Singapore bank OCBC's US$70 million purchase of a 12.2% stake in Ningbo City Commercial Bank (CCB) in January was a deceptively significant development in China's financial sector. Not only had another of the top 10 CCBs opened itself up to foreign investment, but it had done so at a good price.
OCBC paid about 2.5 times book value for its stake; compare that to the 1.5-times premium in Commonwealth Bank of Australia's (CBA) deal to buy 19.9% of Hangzhou CCB for US$77 million last April. In effect, OCBC spent relatively more than CBA for part of a bank that is both smaller and less profitable. This reflects the rising competition among foreigners for access to China's financial sector.
"I'd hate to be looking for deals right now as there is competitive bidding and you can't get access to the management to perform proper due diligence," said one banker. "The people coming in now are three years too late."
The CCBs occupy the third berth in China's banking system, below the Big Four state banks and the 13 joint stock commercial banks. From Bank of Shanghai, with its US$27 billion in assets, to Zunyi City Commercial Bank in western Sichuan province, which has yet to publish any financial results, the 117 institutions in this tier were responsible for just 5%, or US$247, billion of the country's banking sector at the end of 2005.
Yet it is this narrower focus that is popular with certain foreign investors. "These banks are more manageable in terms of restructuring and implementing better controls," said John Wadle, co-head of Asian banking research at UBS. "You can also pick a bank with sufficient market share to achieve a critical mass of customers."
The influence a foreign investor can expect to exert is considerably higher than for a similar-sized stake in a Big Four bank. This exposure to the China market also comes with reduced exposure to risk as the investment requirement is comparatively low. "They don't really care if the bank takes a hit in the short term," said another banking analyst. "In fact they might want it to take a hit as this increases the probability of getting control of it."
Some of the CCBs have the potential to become significant money-makers – average asset growth for these institutions was 18% over the last two years, compared to a sector average of 16%. But focus on the east coast CCBs only and the growth figure exceeds 20% for the last 12 months alone.
"In places like the Yangtze River Delta the private economy is growing very fast so the banks are enjoying high growth thanks to high-exporting SMEs," said Yan Meizhi, senior analyst for Asia Pacific financial institutions at Moody's.
With this in mind, it's unsurprising that the CCBs in YRD strongholds such as Ningbo, Hangzhou and Nanjing have now have foreign backers with stakes up to the maximum 20%. The banks in the municipalities of Beijing, Shanghai and Tianjin have also attracted funds from overseas.
Before investing in Hangzhou and Jinan CCBs, CBA spent months identifying suitable targets, paying as much attention to the health of local economies as to the balance sheets of the banks themselves.
"We looked at regional economic data and consumer economic data," said Richard Williamson, general manager responsible for business development at CBA. "For example, in Zhejiang, foreign direct investment and GDP per capita are both relatively high for China. And then the percentage of the economy driven by private-sector firms is more than 50%, which is higher than anywhere else in the country."
Like the other foreign strategic investors, CBA is helping its partner banks improve IT systems and general commercial operations. It is looking at cooperation on mortgages and wealth management with Hangzhou CCB in particular. CBA also requires regular financial reports, which has prompted the banks to tighten up their auditing procedures.
In general, overseas investors and their local partners have similar goals: combine foreign retail banking savvy with domestic access to customers and develop high-end services such as credit cards and wealth management. However, the stakes the two parties are playing for are different. For foreign banks it amounts to a toe-dipping exercise in a new market that may deliver a profit; but for the city commercial banks, a healthy retail business arm to supplement corporate lending activities could decide their future.
Every one of these banks is keen to exploit its local brand recognition to tap the fast-growing consumer market. The hope is that this will make it strong enough to withstand the impending consolidation of the sub-sector. With local political interests at stake it remains unclear how this will happen, but it is generally agreed that 117 city commercial banks is too many.
"They have to consolidate, they have no choice," said UBS's Wadle. "A lot of these banks are very weak financially, so in five years' time only half may be left. Investment is needed and, in the end, some of these smaller banks are going to realize they just can't afford it. We are always hearing that expenditure on IT is bigger than banks had expected."
In recent years, local governments have written off debts and swapped good assets for bad to boost the CCBs' portfolios. Central authorities have encouraged the institutions to improve their capital adequacy ratios, reduce non-performing loans (NPLs) and diversify lending. Those that fail to make adequate changes can expect to be swallowed up. A proposal was put forward in 2003 for a Northeast Bank, most likely comprising Dalian and Harbin CCBs with a number of others in the region. Nanjing and Wuxi CCBs could see themselves become part of a Bank of Jiangsu.
The more ambitious banks, keen to develop on their own terms, have already drawn up plans to expand into their local regions. "We are seeing it throughout the city commercial bank sector, and not just along the eastern seaboard banks," said CBA's Williamson, adding that Hangzhou and Jinan CCBs are considering expansion. "What they have in mind is expanding first into neighboring counties, then within the home province and finally outside the province."
To receive regulatory approval to move beyond city boundaries, a CCB must first better the average financial performance of the joint stock banks. Bank of Shanghai met the criteria in December 2005, and has since opened branches in nearby Ningbo.
The bank's initial strategy is to serve existing clients whose business interests stretch outside of Shanghai. However, this puts it in direct competition with joint stock banks that are trying to achieve exactly the same thing. These banks may have national licenses but their market shares are not significant outside their home markets.
A recent Moody's report notes that CCBs often "have better local market shares, better local networks, better deposit bases and better local relationships" than their joint stock peers. This points to another possible consolidation strategy: takeovers by the joint stock banks, which tend to be better-funded and more advanced in reform.
Fujian-based Industrial Bank led the way with its purchase of Foshan CCB in Guangdong province at the end of 2004 and similar deals could follow. "Shareholder banks may at some point acquire city commercial banks," said Moody's Yan.
What is likely to develop beneath the Big Four lenders is a more fluid market as the old sub-sectors gradually merge into one regionally focused group. It is up to the CCBs to prove they have sufficient strength and ability to compete with the joint stock banks for both SME and retail customers. "Banks in each tier will outperform banks in other tiers," said CBA's Williamson. "It all comes down to working on people, products and processes."
Haunted by history: legacy of a state lender
As financial reputations go, China's city commercial banks (CCBs) have little to be proud of. Poor asset quality, inefficiency, annual reports published late, little or no corporate governance – all these accusations have been leveled and many of them can be traced back to how these banks emerged.
They came about through the merger of the urban credit cooperatives in the mid-1990s and, under the ownership of local governments, were used as sources of funding for favored projects, regardless of financial viability.
"These banks were effectively the holding company for the corporate sector within these cities," said John Wadle, co-head of Asian banking research at UBS. "At the heart was a very bad triangle of financing arrangements between the banks, local government and state-owned firms. Everyone was assuming loans would be guaranteed by other parties."
The books still bear the scars of this system with the average capital adequacy and non-performing loan ratios sitting at 1.36% and 11.7%, respectively, at the end of 2004, far from the average figures for the sector. Factor in just the fast-growing eastern seaboard banks, which are expanding their consumer services, and the picture becomes more encouraging.
But even these banks priming themselves for expansion are not without risk. Although most local governments now use their influence to play an active role in restructuring the banks, the potential for abuse remains. According to a Moody's report, related party transactions account for nearly 20% of Bank of Shanghai's total capital. This figure rises to 22.1% at the equally forward-looking Hangzhou CCB and 61.2% at Tianjin CCB.
That said, Richard Williamson, general manager for business development at Commonwealth Bank of Australia (CBA), a shareholder in Hangzhou and Jinan CCBs, says he has seen little evidence of directed lending. "Foreign investors should be aware of the risks, but it's not top of the list of things we are concerned about," he said.
Another area of concern is the banks' dependency on certain sectors and corporate customers. Despite efforts being made to expand consumer business, 80.5% of Hangzhou CCB's capital value is concentrated on loans to its top 10 clients, with the single largest client accounting for 9.4%. Dongguan CCB, the ninth-largest in the country by assets, has given loans to its top 10 clients worth 367.4% of its total capital with the biggest client accounting for 86%.
"These banks have a high geographical concentration and this also brings concentration in certain sectors, so if there is a downturn in these sectors the banks will be heavily affected," said Yan Meizhi, senior analyst for Asia Pacific financial institutions at Moody's.
CBA's Williamson is confident that the management teams at Hangzhou and Jinan are committed to upgrading technical skills within the banks, which is likely to put them in a stronger position should a downturn occur. However, given the credit risks involved in SME lending, this is unlikely to be the case for every bank in the sub-sector.
"City commercial banks have been at the forefront of this fixed-asset investment drive and there will be worries about this," said Sunil Garg, head of Asia banks and services at JP Morgan. "What is the true asset picture?"
Movers and shakers: city banks with ambition
Branches – 206
Local market share – 9.8%
The strongest bank in the sub-sector, Bank of Shanghai's application to open branches in Ningbo was green-lighted last year, making it the first city commercial bank to expand outside of its local area. However, under the influence of foreign stakeholder HSBC, it has employed a more conservative lending policy than many of its peers. Consumer loans increased 62.6% in 2004 over the previous year to account for 26.1% of total loans, and the bank has also moved into wealth management services as well as launched a dual-currency international credit card.
Branches – 118
Local market share – 8%
The second-largest bank in the tier, Bank of Beijing serves 130,000 local SMEs – 43% of total SMEs in Beijing – and is successfully branching out into consumer services, which account for 13% of total lending. The bank had issued 2.6 million debit cards by the end of 2004 and has set up a dual-currency international credit card. Dutch bank ING, a 19.9% stakeholder, has been allowed to appoint key executives such as head of risk management and is likely to also help improve technical operations. The bank wants to expand further into the Bohai region with a view to a public listing.
CITY COMMERCIAL BANK
Branches – 70
Local market share – 7%
Like a number of its peers, Hangzhou CCB has a three-stage plan: attract foreign investment; expand out of its local area; and make an initial public offering. With Commonwealth Bank of Australia on board as a 19.9% stakeholder, the bank is working towards stage two of its plan. The Yangtze River Delta is home to many SME customers, who account for 50-60% of corporate lending, and significant progress has been made in retail banking. Consumer lending made up 18% of total loans at the end of 2005 and the mortgage and auto loan business is being developed.
CITY COMMERCIAL BANK
Branches – 59
Local market share – 7%
In addition to corporate lending to YRD firms, the bank has been developing its consumer services, issuing 146,000 "Plum Blossom" debit cards and more than 10,000 credit cards by the end of 2004. Buoyed by BNP Paribas' purchase of a 19.2% stake last year, Nanjing City CCB has set itself the ambitious target of an IPO this year followed by regional expansion. However, it has to work on meeting the regulator's expansion criteria while further delays may be caused by the local government's still-unclear plans to form a provincial Bank of Jiangsu.
CITY COMMERCIAL BANK
Branches – 65
Local market share – 9.5%
Located in the most developed part of the YRD, SMEs already account for 90% of Ningbo CCB's corporate business. Consumer banking is also on the rise with 20% of the bank's loans focused on this area, while movements have been made into credit card services, as well as agency services for pension and unemployment insurance payments. Singapore bank OCBC took a 12.2% stake in January.