IN THE COUNTRY OF NEXT MOVES
These are high times for china’s banks. The reality may be less euphoric.
By Oliver Jones

In his budget address in 2003, Antony Leung, then Hong Kong financial secretary, paraphrased Dickens, noting “this is the best of times, this is the worst of times.” The territory was amid the worst of times with the Sars outbreak. Leung himself was under scrutiny following his purchase of a luxury car prior to raising taxes on them. But shortly before resigning in July that year, the financial secretary signed the Closer Economic Partnership Agreement (CEPA) between Hong Kong and China, a move that helped restore robust growth associated with China’s boom.

Hong Kong’s economy exudes a healthy glow again, and one reason for that restoration is its preferential status as a listing venue for China’s banking industry. This sector has been enjoying very high times indeed. The euphoria culminated this October with the world’s largest-ever initial public offering (IPO) with the listing of the Industrial and Commercial Bank of China (ICBC) – China’s largest lender. Now Leung has found a place as a non-executive director and chairman of ICBC’s audit and risk-management committees.

ICBC is the third of the Big Four state banks to list. The listings of China Construction Bank (CCB) and the Bank of China (BoC) also rank amongst the ten largest IPOs the world has ever seen. These successes have encouraged the authorities to proceed with restructuring the fourth, the Agricultural Bank of China (ABC), rather than breaking it up. Such reform is crucial since the authorities are unlikely to significantly entrust the setting of exchange or interest rates to the market until it has been reformed.

China’s financial services industry has witnessed remarkable changes over the past year, ahead of WTO-mandated opening of the sector fully to foreign competition in December. The leaders of the industry, who are generally also Chinese Communist Party members, are optimistic and emboldened. Pang Xiu Sheng, CCB’s CFO, remarks that “it is estimated CCB’s share of the Hang Seng Index will reach 15% in five years time, the same as HSBC’s”. CCB became the first H-share to join the Hang Seng Index this year.

China’s Big Four banks are undoubtedly big. At the end of June 2006, ICBC’s total assets (some 6.5 trn renminbi) exceeded those of all 13 shareholding banks with national footprints – including China Merchants Bank and the Bank of Communications – put together. Likewise, CCB and the BoC each have roughly the same total assets as the 117 city commercial banks – such as the Bank of Beijing and Bank of Shanghai – and tens of thousands of urban and rural credit cooperatives combined.

Enter the insurers

Apart from increased participation by foreign competitors – who are likely to see their share of the retail market remain small over the next five years – the banks face the greater challenge of disintermediation.

At present, China’s citizens hold virtually all of their assets as bank deposits. The growth of alternative savings vehicles – such as life insurance – was kick-started only in the nineties. Declining interest rates resulted in the insurers offering guaranteed returns in excess of the interest rates they earned on their bank deposits. Like China’s citizens, the insurers had few other places to invest their funds than the banks. Such loss-making contracts were retained by the parent company and not included in the entities which were listed, such as China Life. Likewise, the state banks’ balance sheets were cleansed of their bad debts as part of their restructurings in the lead-up to listing. The negative spreads the insurers faced are, however, less likely to reoccur than the banks’ bad debts. In fact, the regulator has introduced a maximum guaranteed return the insurers can offer.

This year, the insurers’ options for investing their funds have expanded dramatically – they have been allowed to buy other financial service players, including banks and brokers, and permitted to invest in infrastructure projects. A small percentage of their assets can now even be invested overseas. They have participated in the bank IPOs, effectively shifting some of their funds from deposits to equity in the banks. Nine of the 23 domestic strategic investors in ICBC were insurers, for example. In short, the banks’ former monopoly on deposit-taking has been significantly eroded.

There are, however, more than enough deposits to go around. Indeed, a vociferous appetite for saving means that China’s savings rate is double that of other large Asian countries, such as India and Indonesia (see table, above). A sea of savings has resulted in a flood of liquidity, with credit as a share of GDP more than doubling over the past 20 years. Even such heady rates of investment spending are easily covered by domestic savings. In contrast, both India and Indonesia require foreign capital to fund investment needs due to the gap between savings and investment as a share of GDP. They also have room for continued rapid credit growth. In China, credit expansion has run its course. Investment as a share of GDP is 84% of savings’ share. Even ICBC lends less. For the six months ended June 2006 its average ‘loans to customers’ balance (3.39 trn renminbi) was only 57% of its liabilities ‘due to customers’ (5.93 trn renminbi). The average rate it earned on loans to customers was 5.28% while its average cost of deposits was 1.63%.

Investing in the banks is an obvious – and one of the few – options for the life insurers, as they seek to match the duration of long-term liabilities with long-term assets. It is highly likely that the majority of state-owned banks will be around longer than most other China enterprises. China’s underdeveloped debt markets are the reason for the dearth of long-dated, tradeable assets available for the insurers to invest in, resulting in the insurers’ liabilities being longer-term than their assets.

The banks face the opposite problem. Their liabilities are shorter term than their assets, due, in part, to an exceptionally low level of consumer lending but also to the structure of the industry. The city commercial banks meet the working capital requirements of small- and medium-sized enterprises, a role played by the big banks in the West. China’s companies generally fund their operations from retained earnings and bank loans. The big banks lend to the large enterprises, which are served by debt markets in the West. Poorly developed debt markets also make it harder for the banks to figure out their capital requirements since companies have little incentive to pay for international credit ratings. The result is that China’s banks have very low financial strength ratings. Implicit government support, however, means that the Big Four’s deposit/bond ratings are higher than the shareholding banks even while their financial strength ratings are lower.

During the week of ICBC’s listing, the chairman of the China Banking Regulatory Commission (CBRC), Liu Mingkang, noted that the proportion of loans with durations over one year rose to 47% – or 10.9 trn renminbi – of total outstanding loans by the end of September, up 21% from a year earlier. In other words, the mismatching of asset and liability durations is getting worse. Such mismatching is not unusual – it is what banks do and how Warren Buffett got rich. The problem in China is that much of this lending finances new factories in already overcrowded industries rather than residential mortgage loans secured by collateral. The lure of higher rates on longer-term loans is strong – even more so now that the banks are expected to deliver returns to shareholders.

Hobbled foreigners

China’s low share of consumer loans is the flip side of its high savings rate. Clearly, consumers with savings don’t need to borrow except to finance major purchases such as homes, with mortgages accounting for about four-fifths of total consumer loans.

This is a challenge for foreign banks, which often use credit card offerings as a bridgehead to enter markets. The beauty of credit cards – apart from high margins – is that little brand equity is needed when you are extending people credit. A great deal of brand equity is beneficial when people are entrusting you with their savings.

The might of the likes of ICBC and BoC are their iconic brands and huge branch networks. Foreign banks cannot compete in terms of retail deposit-taking. Even the city commercial banks have more branches. The largest, the Bank of Shanghai – in which HSBC has a stake – has over 200 branches and thousands of small- and medium-sized enterprise customers.

To put this in context, the foreign bank with the most branches in China at present – the Bank of East Asia – aims to double its China coverage from 27 to 60 outlets within the next five years. Even this target implies that the authorities will significantly speed up the rate at which they grant licenses, and many of these will be sub-branches, which require lower levels of registered capital than branches. Estimates for the number of branches required to attain a decent level of economies of scale range from a dozen per city to one branch in 20 cities.

In any case, the Bank of East Asia’s target is in the same ballpark as the number of branches which the likes of Chongqing Commercial Bank, Nanjing City Commercial Bank, and Ningbo City Commercial Bank operate in these cities alone. And even these banks struggle to attract retail depositors – with corporate deposits accounting for around three-quarters of their deposits. A greater share of corporate deposits is also the case for the shareholding banks. The city commercial banks generally rank third or fourth in their local loan and deposit markets, behind the likes of ICBC and CCB. They are much more vulnerable to foreign competition than the Big Four. In theory, corporates should be less brand sensitive than individuals, placing a higher premium on services and the international networks which overseas banks offer.

In the case of ICBC, 44.3% of its deposits were corporate deposits at the end of June 2006 (less than a third of which were time deposits costing 2.35% on average and two-thirds demand deposits costing 0.85%); 54.4% of its deposits were personal deposits (about two-thirds time deposits costing 2.35% on average and one-third demand deposits costing 0.72%); with 1.3% deposits from overseas operations (costing 4.65%). Clearly, the interest rates demanded from overseas depositors are far higher than the cheap – barely tracking inflation – cost of funds available to ICBC in China.

Despite closing outlets at a rate of 3,000 a year since mid-2006, ICBC still has a branch network of 18,038 outlets, less than half the 41,990 it had at the end of 1997. Of these, 17,506 are sub-branches and almost half of the total are located in western and central China. The ABC has even more branches. The postal savings system has 270m customer accounts – more than Citibank’s 200m customers worldwide (80m of which are outside the US) or ICBC’s 150m. In June this year, the China Banking Regulatory Commission approved the postal saving system’s plan to become a bank, allowing it to lend. It has not suffered from bad loans since it previously only took deposits which it subsequently deposited with the banks. The new bank will provide some competition to the ABC, which can use the threat to reduce its branch network, avoiding excessive resistance at the local level.

The hope is that, as the banks reduce their role in deposit-taking, they will be able to develop more fee income. Bancassurance – or the sale of insurance products through their branch outlets – has been a boon for the banks since it was permitted. Likewise, it is hoped that the banks can sell more and more wealth management products through their branch networks. Nevertheless, non-interest income is only a tenth of interest income.

The greatest share of gross fee and commission income in the case of ICBC was renminbi settlement and clearing (a quarter of such income in the first half of the year), wealth management and agency fees (almost a quarter), investment banking (a fifth) and bank cards (15%). Fee income is an area where China’s banks are learning the most from their subsidiaries in Hong Kong – with CCB facing the steepest learning curve in customer retention with the takeover of Bank of America (Asia). The other banks took over more local banks.

In the case of ABC – which has the least exposure abroad – bank cards account for the majority of fee income. These are mainly debit cards and their share of fee income is falling. Between them, China’s banks have issued about a billion bank cards but less than 5% of them are credit cards. Investor enthusiasm for China Merchants Bank is partly based on its greater success in aquiring credit card customers. Undoubtedly, the emergence of a credit card carrying consumer culture in China holds great promise, but is probably not one which the Big Four are as yet ready for. Of ICBC’s 355,312 employees, only 39,625 are under 31 years old. And only 4,193 have graduate degrees.

Unlike its employees, the bank has had a very short history. It was incorporated as a shareholding company in October 2005 – a year before its listing. A product of urbanization, it took over the commercial banking functions of the central bank in 1984, six years after the start of the reform process. The other three of the Big Four were established after the founding of the People’s Republic of China – with BoC and CCB originating as the international business and infrastructure funding arms of the central bank. The ABC was established to provide financing for the agricultural sector.

Perhaps it is because they have achieved so much so quickly that they have such great ambitions. Some of the of executives running China’s fledgling giants experienced the growth-by-merger wave of banks in the US while working with US financial institutions. Leung, for example, was Asia Pacific chairman of the Chase Manhattan bank – a bank he joined in 1996, the same year it was acquired by Chemical Bank. Four years later, the bank acquired JPMorgan and became JPMorganChase. It’s not far-fetched to imagine that the practictioners shaping China’s banking industry see such a route as one possible outcome. Chemical Bank started life as a relatively small institution before going on to acquire one of the most prestigious names in banking. As China’s banks take further tentative steps overseas, their presence will be increasingly felt – from Almaty to Alaska – perhaps their managers harbor a similar ambition to nab a blue chip financial institution in the process.

A transforming role

Their emergence has certainly shaken up Wall Street. Goldman Sachs made a mint as a stategic investor in ICBC , but was disappointed not to have gained a role in the IPO. The joint global coordinators were ICEA Capital (a Hong Kong-based subsidiary of ICBC in which the Bank of East Asia has a 25% stake), China International Capital (CICC, a joint venture between CCB’s parent and Morgan Stanley) and Merrill Lynch with Credit Suisse and Deutsche Bank’s Hong Kong branches participating as bookrunners.

The banks’ choice of strategic investors will have a significant role in their development. In contrast to their gradualist approach, after long periods of organic growth the likes of Citibank, HSBC, and JPMorganChase participated in transformative deals to forge global powerhouses relatively shielded from the cycle. Some protection against an economic downturn is the idea behind the banks’ attempts to grow alternative income sources other than interest. They have had limited success (see table, below). ICBC increased fee income about nine times as fast as net interest income over the period, compared to about four times as fast for Bank of China and CCB. (As noted, CICC is not part of the listed entry in CCB’s case. ICBC’s investment banking arm is.) Meanwhile, non-interest income makes up a far greater share in Bank of China’s case – due to its history as the central bank’s overseas arm and greater presence in Hong Kong. A lack of experience in managing foreign currency exposure is highlighted by the fact that non-interest income declined in CCB and ICBC’s case – mainly due to foreign exchange dealing.

The transformative role that the banks’ strategic investors have to play include American Express helping ICBC develop its card business, the Royal Bank of Scotland Group’s private bank (Coutts) is working at developing such a business with Bank of China, and Bank of America is aiding CCB to strengthen its retail banking offering. Their large number of customers will enable them to attain economies of scale in multiple customer segments. Additional strategic investors include the Asian Development Bank, Temasek, Goldman Sachs, Merrill Lynch, UBS, and Allianz. The Royal Bank of Scotland and Bank of America have both grown by acquisition and focused less on trying to combine high margin investment banking with lower margin corporate and retail banking than the likes of Citi, HSBC, and JPMorgan Chase.