Foreign Banks in China: Wolves on a Tight Leash
“The wolf is at the door!” Expect to read that headline a lot in the
months leading up to 19 December 2006, the date on which the
last formal concession China has made to open up its banking
sector to foreign competition is implemented. After that date,
foreign banks will finally be able to do renminbi (RMB) business with
Chinese residents and all geographic limits on their activities will
be eliminated. These moves are the last in a line of concessions
agreed back in 2001 when China joined the World Trade
Organization (WTO). Domestic banks have apparently been
quaking in their sheep pens at the prospect of the foreign bank
‘wolves’ gaining untrammelled entry into their sector.
In actual fact, foreign banks will remain well regulated in 2007 and
beyond and it is important not to exaggerate the scale and
significance of the change that will take place at the end of 2006.
New business activities will become possible for foreign
banks, and no one is under-estimating the importance of being
able to bank renminbi savings, lend mortgages to China‘s
booming middle class, and manage all that renminbi wealth,
which in the long run will help China to develop a more efficient
and competitive banking system. But we will leave it to the
strategy people to scale these markets and advise on how
profitable they are. Instead, we highlight the key regulatory
challenges that will remain after 2007 for all foreign banks.
Our view is that these restrictions will have a major impact.
China has taken a cautious approach to
opening up to foreign banks. First, the authorities allowed foreign
banks to do only foreign currency business with only foreign invested
companies in only some areas of the country. Then, in
December 1996, the People’s Bank (then the bank regulator)
allowed some qualified foreign banks to do RMB business with
foreign firms and individuals on a trial basis in Shanghai and
Shenzhen, slowly extending the geographical limits of this
experiment. Later it allowed FX business with foreign firms and
individuals. Foreign banks are still only allowed to do business in
specified cities and their surrounding provinces, although the
number of areas has expanded. Before September 2004, the
China Banking Regulatory Commission (CBRC), the new
regulator, only allowed a foreign bank to open one new branch a
year, but this rule seems to have been partially relaxed. And in
September 2003, foreign banks were allowed to start banking
Chinese corporates, as per the WTO agreement.
So, after 2007, what issues will foreign banks have to deal with?
1. To do business, a foreign bank needs a banking
licence, and getting one of these requires time and money.
Banks are required to maintain
representative offices in China for two years before they can
apply to open a branch and this is likely to continue (so any new entrants in 2006 will need to
be patient). For banks with more than two years in China, to apply
for a branch license there are capital requirements which vary
depending on what business the branch hopes to do. To do a full
range of FX business one needs capital of at least RMB200m(US$25m) equivalent in a convertible foreign currency. As for
RMB business, the CBRC requires not only capital of at least
RMB300m (US$37.5m), but also asks that the branch has been
operating its FX business for three years and has two years’ worth
of consecutive profits. These capital requirements are per branch,
and, despite having been reduced in recent years, remain among
the highest in the world. This has three main consequences. First,
any foreign bank will have to pay for its expansion in China, and
capital is a scarce resource for any well-run bank. Second, these
rules mean that only the best prepared banks (i.e. those who
have branches already doing FX business) will be able to open
branches to do renminbi business in 2007. Third, given that a
branch network is hard to build, gaining a large deposit base will
be very difficult – which means that Chinese banks with large
networks will retain scale and the ability to use their balance
sheets to win deals. It is also worth mentioning that foreign banks
can only borrow funds from the inter-bank market up to 1.5 times
their branch capital, so cannot fund expansion this way either.
Domestic banks operate under a different capital regime.
They are governed by the Commercial Bank Law (CBL) while foreign
banks currently come under a separate set of rules. Article 19 of
the CBL says that domestic banks are more or less free to
allocate capital, with no per branch requirements. The only limit is
that the sum of the working capital allocated to branches should
not exceed 60 per cent of the bank’s total capital. The reason for this
different treatment is, in theory, prudential. PRC banks have their
capital in China, whereas foreign banks have the majority of theirs
offshore. Therefore, the reasoning is if a domestic bank
branch had difficulties its other branches would supply funds.
Foreign banks need to be required to have their capital onshore
just in case. However, a concern for its reputation in China alone
would likely mean that any reasonably well-run foreign bank
would be willing to import capital to sort out any onshore
problems if they occured. There is therefore a strong case for
reducing this branch capital requirement.
2. Once you have got your two licences, the second issue for foreign banks is that business is
circumscribed by the scope of business outlined in the licences. For
instance, the licences do not allow banks to do RMB or FX
derivatives, structured deposits, bank cards, or primary dealing in
treasury bonds, etc. A separate licence is required for all these
things. Such licence requirements will remain after 2006, although
licences should be issued on a prudential basis alone.
3. The third set of challenges involve ratios. This gets a little
technical, but is important since these ratios make a huge
difference to how foreign banks operate. There are a number to
consider, but here we focus on the capital adequacy ratio (CAR),
which is an international standard meant to ensure that a bank
has adequate capital to back its loans in case they go bad. China
is currently implementing the Basel I standard of 8 per cent risk-adjusted
capital. Foreign banks need to meet the 8 per cent ratio for each branch
at present – Chinese banks face a 2007 deadline to meet this
deadline, though some already meet it. This is standard banking
practice – so where’s the problem? The issue is that foreign banks
must apply to import and expand their branch capital – a
process which can take considerable time. If they have to wait,
this means that their loan expansion has to slow down. There are
other ratios which impact too, but we will move on.
4. Interest rates – all banks of course have to obey the
same interest rate rules. Now, this is not all bad. The
administered 300bps or so margin between loans and deposit
base rates helps foreign banks as well as domestic banks.
Moreover, the PBoC’s move in October 2004 to allow freedom
above the base loan rate means that experienced banks should
be able to price SME credit accurately and manage the risks
entailed more efficiently than most domestic banks which do not
have this experience. However, interest rate limits also impinge.
For instance, in theory efficient banks are able to pass on cost savings
to their clients in the form of lower borrowing costs – and
thereby win market share. But this is not possible in China at
present, because all banks make a healthy profit lending at the
lowest loan rate possible, 90 per cent of the base rate. Overall,
while all banks profit from the fixed margin, the relative
competitiveness of foreign banks is affected by the rate controls.
5. There have been reports in the press that foreign banks,
which currently operate as branches of offshore entities, will
be encouraged to incorporate and become standalone Chinese
companies. We do not know how likely such a move is, but it
would have a number of effects if it were introduced. Reporting,
currently done on a branch-by-branch basis, would become
consolidated, and this would mean more flexibility for managing
funds across the bank. It would also mean that a ‘local foreign’
bank would operate under the same regulations as a domestic
bank – thus removing, for instance, the branch registered capital
requirement. Some of the ratios ‘local foreign’ banks would have
to meet as domestic institutions are also different. However, a
bank would need to import capital to locally incorporate in the first
place, and would lose easy access to the funds and credibility of
its parent. It is also likely to face a higher de facto tax rate. In
the meantime, the CBRC and other regulators are reportedly
preparing draft legislation to cover all foreign financial institutions
operating in China, in an attempt to unify and update all the
current regulations that govern the sector. Whether it will
introduce new unforeseen challenges is another unknown.
6. The foreign debt quota. There is a factor that limits foreign banks and foreign businesses of regulations to control China’s foreign debt. Given their
limited ability to raise deposits onshore, any limit on the FX funds
foreign banks can import restrains their ability to grow their FX
loan books. This quota is having a major impact.
7. In terms of
allowing foreign ownership, the authorities have allowed foreign
banks to take equity stakes of up to 20 per cent each (up from 15 per cent in
January 2004), and 25 per cent in total (up from 20 per cent), in domestic
banks. This means control will usually remain in domestic hands
(although in the case of Shenzhen Development Bank,
Newbridge’s 20% stake is enough to give it control, at least in
theory). Chart 1 shows assets owned by banks with 50 per cent
or more foreign ownership in 2002 in various countries, as a
proportion of total banking assets (apologies for using old data –
cross country comparisons are not easy to find). China’s sub-2 per cent
(foreign banks) is clearly among the lowest. The CBRC is keen to
allow more foreign investment, particularly in the city commercial
banks (at least seven of which have already attracted foreign
investors). Domestic banks benefit from the technology and
management expertise foreign shareholders can bring. The
20 – 25 per cent restriction should be lifted at the end of 2006, but any
deals will still need CBRC and probably also state council
authorization. This is clearly an issue the authorities are grappling
with, amid much talk of something called ‘financial security’ –
which some believe would be enhanced if institutions remained in
Chinese hands. The CBRC and SAFE Huijin Investment have
come under criticism for selling stakes too cheaply (though critics,
strangely, never propose how they would have set prices – or
recognise the importance of pre–IPO investors for the success of
the IPO). Such sensitivities are, of course, not unique to China. A
sensible compromise – keep large banks under domestic
ownership and allow smaller ones to be sold to both domestic and
foreign owners – appears possible, according to recent reported
comments by Tang Shuangning, a vice–chairman of the CBRC.
But in the present political climate even that could change.
Source: Moreno and Villar (2002)In short, the scope of foreign bank activities and their ability to
exploit their experience, products and capital will be carefully
managed post–2006. The authorities no doubt believe that the
domestic sector still needs some time to adjust to the full force of
global competition. Foreign banks are likely to enjoy continued strong
growth – many are currently growing revenues at 50+ per cent a year,
albeit from a very small base. But anyone claiming that domestic
banks are going to be faced with untrammelled competition in
2007 could be crying wolf.