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The proposed merger of HDFC entities and the acquisition of Citibank India's consumer business by Axis Bank can trigger M&A trend in the banking sector, said rating agency Fitch Ratings.

According to it, the merger between HDFC Bank and its shareholder HDFC may have long-term implications for the nation's banking and non-bank financial institution (NBFI) sectors.

Besides, it said that the proposed merger could redefine the competitive landscape for banks, and increase the prominence of M&A among banks seeking to close the market-share gap with the merged HDFC Bank.

"It could also influence the evolution of the NBFI sector, particularly for large entities that have nurtured banking ambitions amid tightening sector regulations," the agency said.

As per Fitch Ratings, Indian banks intermediate roughly 60 per cent of system credit, but face stiff competition as the market is fragmented and products are fairly homogeneous. Since 2017, there have been three rounds of state bank mergers which have led to some consolidation but with limited impact on pricing power.

"Fitch believes that the proposed merger of the HDFC entities and the recently announced acquisition of Citibank India's consumer business by Axis Bank Ltd could encourage banks to turn to M&A.

"Large NBFIs could be acquisition targets, given their higher-margin products, large pools of priority-sector customers and loans, and potential cross-selling opportunities. However, the regulatory attitude towards such acquisitions will be an important factor in their success."

Furthermore, it said that the combined HDFC entity will have an asset base of $340 billion, nearly half the size of the largest bank, State Bank of India, and double its nearest competitor, ICICI Bank. It will account for nearly 14 per cent of system loans and 9 per cent of system deposits - a roughly 300 bp jump in loan market share and about 100 bp for deposits from the standalone HDFC Bank. The all-stock merger will take between 12-18 months to complete, subject to regulatory approvals.

"Fitch believes both entities stand to gain from the deal. HDFC Bank will gain about 500 new branches, improve its operating efficiency as HDFC Ltd's cost or income ratio is 10 per cent versus the bank's 36 per cent, and diversify its loan book, as the bulk of the loans will be mortgages.

"HDFC Ltd will benefit from greater liquidity and a gradual shift to lower-cost deposits to support a more competitive offering in the large-ticket housing space. It will also be able to expand in affordable-housing financing, underpinned by the combined distribution network."

In addition, the rating agency said that harmonisation of NBFI regulations with that of banks over the past few years may have played a role in the merger decision.

"Tighter regulations amid some high-profile NBFI defaults should ensure stronger risk and governance standards and narrow the regulatory arbitrage between NBFIs and banks.

"However, the trend will continue to drive greater costs, which will weigh on profitability. Higher capital requirements, stricter norms for non-performing loans and the introduction of a liquidity coverage ratio, risk-based internal audits and core financial-service solutions, imply further increases in the cost of doing business for NBFIs."