RBI had questions about home loan agreement between HDFC and HDFC Bank

The regulator had been bringing up the issue of the unique agreement between

and HDFC Bank over a period as it thought the arrangement was not good for the industry from the structure as well as the risk point of view, claimed the three people who did not want to be identified.

“The RBI was getting uncomfortable with the arrangement,” one of them said. “There might have been other considerations like the regulatory convergence between NBFCs and banks, but the arrangement could not have remained for long once the regulator begins to question it. Better to end it before the regulator acted.”

HDFC Bank sources loans for the parent for a 1.10% fee and it has the right to buy 70% of the loans it originates. So far, except one year, the bank bought back 70% every year. The bank pays 75 basis points to HDFC for servicing the loans bought back from the parent.

The arrangement is similar for other banks with which HDFC has tie-ups where businesses are small compared to HDFC Bank. But banks such as

and do not buy back their full limit.

Some executives said regulatory issues were not the trigger for the merger.

“Since this loan buy back is a related-party transaction, the RBI scrutinises it more than normal,” said an HDFC executive who did not want to be identified. “Every year, there is a meeting with large conglomerates with substantial amounts of financial services businesses. This meeting also includes other regulators like Sebi, IRDAI and PFRDA. Three people from HDFC always attended these annual meetings which started with a business presentation and followed by questions on related party transactions. There has never been any questions or red flags raised by RBI on this arrangement.”

HDFC did not reply to an email seeking comment.

HDFC and HDFC Bank in April proposed to merge to create a financial services behemoth of nearly ₹13 lakh crore in market valuation, ending nearly two decades of speculation.

HDFC Bank said the opportunity in the market was the primary reason for the merger. “This presents substantial cross sell opportunities, particularly as 70% of HDFC Ltd’s customers do not bank with HDFC Bank. Also, about 5% of HDFC Bank’s customers take home loans from other sources,” it said in a statement.

Existence of two entities in the lending businesses restricted growth opportunities. Furthermore, the tightening of regulations for NBFCs narrowed the regulatory arbitrage for HDFC.

“Over the last two years, there have been regulatory changes for banks and NBFCs which have considerably reduced the barriers for a potential merger,” Deepak Parekh, chairman of HDFC, had said while announcing the merger in April.

“The strategic rationale for the proposed merger includes SLR CRR for banks, which was 27% and has now been reduced to 22% (18% for SLR and 4% for CRR). Interest rates are more favourable today than earlier years. The merger is coming together of equals.”

HDFC is the dominant shareholder in HDFC Bank with a 25.78% stake, which prevented the bank from selling mortgages to avoid conflict with the parent, which led to an arrangement in 2003, nine years after the bank was seeded. HDFC also owns stake in a mutual fund, life and general insurers, which would be owned by HDFC Bank post the merger.

“May be, they did not have the demand before that but since we were doing that business it was felt that two entities from the same group could not do the same business,” said the HDFC executive cited above. “The arrangement has now continued for 19 years.”

While the merger proposal is awaiting approval from the banking regulator, HDFC Bank chief executive Sashidhar Jagdishan is confident of securing it. “The structure that we have applied for is the structure that has been asked by the regulator,” he told analysts last week.

Analysts ranging from Nomura to ICICI Securities are upbeat about the merger and have a buy rating on the HDFC Bank stock.

“The bank now felt that conversion of mortgage from an agency product to an in-house product was required,” said Kunal Shah, analyst at ICICI Securities. “Home loan customers reflect potential of 7x deposit balance vis-à-vis those not availing home loans.”

As per Nomura Securities, the merged entity’s biggest challenge would be raising deposits to fund growth. “Generating liabilities to support this growth will be the limiting factor, according to management,” said Nomura’s Nilanjan Karfa. “To this end, management has called for deposit growth to exceed loan growth but without having to raise deposit rates competitively. Deposits will be mobilised by increasing the bank’s presence in areas where it has a very low wallet share. The management expects to add 1,500-2,000 branches per year.”