David vs. Goliath in the Far East

Question: What country has a GDP growing three times faster than the United States’s and projected to top it in less than twenty years?

Answer: China.

China’s purchasing power parity is rising even faster, potentially passing the United States’s by 2011. These forecasts make clear that China’s banking and financial systems will grow in leaps and bounds. And such growth, while beneficial in many regards, always comes with new dynamics and challenges for the players involved.

A head-to-head analysis of two very different Chinese banking firms, Minsheng Banking Corporation and Industrial and Commercial Bank of China (ICBC), against the backdrop of China’s financial industry and regulatory history highlights the challenges players in this high-growth arena face.


The Stage: China’s Financial Industry

By 1955 the People’s Republic of China had consolidated the fragmented system of nationalized banking institutions into the People’s Republic Bank of China, which focused primarily on public financing and government-related finance. With no free market and the Soviet Union as the only trading partner, China’s banking sector was quite underdeveloped.

In 1978 Deng Xiaoping instituted economic reforms to promote the “modernization of the mainland China economy.” These efforts accelerated after the Soviet Union collapsed in the 1990s; China welcomed foreign direct investment from the West and joined or rejoined several international trade/financial organizations, culminating with WTO membership in 2001. That year also marked a major shift in China’s foreign banking regulations, allowing foreign banks to offer services in China. By the end of 2004, sixty foreign banks had established businesses in China, and another two hundred opened branch offices there. Eighteen Chinese cities now house foreign banks including Citibank and Morgan Stanley, who have established partnerships with their Chinese counterparts. And the banks are no longer limited to foreign currency deals, providing local currency services to Chinese consumers.

Several issues have emerged amidst this rapid growth: $204 million of non-performing loans (NPL) on the books of state-owned banks (13 percent of total banking assets); poorly established corporate governance, risk management, and accountability; capital markets lacking innovation.


The Players: China’s Banking Institutions

“The Big Four” refers to the banks that hold 60 percent of all deposits in China: Agricultural Bank of China; Bank of China; China Construction Bank; Industrial Commercial Bank of China (ICBC). These banks face two major challenges: (1) The NPL issue mentioned above (by some estimates Chinese NPLs may rise to $225 billion eventually) affects them disproportionately, and government reforms removing government-issued NPLs from the Big Four’s books have not changed aggressive lending processes; (2) The banks’ governance and risk management practices are fraught with legal inefficiencies. The latter problem has led the Big Four to take on greater foreign investment and allow partial privatization, with three of them going public recently, raising $42 billion. In this context ICBC, which raised $21.9 billion in its late-2006 IPO, is the proverbial Goliath, China’s largest wholesale and retail bank, with 18,000 outlets, 360,000 employees, and RMB6.3 trillion in total assets at the end of 2005.

China’s middle-tier banks are smaller, typically “private” commercial institutions that compete with the Big Four. They may be government-owned in part, but also linked to foreign investors (e.g., IFC/New Hope own 7 percent of Minsheng), and tend to have more sophisticated governance and risk management, and thus healthier asset quality and profitability. Minsheng, David to ICBC’s Goliath, is a Chinese majority-held bank and one of the country’s most profitable. It has also launched a new Chinese joint venture fund management company with Royal Bank of Canada.

While foreign banks remain potential contenders in China, for now they have relegated themselves largely to advisory and investor roles, though HSBC and Citigroup were set to offer banking services in April 2007. Thus foreign banks are beyond the scope of the current discussion.


David vs. Goliath on Five Key Banking Dimensions

ICBC was compared to Mingsheng on five factors crucial to a well-managed and profitable bank.

Product and Service Offerings (Winner: ICBC). ICBC includes corporate banking, personal banking, and international businesses, with products offered through branch offices, the Internet, telephone, and ATMs in China, Hong Kong, and London. Within corporate banking, ICBC seeks to improve share of high-margin businesses including investment banking and wealth management. Assets under custody grew 73 percent in 2005, and ICBC hopes to continue this growth partly through alliances with insurance and securities/futures companies. ICBC’s savings deposits and personal loans increased 9.9 percent and 5.0 percent respectively in 2005, and its seven bank card products have been successful, with the total number of cards increasing over 30 percent annually by the end of 2005.

Minsheng competes with ICBC in areas including corporate lending to state-owned enterprises. State-owned banks such as ICBC have distinct advantage in this market due to historical relationships with such customers; as a result, Minsheng has tried to gain share using discounted loans, which mean lower margins (averaging under 1 percent). Within personal banking, Minsheng is trying to strengthen its private wealth management offerings and rolling out co-branded credit cards, along with a Minsheng VISA/MasterCard. But these personal banking efforts, while promising, may not be enough to offset the bank’s disadvantages in corporate banking.

Ownership Structure and Strategic Partnerships (Winner: ICBC). The Big Four, including ICBC, continue to benefit from partnerships with the government, which recently took on many of the banks’ NPLs, and foreign investors; for example, Goldman Sachs and others paid 38 percent over market value for ICBC shares at IPO. The perceived lower risk profile of ICBC results in this foreign investment advantage over private banks such as Minsheng.

Yet Minsheng, too, has carefully selected foreign allies, a process one executive describes as akin to “selecting a marriage partner.” Through this process, Minsheng has tended to select smaller, more strategic partners, in contrast to the “big guns” backing ICBC. Yet the sheer size and reach of ICBC’s foreign partners (e.g., distributing credit cards with the help of American Express) will give it the edge in this growth phase.

Corporate Governance and Risk Management (Winner: Minsheng). Largely to counteract the NPL crisis, ICBC has made improvements to its risk-management systems. For example, local branches that have NPLs that “exceed the risk control line to effectively control total risk” face new penalties. Yet the impact of these measures is difficult to discern given the Chinese government’s recent taking on of a large portion of NPLs. And the penalties may be viewed largely as “slaps on the wrist,” rather than more meaningful punishment. Despite enhanced auditing (including hiring an external firm), ICBC was accused in 2004 of accepting false documentation related to loans and going beyond established lending limits.

Mingsheng, on the other hand, has a loan approval process that has yielded one of the lowest NPL rates industry-wide. Currently a centralized team of specialists approves the bank’s loans, and a chief risk officer reports directly to the president (since 2002). Mingsheng has also incorporated an independent auditing system since 2003, sending centralized auditors to local branches. ICBC still maintains a much greater degree of “local flexibility,” which is less ideal. Note, however, that Mingsheng has also made missteps in this arena, including a recent forged shareholder’s signature on a proxy form.

HR Practices and Employee Incentives (Winner: Mingsheng). Chinese consumers currently tend to select banks for convenience (e.g., proximity), but as the government relaxes its hold on interest rates, customers will consider yields and customer service more carefully. Providing the latter will depend heavily on bank employee skill and commitment levels. Mingsheng has a clear advantage through employee incentive structure. For example, it was one of the first Chinese firms aligning managers’ compensation with overseas stock value. These and other profit-based incentives have led to an employee turnover rate of 4.2 percent.

ICBC, like its Big Four peers, still generally allocates salaries without consideration of profit and performance, though it is trying to improve its incentives, recruiting, and training systems. In this regard the bank has been moving toward linking pay to performance and developing longer-term incentives, among other measures. Nonetheless, forward-looking Mingsheng has the advantage here.

Strategic Goals (Winner: ?). Both ICBC and Mingsheng face crucial questions with regard to their overarching goals. Is ICBC, for example, moving too fast, especially given its reliance on the shareholding Chinese government? The firm is making a major push into the lucrative private wealth management market, but remains well behind Wall Street stalwarts in the sophistication of its offerings here, and must be careful not to repeat the NPL fiasco by overzealously approving loans for this segment.

The question for more government-independent Mingsheng is whether the nimbler firm is succeeding in carving out a niche in the evolving Chinese financial industry, largely through strategic partnerships and a more customer/employee-centric focus. Mingsheng, in contrast to ICBC, may be moving too slowly, carefully selecting partners and new products/services to roll out.

Overall this analysis gives ICBC-Goliath and Mingsheng-David each the edge on two key factors, while suggesting a draw on the fifth. But Mingsheng is expected to be able to reinvest profits and leverage reputation more capably to better serve both personal and retail banking clients, especially as state involvement in the banking industry declines. For now, both firms and all of their peers will do well to approach the rising tide that is China’s financial markets as strategically as possible, lest they risk crashing on the ever-present rocks of NPLs, corruption, and mismanagement.