Sushil Saluja is senior managing director (financial services) for Europe, Africa, the Middle East and Latin America of management consulting, technology services and outsourcing firm Accenture. His expertise includes China and India; he was earlier senior managing director for financial services in the Asia Pacific region and oversaw Accenture’s financial services business in India.

Last month, Saluja was named chairman of TheCityUK’s ASEAN market advisory group. TheCityUK is a lobbying group for the financial and related professional services industry. He is also on the board of Heart of the City, a London-based charity promoting corporate and social responsibility among smaller companies in London.

In this interview with Knowledge at Wharton, Saluja discusses expansion strategies that foreign banks have used in building their operations in China. “While the speed with which the industry has opened is staggering, there is still a high barrier to entry.” he says.

An edited transcript of the conversation appears below:

Knowledge at Wharton: What is your overall assessment of the openness of China’s banking industry to competition from international banks? What are the major opportunities and pitfalls?

Sushil Saluja: China’s banking industry is gradually opening up. Landmark events include the nation’s entry into the World Trade Organization in 2001 and the establishment of free trade zones (FTZs), which have put China on a path of deregulating its banking industry and economy. Today, foreign banks can set up locally-incorporated banks in China. 

While the speed with which the industry has opened is staggering, there is still a high barrier to entry given regulations on minimum registered capital and administrative requirements that constrain foreign banks from growing their network and profitability. This mutes foreign banks’ competitiveness with domestic banks. For example, the China Banking Regulatory Commission (CBRC) has stringent requirements on foreign banks to open branches and locally incorporate in China, though recently these requirements have relaxed.  This is coupled with the documentation and approval process being complex and long since the banking industry, including its sub-sectors, is governed by different national entities and local government offices.

Nonetheless, there are opportunities for foreign banks, which include focusing on treasury and investment banking, corporate banking, trade finance, cash management, and securities and asset management. In these sectors, foreign banks can leverage both their expertise and their international networks. But domestic banks are also building expertise.

In the retail space, foreign banks have been successful at high-end wealth management, bank cards and Internet banking, but again the competition is increasingly becoming formidable from domestic banks as well.

So the major pitfall is not recognizing the competitive pressures that are building up in a banking environment that requires significant capital expenditure simply to get started. Collectively, foreign banks have grown assets at approximately 20% CAGR (compound annual growth rate) between 2007 and 2013, compared with an average growth of 26% at the Chinese joint stock and city commercial banks. This slower pace implies the market share of foreign banks is not rising. Foreign banks together hold only 1.7% of the total $24.6 billion of industry assets as of 2013. This figure has shrunk from 1.9% in 2011 and 2.4% in 2007.

The banking industry in China is large and complex. I think what we have seen over the past 10 years is different waves of change. We had a wave where a number of the domestic Chinese banks went through IPOs; many of the large state-owned banks are now publicly listed, albeit with large, state-owned holdings. I think we’ve now entered a period in which there’s a big push by overseas banks to get into China. 

Some foreign banks have been moving out of Asia generally; this is not specific to China. They have been getting out of non-core business lines or core business lines in markets they consider non-core.

Looking forward, we see continued change, particularly when you look at the combination of interest rate liberalization and FX liberalization. It is clear that the Chinese government is heading toward more market reforms, rather than less. If you look at the implications of interest rate liberalization, there’s no doubt that it will place greater pressure on some of the domestic banks, both in terms of their risk management capabilities and also in terms of their cost efficiency. Many Chinese banks are adapting and getting ready for these changes.

We also see opportunities for overseas banks looking to provide expertise in new product offerings that I think consumers and corporates will demand. Some of the expertise that Western banks have developed in areas such as risk management will also become more important for banks in China, be they domestic or international. We will see greater demand for some of that expertise from overseas banks in China.

Knowledge at Wharton: Which banks have done well and why? How do Asian (Taiwanese, Japanese, etc.) banks compare with their counterparts from Europe or the U.S.?

Saluja: Broadly speaking, both regional and multinational banks have done well in serving large corporate and financial institutions, particularly at meeting the cross-border needs of multinational businesses and expatriates. The growing base of affluent customers and small and medium enterprises (SMEs) are also attractive segments for foreign banks.

The likelihood of success is less based upon where a multinational bank is from and more a result of how willing the bank is to invest time and resources into their ventures in China. The banks that recognize that leveraging digital offerings is a way to provide increased service at reduced costs with [a] limited brick and mortar [presence] are the ones best positioned to continue to succeed.

Knowledge at Wharton: Can you give any examples of banks that have followed this strategy?

“The likelihood of success is less based upon where a multinational bank is from and more a result of how willing the bank is to invest time and resources into their ventures in China.”–Sushil Saluja

Saluja: Sure. Let me start with a little bit of context: Modern forms of Internet-based communication have really accelerated in China over the past few years. So, there’s been a huge uptake in social media; we’ve seen significant growth in Internet-based organizations. Tencent and Alibaba are two very well-known organizations. But, of course, there have been many others, as well. We have seen in China a willingness to use Internet and mobile technology, which has exceeded expectations for the pace of change. That’s driven partly by demographics, partly by geography and partly by some of the entrepreneurial Chinese offerings that exist in China today. The population in absolute terms in the non-urban areas is significant. So we are seeing increased use of digital and mobile technology to meet that demand. Banks are using digital technologies to extend their reach into non-urban areas in a way that’s more speedy or cost-effective than a traditional bricks-and-mortar approach. The other driver is to meet the needs of technologically sophisticated and savvy users, who demand to be able to do more on their mobile device than, perhaps, some of their Western counterparts.

Knowledge at Wharton: Right now, it’s primarily the Chinese Internet companies like Alibaba, Tencent and Sina that have started offering these financial services. How will foreign banks respond and how should they respond?

Saluja: We are seeing Chinese companies providing Internet-based products, but we’re also seeing banks offering more sophisticated alternatives on the mobile and Internet-based devices. We’re seeing a number of satellite branches, often connected by telephone or video link. This gives banks a very neat hub-and-spoke model. Multinational banks in China have tended to start with servicing corporate customers; their needs for Internet and digital-based offerings are different from retail customers. There are a number of banks that have taken equity holdings in retail banks, and you can already see some of the influences on both sides. So, the strategies are very similar to the ones I’ve outlined, looking at core offerings and seeing which of those can be digitized and delivered through a different channel, a digital delivery channel.

Knowledge at Wharton: Which banks have flopped and why?

Saluja: Operating in China, as in other emerging markets, requires capital muscle for the long run. The capital and liquidity constraints faced by foreign banks in China is a major hurdle to sustaining operations. For example, in late 2013, China proposed to more than triple the minimum registered capital for newly-incorporated foreign banks from Rmb300 million ($48 million) to Rmb1 billion. In the aftermath of the global financial crisis, a few foreign banks started divesting to free up capital. Also, new international rules under Basel III make it expensive to hold significant stakes in other lenders. One should be careful in jumping to conclusions. This does not imply that banks that have reduced their investments in China have flopped, but rather that given the competition, coupled with the increased capital requirements and liquidity constraints, some banks have chosen to focus on other opportunities.

Knowledge at Wharton: When we talk about which international banks have not been particularly successful and the reasons for that, would you be able to give any examples of banks that have failed and what lessons can be learned from those failures? 

Saluja: It’s difficult for me to comment on specific cases, but let me talk about some overall trends. I think the business environment and the general way of doing business in China is very different from some Western markets. For example, decision making is handled very differently. The time taken for decision making varies.

In the West, banks are relatively sophisticated in their customer segmentation and their understanding of the needs of different customer segments, be those segments by life cycle or by demographics or by economic status. In China, the market is less mature in its customer segmentation analysis. Banks are probably less used to using customer segments in a way that some Western banks do. So, adapting to the different customer needs takes longer.

If you look at the corporate segment, China has a different regulatory and statutory environment from some parts of the West. When you look at the interest rates regime, it’s clear that the environment is very different.

So, what are the keys to success for banks? They include taking a long-term view of both capital and liquidity. Organizations that take a very short-term view find it less easy to sustain the course, because they’re more susceptible to the impact of changes as they get into the business of China. The second key is really getting to the heart of what consumer needs are in China versus other markets, and being able to adapt offerings.

Knowledge at Wharton: Historically, what kinds of investments have foreign banks pursued in China? To what extent have their expectations been met? 

Saluja: Prior to being allowed to incorporate locally, many foreign banks invested in domestic Chinese banks. China has set an upper limit for foreign shareholders in domestic banks: 25% for total foreign ownership and 20% for a single foreign investor. Expectations on returns from these investments have been realistic. Banks recognized that this was a first step for them to obtain local incorporation in the long run, and that it was also an opportunity to learn about the market on the ground.

As foreign banks are increasingly able to open more of their own branches, and conduct more business, particularly in FTZs, expect investments from banks committed to remaining active in China’s banking landscape to increase.

Knowledge at Wharton: What expansion strategy have foreign banks — especially Asian banks — followed in China? Have they focused on a few regions or expanded broadly throughout the country? What are the pros and cons of each approach? 

“We have seen in China a willingness to use Internet and mobile technology, which has exceeded expectations for the pace of change.”–Sushil Saluja

Saluja: Foreign banks have primarily focused on opening branches on the east coast of China, particularly in the Tier 1 cities of Beijing, Shanghai, Guangzhou and Shenzhen, which are home to large businesses and affluent Chinese. They have moved west, following corporate expansion, to cities such as Chongqing and Chengdu in Sichuan province.

The advantage of this approach is gradual expansion with a focus on following the economic growth plan of China itself. A drawback is that vast swathes of the country remain underbanked as the foreign bank expansion largely follows the domestic Chinese bank expansion plans as well. I’m not sure that it might be an effective strategy going forward.

I think we are seeing increased investments by foreign banks in domestic banks. That has been a trend for some time. And I think we will continue to see that. There are city banks in China that have overseas Western bank holdings. In addition to getting overseas equity holdings, they are also pursuing strategies of regional and geographic expansion within China. They are targeting two cities or the urban spaces. There’s a combination of different things going on. The banks are also looking at the FTZs.

Knowledge at Wharton: What would be some of the advantages of being based in a FTZ?

Saluja: Some of the specifics are still being worked out. There could be, for example, some tax breaks for banks. There could be some different regimes for level of ownership and regulation around foreign ownership. Also, the FTZs often act as a clustering zone; you have dramatic growth in different industries and corporates in a FTZ. Then, being located there as a bank can help that bank serve the industry’s customers as well. So, there are conglomeration effects that come with a FTZ.

Knowledge at Wharton: How does the profitability of foreign banks compare with that of Chinese banks? Are any sectors of business restricted to foreign banks, especially Asian banks?

Saluja: Foreign banks’ profitability in China has begun to pick up in the past two years after a slump post the financial crisis. Yet, their return on assets (RoA) at around 0.6% in 2013 is lower than Chinese banks, which earn between 1.2% and 1.3% RoA.

In the aftermath of the 2007-2009 financial crisis, Chinese regulators have been cautious about opening the market to complex financial products; securitization products and OTC derivatives are closely monitored. The role of foreign banks in the derivatives market is also limited by regulations, as is access to the bond underwriting market. 

Knowledge at Wharton: You say that the RoA of Chinese banks is higher than the RoA of foreign banks. What are the reasons are for that?

Saluja: There’s no doubt that Chinese banks have benefited from significant growth in GDP and that has led to growth in assets of all classes. The growth of some Chinese corporations and trade has allowed the growth of a profitable banking business. Western banks have been restructuring and transforming themselves. It is no surprise that the banks in China are also looking at how to transform themselves and make themselves sufficient on a global basis in order to meet the needs of their customers. So, there has been a difference in profitability. I think that relates to the different macroeconomic environments. But I also think that you can see the direction of travel for both, perhaps pointing more towards the same point, than the direction of travel has in the past.

Knowledge at Wharton: What regulatory hurdles do foreign banks face in China? What strategies have they adopted to overcome these hurdles?

Saluja: The capital, liquidity and administrative requirements are regulatory hurdles that foreign banks are battling. The CBRC requires that foreign banks have to operate a representative office in China for at least two years before they are allowed to open a branch in mainland China. Foreign banks can apply for only one new branch at a time. Nonetheless, the situation is improving under the central government’s drive to reduce the administrative burden for companies in the private sector.

Most banks have taken the long view. They have tried to focus on services such as trade finance and cash management, where they can also provide offshore expertise. They have also sought licenses in FTZs, where regulations are more relaxed.

Knowledge at Wharton: What impact are banking reforms in China likely to have on foreign banks, especially Asian banks?

Saluja: China has announced broad-brush plans for several banking reforms, which include the relaxation of interest rate controls and speeding up the process of renminbi convertibility. This implies state-owned banks will ultimately have to compete for deposits and lend on the basis of risk-adjusted returns, placing downward pressure on profitability whilst also opening up opportunities for new product lines such as in the capital markets arena.

“The capital, liquidity and administrative requirements are regulatory hurdles that foreign banks are battling.”–Sushil Saluja

Other reforms include market pricing and transformation of state-owned enterprises (SOEs). For example, SOEs will have to pay 30% dividend to the government by 2020 (current dividends are between 5% and 15%). Many expect these changes to result in the privatization of some SOEs in the medium-to-long-run.

China has also called for the establishment of more FTZs, similar to the one announced for Shanghai, to attract greater economic activity into key cities. These FTZs will house the country’s most relaxed banking and exchange rules, allowing international banks to capitalize on their offshore service capabilities.

Foreign players are well placed to provide expertise in capital market products in China, in areas such as FX, hedging and derivatives along with enhanced techniques for risk management. Any future privatization process may also favor multinationals with expertise in M&A, providing opportunities for financial services institutions currently not active in China. Those who have worked in Russia and Vietnam, who have experience in SOE privatizations in critical industries, may have an edge when the time comes in China.

Domestic Chinese financial institutions will continue to expand overseas, following their corporate clients and increased trade flows. As a result, we foresee more competition for mergers and acquisitions of other financial institutions in Asia-Pacific, particularly in Hong Kong and the ASEAN region.

Knowledge at Wharton: How will foreign/Asian banks in China be affected by the internationalization of the RMB? How should they hedge their risks?

Saluja: More than 900 financial institutions in more than 70 countries are already doing business using renminbi, according to SWIFT (the Society for Worldwide Interbank Financial Telecommunication). A number of banks are pitching for this business. The biggest opportunity lies in renminbi settlement and payments.

Hong Kong, Singapore, London and New York are taking steps to ensure they become integral centers for renminbi settlement and, ultimately, FX transactions. Hong Kong has become the main offshore RMB clearing center by developing the Renminbi Real Time Gross Settlement system. As of the end of 2013, a total of 216 banks participated in Hong Kong’s RMB clearing platform, including 191 branches and subsidiaries of foreign banks and overseas arms of Chinese banks.

Hedging RMB risk will entail the same concerns as hedging any other currency used in global transactions.

Knowledge at Wharton: How do you see the future over the next five years for Asian banks in China? What opportunities should they pursue? What are the biggest risks they should be aware of?

Saluja: China is forecast to continue to grow and, therefore, the opportunities for banks operating in China should increase as well. Those opportunities are most noticeable in trade, digital services and wealth management.

It is estimated that Asia-linked trade will rise to 60% of global trade by 2020. Much of Asia’s trade will be with China, which will overtake the U.S. as the world’s largest trading nation. Asian banks, more than European or U.S. banks, stand to benefit from this intra-region trade pattern given their relationship with regional corporates.

Today, China’s fastest growing segments are mobile and Internet banking where many Asian banks have strong capabilities. Standard Chartered, for example, has overcome the limitations of restrictions on branch networks by launching “Breeze Banking” in China, which is a full-service digital platform that has enabled it to build its customer base. 

Many regional banks with strong private banking arms have also focused on Chinese ultra-high net-worth and affluent individuals with specialized offerings around offshore investments, family office expertise, philanthropy services, etc. This is forecast to remain a growth area for banks.

Foreign players are also well placed to provide expertise in capital-market products in China, in areas such as risk, FX, and hedging and derivatives products, as well as M&A.

The risks for banks operating in China are typical of many growth markets transforming from state-controlled to market-oriented models. Specifically, China needs to handle concerns about capital flows, shadow banking and managing inflation. One example is how concerns have emerged regarding the opacity of wealth-management products offered by banks via trust companies (that is, shadow banking). The CBRC is evaluating the need to segregate lending, wealth management, brokerage, and securities investment businesses by implementing protective barriers around each.

Ultimately, a risk will be in remaining competitive. Banks that leverage digital capabilities, not only increase the likelihood of expanding market share, they also are better positioned to manage costs, which will give them competitive advantage.