Standard Chartered has big plans for China these days. The British bank plans to open 170 branches in China by 2011, growing its network a minimum of 60% annually. Mike DeNoma, the company’s head of commercial banking, has said that he intends for China to become the “heart” of the bank’s operations. “We want to expand our network in China as fast as we can within the regulatory regime, and we will move to as many new cities as we are allowed to,” DeNoma said in a recent interview with China’s official Xinhua news agency.


In prominent glossy advertisements throughout China’s major cities, foreign banks are playing up their global expertise and are showing friendly images. Citibank’s ads show a team of smiling associates from across the globe, while HSBC posters show a photo-shopped skyline of the Forbidden City, the Sydney Opera House, the Arc de Triomphe and the NASDAQ building.


They are also ramping up their visibility in smaller markets. In Hangzhou, a small but affluent city several hours from Shanghai, new branch offices of HSBC and Citibank square off at each other from opposite corners of the city’s busiest intersection, with Times Square-sized corporate logos stretching several stories above street level.


A spokesperson at ABN Amro, which is currently in the process of converting its China business into a domestically incorporated entity for retail banking, said the Dutch bank plans to “leverage its global products with local knowledge.”


That is an obvious angle for foreign banks to pursue; they have global knowledge and expertise and are busy hiring top managers from local joint-stock banks to complete the second half of the equation. But foreign banks may take some time to adjust to the demands of the Chinese consumer. According to Xi Junyang, deputy director of the Modern Finance Institute at the Shanghai University of Finance and Economics, Chinese banks “have a better understanding of local culture. They know how to interact with Chinese clients, and what techniques to use to attract new business.”


Indeed. Within a few days of Standard Chartered’s DeNoma’s statements, Claude Haberer, a senior executive for BNP Paribas, the French bank, presented a diametrically different view on the future of foreign banks in Asia. Haberer warned that tougher than expected competition in Asia may soon force outsiders to withdraw “either voluntarily or involuntarily” from the region.


Luxury Banking


It has been more than six months since China lifted the final major obstacle to foreign banks offering full renminbi services in China by doing away with restrictions that had limited foreign banks to serving only foreign clientele, and only in 25 cities. Multinationals are now allowed to compete for the nation’s $2.2 trillion of household deposits. The question is whether it’s in their best interest to do so.


Xi Junyang believes foreign banks are handicapped starting out because of the obvious; they are not as familiar with Chinese culture as the Chinese banks. “This includes understanding the financial needs of Chinese customers, the ways government officials make decisions and how to understand China’s regional differences.”


Peter Tebbutt, an analyst at Fitch Ratings, the international rating agency, put it more bluntly: “Foreign banks don’t break people’s arms when they don’t repay them, like some Chinese banks might. They can’t operate like that, so what they have to focus on is the high end of the retail market.”


Walk into the lobby of an HSBC (Hongkong Shanghai Bank Corporation) branch downtown and you might feel like you have stepped into an upscale café, not a bank. There’s a carpeted waiting room with plush couches, a snack bar with Hong Kong-style milk tea, cookies, and a flat-screen television tuned to CNN. At HSBC in China, all the customers are treated like very important people because, at least by the size of their financial portfolio, they are.


Instead of targeting ordinary, middle class Chinese citizens, most foreign banks are going after the wealthy and business services. It’s a recognition that that their strengths are different from those of the large state-owned banks they compete against.


Under new regulations that were clarified this year, foreign banks are now able to offer foreign currency and renminbi services to Chinese nationals throughout China and soon will be allowed to issue credit and debit cards. In order to do so, however, a bank must first establish a locally incorporated entity. This requires the parent company to deposit hundreds of millions of dollars in registered capital, a near impossibility for smaller banks.


Only a handful of foreign banks have established local corporations in China today — with Citigroup, HSBC, Standard Chartered, and ABN Amro among the largest — but the number is set to grow rapidly. According to a 2007 PricewaterhouseCoopers LLP survey of multinational banks, between 20 and 30 banks said they were interested in forming locally incorporated subsidiaries in China.


Still, by many measures, foreign banks conduct just a small fraction of banking transactions in China. Foreign lenders control just 2.1% of China’s $6 trillion of banking assets and less than 1% of total deposits. Their combined profit accounts for 1.2% of the total earned by banks in China, according to a report by China’s Central Bank that was published in the official China Securities Journal.


Credit Rating System to be Established


Foreign banks won’t be overtaking their Chinese competitors any time soon. For one thing, they cannot beat the domestic banks on loans or deposits. According to Fitch’s Tebbutt, because interest rates in China are heavily regulated, banks are unable to compete with domestic banks by offering competitive rates. Instead, banks like HSBC, ABN Amro and Standard Chartered are offering wealth management and other services that leverage the bank’s technical expertise and capacity for innovation.


The fixed deposit-loan spread also guarantees a healthy profit margin for traditional banking, and foreign banks are eager to lend. But they are only just starting to accumulate local-currency deposits, which are needed to support renminbi lending. Instead of competing directly with Chinese banks by lending to large Chinese corporations, the banks are likely to start by lending to wealthy individuals and small and medium businesses, a group that has traditionally had difficulty obtaining credit from state-owned banks.


And while foreign banks have a vastly better track record in risk management, they will find it difficult to apply this know-how to the Chinese market. China’s state-owned banks issue less credit to small businesses and individuals because it is harder to evaluate lending risk. Large corporations publish financial reports and often have ties to the government, making it easier for banks to investigate credit risk.


For loans to individuals, there is no nationwide credit rating system and banks can only verify the employment status of the borrower. According to Tebbutt, “you might not know how much they earn. [Chinese borrowers] will prove to you that they’re working for such and such a company, that they’ve got such and such a position in that company, and from that you get a rough idea of how much they’re earning.” Evaluating lending risk does not stop there, however. According to Tebbutt, loan officers in China “might even walk down to their house and ascertain that they do actually live there,” or even interview neighbors or the local Communist Party Residents’ Committee.


Until there is a nationwide credit rating database, foreign banks will also find it difficult to evaluate lending risk. “They can’t lend to the small Chinese companies, because they don’t understand [them]. Those companies often don’t have good accounts, they don’t have good corporate governance, and foreign banks will have difficulty evaluating these borrowers,” said Tebbutt.


For now, the solution is to target wealthy customers, although each bank defines this group differently. ABN Amro is targeting “mid-market” customers with investment portfolios in the neighborhood of $100,000, while Standard Chartered is hoping to focus on high-income customers with over $1 million to invest. Wealthy customers are seen as more likely to pay up on their mortgages and credit card bills.


Shortage of Talents


The Chinese market is unlike any other market that even the largest, most experienced multinationals have dared to enter. It’s a matter of scale. They are having trouble hiring qualified managers, negotiating with Chinese regulators and adapting to China’s fast and loose risk management practices.


According to a report by PricewaterhouseCoopers, foreign banks plan to expand their workforce to twice the current amount by 2010. China’s state-run Xinhua news agency reports that HSBC plans to hire 1,000 new employees per year in the next two years, a figure that May Yan, vice president and senior analyst at Moody’s in Hong Kong, said is typical of foreign banks in China.


Services for small-to-medium enterprises and wealth management will be the engine for growth in banking for China, DeNoma noted in the above-mentioned interview with China’s official Xinhua News Agency. DeNorma said Standard Chartered’s private banking operations will start in Shanghai and Beijing and focus on entrepreneurs and senior executives who can afford to invest more than $1 million.


But a shortage of management talent will make it hard for Standard Chartered and other foreign banks to meet their expansion targets. According to Yan, these plans may be unrealistic. “For middle and upper management I think there’s a shortage of experienced people in China,” she said. In addition, hiring and training the employees to manage so many customers isn’t as simple as it might be in more developed markets. Yan said foreign banks plan to expand by roughly 60% a year. But hiring all those people, “training them and getting them up to speed for the job and not having fraud and non-compliance” is a major challenge.


It will be a very long time before foreign banks can match the size of domestic banks in terms of retail networks. The state-owned Bank of China, for instance, has 11,000 branches and sub-branches, 580 self-service centers and 11,600 ATMs. ICBC, China’s largest bank, has 28,000 branches, and the Agricultural Bank of China has 31,000. In sharp contrast, most foreign banks in China have about a dozen branches even though they are moving to expand quickly. Unless they can expand much faster, foreign banks will be unable to match the retail networks of Chinese banks for a very long time.


One Foot in the Door


In the long term, of course, most foreign banks are eager to tap into China’s $2.2 trillion in household deposits. The only way to gain enough market share is through acquisitions of domestic banks, something that regulators have ruled out for the time being.


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