China: Foreign banks fumble over their expansion strategies
China has finally started to open up its financial sector, but international banks seem to be struggling to find a clear or coherent strategy for tackling the market. It may be time to start worrying.
By Paolo Danese
To understand how foreign banks operate in China, it’s important to look at their recent history.
The presence of foreign banks in China is nothing new: the first to enter the market, Bombay-based British Oriental Bank, opened a branch in Shanghai in the 1840s. Then came the blackout years of the communist revolution and the Maoist era, meaning that the story of foreign banks in China only really begins again in 1979 after the passage of a law permitting them and other foreign firms to form joint ventures.
One year later, China’s then president, Deng Xiaoping, created four special economic zones, including Shenzhen, which put China on its path to becoming a global economic power.
The next important step was the establishment of the China International Capital Corporation, the first Sino-foreign joint venture investment bank, in 1995. At the time of CICC’c creation, Morgan Stanley was the second-largest shareholder in the company, with a stake of just over a third – but eventually quit the venture in 2010.
When China joined the World Trade Organisation in 2001, it committed to fully opening a broad range of service sectors, including banking, insurance, asset management and securities to foreign direct investment, which should have made things easy for foreign banks seeking to enter the market, either solo or as a joint venture, as Morgan Stanley had done.
At the time, China promised that full market access for the banking sector and the elimination of restrictions to foreign ownership would be achieved within five years and, indeed, China did allow foreign-owned banks in to China in 2007. Looking back on the decade that has passed, however, things have turned out rather less rosy than they first seemed in the aftermath of China’s WTO entry.
To take just one measure, foreign banks have a tiny 1.32% share of domestic banking assets at the end of 2017, according to China’s authorities, down from a 2.38% share a decade earlier right after the market opened up, according to KPMG data.
The list of contributing factors is a long one.
Some would argue that China was allowed to fudge its WTO commitments, abiding by the letter of the law while laying out numerous obstacles to stop them being implemented in practice.
That, plus factors such as foreign investors’ poor understanding of the local market and, in some instances, regulators pressuring foreign players in matters such as where they may open branches explain why even the big names in finance failed to make much of an impact in the world’s fastest-growing economy.
Not that foreign banks can be blamed for lack of trying. Getting a banking licence in China has been, in fact, just the start of a steep journey.
That first step is followed by the need for branch licences and, should such banks want to do anything other than hope (with little chance) to beat the domestic banks at the deposit-taking game, they also have to apply for several business licences, such as those required for bond trading, settlement and underwriting (each with its own lengthy process).
HSBC is possibly the closest thing to a success story. The bank has continued to make its part-Chinese DNA count, by not only piling resources into building global China-related capabilities, but also by nailing the first majority-owned securities joint venture – called HSBC Qianhai Securities – which became operational last year. It took the bank three years to go from regulatory application for its Shenzhen-based JV to live business, and it could well give HSBC an edge over the competition.
One reason is that its partner is a local government entity and not a financial institution, which will likely reduce the risk of conflicts over market strategy, according to a source at the bank.
The market structure [in China] is dominated by the big, established banks. New entrants have to overcome that challenge - Nicholas Zhu, Moody’s
Among the rest of the potential-JV crowd, a number of banks decided after a few years that the effort was simply not worth it and gave up. A classic example of this, though with a sequel, was JPMorgan’s decision – announced in October 2016 – to walk away from its Shenzhen-based joint venture, called JPMorgan First Capital.
For everyone else, though, president Donald Trump’s first official visit to China last November may have been a game changer.
To give credit to the former reality TV star, until that trip it had looked as though things would continue to go from bad to worse for most foreign banks trying to tackle the Chinese market.
The threats of tariffs and the increased likelihood of a trade war between the largest and second-largest global economies have probably contributed to the Chinese loosening up a little.
Foreign financial institutions, the Chinese promised as Trump was (literally) boarding a plane out of Beijing, would be allowed to raise stakes from 49% to 51% in securities, fund management and futures companies – with limits scrapped after three years.
For banks, the current 20% cap on foreign ownership in banks and asset managers is being scrapped entirely.
Was there a big sigh of relief? Not quite. Most of the largest international banks have issued little more than vaguely worded press releases.
JPMorgan is among them, though chief executive Jamie Dimon did promise to leverage the new rules with slightly more forceful wording than his peers. The bank announced in May that it has already submitted an application to the China Securities Regulatory Commission to establish a majority-owned securities JV, with the aim of fully controlling it within a few years; the bank has already hired a new chief executive for the country, Mark Leung, the former co-head of global equities and prime services.
“Our investment in China is a commitment to bring the full force of JPMorgan Chase and our resources to the country,” said Dimon.
Lack of response
One would expect the banks to show signs of frenzied activity after waiting a decade and a half for China to give them the green light, but that does not seem to be happening.
The lack of response could be explained by ‘promise fatigue’, an expression that was coined by the EU Chamber of Commerce in China to describe the outcome of China’s habit of promising so much and delivering so little.
It is possible that foreign banks will decide to do nothing. But that would be unwise for the simple reason that China’s large banking firms have already secured a nearly unbeatable primacy at home and may well end up eating the lunch of global banks abroad.
They are no strangers to international M&A, as demonstrated by the diverse cases of South Africa’s Standard Bank, Hong Kong’s CLSA and Portugal’s Banco Espírito Santo and BCP. And it does not end there, as anyone familiar with the Belt and Road Initiative’s grand plan knows.
Some experts underline that there is indeed interest in the market and that now may be a propitious time to move.
For a start, foreign banks benefit from much lower non-performing loan ratios. It is no secret that domestic banks have built balance sheets so rotten that the pain from the current deleveraging process, a central government priority, will probably take years to unfold. But the key will be how quickly those foreign players can build a critical mass to compete in a meaningful way.
“The foreign banks’ numbers are really small,” says James Chang, China financial services consulting leader at PwC. “Their overall NPL and bad debts are relatively insignificant, but because they have no scale, they have larger fixed costs and their overall capabilities are not strong. That has been the reality in recent years.”
Nicholas Zhu, senior analyst in the financial institutions group at rating agency Moody’s, agrees.
“The market structure [in China] is dominated by the big, established banks,” he says. “New entrants have to overcome that challenge. The foreign banks are huge like the Chinese banks as a group, but their investment in China has not been that big.”
Going solo or investing in a JV remains a crucial decision.
Both models have so far disappointed, clearly, but external events have probably played a part in global banks’ misfortunes in China. Timing-wise, 2007 was probably the least propitious year since 1929 to open. Several global banks were nearly obliterated in the aftermath of Lehman Brothers’ collapse in September 2008 and the global financial crisis that followed.
“Many major banks sold out ownership stakes in Chinese banks as they needed the money for their home markets after the GFC,” says Moody’s Zhu.
European and US bank regulators set stricter regimes after the crisis, which reduced the amount of capital available to be deployed to expand China operations, further compounding the issue.
The Chinese also bear some of the blame. The China Banking Regulatory Commission, which merged with the insurance regulator earlier this year, has for years played chicken with foreign banks looking to boost their solo commercial banking and retail capabilities.
One source close to the regulator noted how CBRC has used its power to force concessions from applicants, for example by demanding that foreign banks that want to open branches in the richer coastal Chinese hubs also commit to investing in lower-tier cities.
There are other, non-regulatory factors at play. A number of experts told Asiamoney about diverging cultures and business practices.
“In the US, most banks run the business by lining up services rather than branches,” says Chang. “The branches just execute what headquarters tell them to. But in China, the branches have a lot of power. The line of business is subordinate to branch management. [The latter] decides the products and strategies.”
In communist party-led China, politics is part of the picture, too.
Wang Chunyang, economics professor at the Peking University HSBC Business School in Shenzhen, tells Asiamoney that foreign banks have fared better so far in betting on coastal cities, where markets are more developed and there is less corruption among local political and regulatory bodies.
“You look at Inner China, the more inward you go, they want you to come,” he says. “But foreign banks should not be lured by that. Once you come in you are faced with a whole set of different issues.”
While some banks have moved in land, such second-tier locations have exposed them to the risk of personnel changes at the local political level.
“It becomes a headache and the costs can be high,” says Wang.
The new rules on ownership levels could boost banks’ abilities to go solo, but it is not clear that will ultimately provide an advantage.
“Even with the lifting of ownership caps, we have seen that not all foreign banks want to set up these wholly owned subsidiaries,” Kimi Liu, a senior associate at law firm Clifford Chance, tells Asiamoney.
He points to a few reasons, cultural factors included, whereby foreign banks feel the need for a local counterpart to gain a better understanding of local market practices, form better partnerships with the stakeholders, and can tailor a better product experience for the Chinese saver and investor.
Wang agrees, but notes that a foreign institution may face the double challenge of dealing with local customers’ home bias as well as its own lack of understanding of the country. The same goes for the relationship with the regulators.
“The cost of political influence is very high here,” Wang tells Asiamoney. “Local leaders have different thoughts from those in Beijing. The foreign banks doing business here have had troubles understanding the importance of local leaders.”
The implications for the bottom line can be substantial. In the West, if a borrower does not repay a loan, banks normally pursue legal action and try to recover some of the funds through that channel. But in China, if the lender has a good relationship with local governments, other avenues open up to address the situation. In short, the power of so-called ‘guanxi’ is still going strong in the 21st century.
The Chinese government has a supportive view on developing fintech to help the financial services sector to grow, but it is also aware of the risks - Kimi Liu, Clifford Chance
In a business world driven by compliance, that is a difficult obstacle for those unable to play the game.
As for the various licences necessary to develop a comprehensive business offering, there appears to be a change in the pace of how these are awarded to foreign banks.
“I get a sense they are trying to improve that process,” says Chang.
That, at least, has been the case for the foreign-owned enterprises of global asset management firms such as BlackRock and Fidelity, which received their private fund management licences far faster than applicants in previous years. Several of these players have already managed to begin offering private funds to domestic investors.
Clifford Chance’s Liu also believes the authorities are taking a new approach to the licensing issue.
“The regulators already removed many restrictions for commercial banks on what business can be done and what licences are needed; we see them deregulating the licensing regime,” says Liu. “This creates more flexibility for foreign banks doing business in China, which will lead to more market share and track record. At that point, we will see them having more market share in the domestic capital markets as well.”
Banks will have to choose which business lines to target, but it is not clear that there is an obvious answer in a market as complex and increasingly sophisticated as China’s.
“Everyone believes the retail side, consumer finance, is where the future growth is,” says PwC’s Chang. “The corporate banking area is quite saturated, but for retail and small and medium-sized enterprises you can see more demand and growth. But dealing with those segments really requires you to be very localized. It would be difficult for the foreign financial institutions to build that.”
Financial technology companies present a novel point of entry into the market.
“We are helping foreign banks explore potential partnerships in fintech-related sectors,” Chang says. “These firms lack some of the financial services industry’s capabilities, but they have tech capabilities. They are trying to team up with foreign financial institutions, they want to work with them.”
For foreign banks to manage to differentiate themselves, fintech capabilities can give them an edge in the domestic market more than would, say, a stake in a local rural commercial bank, he adds.
“But if you have that tech capability,” says Chang, “you could help a local or a city bank to improve significantly and gain the ability to compete with the big guys. We are working on several cases like this for foreign financial institutions.”
He adds that PwC is advising a leading European wealth management company in partnering with local tech companies to design a pure digital-based business model.
“We also see demand from other major leading US banks doing similar deals,” he adds.
Moody’s Zhu says the fintech race is very much on, as banks adapt to the changing landscape of how people seek and use financial services.
“Those that don’t adapt will suffer more,” says Zhu. “That does not mean that any fintech investment will benefit the foreign banks. It depends on the adaptation and learning from mass feedback in the market.”
Success will also depend on not getting caught in bubbles, as is often the case in a fast-growing industry.
“The Chinese government has a supportive view on developing fintech to help the financial services sector to grow,” says Clifford Chance’s Liu. “But it is also aware of the risks; with the peer-to-peer lending industry, for example, there have been several scandals and fraudulent activity.”
Peking University’s Wang agrees.
“This P2P business is like gambling,” he says. “The risks are high there, very high.”
That said, he notes the rise of some fintech banks, the likes of Tencent-sponsored private bank Weizhong Bank, which could represent an ideal segment to target for foreign players.
“There are new banking licences to these private banks and they need capital, they’re basically start-ups,” Wang says. “They need a partner more than others.”
In investment banking, while domestic banks have a tight grip on origination for local firms, there may be room for foreign banks to squeeze in as the market becomes increasingly open to foreign investment flows, not least due to the increasing level of inclusion of onshore assets in global indices – for example, the inclusion of A-shares in MSCI’s emerging market index in June.
Bond index providers are set to follow over the next year.
“We see direct funding channels growing at a much faster pace than banking channels,” says Harry Qin, a financial services consulting partner at PwC.
Majority ownership in local entities may also allow for strategies to be deployed more effectively than before.
“With a JV with majority ownership, many global investment banks think they can achieve that growth,” Qin adds. “Many foreign financial institutions have a mature business model outside and want to replicate that here ‘with Chinese characteristics’.”
As for the likely targets, banks have kept silent, though consultants think they have a variety of options.
“To do IPOs, they will need to partner with a local securities firm under the China Securities Regulatory Commission,” says Qin. “That means they have many choices. And while it may be difficult and expensive to form JVs with the likes of Citic or Guotai Junan at this stage, there are many regional players they can consider. There can also be potential partners beyond the securities firms, like boutique investment banks, which are specialized in M&A, for example.”
Qin notes these firms focus on specific industries such as telecoms, finance and technology.
“They are typically privately owned and their structure is much simpler than an state-owned enterprise. Those can be potential JV partners.”
Qin rejected the characterization of the recent round of capital markets liberalizations as too little too late. Large segments of the retail and corporate markets remain untapped across China, he says. With the tightening of the screws on shadow banking, lending activity will slowly be brought back into the purlieu of regulated financial activities by licensed operators, domestic and foreign.
The same reasoning applies to investment banking and brokerage activities. The latter sector is still very retail centric, but it will slowly morph into a more in
stitutional investor-driven market, like the US, an area where both American and European firms will be much more at ease.
“If we had one message for the foreign financial institutions it is that you have to be in it to have a successful business,” Qin concludes. “You really have to be inside of China, know local regulation, customise products and focus on servicing those sectors of the Chinese markets that are still under-served.”
That will mean growing business not just in the secondary markets, where foreign banks are already taking a share of the pie both onshore and through schemes such as Stock Connect and Bond Connect, but also, soon enough, directly into the primary markets.
“Cross-border capital movement is still subject to restrictions, and one area with most restrictions is the primary market,” says Clifford Chance’s Liu. “So this might be the area with the most potential and opportunity for foreign players as the market is opening up, but this is still subject to multiple considerations and an uncertain timetable.”