Short cut to maturity

The Royal Bank of Scotland propelled itself to global giant status with a US$1.6 billion deal for a 5% stake in state-owned Bank of China, one of China's Big Four state banks. The announcement marked the entry of Europe's second-largest lender into the world's largest growth market for financial services.

Along with a truckload of cash, RBS offers to BoC corporate governance, management know-how and the advantages of linking to a global network. It could well be a shortcut to a mature banking sector for BoC and the entire Chinese banking sector.

The RBS deal was just one of a host of deals in recent weeks with foreign banks buying new or expanded stakes in various Chinese banking entities (see box next page).

In the countdown to the end-2006 banking liberalization that China promised the WTO, regulators are allowing the sale of minority stakes to foreign lenders of up to 25% in Chinese banks in a process calculated to revolutionize China's infamously messy banking system. They are betting that the result will not be a colonization of the banking business by foreign giants so much a transfer of skills and knowledge helping China to solve the deep inefficiencies that characterize the banking sector, boost personal finance and credit, and strengthen domestic banks in the face of growing competition from foreign banks' fully owned China ventures.

"Right now, mainland banks are 15 years behind the rest of the region, meaning Hong Kong, Taiwan," said Samuel Chen, Asian banks analyst at Chen, Asian banks analyst at Fox-Pitt, Kelton. "It won. Take them 15 years to catch up as long as there remain active, open-minded regulators. Five years from now we're going to see a totally different picture in the banking sector."

A symbiotic relationship
RBS joined a long line of foreign lenders, including HSBC, Standard Chartered and Citigroup, lured to China by a banking sector that boasts 12-13% growth in annual loans, compared with 0% growth in the stagnant markets of the US, the EU and Hong Kong. According to a 2004 report by McKinsey Consulting, revenue from mortgages, auto loans and credit cards is expected to grow each year by 20%, 25% and 54% respectively from 2003-2013, while growth in corporate lending is set to plateau by 2013.

With personal finance and credit on the way to overtaking commercial lending as the main growth sector in Chinese finance, foreign banks have clearly decided they need to be on the ground forming domestic alliances as well as operating independent wholly owned branch networks. Foreign banks want market access and the potential returns seem to be significant enough to allay buyer concerns over the Chinese banks' massive non-performing loans and poor risk-assessment.

"And the price these foreign banks are paying – the recent investments in BoC and CCB are about 1.2 times 2004 book value – is really quite good," said Chen.

China, in turn, is hoping the foreign share-holders will help solve some of the mismanagement problems endemic in the industry. RBS was attractive as an investor to BoC, in part because of the success of CEO Sir Fred Goodwin (nicknamed Fred the Shred for his cost-cutting skills) in restructuring London's NatWest bank after RBS hostile takeover five years ago. In the 1990s, RBS reorganized its own retail banking division, centralizing processes formerly carried out in branches. And cost cutting is a major requirement facing all of China's banks.

Also essential is a transfer of the skills and technology required to issue credit cards, finance car loans, write mortgages and conduct all the daily retail banking business that consumers in developed economies take for granted.

Only about one million Chinese currently have credit cards, for example, as banks are largely restrained by "A lack of skills need to market credit cards to the more attractive customers, and by the difficulty of managing risk", according to the McKin-sey report.

"Demand is still unchartered territory," said Frederick Cho, manager of Chinese equities at Sweden's Hagstromer & Qviberg. "Foreign banks will help in educating the consumer about what services can be had from a bank."

Banking on growth
Will these massive investments pay off for both sides? One obvious concern is that foreign banks, whose stakes are capped at 20% for individual banks and 25% total, may not have enough control to pull off much-needed reforms. Several foreign banks have chosen to invest in smaller banks where their voices may carry more weight. After declining a stake in state behemoth China Construction Bank, Citigroup upped its share in the younger, leaner Shanghai Pudong Development Bank. In another example, Standard Chartered is expected to have enormous influence in upstart Bohai Bank. But it is clear that the Chinese government has recognized the need for banking reform and the value of outside input, giving foreign lenders a larger influence than may appear on paper.

Foreign banks still face the challenge of defining an appropriate role in China's hugely regulated, geographically dispersed market. The banking industry is to be further liberalized at the end of 2006 in line with WTO rules, but this will by no means translate into a banking free-for-all.

"2006 is not going to make a difference in terms of foreign banks' direct involvement," Fox-Pitt's Chen said. "Domestic banking may lose some high-end customers, but it will be limited. They're fighting for different groups."

Chinese banks, with their massive branch networks, will still dominate mass-market retail banking. But foreign banks are expected to sell products through the branches of their local partners, while aiming to win a significant market share at the top end of the personal finance and loan markets in the rich coastal cities. Rich clients account for only 2% of customers at China's retail banks but 55-65% of retail banking profits, according to McKinsey.

Still, there are no guarantees for the realization of the China dream in banking, or in any other sector. RBS insists that it does not intend to expand its 5% BoC stake, probably to appease critics wary of the bank's entry into a market of which it has little knowledge.

"We'll see over time which investments turn out to be good and which turn out to be bad, I can't imagine a 100% success rate," said Cho. "Some investments made in haste, designed to impress the stock holders at home, may not work out. But those who've done their homework, who have China knowledge, they will succeed."