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Impact of merger and acquisition on the efficiency of Indian banks: a pre-post

analysis using data envelopment analysis

Article  in  International Journal of Financial Services Management · January 2014

DOI: 10.1504/IJFSM.2014.062287

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Int. J. Financial Services Management, Vol. 7, No. 1, 2014 1

Impact of merger and acquisition on the efficiency

of Indian banks: a pre-post analysis using data
envelopment analysis

A.R. Jayaraman*
Department of Statistics and Information Management,
Reserve Bank of India,
Bangalore 560 001, India
Email: arjayaraman@rbi.org.in
*Corresponding author

M.R. Srinivasan
Department of Statistics,
University of Madras,
Chennai 600 005, India
Email: mrsvasan8@hotmail.com

R. Arunachalam
Department of Economics,
University of Madras,
Chennai 600 005, India
Email: arunachal_r@rediffmail.com

Abstract: This paper examines the impact and efficiency of Indian banks
pursuant to merger and acquisition using data envelopment analysis. The
impact has been studied by comparing the efficiency of merged banks three
years before and after the merger. To validate whether change in efficiency of
banks is due to merger effect, this study compares the efficiency of merged
banks with non-merged banks. Further, through interval estimation, this paper
provides how close or far away the banks are from the efficient frontier. It is
observed that technical efficiency of merged banks deteriorated immediately
after the merger and showed improvement from the third year of post-merger
period. Further, the effect of merger and acquisition on the profitability and
operational cost of merged banks, in general, is not significant during the initial
phase of merger, i.e. initial three years.

Keywords: merger & acquisition; DEA; data envelopment analysis; efficiency;

banking.

Reference to this paper should be made as follows: Jayaraman, A.R.,

Srinivasan, M.R. and Arunachalam, R. (2014) ‘Impact of merger and
acquisition on the efficiency of Indian banks: a pre-post analysis using data
envelopment analysis’, Int. J. Financial Services Management, Vol. 7, No. 1,
pp.1–18.

Copyright © 2014 Inderscience Enterprises Ltd.

2 A.R. Jayaraman, M.R. Srinivasan and R. Arunachalam

Biographical notes: A.R. Jayaraman is working as Asst. Adviser at the

Department of Statistics and Information Management, Reserve Bank of India,
Bangalore. He is pursuing PhD from the Department of Statistics, University of
Madras. His few papers published in the area of banking and his area of interest
is banking and DEA.

M.R. Srinivasan is working as Professor and Head at the Department of

Statistics, University of Madras. Guided eight students for doctoral degrees and
six are working for PhD. Short-term assignments at the USA, Canada, UK,
Italy and ISI (India). Published around 40 papers in national and international
journals and attended many conferences in India and abroad.

R. Arunachalam is Professor and Head (Retd.), Department of Economics,

University of Madras. He has published papers in the area of rural development
and his area of specialisation is agrarian structure, monetary economics and
new economic policy issues.

1 Introduction

The financial sector industry, in particular, the banking industry has undergone significant
transformation all over the world since the early 1980s due to the impact of technological
developments, globalisation and deregulations. An important aspect of this process is the
consolidation of banks through mergers, amalgamations or restructuring of banks. While
in the developed countries the prime driving force behind merger and acquisition (M&A)
is market forces, in many of the Emerging Market Economies (EMEs) it has been driven
by the governments to restructure the banking systems. The Indian banking sector has
also undergone a metamorphic change following the economic reforms in early 1990s.
The reform process brought out a comprehensive change in the business strategy of
banks and the banks resorted to mergers and acquisitions to enhance the size, efficiency
and productivity. The second phase of banking sector reforms in 1998 initiated the
process of merger and acquisition and recommended that mergers between banks and,
between banks and DFIs and NBFCs need to be based on synergies and locational and
business-specific complementarities of the concerned institutions and must obviously
make sound commercial sense. The committee also recommended that mergers of public
sector banks are worthwhile only if they lead to rationalisation of workforce and branch
network. Moreover, the committee suggested that merger should not be seen as bailing
out of weaker banks and if need arises, the weak bank can be merged with another bank
after cleaning up their balance sheet. The Banking Regulation (BR) Act, 1949, provides
two types of amalgamations in Indian banking sector: (a) voluntary and (b) compulsory.
The compulsory amalgamations are induced or forced under the BR Act to take care of
the public interest. There have been several bank amalgamations in India in the post-
reforms period, especially after 1999, and there have been more than 35 M&As since the
nationalisation of banks in 1969.
In Indian context, there are few studies that analysed merger and acquisition of banks.
Further, to the best of the authors’ knowledge, there are no previous studies in Indian
context that deals with efficiency of merged banks vis-à-vis efficiency of equivalent non-
merged banks, which help to validate whether the increase or decrease in efficiency of
merged bank is the resultant of merger effect. This paper examines the impact of M&A
 Impact of merger and acquisition on the efficiency of Indian banks 3

on six Indian banks that had mergers during 2006–2008 using Data Envelopment
Analysis (DEA). The main objective of this paper is to: (a) measure the efficiency of
merged banks during pre-merger and post-merger periods and examine the effect of
merger, (b) compare the efficiency of merged banks with non-merged banks to validate
whether increase or decrease in efficiency of merged banks is due to merger effect, (c)
test whether the merged banks operate on efficient frontier during pre- and post-merger
periods, (d) calculate the confidence interval of technical efficiency and study how close
are the merged banks to the efficiency frontier, (e) study the efficiency gains after M&A
and, (f) study the effect of M&A on the profitability and operational cost of merged bank
during the post-merger.
The rest of the paper is organised as follows: to understand the general banking
developments in India during the period of study, Section 2 provides year-wise overall
performance of Scheduled Commercial Banks (SCBs). Section 3 discusses about merger
and acquisitions, various approaches to measure its effect and a brief literature review on
M&A of banks. Section 4 discusses about DEA and the models used in this paper and
Section 5 discusses the selection of input and output variables for the study. Section 6
discusses the empirical results of the study and the final section summarises the findings
and the conclusions from the study.

2 Performance of scheduled commercial banks in India

The business and financial performance of SCBs during 2003–2004 to 2005–2006 was
underpinned by strong macroeconomic environment and supporting monetary and
financial policies. The SCBs exhibited robust growth in terms of aggregate deposits and
gross bank credit during this period. The cost of funds, return on advances and net profit
of SCBs remained more or less same during this period.
The operations of SCBs during the year 2006–2007 were marked by a large
expansion of credit with some moderation. Aggregate deposits and loans & advances
grew by 24.6% and 30.6%, respectively, as compared with 17.8% and 31.8% during the
previous year. The investments of SCBs also registered a moderate growth of 10.6%
during this year. Due to continued high credit demand, there was an upward pressure on
lending rates as well as deposits rates during this year. The hardening of interest rates
caused increase in cost of borrowings and return on advances. Due to strong credit
growth, controlled operating expenses and sharp increase in net interest income of SCBs,
the net profits of SCBs increased sharply during this year.
The business and financial performance of SCBs during the year 2007–2008 was
shaped by macroeconomic performance. Aggregate deposits registered a lower growth of
23.1% as compared with 24.6% during previous year. The loans & advances decelerated
to 25.0% due to sharp decline in term loans. However, the investments recorded a high
growth of 23.7% as compared to 9.7% during previous year. Lending rates across various
bank groups showed a general upward movement during this year, while deposit rates
showed a general decline. Though there was a marginal decline in deposit rates, the cost
of deposits increased due to average cost of contracting deposits of different types and
maturity periods. There was a sharp increase in cost of funds and return on advances, as
compared to previous year. The net profits of SCBs registered a significant growth during
this year despite a large increase in provisions and contingencies.
4 A.R. Jayaraman, M.R. Srinivasan and R. Arunachalam

The year 2008–2009 was a testing period for Indian banking sector due to global
financial crisis and its repercussions. The Indian banking sector withstood this test and its
resilience was more than evident due to adoption of counter-cyclical prudential
regulations framework, both during credit boom as well as slowdown period. Though the
Indian banking sector was largely protected from the crisis by the policies, it was not
completely insulated from the effects of slowdown of economy. Due to overall slowdown
in the economy, both aggregate deposits and loans & advances decelerated to 22.4% and
21.2%, respectively, from 23.1% and 25.0% in the previous year. However, the overall
growth in investments remained more or less similar to previous year. In general, deposit
and lending rates of SCBs across various bank groups were on upward movement for
major portion of the year and there was reduction in these rates during the end. There was
a marginal increase in cost of funds and return on advances during the year. Net profits of
SCBs decelerated sharply compared to previous year, on account of sharp increase in
provisions and contingencies.
Indian banking sector witnessed a relatively sluggish performance during the year
2009–2010 and there were some concerns with respect to asset quality and deposits
growth of SCBs. The strong Capital to Risk-Weighted Assets Ratio (CRAR) of Indian
banks, above the Basel II requirement, provided the banks with adequate cushion for
their emerging losses. Due to slowdown in the economy, for the third consecutive year,
the aggregate deposits registered a decelerated growth of 17.0% as compared to 22.4% in
the previous year. Lower deposit rate, which prevailed for major part of the year, was one
of the reasons for decline in deposit growth. The continuous decelerated growth in
aggregate deposits affected loans and advances, which registered a decelerated growth of
16.6% as compared to 21.1% growth in the previous year. Further, the overall
investments of SCBs also recorded a decelerated growth during this year. During major
part of 2009–2010, the deposits rates of SCBs were on the declining trend and the
lending rates mostly remained unchanged. There was a significant decline in both cost of
funds and return on advances during the year and due to sharp decline in both income
and expenditure of SCBs, the net profit of SCBs recorded a very low growth as compared
to previous year.
The year 2010–2011 was again testing period for Indian banking sector because of
challenging operational environment such as high interest rates, tight liquidity conditions
and high inflation. The higher interest rate environment not only caused concerns about
slowdown in credit growth, but also caused concerns about the possibility of
deterioration in asset quality as well as weakening of the repayment capacities of
borrowers in general. The tight interest rate environment also affected the profit
prospects of commercial banks during this year. The aggregate deposits registered a
higher growth rate of 18.3% after three years continuous decelerated growth. This was
mainly due to accelerated deposits mobilisation of SCBs and increase in term deposits
rates. Despite the widespread concerns about slowdown in credit off-take, the loans &
advances of SCBs recorded higher growth of 22.9% as compared to 16.6% in the
previous year and this was due to higher growth in deposits as well as growth in capital.
The higher credit off-take resulted in overall investments decelerating to 10.8% as
compared to 18.6% in the previous year. As regard the lending rates, the base rate system
was introduced during this year in place of Benchmark Prime Lending Rate (BPLR). The
implementation of base rate system contributed to higher interest income of SCBs during
this year apart from robust credit growth. Table 1 provides the cost of funds and return on
funds of all SCBs during 2004–2011.
 Impact of merger and acquisition on the efficiency of Indian banks 5

Table 1 Select ratios of all SCBs

Ratios/Year 2004 2005 2006 2007 2008 2009 2010 2011

1 Cost of Deposits 4.9 4.2 4.1 4.4 5.4 5.7 5.5 5.0
2 Cost of Borrowings 2.5 2.4 3.0 3.3 3.6 3.9 1.7 2.3
3 Cost of Funds 4.8 4.1 4.0 4.3 5.3 5.5 5.1 4.7
4 Return on Advances 8.1 7.2 7.2 7.9 8.9 9.6 9.3 9.2
5 Return on Investments 8.2 7.8 7.7 6.9 6.6 6.4 6.5 6.8
6 Return on Funds 8.2 7.4 7.4 7.6 8.2 8.5 8.4 8.4
7 Spread (6–3) 3.4 3.3 3.3 3.2 2.9 3.0 3.3 3.7
Source: Trend and Progress of Banking in India

3 Merger and acquisition – types, motives and approaches to measure

the effect

The merger and acquisition provides greater scope for expansion of size of customer or
market or product base of business. It enhances the managerial and technological skills
and also helps to achieve greater economies of scale. In general, there are three major
forms of mergers: horizontal merger, vertical merger and conglomerate merger.
Horizontal merger is a combination of two or more firms in the same area of business.
Vertical merger is a combination of two or more firms involved in different stages of
production or distribution of the same product. Conglomerate merger is a combination of
firms engaged in unrelated lines of business activity.
There are several motives behind M&A activity as follow: (a) synergy,
(b) diversification, (c) strategic realignment (DePamphilis, 2010). The synergy motive
creates greater value for the new entity than two firms operating separately. There are
two basic types of synergy: (a) operating synergy and (b) financial synergy. While the
operating synergy is achieved through economies of scale and economies of scope; the
financial synergy is achieved through consolidation of firms with different cash flows
and investment opportunities. In the case of diversification motive behind M&A, firms
shift from their core area of operations either to related or unrelated area of operation.
Through strategic realignment motive, firms use M&A to adjust themselves to the
changes that arise out of regulatory environment and technological innovations. While
the change in regulatory environment creates competition among the firms, the
technological advances of the target firm provide buying firm to improve its technology
and expand their business and operations.
In general, there are four approaches to measure the effect of M&A (Bruner, 2002).
They are: (a) event studies, (b) accounting studies, (c) survey of executives and (d) clinical
studies. Events studies are also known as ex-ante studies, which examines the returns to
shareholders in the period close to announcement of merger. Accounting studies, also
known as ex-post studies, assess the merger effects by examining the financial performance
of acquiring firm before and after the acquisition. In the survey of executives, a
standardised questionnaire is presented to sample of executives and the results are
aggregated based on their opinion about mergers. Clinical studies are inductive research,
which are based on in-depth analysis combined with deriving insights from field
6 A.R. Jayaraman, M.R. Srinivasan and R. Arunachalam

interviews with executives and knowledgeable observers. Bruner (2002) discussed the
strength and weakness of above approaches. This paper uses ex-post approach to study
the impact of M&A.
There are a number of studies in European countries and USA relating to financial
institutions. Berger and Humphrey (1997) surveyed 130 studies that applied frontier
efficiency analysis to analyse financial institutions in 21 countries. Rhoades (1998)
summarised the nine case studies on efficiency effects of bank mergers that took place
during early 1990s. It is observed that the combined firm achieved the cost cutting
objectives in reasonable time through the cost reductions associated with staff reductions,
data processing system and operations. Out of the nine mergers, four are successful in
improving their cost efficiency. The study noted that a strong commitment to cost cutting
and a relatively efficient acquiring firm are important contributors to a merger, having
a favourable effect on efficiency. Similarly, Berger et al. (1999) studied the causes,
consequences and future implication of financial services industry consolidation by
reviewing more than 250 research literature.
Sufian (2006) studied the efficiency effects of M&A on five Singapore banks using a
non-stochastic window event analysis. It is observed that merger has resulted in higher
overall mean efficiency in post-merger period relative to pre-merger period. Although
mergers have resulted in a more efficient banking system in Singapore, it is observed that
size has become the biggest factor resulting in the inefficiency of Singapore banking
groups. The study also suggests that any further consolidation of Singapore bank to
create ‘super banks’ may not result in desired output from scale efficiency prospective.
Xiao and Li (2008) studied the impact of M&A using DEA for top four Chinese and
five US commercial banks. They observed that M&A has greater impact on banking
efficiency of Chinese banks than US banks. They noted that M&A is an important path in
Chinese banking industry to develop and it can enhance the management efficiency and
core competitiveness of Chinese banking industry.
Al-Sharkas et al. (2008) studied the cost and profit efficiency effects of bank mergers
on the US banking industry. They observed that the bank mergers, in general, result in
increased cost and profit efficiency. Further, the merged banks have lower cost than non-
merged banks because of use of most efficient technology and cost minimising input
mix. Also, they observed that merged banks experience greater productivity growth as
compared to non-merged banks. Malhotra et al. (2009) analysed the performance of
seven North American freight railroads using financial ratios in DEA.
The following M&A studies are related to Indian banking sector. Mantravadi and
Reddy (2008) studied the impact of type of merger on the operating performance of
acquiring firms in India during 1991–2003 and observed that though there is no change
in mean operating profit margins and gross profit margin ratios in the pre- and post-
merger period, there is a decline in the net profitability, return on net worth and return on
capital employed. They also observed that operating performance of merging firms either
stagnate or decline after mergers.
Kaur and Kaur (2010) examined the impact of mergers on the cost efficiency of
Indian commercial banks using DEA. They observed that the merger has lead to higher
level of cost efficiency of merged banks, while the merger between distressed and
stronger banks did not yield any significant efficiency gains. Further, they opined that the
stronger banks should not merge with the weaker banks, as the weaker banks will have
adverse effect upon the asset quality of the stronger banks.
 Impact of merger and acquisition on the efficiency of Indian banks 7

Ravichandran et al. (2010) analysed the CRAMEL–type variables that affect the
performance of Indian banks, before and after merger using regression analysis and
factor analysis. They observed that two variables that significantly affect the performance
of the banks are advances to total assets and profit margin. Also, the profitability of the
banks is significantly affected giving a negative impact on the returns.
Sinha et al. (2010) studied the post M&A performance of selected financial
institutions in India using four parameters: overall profitability, liquidity, solvency and
overall efficiency and observed that there is a significant correlation between financial
performance and merger deals in India. In the long run, the acquiring firms are able to
generate value creation in one form or the other.
Sinha and Gupta (2011) observed that M&A in Indian financial services sector has
positive effects on the profitability in most of the mergers, but the liquidity position
deteriorated in a period of three years after the merger. They analysed 80 cases of M&A
using a set of ten financial parameters representing the various characteristics of a firm,
both individually and collectively. The study reveals that though companies have been
able to leverage the synergies arising out of M&A, they are unable to manage their
capital structure to improve their liquidity.

4 Data envelopment analysis

DEA is most widely used non-parametric technique to measure the efficiency of Decision
Making Units (DMUs). The technique of measuring technical efficiency of DMUs was
first proposed by Charnes, Cooper and Rhodes (CCR) in 1978 and later extended by
Banker, Charnes and Cooper (BCC) in 1984. There are several advantages of using DEA
to study the efficiency of DMUs over other parametric methods. First, DEA enables to
estimate efficiency from the complex production structure with multiple inputs and
outputs. Second, it allows the choice of input–output bundle depending on the managerial
concerns. Third, it is unit invariant, thus allows the choice of input–output bundle to be
different unit of measurement. Fourth, it does not assume any explicit functional form for
production function like parametric methods. And finally, it uses maximum of a ratio of
weighted outputs to weighted inputs, where weights are determined by the model so that
it gives maximum possible score for each DMU and hence does not require a prior
specification of weights. On the other hand, DEA has few limitations such as high
sensitivity to data error and outliers, inability to capture random effects (Wanniarachchige
and Suzuki, 2011).
The efficiency scores obtained by using CCR DEA model are known as Overall
Technical Efficiency (OTE) or simply technical efficiency (TE) and the efficiency scores
obtained by using BCC model are known as Pure Technical Efficiency (PTE). A DMU is
said to be technically efficient only if it operates on the efficient frontier, otherwise the
DMU is technically inefficient and the measure of TE helps to determine whether the
inefficiency is due to input–output mix or scale of operations or both. This is identified
by decomposing the TE into PTE and scale efficiency (SE). The scale efficiency is
defined as the ratio of TE to PTE. While the PTE provides a measure of managerial
performance (i.e. managerial efficiency) in organising the DMU’s inputs and outputs, the
SE provides a measure of ability of the management to choose the optimum size of
resources to choose the scale of production that will attain the expected production level.
The technical inefficiency caused by managerial underperformance (i.e. managerial
8 A.R. Jayaraman, M.R. Srinivasan and R. Arunachalam

inefficiency) and inappropriate size of DMUs are known as pure technical inefficiency
and scale inefficiency, respectively. The scale inefficiency is classified into: (a) decreasing
return-to-scale and (b) increasing return-to-scale. Decreasing return-to-scale implies that
a DMU is too large to take full advantage of scale and has supra-optimum scale size and
the increasing return-to-scale implies that a DMU is too small for its scale of operations
and, thus, operates at sub-optimum scale size (Kumar and Gulati, 2008).
Consider there are N banks producing m outputs yj = (y1j, y2j,…, ymj) from the given n
inputs xj = (x1j, x2j,…, xnj) (j = 1, 2, …, N). The output-oriented CCR DEA model for the
given input-output bundle is defined as (Ray, 2004):

     S   S  
n m
Max   i  r 
 i 1 r 1 
subject to
N

x
j 1
ij  j  Si  xi 0 i  1, 2,  n

y
j 1
rj  j  S j y j 0 r  1, 2,  m (1)

j  0 j  1, 2, , N

where Si and S j are the input and output slacks, respectively. Presence of input and/or
output slack in the optimal solution implies scope for improving the efficiency of a bank
by means of input reduction and/or output increase. The output-oriented technical
efficiency of a bank is defined as: TECRS 1 * .
The output-oriented technical efficiency under BCC model is obtained by introducing
a constrain   j  1 on the CCR DEA model. This technical efficiency under BCC
model is known as PTE and it is defined as: TE 1   * . The scale efficiency is defined as
VRS

the ratio of TE under CRS over VRS, i.e. SE = TECRS/TEVRS.

Any difference between TE and PTE scores indicates the existence of scale
inefficiency. To identify the nature of return-to-scale, the output-oriented technical
efficiency under Non-Increasing Returns to Scale (NIRS) is compared with TE and CRS
and VRS. The output-oriented technical efficiency of a bank under NIRS obtained by
introducing a constraint   j  1 on the CCR DEA model and the technical efficiency
under NIRS is defined as: TE  * . The nature of returns to scale is ascertained by
1  NIRS

comparing the TE scores under CRS, VRS and NIRS models.

 If TENIRS = TECRS, but differs from TEVRS then the bank is said to have increasing
returns to scale.
 On the other hand, if TE NIRS = TEVRS but differs from TECRS then the bank is said to
have decreasing returns to scale.
 And if all three TE coincide, i.e. TECRS = TEVRS = TENIRS, then the bank is said to
have constant returns to scale.
 Impact of merger and acquisition on the efficiency of Indian banks 9

To test whether the merged banks are operating on efficient frontier during pre- and post-
merger periods, t-test has been used to test the hypothesis H0: TE = 1. The upper limit of
95% CI provides how close or far away the merged banks are from the efficient frontier.
If the upper limit of CI is above 1, it indicates merged banks are sure to achieve the
efficiency score 1 depending on the variability in the data. The larger the variability,
faster the bank may achieve the efficiency and the smaller the variability, the bank may
take longer time to achieve the efficiency. This is under the assumption that given
scenario of operation persists for the given set of input–output variables, when the time
horizon expanded either side, i.e. pre- and post-merger periods. If the upper limit of CI is
less than 1, it may be difficult for the banks attain the efficiency frontier under the above
assumptions, unless the bank adopts appropriate measures to improve its efficiency. The
use of input and output slacks in this case may help the bank to improve and attain the
efficiency frontier.
Following Paradi et al. (2011), in this paper, the potential technical efficiency gains
of the banks are estimated by comparing the technical efficiency of the post-merger unit
to the corresponding pre-merger efficiencies of the merging banks. The change in
technical efficiency (TE) is calculated as the difference between the technical efficiency
of the merged unit (TEM) and the weighted sum of the pre-merger technical efficiencies
of the two banks (TE1 and TE2), i.e.
TE = TEM – (w1 * TE1 + w2 * TE2) (2)
where w1 and w2 are the weights for the two banks before the merger and w1 + w2 = 1.
The weights are based on total assets (TA), such that wi = TAi/(TA1 + TA2), where i
denotes the bank 1 or bank 2 involved in the merger.
Further, to test the change in the profitability/efficiency indicators in sample banks
during the post-merger period, paired t-test has been used to determine whether an effect
exists or not. Following two variables, viz. Return on Assets (ROA) and operating cost to
assets ratio have been chosen to study the effect of M&A. Given the fact that
mergers/amalgamations are envisaged to lead to synergy effects, ROA is expected to
increase while operating cost to assets ratio is expected to decrease during the post-
merger period. Statistical significance of increase/decrease in the parameter can be
inferred using paired t-test.

5 Selection of input and output variables

The selection of inputs and outputs plays a crucial role in measuring the efficiency of
banks. However, identification of inputs and outputs for banks is not straight forward due
to their inter linkages. Production and intermediation are the two approaches used in
DEA to study the efficiency of banks. While production approach uses deposits and
advances as outputs using capital and labour as inputs, the intermediation approach uses
deposits, investments and advances as outputs and operational and interest expenses as
inputs. Berger and Humphrey (1997) suggested that the production approach might be
more suitable for branch level efficiency studies whereas intermediation approach is well
suitable for measuring bank level efficiency. Intermediation approach is the most widely
used method to study the impact of M&A on the efficiency of banking sector. The
following set of variables are frequently used by the researchers in different combinations
either directly or with derived variables to study the efficiency banks, which are: (a)
10 A.R. Jayaraman, M.R. Srinivasan and R. Arunachalam

labour, (b) equity, (c) deposits, (d) borrowings, (e) advances, (f) investments, (g) total
assets, (h) interest earned, (i) interest expended, (j) operating expenses and (k) profit &
loss.
Hollingsworth and Smith (2003) suggested that ratios may be used as inputs and
outputs in DEA, if the nature of data availability is mostly ratios or the ratios reflect the
underlying production function accurately rather than absolute values. The present study
uses following ratios: (a) cost of deposits, (b) cost of borrowings, (c) return on advances,
and (d) return on investments, in DEA to examine the effect of M&A on the efficiency of
banks. The rationale behind using the above ratios in this study are: (a) they capture the
essence of the variables listed above, (b) they reflect the qualitative performance of each
of the merged bank across the study period and (c) they depict the underlying business
performance of the merged bank. Apart from the above ratios, the study has also included
number of bank branches, as one of the variable, geographical expansion, is a natural
outcome of bank mergers with additional business. All the above ratios, except number
of bank branches, have been calculated after deflating the data by GDP deflator. The
Mann–Whitney (M-W) test has been used to identify the variables which are significant
and the variables that are significant have been used in DEA to measure the efficiency of
merged and non-merged banks. In this study, following six Indian bank mergers that took
place between 2006 and 2008 have been analysed (Table 2).
Table 2 Bank mergers during 2006–2008

Year Target Bank Acquirer Bank Motive

2006 Ganesh Bank of Kurandwad Federal Bank Restructuring of weak bank
2006 United Western Bank IDBI Bank Restructuring of weak bank
2007 Bharat Overseas Bank Indian Overseas Bank Restructuring of weak bank
2007 Sangli bank ICICI Bank Expansion of size
2008 Centurion Bank of Punjab HDFC Bank Expansion of size
2008 State Bank of Saurashtra State Bank of India Expansion of size
Source: Trend and Progress of Banking in India

The impact of M&A on the efficiency of these banks has been analysed by comparing
their performance with three years before and after the merger. Data have been divided
into two groups: pre- and post-merger group, according to each individual bank’s merger
period. If the merger was before the middle of financial year, then that financial year is
considered as starting period for post-merger analysis and if the merger was after the
middle of financial year, then that financial year is considered as pre-merger period
(Ravichandran et al., 2010).
To validate the effect of merger, this paper also compares the efficiency of merged
bank with an equivalent non-merged bank. A non-merged bank is one which is not
engaged in any form of merger and whose total asset is close to that of merged bank
during the year of merger. The corresponding non-merged bank for merged bank is as
follows: (a) Federal Bank–State Bank of Mysore, (b) IDBI Bank–Union Bank of India,
(c) Indian Overseas Bank–Axis Bank and (d) HDFC Bank–Canara Bank. For State Bank
of India, ICICI Bank being the closest comparison and both are merged banks, they are
excluded from this comparison. The data have been collected from various issues of
statistical tables relating to banks in India, trend and progress of banking in India and
statistical tables relating to banks in India 1979–2009 (Historical Data for 30 years) – CD
ROM. This paper uses MS-Excel solver to calculate the efficiency of the banks (Zhu, 2009).
 Impact of merger and acquisition on the efficiency of Indian banks 11

6 Empirical results and discussion

Mann–Whitney test results (Table 3) show that out of the five variables selected for the
study, three variables are significant. They are: (a) cost of deposits, (b) return on
advances and (c) number of bank branches. These three variables have been used in the
DEA models to measure the efficiency of both merged and non-merged banks. Results of
DEA models are presented in Tables 4 and 5.
Table 3 Results of Mann–Whitney test

Variables Mann–Whitney U Z Sig.

Cost of Deposits (COD) 38 –3.923 0.000*
Cost of Borrowings (COB) 154 –0.253 0.815
Return on Advances (RADV) 68 –2.974 0.003*
Return on Investments (ROI) 141 –0.664 0.521
Number of Bank Branches (No_Br) 93 –2.813 0.029*
Notes: *Significant at 1% and 5% level.

Table 4 Efficiency scores of merged banks

Bank Name Year Merger Period TE PTE TE-NIRS SE Returns to Scale

2004 1.0000 1.0000 1.0000 1.0000 CONST
2005 Pre 1.0000 1.0000 1.0000 1.0000 CONST
2006 1.0000 1.0000 1.0000 1.0000 CONST
Federal Bank
2007 0.9526 0.9534 0.9534 0.9992 DECR
2008 Post 0.9168 0.9333 0.9333 0.9823 DECR
2009 0.9700 1.0000 1.0000 0.9700 DECR
2005 1.0000 1.0000 1.0000 1.0000 CONST
2006 Pre 1.0000 1.0000 1.0000 1.0000 CONST
2007 0.9225 1.0000 1.0000 0.9225 DECR
IDBI Bank
2008 0.7527 0.9719 0.9719 0.7745 DECR
2009 Post 0.6865 1.0000 1.0000 0.6865 DECR
2010 0.6711 0.9203 0.9203 0.7292 DECR
2005 1.0000 1.0000 1.0000 1.0000 CONST
2006 Pre 0.9672 1.0000 0.9672 0.9672 INCR
Indian Overseas 2007 1.0000 1.0000 1.0000 1.0000 CONST
Bank 2008 0.9392 0.9804 0.9804 0.9579 DECR
2009 Post 0.8835 0.9926 0.9926 0.8901 DECR
2010 0.9058 1.0000 1.0000 0.9058 DECR
2005 1.0000 1.0000 1.0000 1.0000 CONST
2006 Pre 0.9304 1.0000 0.9304 0.9304 INCR
2007 0.7791 0.8788 0.8788 0.8865 DECR
ICICI Bank
2008 0.6782 0.9562 0.9562 0.7093 DECR
2009 Post 0.6371 1.0000 1.0000 0.6371 DECR
2010 0.6821 1.0000 1.0000 0.6821 DECR
12 A.R. Jayaraman, M.R. Srinivasan and R. Arunachalam

Table 4 Efficiency scores of merged banks (continued)

Bank Name Year Merger Period TE PTE TE-NIRS SE Returns to Scale

2006 0.9888 1.0000 0.9888 0.9888 INCR
2007 Pre 1.0000 1.0000 1.0000 1.0000 CONST
2008 0.9742 1.0000 1.0000 0.9742 DECR
HDFC Bank
2009 0.9243 1.0000 1.0000 0.9243 DECR
2010 Post 0.8869 0.9497 0.9497 0.9339 DECR
2011 0.9492 0.9693 0.9693 0.9793 DECR
2006 0.8927 1.0000 0.8927 0.8927 INCR
2007 Pre 0.9441 1.0000 0.9441 0.9441 INCR
State Bank of 2008 1.0000 1.0000 1.0000 1.0000 CONST
India 2009 0.9883 1.0000 1.0000 0.9883 DECR
2010 Post 0.9293 0.9718 0.9718 0.9563 DECR
2011 0.9404 0.9494 0.9494 0.9905 DECR

Table 5 Efficiency scores of non-merged banks

Bank Name Year TE PTE TE-NIRS SE Returns to Scale

2004 1.0000 1.0000 1.0000 1.0000 CONST
2005 1.0000 1.0000 1.0000 1.0000 CONST
State Bank of 2006 1.0000 1.0000 1.0000 1.0000 CONST
Mysore 2007 0.9928 0.9959 0.9959 0.9969 DECR
2008 0.9659 0.9791 0.9791 0.9865 DECR
2009 0.9667 1.0000 1.0000 0.9667 DECR
2005 0.9580 1.0000 0.9580 0.9580 INCR
2006 0.9729 1.0000 0.9729 0.9729 INCR
Union Bank of 2007 1.0000 1.0000 1.0000 1.0000 CONST
India 2008 1.0000 1.0000 1.0000 1.0000 CONST
2009 1.0000 1.0000 1.0000 1.0000 CONST
2010 0.9912 0.9916 0.9916 0.9995 DECR
2005 1.0000 1.0000 1.0000 1.0000 CONST
2006 0.9632 0.9646 0.9646 0.9985 DECR
2007 0.9546 0.9618 0.9618 0.9926 DECR
Axis Bank
2008 0.9872 0.9986 0.9986 0.9885 DECR
2009 0.9691 1.0000 1.0000 0.9691 DECR
2010 0.9802 1.0000 1.0000 0.9802 DECR
2006 1.0000 1.0000 1.0000 1.0000 CONST
2007 0.9982 0.9994 0.9994 0.9989 DECR
2008 0.9871 0.9929 0.9871 0.9942 INCR
Canara Bank
2009 1.0000 1.0000 1.0000 1.0000 CONST
2010 0.9732 1.0000 1.0000 0.9732 DECR
2011 0.9783 1.0000 1.0000 0.9783 DECR
 Impact of merger and acquisition on the efficiency of Indian banks 13

The efficiency scores of Federal Bank indicate though the bank is on the efficient frontier
during pre-merger period, there is a marginal decline in technical efficiency during the
post-merger period. The average TE and t-value (Table 6) during the post-merger
suggests that the bank is on the efficient frontier. The corresponding non-merged bank,
State Bank of Mysore also shows similar results as that of Federal Bank during pre- and
post-merger periods.
Table 6 CI of TE and Avg. input slack

95% Confidence Avg.

Merger Interval Slack
Bank Name Mean Std. Dev. t-values
Period
Lower Upper No_Br
Pre 1.0000 0.0000 – – – 0
Federal Bank
Post 0.9465 0.0271 –3.418 0.8791 1.0138 24
Pre 0.9742 0.0447 –0.9997 0.8630 1.0853 217
IDBI Bank
Post 0.7034 0.0434 –11.848 * 0.5957 0.8111 295
Pre 0.9891 0.0189 –0.9989 0.9420 1.0361 0
Indian Overseas Bank *
Post 0.9095 0.0280 –5.590 0.8399 0.9791 0
Pre 0.9032 0.1129 –1.485 0.6226 1.1837 89
ICICI Bank
Post 0.6658 0.0249 –23.218 * 0.6039 0.7277 497
Pre 0.9877 0.0129 –1.651 0.9555 1.0198 10
HDFC Bank
Post 0.9201 0.0314 –4.411 * 0.8422 0.9980 835
Pre 0.9456 0.0537 –1.756 0.8123 1.0789 0
State Bank of India
Post 0.9527 0.0314 –2.615 0.8748 1.0306 1614
Notes: * Significant at 5% level.

Results of IDBI Bank show that though the bank is on the efficient frontier during 2005–
2006, there is a sharp decline in technical efficiency since 2008. The average TE
declined sharply from 0.97 (pre-merger) to 0.70 (post-merger) and the significant t-value
(t = –11.848, p = 0.05) suggests that the bank is below the efficient frontier after merger.
The sharp decline in efficiency is due to the scale inefficiency. It is observed that the
corresponding non-merged bank, Union Bank of India, is on the efficient frontier during
the post-merger period.
The performance of Indian Overseas Bank shows a decline in TE during the post-
merger period. The average TE declined from 0.99 (pre-merger) to 0.91 (post-merger)
and the significant t-value (t = –5.591, p = 0.05) during post-merger suggests that the
bank is below the efficient frontier and it is due to scale inefficiency. Axis bank, which is
the corresponding non-merged bank, also shows similar results during the post-merger
period.
The efficiency scores of ICICI Bank show that there is a significant decline in TE
since 2006. The average TE declined significantly from 0.90 (pre-merger) to 0.67 (post-
merger) and the significant t-value (t = –23.218, p = 0.05) during the post-merger
suggests that the bank is far away from the efficient frontier. The sharp decline in TE
during post-merger is due to the scale inefficiency. It may be noted that during the year
2010, Bank of Rajasthan merged with ICICI Bank and the effect of the merger has an
influence on the performance of the bank.
14 A.R. Jayaraman, M.R. Srinivasan and R. Arunachalam

In case of HDFC bank, the efficiency is below the efficient frontier during the period
of study, except for the year 2007. There is a decline in average TE during pre- and post-
merger period and the significant t-value (t = –4.411, p = 0.05) during the post-merger
indicates that the bank is below the efficient frontier. The decline in efficiency during the
post-merger is due to mix of both pure technical inefficiency and scale inefficiency.
Canara bank, the corresponding non-merged bank, also exhibits similar results.
Results of State Bank of India show that there is a fluctuation in the efficiency scores
during the period of study. The average TE remained close to 0.95 during both pre-and
post-merger period and the t-values suggest that the bank is on the efficient frontier. In
general, below performance is due to scale inefficiency of the bank. It may be noted that
State Bank Indore merged with State Bank of India in the year 2010 and the effect of the
merger has an influence on the performance of the bank.
Results of H0: TE = 1, i.e. average efficiency not differs from 1, examined for both
pre-merger and post-merger individually show that the banks are on the efficient frontier
before the merger, but they are below the efficient frontier after the merger (Table 6).
The confidence interval of TE shows how close the merged banks are to the efficient
frontier. If the upper confidence limit is above 1, it indicates merged banks are sure to
achieve the efficiency score 1 under the assumption that given scenario of operation
persists for the given set of input–output variables when the time horizon expanded. If
the upper confidence limit is less than 1, it may be difficult for the banks to attain the
efficiency frontier under the above assumptions, unless the bank adopts appropriate
measures to improve the efficiency. In the case of Federal Bank and State Bank of India,
it is observed that the upper confidence limit is above 1 and it is expected to achieve the
efficiency with the passage of time. In the case of IDBI Bank, Indian Overseas Bank,
ICICI Bank and HDFC Bank, the upper confidence limit is below 1, which indicates that
these banks need to incorporate appropriate measures, i.e. optimally use their inputs
and/or outputs, to move towards the efficiency frontier. In general, input slack is
observed for number of branches for all the merged banks during the post-merger period.
It implies that the merged banks have to use their bank branch expansion and network
arises out of M&A optimally to improve the efficiency (Table 6). Further, it is also
observed that there is no output slack for the merged banks during the period of study.
In order to estimate the potential TE gains due to merger, the weights for the target
and acquirer bank before merger have been calculated which is presented in Table 7. The
weights of the banks are calculated from the total assets of the target and acquirer bank
prior to merger and the weight determines the potential gains due to merger. It can be
observed from Table 7 that acquirer bank weights are vital in determining the potential
TE gains of merged banks. While the acquirer bank weights are in the range of 0.83–
0.99, the target bank weights are in the range of 0.01–0.17. Except Centurion Bank of
Punjab, the weight (w1) of all the other target banks is below 0.1.
Table 7 Weights of the Banks

Target Bank w1 Acquirer Bank w2

Ganesh Bank of Kurundwad 0.0121 Federal Bank 0.9879
United Western Bank 0.0725 IDBI Bank 0.9275
Bharat Overseas Bank 0.0492 Indian Overseas Bank 0.9508
Sangli Bank 0.0066 ICICI Bank 0.9934
Centurion Bank of Punjab 0.1683 HDFC Bank 0.8317
State Bank of Saurashtra 0.0303 State Bank of India 0.9697
 Impact of merger and acquisition on the efficiency of Indian banks 15

Further, the potential TE gain of acquirer bank has been calculated for the entire post-
merger period using equation (2) which is presented in Table 8. The potential technical
efficiency gains of merged banks declined during the second year of the post-merger
period and show a marginal improvement in the efficiency gains during the third year,
except for IDBI Bank.
Table 8 Potential TE gains

Bank Name Year Gain

2007 –0.0474
Federal Bank 2008 –0.0832
2009 –0.0300
2008 –0.1754
IDBI Bank 2009 –0.2416
2010 –0.2570
2008 –0.0608
Indian Overseas Bank 2009 –0.1165
2010 –0.0942
2008 –0.1024
ICICI Bank 2009 –0.1435
2010 –0.0985
2009 –0.0073
HDFC Bank 2010 –0.0447
2011 0.0176
2009 –0.0108
State Bank of India 2010 –0.0698
2011 –0.0587

The effect of merger and acquisition on the profitability and operational cost of merged
banks in the post-merger scenario has been examined using paired t-test. The two
variables used to study the effect of merger are: ROA and operating cost to total assets
ratio (OCA) and result is presented in Table 9.
Table 9 Changes in ROA and OCA

Bank Name  ROA t-statistic (ROA) S/NS  OCA t-statistic (OCA) S/NS
Federal Bank 0.4667 3.11 NS –0.3267 –17.60 S
IDBI Bank –0.1033 –4.43 S 0.0733 0.65 NS
Indian Overseas Bank –0.3200 –1.23 NS –0.4333 –1.93 NS
ICICI Bank –0.2133 –1.68 NS –0.4367 –2.30 NS
HDFC Bank 0.1200 1.08 NS 0.1000 0.27 NS
State Bank of India –0.0367 –0.27 NS –0.2533 –1.32 NS
Notes: S/NS denotes Significant/Not Significant at 5% level.
16 A.R. Jayaraman, M.R. Srinivasan and R. Arunachalam

It is observed that change in the average ROA during the post-merger period over pre-
merger period is positive for only two banks: Federal Bank and HDFC Bank but not
significant. In the case of IDBI Bank it is negative and significant indicates that the
profitability of the bank significantly deteriorated after the merger. The merger effect in
terms of decline in operating expenditure measured by means of operating cost to total
assets ratio during post-merger period is found to be significant for only one bank, i.e.
Federal Bank. It indicates that the operational cost of Federal Bank declined sharply
during the post-merger period, as expected from the M&A. However, for the other banks,
the change is not significant, reflecting that these banks could not realise the merger
effect in terms of operating cost emanating from the M&A during the initial three years
of merger.

7 Summary findings & conclusion

During the period of study, the Indian banking sector experienced the effect of global
financial crisis. The strong capitalisation of Indian banks provided an adequate cushion
for the bank’s credit risk profile during this period. In general, the overall performance
of SCBs was affected due to high interest rate regime, and tight liquidity, and the
profitability of the SCBs was also under pressure during the post crisis period. The main
limitation of this study is that it could not differentiate the effect of crisis and extraneous
factors from the effect of merger.
From the empirical results, it is observed that: (a) the technical efficiency of merged
banks deteriorated immediately after the merger and showed improvement from the third
year of post-merger period, (b) the underperformance of the merged banks during post-
merger period is mostly due to scale inefficiency rather than pure technical inefficiency,
(c) in general, decreasing returns to scale was the predominant form of scale inefficiency
for both merged and non-merged banks during the post-merger period, which indicates
there is a similarity in the performance of banks in these groups during the post-merger
period, (d) hypothesis results show that four banks out of six were operating below the
efficient frontier during post-merger scenario; in contrast to all the banks operating on the
efficient frontier prior to merger, (e) the confidence interval of IDBI Bank, Indian
Overseas Bank, ICICI Bank and HDFC Bank points out that these banks need to
incorporate appropriate measures to attain the efficiency frontier in the post-merger
scenario, (f) the presence of input slack for number of branches indicates that banks can
improve their efficiency by optimally utilising the branch network, (g) potential technical
efficiency gains of merged banks declined during the second year of the post-merger
period and show a marginal improvement in the efficiency gains during the third year,
and (h) in general, the effect of merger and acquisition on the profitability and
operational cost of merged banks was not significant during the initial three years of
merger.
From the above observations, we may conclude that (a) the efficiency of merged banks
in the post-merger scenario can be improved by optimally utilising the inputs, (b) the
similarity between performance of both merged and non-merged banks during post-
merger period shows that the under- or over-performance of merged banks cannot be
purely attributed to effect of merger and (c) the study cannot rule out the influence of
extraneous factors including global financial crisis in the performance of banks during
the post-merger period.
 Impact of merger and acquisition on the efficiency of Indian banks 17

Acknowledgements

Authors would like to sincerely acknowledge the valuable comments made by the
referees in the improvement of the paper. The observations are based on published data.
The opinions expressed in this paper are those of authors and not of the institutions they
are affiliated.

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