By the time China Construction Bank (CCB) made its Hong Kong stock exchange debut on October 27, investors had committed more than US$8 billion to the country's third-largest lender. Interest from both institutional and retail investors was intense, their demand for shares oversubscribed nine times and 42 times respectively.
Such was the frenzy surrounding CCB, the bank was able to push share prices to the furthest extreme and still defy the naysayers when trading started by holding steady on stock market operating at a three month low. This was the world's largest IPO in four years, the largest ever by a Chinese enterprise, and no one was going to spoil the party.
CCB is the first of China's Big Four state banks to go public and, with Bank of China BOC) and Industrial and Commercial Bank of China (ICBC) talking of listing in 2006, more records could be broken over the next 12 months. Though painful, the transformation from state sector financial prop into commercial entity could see the Big Four become handsome profit makers. They account for 57% of all lending in China and control US$1.8 trillion in deposits: with a developing bond market, stock exchanges being groomed for relaunch, a massive loan sector and an under serviced consumer finance market, this money could be put to very lucrative uses.
Foreign banks bearing gifts
Needless to say, foreign banks are flocking to China to help the Big Four – as well as 13 privately owned national banks and 100-plus city commercial banks – make the most of their growing commercial freedom. They offer training in corporate governance, auditing, risk management, financial reporting, asset liability management and HR management. And a huge amount of cash.
So far, 19 foreign institutions have taken stakes in 16 local lenders, spending a total of US$16.5 billion, or about 15% of the total capital of the banks in which they are investing. HSBC, Citigroup, Bank of America, RBS, Deutsche Bank, Goldman Sachs, UBS: the big players are all involved.
"They are buying the chance to take part in the China story," said May Yan, senior financial institutions analyst for Moody's Asia Pacific. "China is the world's big growth market; elsewhere it's saturated."
In addition to the financial potential of an economy growing about 9% a year and showing little sign of slowing down, the banks are drawn by a middle class that could number as many as 200 million. A lack of exposure to consumer banking makes them prime targets for services such as wealth management, auto financing and credit cards once China's financial sector opens up significantly to foreign competition at the end of 2006 in accordance with WTO accession conditions. "If you take 5% of the Chinese credit card market, then that is 10 million customers. It's equal to 50% of the Korean market and 100% of the Taiwan market," said John Wadle, Asia regional banking analyst for UBS.
They won't get control
Beyond the ubiquitous dollar signs, though, questions remain: exactly what kind of role will the foreign banks get to play in exchange for their money and when will they start to make a return on it?
What they are not going to get is control. It's not unusual for a government to restrict foreign encroachment on its financial sector and China has indicated that the current 20% cap on individual foreign ownership of Chinese banks will remain in place for the foreseeable future. Bank of America may have paid US$2.5 billion for 9% of CCB and spent another US$500 million on equity as part of the bank's IPO, but its level of control over operations is unlikely to stretch further than a seat on the board.
Much has been made of the bank's plan to send in a 50 person "SWAT team" to put things in order at CCB. Ultimately their success will depend on how much the bank, which is still 62.5% state-owned, is prepared to listen. Seminars on corporate governance, effective auditing and risk management will receive full attention; calls for job cuts or fundamental alterations to bank strategy are likely to be acted upon in some cases slowly and reluctantly, and often not at all.
Therefore, an investment in a Big Four bank is more about gaining access than gaining a subsidiary. The foreign banks see a gap in the market for high-end consumer banking services and, thanks to the huge customer bases and established branch networks of their Chinese counterparts, they have a mechanism through which to do business. In exchange for purchasing an equity stake and helping the Chinese lenders carry out their current operations more effectively, the foreign investors are able to skim money off the top of the financial sector through high-end ventures (See 'show me the money').
"It all comes down to the 80-20 rule," explained Alistair Scarff, director of Asia Pacific financial institutions research at Merrill Lynch. "Banks make 80% of their money off the top 20% of their customers."
Leader in consumer banking
It is a rule that has certainly served Citigroup well over the years. The main innovator in modern consumer banking and leader in "Gold card services," Citigroup has pursued what Scarff describes as a "Monoline strategy" when seeking to establish itself in a new market, specifically targeting a high-end or niche service such as credit cards.
The bank's activities in China seem to be conforming to this pattern as Citigroup moved quickly to secure a 5% stake in Shanghai Pudong Development Bank (SPDB) in December 2002. So far it has shunned the Big Four, and has yet to take up an option to increase its holding in SPDB, but at the beginning of 2004 Citigroup launched China's first dual currency credit card created through foreign management and technology. The card allows mainland residents to spend money overseas and then settle the balance in either yuan or US dollars. A joint venture credit card company is scheduled to follow once the regulators allow it.
Around the same time, HSBC launched its own dual currency credit card in partnership with Bank of Shanghai, in which it has an 8% stake, and has since set up a credit card venture with Bank of Communications (Bocom), of which it controls 19.9%. A yuan-US dollar credit card bearing the HSBC logo was launched in May with the aim of signing up many of Bocom's 40 mil-lion debit card holders.
It is important to note that Citigroup and HSBC first took shares in Chinese banks in 2002 and 2001 respectively. Not only have they had a head start on their rivals, they were also developing credit card businesses from a smaller base. While investing in a Big Four bank that has a huge customer database appears a wise move, things will not happen overnight. CCB may know the names of its clients but it can offer little in-formation as to whether these people can be trusted with credit cards.
"To build up a credit card business you need to rate people. There is no system in place [at present] for tracking borrowers, no behavioural scoring system,' said David Marshall, managing director of financial institutions research at Fitch Ratings. "It will be a few years before they have any real meaningful information."
An eye on organic growth
Once again, future prospects seem to hinge on the foreign banks? ability to impart the technical knowledge required to run a commercially successful bank. But this does work both ways. With one eye set firmly on the first bout of deregulation in 2006, foreign banks are eager to learn all they can about the country's banking system.
By investing in a Chinese bank, the likes of Bank of America and RBS are able to look at the market through the eyes of a local operator and gain insight into how it is run. They can identify areas that are ripe for expansion, cross off industries they perceive as being too risk-laden and thereby establish the scope and direction of their own China strategy. It all points to organic growth.
"The banks need to have their own business plans to develop retail and corporate banking," said UBS? Wadle. "If they don't have these or if they don't have a strong enough brand or platform for entry, then the earlier investment is wasted. "Even if you sell your stake [in a Big Four bank], you can make US$2 billion from it and then use the money to fund organic growth."
However, historical examples show that banks have not found it easy to set up shop in an overseas market once the regulatory barriers are removed. The incumbents have huge advantages in terms of branch network and brand awareness, and it is notoriously difficult to persuade someone to change their habits and switch banks.
"I think the potential competition foreign banks can offer has been wildly over exaggerated," said Fitch Ratings. Marshall. "How many foreign banks would have the desire and resources to go head to head with the local banks with their established networks and strong – if underexploited – franchises?"
Barriers to entry remain
To try and match the Big Four in terms of national coverage would be madness, but even if the foreign banks focus on the wealthy eastern seaboard areas in keeping with their ambitions to target high-end services, considerable implicit barriers to entry remain.
As it stands, any foreign bank looking to gain a foothold in a city must open a representative office, which can offer only advisory, non profit-making services, in the city and maintain it for two years. Only then can it apply to open a branch office and actually start doing business. While the representative office rule has been lifted in western China to encourage investment and the government has indicated this could soon extend nationwide, branches have experienced further delays when applying for local currency trading licenses. A minimum capital requirement of around US$62 million must also be met to open a full service branch.
Come deregulation this time next year, foreign banks are hardly going to be able to hit the ground running. "There is no way in the world the government is going to let them have the upper hand anywhere," said Merrill Lynch's Scarff.
Progress will be gradual and banks that prepare for a marathon rather than a sprint are more likely to emerge with their reputations intact. With stakes in Bocom, Bank of Shanghai and Ping An Insurance in its port-folio, HSBC is generally seen as being best placed for the long term (See PwC "Top of the pile?.
Steering clear of the Big Four and targeting Bocom, the fifth biggest lender, seems an increasingly wise move. HSBC has been lobbying for government approval to boost its share in the bank to 40% and, while most analysts remain skeptical about the prospects of a takeover, the possibility is not as far fetched as it might once have seemed.
"Two years ago, I probably wouldn't have said it was possible but now, who knows? It's realistic, although it all depends on the regulators," said Fitch Ratings' Marshall.
Full ownership or not, a successful Bocom will boost HSBC in terms of promoting its own business in China. The bank already enjoys a 90% recognition rating amongst Shangahi's affluent set and joint venture credit cards produced with Bocom and emblazoned with the HSBC logo will only serve to push the brand further.
"In five to 10 years, the likes of RBS and Bank of America will have a number of joint ventures but where do you go with them?? questioned Marshall. "When the Chinese have learnt what they think they need to learn, where does the foreign investor go??
Benefits of local knowledge
HSBC's success in putting down roots in China ultimately stems from its dominance in Hong Kong. It knew the Chinese market, appreciated the need to build and maintain strong relations with the Mainland authorities and was able to ride on the coattails of customers who started to invest heavily in China early on.
"It is making the most of the synergy between growing its China business and maintaining its stake in Hong Kong," explained UBS' Wadle.
Being able to leverage this Hong Kong business certainly sets HSBC apart from the competition. For the other foreign banks, the only real hope of making money out of China in the short term is through IPOs. By selling services to Hong Kong customers who do business on the Mainland, HSBC has a ready made commercial base from which to draw income.
In its September investment research report on Bocom, UBS concluded that HSBC's local knowledge made its investment in the Chinese lender ?unique among the recent investments by foreign banks.? The implication is that the relationship is sufficiently strong that when HSBC speaks, Bocom is inclined to listen.
This is a scenario to which all foreign banks aspire and one that is most purely played out at Shenzhen Development Bank (SDB), where US venture capitalist firm Newbridge Capital has effective operational control of the bank (see "A unique arrangement?). The general consensus is that SDB was a bank in dire straits in need of a big fix; other Chinese banks won't be ceding control to foreign investors any time soon. And when it comes to smaller scale investors putting money into smaller banks, control often isn't on the agenda.
"We wouldn't want to tell them what to do because we don't understand the Chinese market. But we have been careful to select a partner who values our input and will listen," said Richard Williamson, general manager for business development at Commonwealth Bank of Australia.
The bank looked at more than 100 potential partners in China and met with at least 15 before settling on Jinan City Commercial Bank, paying US$17.3 million for an 11% stake, and Hangzhou City Commercial Bank, in which it took a 19.9% stake for US$77.6 million.
Putting a price on influence
Both banks are profitable, generating dividends of 4% and 6% respectively, and Commonwealth Bank believes they have strong potential for regional expansion. Therefore it could be argued that an advisory role is more appropriate in cases such as these rather than the radical approach required at SDB. There is also the issue of getting this advice implemented. With 20% of the fifth-largest city commercial bank costing US$77.6 million while a 1% stake in a Big Four lender equates to about US$300 million, potential influence plays a key role in investment decisions.
"In our view, if you have a 10-20% stake in a city commercial bank, you have a better opportunity to influence the bank than if you have a small shareholding in one of the big banks," said Williamson. The potential customer base for an investor in a Big Four bank may be much higher and the long term revenues are likely to be much greater once reforms have been put in place.
But it could be argued that the new technology and banking systems can be introduced more efficiently if working with an operator that serves one region as opposed to the whole country. SDB chairman Frank Newman readily admits that his job would be considerably tougher at a bank 10 times the size of SDB.
"With the big banks, it's about reeducation," said UBS? Wadle. "Can you teach an old dog new tricks? Or is it easier to take someone young and groom them?" If India's financial deregulation is anything to go by, smaller banks represent a very healthy investment. Once the foreign banks came in and shared their expertise and technology, the midsize lenders adjusted themselves accordingly and saw their market share grow and grow.
A commercial city bank backed by foreign expertise and investment that is able to smoothly incorporate new policies into its day-to-day running, can expect to do well. Consumer banking products are rolled out more quickly, the customer base expands thanks to the introduction of more service-oriented business practices and, before you know it, the bank is ready for a stock market listing. Investors who got in early can expect a considerable return on their original capital.
Responding to change
It all comes down to how effectively banks – from regional operators to Big Four lenders – can respond to the demands of a deregulated market. Five years down the line, the more active foreign banks will probably own more branches but their market share will only be slightly larger than it is now. The state banks will be tested on whether they have taken in their western counterpart?s lessons on commercial banking and can turn in profit. In its November 2005 report on state bank reform, Moody's notes that while the government is playing an active role in resolving bank problems through measures such as recapitalization, its involvement "may also become an obstacle for further reform" as banks pursue more commercial agendas.
Reform is not just about fixing the balance sheets and listing on the stock exchange, it is a balancing act as banks try to adapt to the changing financial environment and regulators try to control the pace of its development.
No one said this change was going to be easy. Bad debts and loan ratios skewed worryingly towards corporate lending to state-owned enterprises still lurk in the back-ground as potential threats. Recent reforms have been backed by consistently strong economic growth: a significant slowdown in the economy and the bank?s ability to manage asset quality will be put under the spotlight. The pending liberalization of ex-change and interest rates is also likely to ask major questions.
"It would be amazing if they could make the transition without experiencing some kind of crisis," said Fitch Ratings? Marshall. "If banks rush into an area where they haven't operated before, it almost invariably involves painful experiences."
Non-performing loans: an Achilles heel?
The government has pumped around US$431 billion into the Chinese banking sector since 1998 through direct capital injections and subsidized sale of non-performing loans, according to Moody's November 2005 report on state bank reform. More than 90% of this figure – which equates to 23% of China's GDP in 2005 – has gone to the Big Four state-owned banks. But there was still US$200 billion worth of bad debt on the books as of the end of June. Such are the trials of turning what was once the internal treasury of the ministry of finance into a sector driven by profitability and able to handle foreign competition.
Nevertheless, China's nonperforming loan (NPL) situation has improved dramatically, with NPL ratios for the Big Four banks pushed down to below 5% from the 10-15% bracket.
What still concerns investors is the high proportion of "special mention" loans on the banks? books, which in some cases represent as much as 20% of borrowing activity. The banks say these loans, classified as neither normal nor underperforming, merely represent a cautious attitude towards certain borrowing agreements that will in all likelihood be resolved satisfactorily. But it remains a gray area. "It seems as though they are trying to make a virtue out of a problem," said David Marshall, managing director of financial institutions research at Fitch Ratings. "But having this number of special mention loans in the current economic environment is a worry."
The fear is that an economic downturn could see many of these "special mention" loans cross over into the nonperforming column. Compared to its Asian neighbors, China's banking sector has weak capital levels while – taking into account the entire process of construction, development and mortgage lending – 20-40% of the banks? loan portfolios are effectively tied to the volatile real estate market. This does not make for a healthy combination: a property price crash would see a host of loans turn bad as, one by one, businesses and consumers found they were unable to make their repayments.
The banks would be left wanting. "If the property market makes a turn down, that could create problems," said UBS regional banking analyst John Wadle. "There is a big oversupply of property and not enough buyers."
UBS concludes that 50-70% of Bocom's loan book is tied to real estate prices and a price decrease of 10-20% would hit the bank's net earnings by 18-73%.
If things do take a serious turn for the worse, most of the big spending foreign banks will be able to fall back on downturn protection deals struck with the government when they purchased their shares. Exact details have not been made public, although it has been suggested that the government has agreed to buy back the banks? stakes at cost price if things go bad or made guarantees that the price of any new equity issues to raise capital will not undercut what the foreign banks paid.
However, it is by no means certain that all the foreign banks would want to take these escape routes. "HSBC takes a long view and so you?d assume they would step in if Bank of Communications (Bocom) experienced problems," said Fitch Ratings? Marshall. "But they would want more control in exchange."
Time to bank vertically
Much of what foreign banks can offer their Chinese counterparts in terms of shared expertise – credit, treasury and liquidity management – all points to one thing: greater centralized control. This in itself represents a huge practical and philosophical shift for the Chinese banks, which have traditionally operated with a large degree of independence from central office.
"Whether these joint stock ventures will work depends on the willingness of the Chinese banks to change themselves," said May Yan, senior financial institutions analyst at Moody's Asia Pacific. "There can be huge resistance to restructuring and this isn't apparent on the surface, it's very subtle. The state is pushing for vertical management and this won't happen in a few days, it will take several years." Retaking control of 237 offices across 18 cities was high on Frank Newman's list of priorities when he was elected chairman of the board and CEO of Shenzhen Development Bank in May.
"A lot of the problems came down to decentralized control, particularly with the credit system," he explained. "If you have a good branch manager making decisions that's fine, but one big mistake can damage the entire bank."
Such mistakes can, to a certain extent, be held responsible for the build up of nonperforming loans that has blighted China's banks. The legacy of self-control is entwined with the branches' close relationship with local government, which has in the past used the banks as a source of capital for projects that turned into financial liabilities.
However, David Marshall, managing director of financial institutions research at Fitch Ratings, believes that foreign banks could help in this area too. "A bank can turn round to the local government and say they can't do things the old way because they have foreign investors to consider," he said.
Show me the money
With more than 85% of loans given by Chinese banks going to the corporate sector, consumer banking is poised to become a principal battleground as the financial markets open up. Foreign banks are likely to focus on the high end of this consumer market.
Credit cards: Bank card circulation reached 762 million in 2004, including 98 million credit cards. The credit market, which accounts for less than 3% of consumer loans, is currently dominated by the Big Four and some of the listed banks who together enjoy a 90% share. As lending rates are regulated at 18% and deposit funding costs below 3.6%, the potential profits are huge and foreign entry will see competition intensify. McKinsey estimates the Chinese credit card market will be worth US$5 billion by 2013.
Auto loans: Success in the near term is heavily dependent on the strength of the car market. Oversupply, declining prices for used cars and imports, and the departure of insurers from the market hit auto finance hard last year, halting several years of growth. Agricultural Bank of China (ABC) and Bank of China (BOC) control 70% of the market, which accounts for less than 1.5% of total loans, following the exit of the listed banks from auto financing due to concerns over poor risk control.
Mortgages: Residential mortgages made up 79% of consumer lending in 2004 but profitability is ultimately tied to the fortunes of the real estate market. Last year average property prices rose 9.7% but government efforts to cool prices this year have slowed growth in the mortgage sector. Taking in everything from construction to mortgages, real estate comprises 20-40% of Chinese banks' loan portfolios, making them vulnerable to market volatility.
Wealth management: Hugely underdeveloped in China, the wealth management sector received something of a kick-start this year as domestic commercial banks were allowed to start their own fund management companies. The low risk high return nature of the business is likely to attract foreign banks as they are able to offer expertise far in excess of that of the Chinese banks.
A unique arrangement
There is only one Chinese bank over which a foreign investor can claim to have control: Shenzhen Development Bank (SDB). When Newbridge Capital, the US venture capitalist firm that successfully turned round Korea First Bank, paid US$149.2 million for a 17.9% stake in SDB last October, it was agreed that Newbridge would assume operational control. The firm recommended the appointment of Frank Newman, an experienced banker who dealt with crises at Bank of America in the 1980s and Bankers Trust in the 1990s, as chairman and CEO and he has been charged with turning things around.
He certainly has a challenge on his hands: profits at SDB fell 21% to US$39.4 million last year while 11.4% of loans were non-performing and the bank's capital adequacy ratio stood at 2.3%, well below the government required 4%. Decentralized decision making, primitive credit controls and an inferior information technology system didn't help things. However, Newman has been able to conduct the kind of keyhole surgery in areas such as corporate governance and risk management that are required to take the bank forwards.
"We have changed a lot of people in the management team," he explained. "Most of the people here are locals but they are good. We brought in people from other Chinese banks and also found the best managers in this bank and promoted them. You have to have the right people in place and establish a set of processes to deal with different situations."
Indeed, the special team he set up to deal with the bad debt problems collected almost US$124 million in the first half of the year, almost all of this from loans that were settled in full. "
In the US you usually expect to lose forty cents on each dollar," said Newman. "However, there are assets that can be found. It involves some detective work – finding out if someone has assets that are not apparent – and you also have to use the legal system. Many debtors will pay rather than enter into a court case they would lose."
In addition, the Newbridge connection may well have secured an infrastructure project that will enable SDB to compete at the highest level. In October, General Electric came on board, paying US$100 million for a 7% stake in the bank and agreeing to install the systems and technology required for SDB to improve its commercial services. "
The thing with consumer finance is there are few people who really know how to do it," said Newman. "GE has considerable experience in this and a number of other fields, so we will be able to build up our commercial finance business much more rapidly."
Third quarter results suggest that SDB is turning the corner. Net income climbed to US$19.7 million between July and September from US$14.9 million a year earlier while NPLs were down to 10.3%. Capital adequacy is clawing its way to the 4% mark, reaching 3.4% by the end of September.