners of these firms.
Lastly, the government has a direct benefit of this improved deal flow in the form of increased tax returns and stamp duty payments that are experienced due to frequent buying and selling of corporations.
The Road Ahead and Strategic Implications
Implementation Schedule and Regulatory Buffer: Although the announcement has been made by the RBI, the implementation is not likely to take place right away. It is undergoing a public consultation stage. This is a gradual, slow process that gives banks time to prepare their capital reserves and risk models.
Most importantly, the RBI is conscious of the possibility of higher risk and market bubbles. The central bank has to juggle between the need to achieve growth and remain competitive and at the same time ensure that there is general financial stability. In case the institutions start using debt excessively in acquisition, regulation may come into force or increase capital requirements.
Mushrooming Demand of Specialised Professionals: Direct and positive effect of mainstreamed M&A activity will be an epidemic rise in the demand of professionals. M&A processes are also people processes (valuation, due diligence, and negotiation) and thus not automatable. Investors are expected to expect an increased demand of M&A specialists, valuation experts, due diligence professionals, and M&A tax experts.
This will also lead to the expansion of the boutique investment banking firms due to the increased deal activity especially among SMEs. These specialised smaller firms are more suited to the large number of smaller transactions that major global IBs are not economical to deal with.
Conclusion
When the RBI gave domestic banks permission to re-enter the M&A debt financing market, it was not simply a technical change but a strategic repositioning of the Indian corporate finance infrastructure. The shift to a regulatory position instead of a prohibitive one is an attempt by the central bank to rectify a market monetary inefficiency that has long existed, and purposely stimulate a new round of consolidation and expansion, which is being catalyzed by the ease of access to capital.
Although the immediate payoffs, including improved interest coverage by the banks, liquidity by the corporations, and demand in the financial professionals, are evident, the investors have to carefully follow the implementation process and scope on how the banks cope with the underlying risk of high interest, collateral-backed lending. This reform preconditions a more active and competitive new financial environment.
This new-found unlocked capital will determine the future of the Indian corporate scene as the ability of domestic banks to use this new-found freedom of capital responsibly will change the availability of market access into long-term economic growth.