My first business trip to India many years ago was a whirlwind affair. I’d gone to scout for investment opportunities and was determined to visit as many financial companies as I could. It was no easy task. There are lots of listed financial companies in India, all with different characteristics: state-owned banks, private banks, non-bank financial companies – each focused on a different segment or region, each with a different return and growth profile. In order to optimise my time, I asked local contacts for recommendations and one name consistently came up: HDFC.

Rather than a single meeting though, my visit to HDFC would require two meetings. For reasons that I would learn, ‘HDFC’ comprised two distinct organisations, each with its own management and balance sheet. One was a specialist in mortgage loans; the other did everything else. They were each leading companies in their field: HDFC had the country’s largest market share in mortgage loans, which it funded by raising finance in the wholesale markets; HDFC Bank was one of the highest return banks in the world, having grown its earnings at double digit rates consistently over many years.

I wondered why the two didn’t just merge to become a single unified entity. Unlike in the US where there is a liquid market for securitised mortgage loans, such a market doesn’t exist in India, making a bank’s balance sheet the optimal place to house mortgage loans. “Perhaps one day,” the vice chairman of HDFC told me.

Fifteen years later, it’s finally happened. This week, the two HDFCs announced a merger to create the largest private sector bank in India. The combined bank will have a loan book of US$240 billion, giving it a 15% share of system loans. While a tie-up may have been inevitable, the divergent paths the institutions took to get there allowed them to refine expertise in their respective fields. ‘HDFC’ provides an interesting case study in how to start a finance business from scratch in a highly regulated and volatile market.

HDFC

Before HDFC there was no real mortgage market in India. The company’s founder, Hasmukh Thakordas Parekh saw the potential for one while a student in London, but he didn’t do anything about it until the end of his career. A successful banker, he rose to become chairman of ICICI, one of India’s leading financial services companies, but his focus was largely on commercial lending. It was only when he retired, at the age of 69, that he decided to launch a company dedicated to mortgages. 

Initially, people thought he was mad – and not just for refusing an easy retirement. Friends cautioned that a general aversion to debt in the population would stifle demand, and an ineffective legal system would make it difficult to collect on bad loans. The stock market was no more welcoming of the idea. Venture capital wasn’t an option in those days, so Parekh was forced to go to the stock market to raise the Rs100 million required to start his business. He convinced his former employer, ICICI, to contribute 5%, and found two other investors willing to put in 5% each – the World Bank and the Aga Khan. But the IPO didn’t go well – the stock fell to a discount on listing. 

Parekh remained unperturbed. He convinced his nephew, Deepak Parekh to join him from Chase Manhattan Bank and together they hired fresh-faced graduates straight from college. “I can understand that at your age you are impatient, but give me a chance,” he pitched them. In September 1978, the newly formed Housing Development Finance Corporation Ltd made its first loan – the borrower a Mr. Remedios from Thane, who took a loan of Rs35,000 to build his own house.

Parekh brought an entirely new philosophy to retail financial services in India. He prioritised customer service, promising that the loan approval process would take six weeks rather than the painful 6-12 months it took at public sector banks. And he shunned the practice of bribes that borrowers elsewhere gave to speed up approvals – anyone offering a bribe had their application instantly rejected. 

Initially, borrowers came to HDFC to top up funds they’d sourced from elsewhere, typically their family or an employer. Employers would offer home loans at concessional rates, but often not in big enough size. Loans were made on a 13 year basis, although the general aversion to debt that Parekh’s friends had cautioned him about meant that many were paid back early. 

To tackle the other objection – that the legal system made it difficult to collect loans – HDFC underwriting standards addressed the borrower’s repayment capacity and not just the value of their home. For years, it was company policy not to lend more than a quarter of a borrower’s income. Even though loans could be extended up to 85% of the value of a home, the average loan-to-value in the early days was only 49% (today, it’s 69%). When loans did go bad, Parekh organised for a “follow-up” department to deal with them rather than the classic “recoveries” department, his guiding principle being that people want to stay current. In its first twenty years of operation, HDFC wrote off less than Rs76 million against disbursements of Rs202 billion. Its ratio of  non-performing assets to total assets was less than 1%. Today, the ratio is 2.3% on the basis of a more conservative accounting treatment. 

In its early days, HDFC didn’t have access to deposits, funding its loans exclusively in the wholesale markets. Throughout this period, management was cautious not to take undue risk. Even though 6% funding was available in US Dollars, the company swapped out that funding into Rupees at a 12% cost to avoid a currency mismatch. 

Later on, HDFC diversified its funding base by raising deposits. Not being regulated as a bank, it was unable to raise lower cost sight deposits; instead, through a network of agents, it went after term deposits. As in its lending business, HDFC’s edge was customer service. It awarded depositors their deposit certificate within days rather than the typical 3-6 weeks customary in the traditional banking sector. Today, around a third of HDFC’s funding is made up of deposits. The company’s total funding cost is around 5.8% which means that on an average 8.1% lending rate, it is able to extract a spread of 2.3%. 

For years, HDFC didn’t have any competition. But Parekh recognised that the demand for housing finance would outstrip any capacity he had to deliver it, so he partnered with state-owned banks to establish new housing finance companies. HDFC took a stake in three such companies and provided management training. Over the years these competitors came and went, but few of them exhibited the endurance of HDFC. It wasn’t until 1997 that competition truly started to take hold. Mortgage penetration was still only around 1% – compared with 46% in Hong Kong and 18% in Malaysia – but disposable income was increasing, interest rates were falling and the government was considering new policies to incentivise home ownership. Two large banks – State Bank of India and ICICI – began ramping up their mortgage operations. ICICI was particularly aggressive, hiring away several of HDFC’s middle managers and replicating its application form.

With funding costs higher than at banks, HDFC had to compete on other metrics. In its early days, it acquired new customers via referral and even twenty years into its life, 55% of customers still came via word-of-mouth. Marketing costs were therefore kept very low. Admin costs were also kept low as the company began to enjoy the benefits of scale. Over the 1990s, for example, assets grew by 7x but headcount grew by only 20%. At the beginning of the decade, HDFC’s expense-to-asset ratio remained below 1% but by the end, it was down below 0.50%. Today, it stands at 0.25%. The cost/income ratio of the institution, another popular gauge of efficiency, is just 8%.

HDFC Bank

Over the years, HDFC management had toyed with the idea of entering new markets adjacent to home loans. Traditional banking, though, was always out of the question because of tight government restrictions on banking licences. Following government nationalisation of fourteen large banks in 1969, followed by another six in 1980, no private bank had been allowed to set up shop. During this period, public sector banks expanded their networks extensively, adding numerous branches. Within two decades of nationalisation, government-owned banks accounted for 91% of the bank branches in the country and 85% of the total business done by the sector. The rest was shared by a handful of foreign banks and old private banks. 

However, in 1993, the Reserve Bank of India announced that it was changing course. “A stage has now been reached when new private sector banks may be allowed to be set up,” it declared.

HDFC was quick to act. Deepak Parekh, having taken over from his uncle as chairman of HDFC, flew to Malaysia to convince an old friend, Aditya Puri, a senior banker at Citigroup, to come on board as CEO of a new HDFC-backed bank. Puri agreed and together they recruited a team of executives from foreign banks, all keen on the chance to build something new.

The team knew that HDFC’s pedigree would give the bank a healthy foundation but they thought formal foreign influence would help burnish their reputation, so they pitched foreign banks to come in as a strategic investor. After discussions in London and New York, they sold a 20% stake to NatWest of the UK. HDFC retained 25% (it was limited by the Reserve Bank of India to a stake of no more than 40%) and the rest would be sold to the public. The team named the bank HDFC Bank – not a straightforward choice: Bank of Bombay and Everest Bank of India were also considered – and opened for business in 1995.

Puri’s vision was to create a “world class Indian bank”. Public sector banks had the advantage of distribution; foreign banks had the products. Puri wanted to combine the products and services of foreign banks with the relationships, funding and distribution networks of state-run banks. 

In its first year of operations, with barely any profits to show for it, the bank took this vision to the public in an IPO. Unlike in the case of HDFC many years earlier, this IPO went well. The deal was 55 times oversubscribed, and the stock popped by 300% on its first day of trading. “A lot of us asked why we weren't pricing it at a premium,” an executive told journalist Tamal Bandyopadhyay. “We could have got a premium but Deepak [Parekh] said, ‘leave money on the table for investors. They will appreciate this in the long term.’”

Initially, the bank’s focus was commercial banking. It’s what Puri and his team knew, and it required less investment in physical infrastructure to launch. The bank’s first customer was German electronics company Siemens; by the end of its first full year of operations, it had 50 corporate customers across its branches in Mumbai, Chennai, Delhi, Kolkata, Bangalore and Pune. 

To compete profitably in commercial banking without taking excessive risk, HDFC Bank had to keep its funding costs low. From the outset, a key part of the bank’s strategy was to raise low-cost deposits. The team devised a number of innovative solutions to achieve this. They offered a service to India’s network of cooperative banks to speed up their cheque clearing process as long as they maintained interest-free deposits as the bank. And they built an electronic processing system for funds that ran alongside the stock settlement system, winning them the cash management business of an entire ecosystem of capital markets participants.  

These days, one of the first ratios an Indian banks analyst will look at is the CASA ratio – the ratio of lower cost current account and savings account deposits at a bank to total deposits. It’s a ratio HDFC pioneered, highlighting it in every internal presentation since 1995. By 2000, HDFC Bank had a CASA ratio of 46% compared with 17-20% at peer banks. As a result, its cost of funds was 150-200 basis points lower than these banks, giving it a significant competitive advantage. 

Eventually, HDFC Bank widened its net from commercial banking to retail banking. “Once we started growing, we realised that we couldn't be a big bank dealing with only triple-A clients,” Puri tells Tamal Bandyopadhyay. “Also, if we wanted to enjoy economies of scale, we would have to fast track our retail banking franchise.”

The bank planned the expansion meticulously. After dealing with only the top 200 companies, the bank first targeted the suppliers and dealers of those companies. From there it gradually moved its threshold smaller and smaller, while also launching a series of retail banking products. By 2000, it was offering stock-based loans to complement its capital markets cash management business, car loans and personal loans. 

For many years the only missing piece was mortgage loans, because it didn’t want to compete with HDFC. But in 2004, the bank struck a deal with HDFC to become a distributor of HDFC mortgages for a fee of 0.7% of the loan. The bank also had the right to buyback 70% of the lonas it originated in order to bolster its own balance sheet. The arrangement was so successful that within ten years HDFC Bank was originating a quarter of total loans disbursed by HDFC.

One HDFC

The mortgage arrangement helped align interests between HDFC and HDFC Bank but over the years the question of a full merger was never far from the surface. Many finance institutions merged with the banking businesses they spawned. In 2002, ICICI, the project finance institution, merged with ICICI Bank; two years later, IDBI merged with IDBI Bank. However, in both cases the trigger was balance sheet weakness at the parent company, an issue that HDFC never experienced. 

In addition, regulatory restrictions made a merger difficult. A bank is constrained by reserve requirements imposed on it by the Reserve Bank of India. Applying those requirements over an enlarged balance sheet would be expensive. Banks are also required to allocate a percentage of lending to priority sectors; again on an enlarged balance sheet this would be tough to maintain. The flipside is the lower cost of funds that could be applied over the entire institution – CASA costs are a lot lower than the 5.8% that HDFC pays. 

After many years of “will they, won’t they”, this week the two institutions decided that the cost/benefit of a full merger makes sense. It will take some time to achieve regulatory approvals and there are still some questions over how the overall business will be structured. But under a single name, two of India’s best financial institutions finally come together.

My next business trip to India will be a lot more efficient.