At the Gate

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At the Gates OpeningFull Foreign Access to
Chinese Banking
Nick Roersma

• Gates of the Forbidden City

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Summary Timeline
"The scale of what is happening has never been
seen in the world" U.S. Treasury Secretary John
W. Snow.
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Communist Banking
1949
1994
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Peoples Bank of China

• Communists aggregated all banks into singular
  bank ? Peoples Bank of China (PBOC)
• Sole bank from 1953 until end of Cultural
  Revolution
• Performed dual-role commercial bank central
  bank
• Few banks resurrected for particular purposes
  (agriculture, industrial funding), but not
  independent from PBOC and often dissolved bank
  into PBOC

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Big Four

• Resurrected banks slowly achieved independence
  (1984) and became Big Four
• Bank of China (BOC)
• China Construction Bank (CCB) medium
  long-term project loans
• Agricultural Bank of China (ABC) for
  agriculture sector, farmers, and TVEs
• Industrial Commercial Bank of China (ICBC)

Big Four are State-Owned Commercial Banks
(SOCBs), but not only
But dont let Commercial fool youthey were
state controlled policy banks (i.e., not operated
for profit or prudential reasons)!
In 1985, CPR wholly substituted SOCB loans for
state grants to SOEs Big Four became only source
funding and de facto subsidies to SOEs!
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Communist Importance

• Communist banking did not resemble Western
  banking
• Bottom-line (profit) was not a primary
  consideration
• Banks served to aggregate national savings and
  aid party allocation of monies throughout the
  country
• Made little or no disclosures
• Run by party and cronyism

• As important, many Chinese banking consumers
  unfamiliar with Western financial services

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Communist Legacy

• Big Four (SOCBs) Dominate Chinese Banking Market
• 2003 Statistics
• 55 of banking loans 59 of deposits (exceeding
  1.05 trillion)
• Assets of each make them members of 30 largest
  banks worldwide
• Present Criticisms about Past
• Party may control (and at least appointed senior
  management of each) and still hold great sway
• Party may subsidize SOEs via these banks
• Chinese unfamiliar with Western bank accounting
• Present Competitive Fears from Past Guanxi
  (connections)

8
Reform Era
Gearing up for making WTO commitments
Actions post-WTO accession
Legal Reforms Banking Law amended, Financial
Reorganization Capital Injection Addressing
Criticisms
Legal Reforms Policy Banks, Bankruptcy,
Securities, Banking Laws Bank Creation Policy
Banks, AMCs, Foreigners
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Policy Banks

• Financial System Reform, 1993
• Created Policy Banks to replace Big Fours
  government spending functions (de facto
  subsidies)
• Purpose
• Alleviate difficulties of SOCBs dual roles of
  commercial policy banks
• Better aid rationalization of state resources

• Agriculture Development Bank of China (ADBC)
• China Development Bank (CDB) infrastructure
• Export-Import Bank of China (Chexim)

• Characteristics
• Financially independent
• Responsible for protecting assets value
• DO NOT compete with commercial financial
  institutions (SOCBs or otherwise)

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Further First-Steps

• Local Coops ? City Coops
• PBOC reorganized urban credit cooperatives into
  City Cooperative Banks (2003 112 coops, with
  5,116 braches)
• Provided more capital and further accreditation
  of their services
• 1995 Law of PBOC
• Formalized PBOC (after 45 years) as central
  banker banking sector supervisor acting in
  coordination with provincial banking
  administrations
• Provided power to promulgate guidelines (with
  force of law) and penalties
• Issuer of PRC government bonds
• Interest rate control over commercial banks
• Continued dual-oversight and influence of PBOC
  and local officials (who possessed guanxi with
  SOEs) over commercial banks

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1995 Law of Commercial Banks

• First Banking Law of PRC!
• Provided for state-guidance commercial banks to
  develop their lending business under guidance of
  state industrial policies based upon the
  requirements of the national economy and social
  development
• But...
• Provided for independent loan granting process
• Required independent credit analysis and
  obtainment of guarantees before credit extension
• Forced Bank Management to be liable for bank
  bankruptcy
• Created basic banking requirements
• 8 capital sufficiency ratio (intl standard)
• Loan portfolio cannot exceed 75 of deposits
• Short-term assets to short-term liabilities
  should not exceed 25
• Single debtor cannot have outstanding liabilities
  greater than 10 of banks capital
• Now Allowed
• Private Chinese Banks (wow!)
• Minsheng Bank incorporated in 1996 as first
  private bank in PRC 6 were exchange listed
  (Shanghai/Shenzhen) in 2003
• Others include Bank of Communication, CITIC
  Industrial Bank, Hua Xia Bank, and many more
  (generally more profitable than Big Four)
• Joint-venture banks (13 by 1998) (first allowed
  in Shanghai in 1991)

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Foreign Financial Institutions

• FFIs existed before revolution, but all left
  first special foreign branch re-established in
  1982
• Provided for limited access until 1996 project
• Solely foreign currency business for businesses
• Uncertain regulations and reporting requirements
  all requirements more onerous than those for
  Chinese banks
• Foreign Banks allowed to RMB business, 1996
  project (1994 regulation)
• Further development of Shanghai JV project
• Required long process (1 yr approval) and larger
  reserve requirements
• Allowed business in Shanghai
• Domestic currency services for business and
  consumers

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Pre-WTO Legal Developments

• Securities Law (amended 2005)
• Providing defined reporting and oversight
  requirements in excess of PBOC requirements
• Requiring for 8K-light disclosure (including
  statements for 10 major changes)
• Bankruptcy Law (1988)
• Cannot file against public utilities an
  enterprises of major importance to national
  economy or general welfare whose debts are
  payable via subsidies or other state arrangements
  (takes SOEs out of it!)
• Liquidation Committee (LC) takes over debtor
  (continue operation or liquidate)
• Creditors may approve conciliation or
  distribution of assets, but LC retains final say

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Asset Management Companies (AMCs) 1999
Great Wall ABC Orient BOC Cinda CCB Huarang
- ICBC

• Purpose
• Purchase non-performing loans (NPLs) from SOCBs
  created pre-1996 at book value
• Complete via Debt-Equity swap
• Finance
• RMB10 billion from state
• PBOC loans formerly intended for SOCBs
• Issued bonds to SOCBs (implicit guarantee?)
• Characteristics
• State-owned, non-banking financial institutions
• Financially independent responsible for
  bottom-line and asset value
• Match up 1-1 with SOCBs

• Auction of NPLs
• Morgan Stanley purchased 4 of 5 asset pools from
  first Huarang offering for over RMB10 billion
  (believed to be 8-9 cents on dollar)
• Valuation difficult because mostly SOE loans
  burdened with socio-economic obligations and bad
  assets!

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Asset Management Companies (AMCs) 1999
Great Wall ABC Orient BOC Cinda CCB Huarang
- ICBC

• Didnt the PRC already attempt to solve this with
  policy banks?

Yes, and failure exposes serious problems of
communist legacy NPLs!

• SOE management (responsible for 69 of NPLs)
  burdened with communist hold-overs and local
  bureaucrats

• Problem of minimal disclosure requirements and
  inadequate loan classification (still using local
  4 tier)

• SOBCs had NPLs accounting for 25 - 40 of loan
  portfolio at this time (and through 2003)

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WTO Commitments

• Banking Sector to be open (I. Horizontal
  Commitments)
• Taking Deposits
• Lending
• Financial Leasing
• Payment Money Transmission Services
• Guarantees Commitments

• Will remove all non-prudential limitations by
  Dec. 2006 (Id.)
• Ownership (not wholly)
• Geographic Operation
• Juridical Form of Financial Institution

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WTO Commitments

• Current Non-Prudential Limitations
• Ownership
• Max 25 foreign interest in Chinese bank
• Strategic investment required (5 stake, not
  greater than 20)
• Cannot purchase interest in more than two Chinese
  banks
• Operation
• Geographic limitation
• Different regions provided for consumer and
  business services

• Must end subsidies (loans via SOCBs), violate
  Protocol if
• SOEs are prominent recipients of such subsidies
  or
• SOEs receive disproportionately large amounts of
  such subsidies or provided such beneficial terms
  (Protocol for Accession, 10.2)
• 7 year subsidy exception (but hopes to not use
  and not aggressive exception)

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WTO Commitments
Should Bind Chinese Bankers to other intl
standards

• Basel Committee on Banking Supervision (Core
  Principles, 1999)
• Minimum capital requirements
• Supervisory review of institutions internal
  assessment process and capital adequacy
• Effective use of disclosure to strengthen market
  disciple and complement supervisory efforts

• IMF
• Provide stability
• Foster orderly economic and financial
  conditions)

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WTO Commitments
Was China ready to meet all its banking
commitments immediately? NO!

• Need to create western banking ideology to
  compete
• Provide disclosures to create investor and public
  confidence (not diminish it)
• End SOEs subsidy reliance

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Foreign Banks Post-WTO

• Could immediately provide
• Limited consumer foreign exchange services in
  Shainghia and Shenzhen (extension of 1996
  project)
• 31 banks approved for business in 2001
• No geographic restrictions as of Dec. 11, 2006
• Approval process being quickened (1 year wait
  removed), but not a fast process
• Expanded
• Total of 62 foreign banks were approved for some
  sort of business in country in 2004
• Geographically
• 13 cities were approved for business service in
  2004 25 cities in 2005
• Only 4 were given initial approval to provide
  services in new cities in 2004
• Still subject to more onerous reporting
  requirements but laws lowered capital
  requirements

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2003 Amendments to Banking Law

• Removed direct government influence
• Allowed for banks to invest in other sectors of
  economy trust investment and stock operations
• Not
• Non-financial industry investments
• Securities investments if bank majority
  state-owned
• Real estate
• Why? Banks had funneled money for such
  investments through Trust and Investment
  Companies (TICs) which directly engage in
  investments, creating inflation
• Real estate investments without state approval
  lead to bad run in 1988 (Notice of PBOC on Policy
  Issues of Clearing Up Real Estate Companies Owned
  by Specialized Banks, 1990)
• Much speculation already in hot Beijing and
  Shanghai real estate markets (among others) and
  securities market underdeveloped

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Chinese Banking Regulatory Commission

• Purpose
• Expressly, to assume the regulatory function of
  PBOC over AMCs, trust and investment companies,
  and deposit-taking financial institutions to
  ensure stability of operations
• Implicitly, to expedite solid SOCBs balance sheet
  before for listing The government will no
  longer pay for the losses made by commercial
  banks Liu Mingkang (CBRC chief)
• Arm of State Council!
• PBOC remained central bank for monetary purposes
  (analogous with Fed Reserve)

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Disclosure Changes

• PBOC required banks to use 5-tier loan
  evaluations (international standard) in 2002
• Promoted in 1994, and allowed for use in 1998
• No one used it, but continued with old 4 tier
  (which understated NPLs by 15)
• Standard requires bank evaluate loans before
  calculating profit and capital adequacy
  requirements
• MOF providing new accounting rules for businesses
• CBRC requires quarterly reports
• More and more banks exchange listed and subject
  to securities reporting requirements (which are
  more thorough than the CBRC requirements)

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Cracking Down on Corruption

• Alleged banking frauds are ridiculously large and
  frequent
• Crack down
• DEATH PENALTY (though suspended sentence) imposed
  on former head of BOC Hong Kong
• PRC claims
• Over 50,000 defrauders caught
• Estimates 5,000 have fled abroad (U.S. has
  provided extradition on specific terms excluding
  death penalty, torture, and sometimes limiting
  prison sentence)
• Foreigners on the Look Out
• DOJ recently charged three in Vegas on scheme to
  defraud BOC exceeding 400 million
• CCB chief resigned for personal reasons and
  bribery allegations in 200 (case filed in CA)
  Note Bank listed with a year of resignation

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International Investment

• All major banks in China have sought capital from
  foreign investors, especially the
  under-capitalized SOCBs
• Major international financial firms have
  invested Bank of America, AMEX, Royal Bank of
  Scotland, and more
• Have provided over 40 billion to date
• Cannot invest in more than two banks forego
  independent branch operations in country
• Justifications
• Chinese banks, generally, are under-capitalized
  and have low-implied NPLs of 7.7 and recent PBOC
  disclosures claim NPLs may be around 5 (though
  Western banks average lt1 NPLs)
• Opportunity for foreigner bankers to become
  acquainted with Chinese market
• Opportunity for Chinese bankers to become
  acquainted with international standards

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International Investment

• Next Steps
• Greater Interests?
• Citi leading foreign group to purchase 85 of
  Guangdong Development Bank
• Chinese government has suggested it may allow
  greater foreign interest than 25 but have not
  ruled on this application
• Consumer Credit?
• Credit cards short term consumer credit is
  small (90 of plastic carried is debit) great
  expanses seen in Eastern Europe in this market
• Credit ratings created in 2000, regionalized but
  being nationalized

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Opening the Gate
2006
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Foreigners at Gate

• InvestingBanks
• Ownership and interest conflicts with present
  management and party
• Gain foothold for regulation and further
  investment opportunities and negotiations
• Forego opportunities to expand business
  operations in country for time being
• Subject to lower tax rates (33 as opposed to 55)

• Independent Banks
• Small - Only 2 of banking assets in PRC
• NPL problems - 23 foreign banks (30 of foreign
  banks) had NPLs in excess of 20 in 2004 (problem
  is SOEs)
• Gain marketplace understanding and market
  presence many hedging bets (Citi)

2006
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Popular Complaints

• Too much state control or influence (at least
  possible)
• Disclosures are not all adequate, should
  subscribe to Basel II
• Continue to reduce NPLs (and improve SOE
  governance)
• Controlled savings rates for smaller accounts and
  fixed loan spread

• Bankruptcy Lawdoes not provide adequate
  protection
• CBRC control interest rates paid to depositors
  (little competition at base consumer level)
  controls loan spreads
• Limited investment amount
• Under developed securities markets

2006
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Chinese Goals

• Grow capital markets, establish confidence in
  securities and other financial sectors
• Increase confidence in CBRC and PBOC
• Exchange list all SOCBs
• Utilize growth to advantage of PRC (e.g., capital
  investments of state pension funds)

• Refine allowedbank financial investments
• EU - universal style
• US - financial holding corp.
• Stop dumping capital into SOCBs (270 billion
  over last 15 years)
• Develop consumer credit and complex instruments
  markets expand banking services internationally

2006
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Observations

• Chinese banks will continue to be successful at
  acquiring foreigninvestment
• CCB listed late last year and garnered 9 billion
  (largest in the world since Kraft in 2001)
• BOC to list, hoping to garner more than
  12million
• BOC and CCB were recently improved to investment
  grade (Moodys)
• Huge assets and establishment, much to gain from
  management synergies, great national savings
  habit, and an extraordinary growth market
• Face stiff market in services Chinese firms,
  including banks, favoring foreign underwriters
  (Morgan Stanley and Goldman lead)
• Chinese banking will succeed in the global
  marketplace
• Significant PRC recapitalizations
• Chinese banks are taking interest in
  international banks and establishing more
  prominent braches
• Short term uncertainty, however, remains
  justified
• SOEs remain problem at home, but much interest
  exists both within and outside the banking sector
  to rein them in
• Remains greatly susceptible to macro-economic
  swings
• State to retain majority control of Big Four post
  listing (62.5 of BOC)

2006
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National Observations

• It took a myriad of changes to arrive at Gates
  Opening
• More remains to be done (Complaints Goals), but
  CPR proven willing to make drastic changes in
  banking market

"The scale of what is happening has never been
seen in the world." - U.S. Treasury Secretary
John W. Snow.
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Questions?