Industry Risk - Banks Flocking to China, but Potential Losses are Imminent

As China gets ready to welcome foreign banks by the end of the year, there's a gold rush among global banks to claim their stake in China's financial services market.  But analysts warn that banks that they may find little more than fool's gold in China, given the country's regulatory environment, the high cost of entry and the potential for significant loan losses due to the country's often unstable lending environment.

In the last year, China has seen an influx of about $15 billion from foreign banks with large players such as Bank of America and Goldman Sachs investing over $3 billion each to buy small 10 percent stakes in two of the Big 4 Chinese banks.  And JPMorgan Chase, which actively sought to buy a controlling stake in troubled Chinese broker Liaoning Securities before the Chinese government rejected the deal, is on the hunt for other acquisition targets in China, according to the company's chief executive Jamie Dimon at a speech before the Detroit Economic Club earlier this week.

Richard Bove, analyst at Punk & Ziegel, said global banks are being lured by the promise of wealth in a country that has averaged about 9 percent annual growth over the last several years.  And as part of China's entry into the World Trade Organization, China will allow foreign banks to operate in any part of the country -- opening up the possibility for global banks to expand within a market made up of 1.3 billion people.  "China has a population that's (four) times the population of the U.S," Bove said. "The growth potential is so phenomenal from a population-based standpoint... that banks have no choice but to pursue it as rapidly as they can."

In the short-term, global banks see plenty of potential for profit from underwriting and investment banking fees as the Chinese markets open up and a fresh wave of initial public offerings, including banks, hit the markets.  But the real attraction, experts say, is the large untapped market for consumer-based financial services products such as credit cards, mortgages and car loans.  According to a report by consulting firm McKinsey, by 2013, China's consumer credit market will account from about 14 percent of profits, up from a mere 4 percent current.  But the report indicated that foreign banks face difficulties winning over clients in China without partnering with a domestic Chinese bank, given the propensity for Chinese customers to sign up for cards with those local banks they have a direct relationship with.  Bank of America, which paid $3 billion for a 9 percent stake in China Construction Bank last year, has made it clear that the acquisition was part of its strategy to expand its credit card operations in China.

But some critics fear that global banks may be in for a rough road ahead.  William Gamble, principle at consulting firm Emerging Markets Strategy, said the Chinese banking market is rife with corruption and side dealings, as banks -- which are owned by the government -- lend money based on political connections and influence rather than sound economic practice.  In addition, there is no official credit bureau to highlight high-risk loan applicants and no solid regulatory oversight to insure that loans are paid back to banks.  "The problem with investing in emerging markets is that although the growth rates are often much higher than for companies in developed countries, the economically inefficient or nonexistent legal systems also increase the risk," he said. "If the profit potential is not commensurate with the risk, it might be a better idea to stay home."

Punk & Ziegel's Bove said foreign banks, which already have to pay a hefty $50 million entry fee to expand within China, stand to "lose a lot of money initially as they try and put together a reasonable balance sheet" for the Chinese banks that struggled for years with high levels of non-performing loans and tricky transactions that have muddied their financials.  He added that large international players, like Citigroup have experience in maneuvering the Chinese market and stand to benefit from the burgeoning credit card market, as well as other consumer finance and wealth management products. Citigroup opened its first private banking office in mainland China and will focus on wealthy citizens with at least $10 million in assets.

But David Easthope, analyst at independent research and consulting firm Celent LLC, said the global banks aren't going to be satisfied with just a small piece of the pie.  "The goal is to supplant the banks that are already there," he said.  And that is unlikely to appeal to the Chinese government.  While many of the Chinese banks are struggling with dismal loan losses and looking for a capital injection from a foreign player, Easthope said the government is unlikely to allow Western banks to develop much influence in China and foreign banks may lose a bundle in the quest for control.  But Neil Torpey, chair of international law firm Paul Hastings' Hong Kong office, said the concerns may be overblown.  "I think the Chinese market is becoming more and more open to and friendly to all kinds of outside influences," he said. "As the Chinese banks, both large and medium-sized continue to grow domestically, there will be a need for more management expertise and best practices. That will come from the global banks."