BANKING
Foreign Banks in China: Wolves on a Tight Leash
July 31, 2006
Stephen Green, Standard Chartered Bank

"The scope of foreign bank activities and their ability to exploit their experience, products and capital will be carefully managed post-2006." ARTICLE TOOLS Print Version Reprints RECENT ARTICLES China is the region's top stop for exporting Improving wire transfers Quantifying your banks' performance RMB roams the region

"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 llow 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.

Chart 1: Assets by banks with 50 per cent or more foreign ownership, per cent of total banking assets, 2002

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.

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