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China opening

International Finance Corp.'s investments in China's city commercial banks could be the model for other foreign investors.

For nearly a decade the International Finance Corp., the World Bank's private sector arm, entreated Bank of Beijing to upgrade its operations by accepting a foreign strategic investor. The ultraconservative Chinese city commercial bank kept rebuffing the agency. "Our advice just didn't take," recalls Timothy Krause, who oversees the IFC's day-to-day operations in Asia from Hong Kong.

Still, Krause and his colleagues made progress. In 1996, not long after Bank of Beijing was formed from the merger of 90 urban credit cooperatives, the IFC, preaching better governance, financial transparency and a sound board structure, persuaded it to accept $700,000 in technical assistance for staff training. In 2002 the IFC convinced the bank to submit to an audit by PricewaterhouseCoopers that brought its books into line with international standards.

Meanwhile, the agency prodded other city commercial banks, providing advice and investment. It became the first foreign entity, public or private, to own a stake in a Chinese bank when it bought 5 percent of Bank of Shanghai, the nation's biggest city commercial bank, in 1999. The IFC also invested in Nanjing City Commercial Bank in 2001, China Minsheng Banking Corp. in 2003 and Xi'an City Commercial Bank and Fuzhou-based Industrial Bank in 2004. In all, the World Bank affiliate, whose mission is to combat poverty by fostering private enterprise in developing countries, has invested $235 million in six small to midsize banks, four of them city-based institutions.

Finally, Bank of Beijing came around. With the IFC holding its hand, the bank, which posted a profit of $87.3 million last year, opened negotiations with 11 foreign suitors. In April, ING Group agreed to buy 19.9 percent of Bank of Beijing in cooperation with the IFC, which took a 5 percent stake. Their joint investment: $266 million.

"This is a hot market, and this was certainly one of the best parties available," says Jacques Kemp, ING's CEO for Asia. The Dutch firm's reputation as an insurer and asset manager helped it steal a march on other bidders, including Deutsche Bank. For Bank of Beijing, a novice at consumer banking, ING's expertise should be a boon in developing retail products for China's growing affluent market.

"We saw the cooperation between IFC and other banks in China, and this gave us encouragement," says Bank of Beijing president Yan Xiao Yan. "Maybe before that we were not open enough to take this action."

ING is far from being alone in making a China play. A Goldman, Sachs & Co. private equity fund is teaming up with American Express Co. and Germany's Allianz to buy 10 percent of Industrial and Commercial Bank of China, the nation's biggest bank, for about $3.1 billion, in a deal expected to be finalized this month. Two of China's other Big Four state-owned banks also have taken foreign partners recently. Royal Bank of Scotland, Merrill Lynch & Co. and Hong Kong investor Li Ka-shing agreed last month to pay $3.1 billion for a 10 percent stake in Bank of China, and Bank of America Corp. signed a deal in June to pay $3 billion for a 9 percent stake in China Construction Bank. These alliances are being driven by the liberalization of China's financial markets. As part of its agreement to join the World Trade Organization in 2001, China pledged to allow foreign banks to offer yuan-denominated accounts beginning in 2007.

As with any great investment enthusiasm, the race into China may offer bountiful opportunities, but it is fraught with risk. Most of the country's banks are a shambles. The government has already spent $257 billion to bail out the industry, and ABN Amro's Hong Kong­based China banking analyst Simon Ho estimates that it will take $220 billion more to fully recapitalize the sector.

Amid this gargantuan rescue effort, the Washington-based IFC's aim is to help turn smaller lenders into models. City commercial banks fit the bill nicely. These institutions are, by definition, restricted to operating in individual metropolises. They account for only 5 percent of China's total banking assets of $3.8 trillion, but the IFC hopes that success in modernizing city commercial banks will catalyze industrywide reform. The IFC also is now turning its attention to nonbank financial companies (see box, opposite).

Thanks largely to the agency's pioneering investments, numerous foreign banks are now sizing up China's city commercial banks. Commonwealth Bank of Australia has been the most aggressive, paying $17 million for 11 percent of Jinan City Commercial Bank (with an option to go to 19.9 percent) in September 2004 and acquiring 19.9 percent of Hangzhou City Commercial Bank for $78 million this March. In July government-owned German Investment and Development Co., or DEG, shelled out $3.6 million for a 10 percent stake in Nanchong City Commercial Bank, based in the remote southwest; Germany's Sparkassen International Development Trust simultaneously bought a 3.3 percent stake for $1.2 million. Press reports suggest that other foreign banks are pursuing investments in a dozen or more city commercial banks, including those in Changsha, Chengdu, Chongqing, Dalian, Guangzhou, Harbin, Ningbo, Shenzhen, Suzhou, Tianjin, Wuhan and Xiamen.

Many of these banks have tremendous growth potential. Chongqing City Commercial Bank, for example, has total assets of less than $3 billion but serves a city of more than 10 million. The metropolises of Wuhan (7.8 million), Tianjin (7.6 million) and Guangzhou (5.9 million) likewise offer huge scope for growth to their city banks, none of which has taken a foreign partner yet.

City commercial banks frequently hold a top-five position in their local markets, and some are in the top three, says Paul Brough, head of KPMG International's financial advisory practice for Hong Kong and China. Beijing-based CCID Consulting Co. estimates that city commercial banks' collective assets will grow at a compound annual average growth rate of 26 percent, reaching $656 billion by 2009.

Foreign bankers need to beware, however. ABN Amro's Ho cautions that China's 112 city commercial banks are a disparate group. Some are of decent quality, he says, but many others "have high nonperforming loans and are underprovisioned, undercapitalized and plagued with overinfluence and control by local governments." The China Banking Regulatory Commission estimates city commercial banks' bad loans at an off-putting 14.5 percent on average at the end of last year, compared with 13.2 percent for all Chinese banks and 10.1 percent for the Big Four. Still, the city banks' nonperforming-loan ratio has fallen substantially from 31 percent four years ago.

Chinese bank regulators, who tend to be cautious about change of any sort, generally welcome the IFC's efforts. Indeed, the People's Bank of China asked the agency to help establish an institute to train the country's bankers in such neglected skills as risk assessment. The Shanghai International Banking and Finance Institute -- in which the main shareholders are the IFC; Bankakademie, one of Germany's leading banking and finance institutes; and the Shanghai University of Finance and Economics -- opened its doors to 300 students in April.

The IFC is not averse to making a profit, but its main purpose in buying into Chinese banks is to collect a different sort of return on investment. "You can invest $10 in a shoe factory and employ 100 shoemakers, and the knowledge of shoemaking in that city goes up, and you increase the tax base of that city a little bit," says the IFC's Krause. "But if you invest $10 in a bank and that bank becomes an effective financial intermediary by mobilizing savings and directing it toward borrowers that can use it most effectively, you can end up funding 150 shoemakers. The developmental impact of a good financial intermediary on an economy is huge. That's why we focus so much time on the financial sector."

The IFC has long put a priority on the financial sector, notably to aid the transition of Eastern European countries from communism to capitalism. Last year the agency devoted nearly 30 percent of its investment, $1.67 billion, to banks, insurers and other financial service providers in such countries as Afghanistan, Brazil, Indonesia, Mongolia, Romania, Russia, South Africa and Turkey.

Chinese entrepreneurs and executives seem to appreciate that the IFC is not driven by short-term profits. Liu Yonghao, chairman of Chengdu-based agricultural and property conglomerate New Hope Group and controlling shareholder and deputy chairman of China Minsheng, says he likes dealing with the IFC because the agency's many other investments help peasants in his native province of Sichuan. "The IFC cares about people; it cares about the environment," he says. "It wants a win-win." Li Ren Jie, president of $42 billion-in-assets Industrial Bank, says that when he sought a foreign shareholder to complement HSBC Holdings' Hang Seng Bank, he particularly liked the IFC because it "is not only a profit-making institution -- it also wants to help improve management and the overall market."

Although China Minsheng and Industrial Bank have national charters, unlike the city banks, they are similarly modest in size. China Minsheng reported earnings of $250 million in 2004, and Industrial Bank posted a profit of $130 million.

The IFC concentrates on smaller institutions rather than China's giant national banks for a good reason. Karin Finkelston, the agency's China chief, says that while the Big Four -- Agricultural Bank of China, Bank of China, China Construction Bank and Industrial and Commercial Bank of China -- are preoccupied with sorting out their sour loans and operational problems, "there's an opportunity for smaller banks that are a bit more nimble and easier to move." Four of the IFC's investments are in city commercial banks; the remaining two are in nationally licensed but relatively modest-size institutions, Minsheng and Industrial Bank.

City commercial banks' compactness is part of their appeal. Most have assets ranging from $500 million to $3 billion and maintain between 30 and 100 branches. Foreign banks can afford to buy fairly sizable stakes -- a maximum of 19.9 percent is permitted for a single foreign investor, and a total of 24.9 percent for all foreign stakeholders. And the investments cause barely a blip on their balance sheets, lowering the risk of venturing into the Chinese market.

Finkelston contends that with the help of strong strategic partners like ING, city commercial banks "can, if they focus, do some really interesting things." Although confined for now to particular urban areas -- hence the "city" in their names -- the banks, she says, "have to think hard about what niches they will focus on and how they are going to play as the banking sector goes through an inevitable consolidation over the next five to ten years." With the right encouragement, and a change in regulations to allow expansion outside their home cities, a number of the bigger city commercial banks could emerge as regional powers.

Critics of the IFC's methods say the agency's small stakes don't give it enough influence to push through real reforms. "It is tough bringing about change even in Chinese firms where I own a majority stake," says one Beijing-based American businessman with extensive experience with Chinese joint ventures. "If you own only a minority stake, forget about it. It's impossible to bring about meaningful change." The head of research at a leading Asian investment bank largely concurs. Perhaps the agency "can help a little bit," he adds, "but if you don't have a controlling stake, there's a limit to how much these banks will absorb. All these training courses for risk control and credit analysis and stress-testing loan portfolios don't mean anything. You can put the best systems in the world in place, but in the end it boils down to corporate culture and experience."

Finkelston acknowledges that banking reform is a long-term process, but she insists the IFC has achieved a lot, particularly in governance. Persuading banks to have audits under international standards, installing the first foreign bankers on boards and making audit and compensation committees accountable to the board rather than management have produced real change, she says. More broadly, she contends that the IFC's efforts at Bank of Shanghai, which the government regarded as a pilot reform project, led to changes in legislation that "have allowed some of the world's top international banks to invest in Chinese banks and to bring their expertise to bear at the local level. This type of impact was unthinkable even five years ago."

Yin Jianhong, president of Xi'an City Commercial Bank, known as XACB, sees the agency-inspired makeover of banks like his as "a mighty project" and predicts big changes in the city commercial bank sector in the next three years. "Some banks with good management and administration systems will go regional, while banks with high risk are about to face market withdrawal," he says. The bank does not disclose its results.

One IFC accomplishment is indisputable: The agency has played a pivotal role in bringing foreign banks to China as strategic investors. Krause says that when the IFC bought into Bank of Shanghai six years ago, "we would have loved to bring in a strategic foreign investor with us -- at that point there was no strategic investor that wanted to go into China."

"They started the ball rolling," says Robin Hibberd, senior vice president for Asia-Pacific and the Middle East at the Bank of Nova Scotia, which last year invested in the Xi'an bank alongside the IFC. "By going in early into Chinese banks before others were willing or allowed to and by working on things like governance and by creating some examples that can now be held up, they've said, 'Look, China is ready; the system is developing such that you can get these kinds of results.' They've done a great service to China."

The IFC played a part in attracting HSBC to invest alongside it in Bank of Shanghai, and the agency is co-investing with HSBC's Hang Seng subsidiary in Industrial Bank, based in Fuzhou in Fujian province. Nanjing, in which the IFC bought a 15 percent stake for $27 million four years ago, recently disclosed that it was negotiating with ten foreign strategic investors. Later this year or early next, the bank intends to become the first city commercial bank to list its shares, in either Shanghai or Shenzhen.

But with the IFC having snapped up stakes in four of the ten biggest city commercial banks and Australia's Commonwealth Bank holding shares in two more, how many good ones are left? KPMG's Brough reckons that only 15 of the city commercial banks that don't already have foreign partners are worth investing in. The consensus among bankers is that the top three targets are Dongguan, Shenzhen and Tianjin. The biggest banks by assets that have not yet taken a foreign partner are Shenzhen ($7 billion in assets), Nanjing ($3.5 billion) and Dongguan ($3 billion).

The city commercial banks have plenty of problems, which explains why they remain wallflowers at the coming-out ball. A survey of 20 city commercial banks released late last year by the State Council's research center and commissioned by the Asian Development Bank found that 18 did not have separate risk management departments, that local governments effectively controlled the banks, and that they concentrated their loans on a small number of customers, many of them also owned by the same local governments.

Indeed, the notion that such banks are more manageable than the country's troubled giants is disputed by some foreign investment bankers. "City commercial banks are smaller but less manageable than the Big Four," asserts the China head of a bulge-bracket investment banking firm. "The Big Four banks have all the pressure of the central government on them and they really have nowhere to hide, and they are magnets for the best people in the system. When you get down to the provincial or city level, you have a whole different quality of staff and a whole different quality of local government penetration, and thus less independence."

Under the circumstances, the IFC proceeds on the assumption that it can afford a few bad loans but no illusions. It insists on international audits for the banks it invests in and often helps train their executives in how to price risk and stress-test loan portfolios as well as how to set up human resources and information technology departments.

Ultimately, though, the IFC is not a bank. So at the earliest opportunity, it must attract a bona fide bank to assist its partner bank in bringing risk control and operations up to international standards -- and this can take some doing. The strategic investor also invariably supplies consumer banking know-how.

Bank of Shanghai is the IFC's flagship. The bank was created in 1995 by amalgamating 99 Shanghai credit cooperatives, each of which had its own king and culture. The IFC bought its 5 percent stake in 1999. "I frankly wondered how this thing was ever going to work," the IFC's Krause remembers.

Somehow it did. Restructuring the board was key, says Krause. The board's main function had been to approve annual business plans and dividend payments. Today it has three core functions: strategy development, accountability and control, and management selection and remuneration. Board meetings have been increased from two to four a year, and directors have set up audit, compensation and risk management committees.

IFC East Asia chief Javed Hamid notes that the bank's auditors report to the board's audit committee. "This is absolutely unheard of in China, because many people feel insecure about this kind of thing," he says. The compensation committee sets annual targets for management based not just on growth, as is common in Chinese banks, but also on capital adequacy, nonperforming loans and profits. Says Hamid, "To me, this was revolutionary in the Chinese context."

The IFC insisted that Bank of Shanghai have a full-blown international accounting standards audit. "When we first asked for international audits, people were saying, 'What the hell is all this for?'" IFC China chief Finkelston recalls. "Even though there are Chinese companies that are interested in corporate governance and financial transparency, they often don't know what goes into it. Their first audit can be a complete shock to them. We are convincing them to pay $60,000 for an audit, and they don't like it." The bank reported profits of $180.6 million last year.

The audit demand wasn't the only imposition. The IFC got John Langlois, J.P. Morgan & Co.'s former China chief, appointed to Bank of Shanghai's board. Although Finkelston cautions that "nothing can be changed overnight" at a Chinese bank, she says that even a single independent director can have a profound impact on the way the bank does business. "Just by saying, 'This information is inadequate; I can't make a decision based on this,' helps change thinking," she says.

Of the IFC's six groundbreaking bank investments, none was more intrepid than XACB. Krause recalls that the bank "had a negative net worth, it wasn't transparent, and it wasn't in any way ready for a strategic investor. You wouldn't find a commercial investor investing in a bank like this." Adds Finkelston: "People say you can do anything in Shanghai. We wanted to show people we could do something in Xi'an."

The bank's president, for one, recognized the need for radical action. Yin believes that his bank is faced with ever more severe competition from foreign banks and "must grasp the opportunity of participation from foreign capital to remold ourselves thoroughly, become a modern institutional bank, further change the operating mechanism, strengthen internal management, make managerial skills totally improved."

For a start, the IFC advised the $3 billion-in-assets bank on a recapitalization involving $63 million in fresh funds from local investors. It provided XACB with staff training and advice on IT systems. And with the support of the Swiss government, it gave $220,000 in technical assistance for credit risk management. In all, it took XACB three years to sort out its problems, come to an agreement with the IFC and Scotiabank on their equity investment and gain approval from regulators and three layers of government officials: national, provincial and municipal.

"We took a long time, and that is a reflection of how inexperienced the local regulatory and government people are in dealing with foreign investors," says Krause. "It takes them a very long time to make decisions because these are decisions of huge importance to them that they don't make every day."

XACB's local government shareholders even wanted Chinese academics to scrutinize Scotiabank's proposed purchase of a stake "to see if the structure made sense," says Scotiabank's Hibberd. "It takes an awful lot longer to get things done, because you don't have crisp decision making in China -- the buck-stops-here kind of thing. There are a tremendous amount of people who are very uncertain as to the quality of their decisions, and therefore they defer and defer."

Progress has been slow: All of the IFC's proposals for governance reforms -- akin to those it introduced at Bank of Shanghai -- remain under discussion. "XACB is now where we were with Bank of Shanghai a couple of years ago," says Finkelston.

For its part, Scotiabank is proceeding no faster. It dispatched Terry Watkins, who had been the bank's assistant general manager of administration for India in New Delhi, to XACB last February. He was supposed to float from department to department to determine where Scotiabank could best provide help. Within four months, however, differences between Scotiabank and XACB surfaced over Watkins's role. The problem? Says XACB president Yin of Watkins: "He's not familiar with the supervision environment, the operation, management and legal environment in China. All these need a long time to absorb."

Hibberd says Scotiabank must be "patient," and he does not expect to push for significant changes at XACB in the near term. "It takes time to know what's going on," says Hibberd. "It takes months, maybe years, to say, 'This is what is holding you guys back.'"

Patience is at a premium. In that respect the IFC's presence provides reassurance. "We would not have invested in XACB without the IFC's involvement," Hibberd says. "It helped us sell the idea to [our headquarters in] Toronto. We could say, 'We're not on our own; we're in a partnership. We'll do the banking, and we've got somebody, frankly, giving us political cover.'"

"Is what we've done perfection?" asks IFC East Asia boss Hamid. "No, it's a process." He believes that the IFC's main contribution to Chinese bank reform will come from the impact its investments and knowledge-sharing have had on China's regulators. "The Chinese government and regulators are very cautious, and they don't want to take very big steps that would be destabilizing," says Hamid. "But with Bank of Shanghai, they could see how things worked, how they did not destabilize and in fact strengthened the bank. Then regulators told other banks to go look at what Bank of Shanghai is doing and suggested, 'Maybe you can do something similar.'"

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