Foreign investments into Chinese commercial banks, which began just a few years
ago, have accelerated to a frantic pace in recent months, with
record-shattering deals being announced seemingly almost weekly. Three of the
four big state-owned commercial banks (SOCBs) that acquired foreign funding -
Bank of China (BOC), China Construction Bank (CCB), and the Industrial and
Commercial Bank of China (ICBC) - have received the most attention from the
media, as each is preparing for a listing on overseas stock exchanges within
the next two years. Bank of America (BoA), UBS, Merrill Lynch, Goldman Sachs
and the Royal Bank of Scotland (RBS) are just a few of the major foreign
financial institutions that joined the bidding race. Considering the fact that
the three SOCBs collectively have 900
billion yuan (US$111 billion) of non-performing loans (NPLs) on their balance
sheets, why would BoA or RBS spend north of $3 billion for just a 10%
non-controlling equity stake in a Chinese bank? There is no simple answer to
this question.
Limitations on foreign control
With its ascension to the World Trade Organization in 2001, the Chinese
government promised to open up its banking sector to full-fledged competition
from foreign banks by the end of 2006. This pending development posed a
significant challenge to the domestic banks. The four SOCBs and five
joint-stock commercial banks, which together control almost 70% of total assets
and liabilities in the banking system, are burdened with 1.2 trillion yuan
(US$145 billion) of NPLs on their books, not to mention the mountain of bad
loans at 112 city commercial banks and thousands of credit cooperatives
throughout the country. As a result of lending for decades to loss-making
state-owned enterprises under the government's "policy lending" guidelines,
many Chinese banks do not have a commercially oriented credit culture. They are
typically plagued by poor management, an excessive number of branches,
ineffective information systems, and massive corruption. Due to high NPLs and
low profitability, the capital adequacy ratio at the majority of Chinese banks
falls far below the internationally accepted standard of 8%.
In response to the massive NPL problem, the government transferred $315 billion
of bad loans to asset management companies that specialize in NPL resolution.
It further injected $94 billion of fresh capital into the four SOCBs to boost
their capital adequacy ratio. Lastly, the government began to encourage foreign
investments in the domestic banks, in order to benefit from such investors'
financial resources and more importantly, their expertise in risk management
and corporate governance. However, unlike in Japan and Korea, where buyout
funds such as Ripplewood and Newbridge Capital have taken over distressed
domestic banks outright and returned them to profitability, China still has
stringent restrictions on the level of control that can be granted to foreign
investors. Currently, equity ownership in any one domestic bank is capped at
20% for a single foreign investor and 25% for aggregate foreign shareholding.
While the 20% cap was an improvement from the 15% limit prior to December 2003,
it is still a far cry from ceding meaningful operational and managerial control
to foreign investors.
Nevertheless, the flood of foreign investments in Chinese banks (summarized in
the table below), especially in 2005, seems to indicate that foreign investors
may be content with their status as minority shareholders. The targets include
not only the "big-four" SOCBs and the joint-stock banks, but also the smaller
city commercial banks and credit cooperatives.
Foreign Equity Investments in Chinese Banks
* The investors were given the option to increase their equity stake to 20%
over the next few years. Source: Big Brains Ltd Almanac of China's Finance and Banking
2004, and various news articles.
Why are they buying?
The obvious question is: why are all these sophisticated financial institutions
and entities willing to take minority stakes in Chinese banks? On the one hand,
it is not hard to see why China's vast retail investor base is so attractive to
banks like Bank of America, RBS, HSBC, and Citigroup, all of which have a
strong focus on consumer banking. Currently, foreign banks are allowed to do
yuan business only on a limited basis and have little direct access to retail
customers. Even though this policy will be relaxed by the end of 2006, the
early investments of BoA and RBS will help them to gain a lead on establishing
their brand names in China and tapping the massive $1.5 trillion of savings
deposits in China.
By investing in CCB, Bank of America will gain distribution to the domestic
bank's 136 million active deposit accounts and a network of 14,500 branches
across the country. It will also give BoA the opportunity to market credit
card, mortgage loans, and other wealth management products to the flourishing
middle class in China, who are increasingly seeking alternative options to
low-interest savings accounts. Likewise, RBS will be able to tap into the
client base of BOC, which operates 11,307 branches and holds 14% of all
deposits in China.
The second type of investors adopts more of a private equity-oriented approach,
including Singapore's Temasek, Goldman's private equity arm, and Newbridge
Capital. Temasek, in particular, has invested in three different Chinese banks
over the last two years. Similar to the strategic investors, these firms are
also attracted to the size and growth prospects of the Chinese market. However,
immediate benefits to these investors are more difficult to ascertain,
especially when, in most cases, they are able to take only a minority stake in
the respective domestic banks.
Historically, buyout funds have targeted distressed financial institutions in
Japan and Korea that were burdened with huge NPL portfolios as a result of poor
credit controls and the impact of the Asian financial crisis. In these
countries, the investors were able to take full control over the bank in
question, revamp the management team, align credit controls with international
standards, and aggressively collect on NPLs. Successful turnarounds could be
highly profitable for private equity investors. Ripplewood generated a profit
that was 10 times its investment in Japan's Shinsei Bank by taking it public.
Newbridge Capital sold its stake in Korea First Bank to Standard Chartered for
five times its original investment. The Carlyle Group and JP Morgan Corsair
made three times its initial investment by selling their stake in Koram Bank to
Citigroup. In China, it is unlikely that the private equity-type investors
would be able to replicate such success without obtaining control of the
domestic banks. State-owned entities, who continue to hold majority equity
stakes in the banks, could potentially prevent foreign investors from
implementing effective turnaround strategies. Ripplewood faced immense
political pressure when it declined to participate in bailouts of distressed
Japanese debtors: one can only imagine what resistance it would have
encountered if it had been a minority shareholder of Shinsei.
Newbridge - setting the example
Among all the new foreign investors, Newbridge Capital is the only one to
obtain de facto managerial control of a domestic bank, Shenzhen Development
Bank (SDB). Even though its ownership is capped at 20%, 72% of SDB's shares are
publicly traded, enabling Newbridge to control the board of directors as the
largest shareholder of SDB. At the time of Newbridge's investment in October
2004, SDB had the weakest financial record among the joint-stock banks. The
bank's NPL ratio stood at 11.4% at the end of 2004, and its capital adequacy
ratio was only 2.3%, far below the required 8% threshold.
Following its investment, Newbridge focused on rebuilding SDB's balance sheet
and reshaping its credit culture. It centralized SDB's NPL collection into a
130-person team, and established a central credit committee for corporate
lending, with the intention of cutting the NPL ratio to under 5% in the future.
It is also planning on raising capital in the public domain to boost the bank's
capital adequacy ratio. For the first half of 2005, SDB collected $185 million
of bad loans, reducing NPL to $1.8 billion, or 10.7% of total loans. The
capital adequacy ratio also increased to 3.1%. Similar to what other private
equity groups have experienced during bank restructuring in Japan and Korea,
aggressive measures were called for in the NPL collection process. Frank
Newman, chairman of SDB, recalled in an interview with BusinessWeek:
"Collection has its own special set of techniques. You have to know how to work
with lawyers, sometimes the local government, and sometimes you need to do a
little detective work to see where people have assets hidden." Not
surprisingly, the Shenzhen police were occasionally called in to help collect
from local companies unwilling to repay their loans.
An important first step in Newbridge's restructuring was the revamping of the
management team. The new CEO of the bank is a Chinese-speaking industry veteran
who opened the Shenzhen branch of Citibank in 1988 - the first mainland branch
of any US bank. The chairman is a turnaround specialist with former experience
at Bankers Trust and Bank of America. The CFO, credit and system officers were
recruited from the US, Taiwan, and Hong Kong; whereas the head of retail
banking and the NPL workout officer were hired from other mainland banks. Half
of the branch managers were replaced, and the bank is trying to increase the
accountability of branches to the central office.
As Newbridge has promised to retain its equity stake in SDB through the end of
2009, there is ample time for the private equity firm to grow both the top and
bottom line of the bank. The next step will be to grow SDB's loan book and
retail business, in conjunction with continued NPL reduction and operational
restructuring. According to a Reuters report, in order to grow its retail base,
the bank has already introduced innovative strategies, such as sending
customers phone messages to confirm account withdrawals and installing ATM
machines in busy subway stations of major cities.
Many foreign firms are anxiously scrutinizing Newbridge's progress in its
turnaround management of SDB, as it sets an example of what foreigners may
expect to achieve if they gain control of a Chinese bank. However, it is worth
noting that overseas investors may be able to exert a certain influence over a
bank's management, even without necessarily obtaining control. HSBC currently
has two seats on the Board of Bank of Communications and has sent two dozen
people to help manage the bank since its investment in 2003. BoA and RBS have
also been granted seats on the boards of CCB and BOC, respectively. BoA is
planning to dispatch a further 50 people to CCB to assist with management.
However, only time will tell whether the addition of foreign minority
shareholders will ultimately improve the operations of the banks.
The guarantee
Interestingly, HSBC, BoA, the RBS consortium and Temasek have obtained
unprecedented guarantees for their investments in domestic banks. According to
the South China Morning Post, RBS would receive compensation over three years
if (a) the joint venture between RBS and BOC performs poorly, (b) BOC's initial
public offering (IPO) price falls below the price that RBS paid for its
investment, or (c) BOC's net asset value declines year-over-year. Temasek is
believed to have negotiated similar provisions for its stake in BOC. For the
minority shareholders, these guarantee provisions will no doubt add some
downside protection to the value of their investments. The government, however,
faces the dilemma of having to make similar concessions to other foreign
investors with an interest in domestic banks.
While many believe that the guarantee clauses are unlikely to be invoked, one
only has to look at Ripplewood's decision to exercise the safeguard provision
it received for its investment in Japan's Shinsei Bank. As the actual size of
the NPLs on Shinsei's balance sheet was hard to determine at the time of
Ripplewood's investment, the Japanese government agreed to repurchase bad loans
that lost 20% of their value within three years from the acquisition. But the
government did not expect Ripplewood to take the cancellation rights provision
seriously, and Shinsei's subsequent decision to bind the government to the
agreement and sell 1 trillion yen of NPLs back to the government stirred up
considerable controversy in Japan. While foreign investors in China will have
their long-standing relationship with the state at stake, their profit
orientation may very well drive them to invoke the guarantee provisions if
necessary.
Bigger not always better
While much of the media exposure was directed at foreign bidders for three of
the "big-four" SOCBs, notably the joint-stock banks, city commercial banks and
credit cooperatives have also received much attention from overseas investors.
Instead of tens of thousands of branches, these smaller banks have only
thousands of, or even hundreds, branches, and often carry a lower NPL ratio
than the SOCBs. Due to their size, they are usually more manageable for
operational restructuring, and more nimble in changing their commercial
strategy as a result of the foreign partnership. Foreign investors also
recognize that it is much cheaper for them to purchase a 20% stake in a smaller
bank than to buy a 10% stake in one of the SOCBs. Likewise, it is probably much
easier for them to exert more influence over management and operations at a
smaller bank that typically receives less scrutiny from state-owned entities.
This might have been the reason behind Citigroup's decision to forego an
investment in CCB, but rather explore the option of increasing its existing
stake in Shanghai Pudong Development Bank, a joint-stock bank with only 328
branches, from 5% to 20%.
HSBC's 2004 investment in another joint-stock bank, the Bank of Communications,
has also fared well. HSBC is currently the second largest shareholder, behind
only the Ministry of Finance, which owns 22% of the bank. Since its investment,
HSBC has claimed two board seats and sent two dozens of people on the ground to
help manage the bank, including an executive vice president. The two banks
cooperated in developing a dual-branded, international credit card and three
types of consumer wealth management products. Through June 2005, the Bank of
Communications generated 4.7 billion yuan of net profits, versus a net loss of
1.9 billion yuan during the 12-month period ended June 2004. NPL ratio declined
from 2.91% to 2.45% year-on-year, while the capital adequacy ratio increased
from 9.5% to 11.3%. The bank's IPO in June 2005 was 200 times oversubscribed
among retail investors and 20 times oversubscribed among institutional
investors. Share price rose 13% the day the stock went public, and has
increased a further 11.5% since then. The stock is currently trading at HK$3.15
per share, far above HSBC's valuation of 1.86 yuan (HK$1.78) per share at the
time of its original investment. While HSBC has committed to retaining its
shareholding until August 2008, it has the option of doubling its 20% equity
stake after 2008, should the regulatory cap on foreign control be increased by
then.
Standard Chartered has taken on yet another unique approach to establishing its
presence in the growing Chinese market. It recently bought a 20% stake in a
newly established bank, Bohai Bank, and became the second largest shareholder
behind a state-owned investment company. Unlike the other domestic banks, Bohai
will not be burdened by the legacy of the NPL problem, and will adopt
international operational standards from the very beginning. Instead of
focusing its efforts on restructuring and getting rid of NPLs, Standard
Chartered can start with a clean slate and focus on building the business for
top-line growth.
What the future holds
The Chinese government's tactic of using foreign buy-ins to accelerate the
commercialization of financial institutions will not be limited to banks alone.
On September 24, the government announced plans to allow foreign financial
firms to take management control of domestic securities brokers for the first
time. Many of these brokerages are on the verge of bankruptcy due to poor
management controls and the extended slump in the stock market. This move will
grant foreign investors full exposure to the potentially lucrative capital
markets. Such relaxation of the limits on foreign control of domestic firms has
occurred frequently in China over the last five years, reflecting the state's
willingness to open up the market to outsiders to hasten reform. Many of the
foreign investors who joined the bidding race for domestic banks are probably
betting that this trend will continue, and result in them obtaining meaningful
control in the near future. For now, they will have to pay an entry price to
access the vast Chinese market. Yet, by building the necessary relationships,
they are setting the foundation for ample rewards over the long run.
Min Xu is a Shanghai native and a recent graduate of the MBA program at
New York University's Leonard N Stern School of Business. She has worked in
corporate finance.
(Copyright 2005 Asia Times Online Ltd. All rights reserved. Please contact us
for information on
sales, syndication and
republishing .)
