FLIGHT OF THE PHOENIX
A new generation of managers is transforming Chinese joint-stock commercial banks – from companies vainly trying to do everything to more realistic enterprises with specialist goals.
By Wu Chen and Lily Zhang

Fu Neng, CFO of Shanghai Pudong Development Bank, still remembers his negotiations with Citibank two years ago. The American giant wanted to penetrate China’s personal credit card business and thought that teaming up with Shanghai Pudong was the way to go. The small Chinese joint-stock commercial bank was receptive, but insisted on a full-scale strategic cooperation involving the transfer of technology and expertise. In the end, Citibank agreed to buy 5% of Shanghai Pudong for 600m renminbi in a deal that went beyond just credit cards. “There is no blind love in this world,” says Fu. “Citibank is a world-class bank, but at that particular time, it needed us, and we understood our value to it.”

Now that the global giants have bought stakes in newly Hong Kong-listed Construction Bank of China and soon-to-list Bank of China, the curtain has opened on the reform of the Big Four state-owned commercial banks. Outside the spotlight, however, second-tier banks like Shanghai Pudong have already been traversing the same road for a few years, helped by alliances with foreign institutions like Citibank. As a result, this group of commercial banks boasts relatively well-established corporate governance and improved risk management, as well as higher capital-adequacy ratios and lower levels of bad debts compared with the Big Four.

A new generation of CFOs, among them Fu, Wu Touhong of China Minsheng Bank, and Lu Hong of Everbright Bank, is at the forefront of this second-tier revolution. Apart from bringing in foreign banks as strategic investors, they are abandoning their original business model of cloning the full range of services offered by the Big Four. Instead, the joint-stock commercial banks are trying to find their own specialized niches, particularly in retail and intermediary businesses.

“All banks are competing hard in the same market,” says Everbright’s Lu, whose formal title is general manager of planning and finance. “We offer loans to the same few good enterprises and ignore the same bad companies.” His bank is looking at asset management, bond underwriting, and fund custody. Over at Minsheng, Wu says her bank’s traditional revenue mix (mostly leveraging on the margin between loans and deposits) would change as it generate 30% of turnover from consumer lending and 15% from other services. “Hong Kong’s experience is worth noting,” she says. “Some small- to medium-sized banks there focus on retail banking and SMEs” – and piling up profits.

By flying on the wings of reform and specialization, the erstwhile sparrows hope to be reborn as phoenixes that can compete with the resurgent Big Four and foreign institutions. Time is running out. In joining the World Trade Organization, China has committed to dismantle by the end of 2006 most barriers that had restricted the scope of business that foreign banks could do in China. “Competition will be fierce,” predicts Oliver Stratton, head of China finance practice at consulting firm Bain & Company. “Foreign banks haven’t figured out which way to go, so they will be launching their assault on many fronts.”

Managing Risk

Aware of the ticking clock, China’s second-tier banks have zeroed in on risk management. In patterning themselves after the Big Four, they had also picked up bad habits such as poor or non-existent risk management, which resulted in the accumulation of bad loans. They have realized, says Dirk Chan-Muller, managing director of financial services at consultanting firm Bearing Point, that “you can no longer manage a bank on instinct.”

As early as 2002, Minsheng appointed a chief risk officer reporting directly to the bank president. An independent auditing system was later established in 2003, involving the dispatch of auditing specialists to main branches. Although they have no veto power on loan decisions, say Wu, the auditors “remind in advance, punish afterwards, and advise in the process.”

Everbright set up a risk management function earlier this year. Lu says the bank is currently focusing on making the entire approval process electronic. The bank has also started calculating the violation rate and loss using risk-management grading and an internal scoring method. Shanghai Pudong has also been refining its risk-management structure, creating the position of chief risk officer in charge of reforming the authorization procedure, and establishing a control mechanism.

Inevitably, the emphasis on risk management is leading to organizational changes. Banks are finding out that in order to impose central control, the pyramidal “headquarters-to-branch-to-sub-branch” structure requires strengthening. They are now concentrating on risk management practices such as setting loan standards at headquarters, instead of allowing branches to implement risk management.

The weakest link in Chinese banks, says Chan-Mueller, is how to establish an independent risk control system on a structure that has headquarters at the apex.

“Most top ten banks have been implementing risk management for one to two years,” he adds. “It will take them another two to three to achieve just the first objective.” Currently, banks are still focused on establishing an effective risk grading system for different loan categories. As the market develops and more complicated products are launched, risk categories will become more complicated.

The relationship between risk managers and operating officers would also take on an adversarial tone. “The chief risk officer should function as the last independent gatekeeper in senior management,” says Lan Wencong, a consultant with Hewitt Associates. This would require another adjustment in Chinese banking culture, which tends to emphasize hierarchy and deference to authority.

Beyond Me-Too

Even as they deal with improving risk management, joint-stock banks are also reinventing their business model. “Chinese banks tend to pursue the me-too strategy – if one lender launches a new product, they feel they will be lagging behind if they don’t offer the same thing,” says Shanghai Pudong’s Fu. “Now that we are integrating with international markets, we have to change our way of thinking. We need to learn to offer unique products and services.”

Currently, banks derive the majority of their earnings from deposits and loans because the state controls interest rates. Knowing they will get the same rate from whichever institution they patronize, depositors and borrowers choose a bank mainly on convenience and proximity, giving the Big Four and their extensive branch networks some advantage. But China is gradually relaxing its hold on interest rates. When consumers begin doing business with a bank based on yields and customer service, lenders will need to work much harder than they do now.

That is what the second-tier banks are beginning to realize, which is why they are looking at developing retail banking and other specialized services. Everbright is even rethinking its geographical reach. It is changing its approach of blanketing the entire country to one of focusing on east China, the Bo Sea area and the Pearl River Delta regions, the better to focus on customer service and specialized services. “Banks need to take quick action to have an advantageous position,” says consultant Lan.

They should also focus on cost control, says Stratton, noting that Chinese consumers are extremely sensitive about pricing. The biggest issue for the banks is providing better service without overspending. “Banks can very well copy western models and cost structures, but whether they can be profitable is the key,” he says. Wu says Minsheng Bank is aware of the issue. It is experimenting with central procurement, which involves headquarters bidding out bulk buying, and planning centralized accounts settlement by issuing each employee with a credit card, integrating all their expenses into one account, and reimbursing them as appropriate.

Banking the Chinese Way

In all this, the second-tier banks look to foreign expertise for guidance. Since 2002, Minsheng has been sending groups of sub-branch and division heads and other middle managers to Hong Kong and Singapore for training. It is not just a question of skills, says Wu, but cultivating a “customer- and employee-oriented” culture. That is relatively easy to inculcate among the grassroots employees, whose average age is less than 30. The bottleneck is with middle management, which is why senior managers focus on them in capacity building.

Also on the agenda: recruiting professionals experienced in international trade, derivatives, and risk management now working for foreign banks. “We have a war chest to bring them in,” says Wu. The bank is also considering incentives such as stock options to attract them, which Hewitt’s Lan thinks make good sense. “Short-term incentives are certainly important, but the key is for managers to have a long-term horizon.”

For all the usefulness of foreign expertise, however, Everbright’s Lu says his bank is not copying outside systems entirely because China’s regulatory environment, taxation, and corporate culture are different from those of foreign banks. “The key to banking reforms is what strategic objectives you want to achieve,” he says. “Are you copying the nose or the leg of the elephant? You might end up worse off than before.” The learning must be integrated with local business situations. Call it banking with Chinese characteristics.

Minsheng is counting on this amalgam come 2007, when foreigners are given more latitude in their operations in China. “Foreign banks are not that frightening,” says Wu, “because we have the local advantage in network and talent.” At Shanghai Pudong, Fu points to his bank’s advantages in labor and other costs, customer base, and a deep understanding of regulatory bodies, policies and markets. But he is also counting on continued cooperation with Citibank, which is said to want to increase its stake to 19.9% and thus become Shanghai Pudong’s biggest shareholder.

The transformation won’t happen overnight, says Lan. “Many banks think reforms can be implemented in one go and that success can be ensured by launching large-scale reform. This is wrong. In fact, change is an ongoing process. The sparrows of Chinese banking can become genuine, flying phoenixes one day only by constantly pushing new reforms and adapting to them.” The making of the phoenix has only just begun.