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Riding the financial dragon without getting bucked off E-mail

Can foreign banks find real success in China? Mixed outlook hinges on government’s role

 

By Susan Krause Bell, Promontory Financial Group, LLC, and Howard Chao, O’Melveny & Myers, LLP. See endnotes for more information.


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The financial crisis has reversed the perceived pecking order of global financial institutions.

While western financial institutions are struggling, China’s banks appear to be ascendant. Most of the world’s major financial systems are in a period of retrenchment and reform as a result of the crisis. Governments are strengthening approaches to financial regulation, and commercial banks and other financial firms are attempting to internalize lessons from the financial crisis, improve their reputations, and prepare for new restrictions.

While the financial crisis underscored just how interconnected our global financial system is, the large Chinese banks remained vital, profitable, and growing throughout the disruption. The assets of the Chinese banking system are increasing rapidly and have almost eclipsed the assets of the U.S. banking system. Agricultural Bank of China has begun the process for listing on both the Hong Kong and Shanghai exchanges in an IPO estimated to be between $20 and $30 billion.

Why is China rising? And where is it heading?
China's financial sector was relatively unscathed by the global financial crisis for several reasons. These include the inconvertibility of the RMB (the renminbi, or Chinese Yuan); protection from foreign competition within China; restrictive regulation; and the overall growth of the Chinese economy.

The global financial crisis did hit Chinese shores, however, through the worldwide decline in export demand.

China’s GDP growth dropped in late 2008, but remained positive and rebounded quickly in 2009 following a massive government stimulus package. This strong growth notwithstanding, China's economy and its financial system face challenges. In the short term, the surge in bank lending as part of the fiscal stimulus program may be creating overcapacity. Further, it will likely generate new non-performing loans and weaken bank balance sheets. Moreover, rapid change in the form of further financial liberalization; internationalization of Chinese banks; and the eventual convertibility of the RMB will bring new risks into the system.

As governments around the world undertake reforms to financial oversight in the wake of the crisis, China is also working to bring its banking system up to world standards. This revamp addresses both sound banking practices and the competitiveness of the system.

Regarding banking practices, in many respects, China is broadly in sync with the rest of the G20 in its approach to bank supervision, except for one area. The Chinese government has consistently had a significant ownership position in the financial industry and participates in managing the banks. In addition, Chinese financial regulators tend to actively pursue macroeconomic policy goals through the regulated institutions, particularly the banks and securities firms. These practices present problems in an era where China otherwise plans on opening up its financial system to more international interaction and competition. Chinese banks are not practicing truly commercial-based decisionmaking if State officials are present as owners, managers, and directors.

China also has an implicit policy of not permitting banks to fail. In the short run this may play a stabilizing role, but in the long run it creates moral hazard. In addition, it may have the effect of facilitating a buildup of systemic risk and lessening the pressure for Chinese banks to become internationally competitive. This will also make it difficult to realize convergence between the international and Chinese approaches to bank regulation and harder to create a level playing field among Chinese and international banks.

Implications for other nations

What does this all mean for U.S. and other foreign banks? Foreign companies have been trying to enter or expand in the Chinese banking market for many years. This is understandable—China is now the world’s third-largest economy, and will soon be the second-largest. China’s economic growth and increasing wealth have been impressive. Foreign commercial banks have entered the China market in two ways: by making an investment in Chinese banks, or by establishing branches or wholly-owned subsidiaries.

Chinese regulations in 2003 permitted “foreign financial institutions” to make strategic minority investments in Chinese domestic banks of up to 20% ownership per investors, with aggregate foreign ownership capped at less than 25%. Foreign banks enthusiastically responded to this opportunity, which in reality was akin to an investment in China itself, given the protected status of the Chinese financial sector.

One issue a foreign minority investor should consider is the continued role of the government in the banking system and its impact on the risks facing the firm.

For example, does the perceived Chinese policy of supporting its financial institutions mean that investing in a Chinese bank has little downside because it will not be allowed to fail? 

The government’s more recent actions suggest that ensuring survival of the banks does not equate to protecting the shareholders. Now that the banks are listed, it seems unlikely that the government will absorb non-performing loan losses as it did in 1999 and the early 2000s. Recently the Chinese Bank Regulatory Commission required banks to increase capital and reserves to address potential credit quality problems. This potentially dilutes existing shareholders and prepares the banks to absorb possible future losses.

Even the government’s practice of not allowing banks to fail may need to be reconsidered. China could well come under pressure to modify that policy for large banks as international regulators attempt to address various problems inherent in the “too big to fail” problem.

Lackluster progress in China markets

Many foreign commercial banks have established branches or wholly-owned subsidiaries in China, in both the retail and wholesale banking business. Yet these institutions have yet to make significant inroads into the domestic marketplace.

Foreign commercial banks only hold about 2% of Chinese domestic banking assets. Their ability to expand and compete is limited. Constraining factors include their small deposit base and consequent higher cost of funds; their small branch networks; and various regulatory restrictions.

By contrast, the large Chinese banks have enormous branch networks, very deep financial resources, and deep relationships with customers throughout China.

Ultimately, the greatest challenge that foreign financial institutions face in China is more intangible—they simply are not “insiders” in China, in the sense that the major domestic banks are majority state-controlled. The state-controlled banks benefit from the favor of the State, which also holds controlling interests in the best domestic clients. Thus, foreign banks traditionally have had to rely on their international client base for business, although they are certainly trying to expand their mainland Chinese client base.

Hope on the horizon? Or caution?

The growing financial strength of Chinese banks will make it challenging for foreign institutions to compete with them and expand their businesses in China. However, in the longer run, as China liberalizes its regulation of foreign and domestic banks in China and allows them more freedom to innovate, the foreign banks should be able to compete more effectively.

Though Chinese banks are large and successful, their product offerings are fairly traditional (some 90% of commercial financing in China is by bank loans). Foreign banks may be able to offer more innovative and tailored financial services to China’s diverse population. Moreover, highly developed risk management skills may put foreign financial institutions in a superior position in terms of pricing and managing ongoing risks on both sides of the balance sheet. The international expansion of Chinese companies will also offer new opportunities for foreign financial institutions to service these companies outside of China, which will of course play to their advantage.

That said, some of these advantages will be of less value if the government continues to have a prominent role in owning and managing—and otherwise supporting—Chinese financial institutions.

Appreciating the Chinese government’s aims
Foreign financial institutions considering entering or expanding in the China market obviously have to weigh the risks and benefits of the strong government role in the financial sector and the economy at large. The State has demonstrated its ability to keep the economic growth reasonably on track, although this has required intervention in resource allocation that has implications for the efficiency of many markets.

The other aspect of the government’s role that must be considered is its pure power to accomplish its policy objectives, while subordinating the interests of individual enterprises.


China’s current goals for the financial services sector are consistent with growth and international integration, creating a favorable environment for foreign institutions (although they do tend to favor Chinese institutions in more subjective ways). If, on the other hand, China’s policy goals become at any point inconsistent with a firm’s individual business strategy, then that business strategy is at risk.

Foreign financial firms wanting to establish or expand independent operations in China must assess the multi-faceted role of the government and determine how it will affect their business strategy.

They may also want to examine niche opportunities. Foreign banks may be more successful than Chinese banks in certain lines of business where they have more expertise, such as fee-based services, although they again face competitive hurdles stemming from the role of the State, which tends to advantage the domestic firms. Foreign banks may continue to be able participate in the profitability of Chinese financial firms through direct investment, although there are some signs that the Chinese government appears to be less willing to protect banks from losses than in the past.

In the end, the predictability of the Chinese government may be the most important, yet most elusive, aspect of evaluating the risk of doing business in Chinese financial markets.

About the authors

http://www.ababj.com/images/stories/susan_krause_bell.jpg
Susan Krause Bell is a Partner at Promontory Financial Group, LLC. Howard Chao is a Partner at O’Melveny & Myers, LLP. This article is drawn from their recent white paper, The Financial System in China: Risks and Opportunities Following the Global Financial Crisis, which can be found at www.promontory.com and www.omm.com.

http://www.ababj.com/images/stories/howard_chao.jpg

 

 

[This article was posted on June 11, 2010, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2010 by the American Bankers Association.]
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