Ken Lewis on BofA's China future

If you can't beat 'em, join up with 'em: That's what Ken Lewis concluded this spring. After several years of scrutinizing his options in the Chinese banking scene, the Bank of America chairman and CEO decided in June to plunk down $3 billion for a nearly 9 percent stake in China Construction Bank, the country's third-biggest commercial bank, with total assets of 3.9 trillion renminbi ($483 billion).

In one swoop, Bank of America goes from having virtually no presence in China -- four branches, to be precise -- to making the biggest-ever single investment by a foreign entity in a Chinese company. "We saw what's been happening in China for several years and wanted to participate in some way in the future growth," Lewis, 58, tells Institutional Investor. "We had opened a branch or two on the retail side, but obviously we weren't moving the needle very much for a company of our size. So we kind of stepped back and said, 'Is there another way to go?'"

The magnitude of the strategic shift is breathtaking, and it has caused a few eyebrows to rise among veteran investment and commercial bankers in Beijing and Hong Kong. They wonder whether BofA has enough local-market savvy to make the investment work. "Too many executives are reading Time magazine and thinking China is the great dragon that is going to eat the world," says the head of research at a leading Asian investment bank. "The rationale for buying a China bank is the same thinking as when automakers, knowing full well there's going to be a huge glut in supply, still all spend $5 billion building new plants. The mentality is, If I'm not there and China takes off, I'm toast. If I'm there with every other guy on the planet, I probably won't lose my shirt entirely."

Indeed, four China-banking novices, including BofA, could soon own significant stakes in a trio of megalithic mainland institutions: Edinburgh-based Royal Bank of Scotland is hoping to buy 10 percent of Bank of China, the country's second-largest bank, and Goldman Sachs, along with the private equity arm of Germany's Allianz, are in talks to purchase a $3.5 billion, 9.9 percent stake in Industrial and Commercial Bank of China, China's biggest commercial bank.

BofA is initially buying $2.5 billion of stock from CCB's largest shareholder, China SAFE Investments, and will follow up with an additional $500 million investment in CCB's planned $5 billion IPO in Hong Kong at the end of this year or in early 2006. CCB intends to sell a 15 percent stake to the public. Asia Financial Holdings, a unit of Singapore's government-owned Temasek Holdings, last month signed an agreement to buy $1 billion worth of CCB shares in the planned IPO.

Lewis says the $3 billion tie-up may be only a start and adds that "the odds are very high" that BofA will later more than double its stake, to the maximum permissible level, 19.9 percent.

"We are aligning our destiny in China with China Construction Bank in that we are making not just a $3 billion bet but more as we get to that 19.9 percent range," asserts Lewis. He says that BofA's board is "excited" about the deal and unanimously behind it: "They saw the potential, obviously, in China, but they also saw the logic of trying to grow with CCB, as opposed to doing it by ourselves."

Though a big bet by local-market standards, the investment is a modest one for the Charlotte, North Carolina, banking giant, which has a $180 billion market capitalization. In June, BofA agreed to buy U.S. credit card issuer MBNA for $35 billion in cash and stock. The two deals share a connection: The CCB purchase included a provision for the U.S. and Chinese banks to begin negotiating a joint venture credit card business in China, which was scheduled to commence last month. One of Lewis's first letters of congratulation on the MBNA deal came from CCB chairman Guo Shuqing, who said he was enthusiastic about the prospect of working with the credit card company. "The acquisition of MBNA makes us more attractive in terms of providing broad product brand into a joint venture," says Lewis. "MBNA has some of the best marketers in the world."

BofA's move into China differs from those of its rivals. Global titan HSBC, arguably the foreign bank with the most experience in China, has hedged its bets by investing in a variety of financial institutions: It holds a 20 percent stake in Bank of Communications, the country's fifth-largest bank; an 11 percent stake in Bank of Shanghai; and a 20 percent stake in Ping An Insurance. HSBC's Hong Kong­based subsidiary, Hang Seng Bank, holds a 16 percent stake in Fuzhou-based Industrial Bank. London-based HSBC has said that it views these investments as part of its research and development. Although the acquisitions could blossom into broader relationships, the bank says, it may simply sell them as though they were portfolio holdings.

Meantime, BofA arch-rival Citigroup has moved tentatively onto the mainland, having bought a 5 percent stake in Shanghai Pudong Development Bank, China's eighth-largest bank, for $72 million in 2003; the pair set up a separate 50-50 joint venture to manage a credit card business. Emerging-markets specialist Standard Chartered has eschewed involvement in established banks and instead paid $120 million for a 19.9 percent stake in newly established Bohai Bank, based in the northern city of Tianjin and backed by the municipal government.

HSBC, Citi and StanChart, the three international banks with substantial consumer banking presences in Asia, are unwilling to subordinate their China ambitions to any of the state-owned Big Four: Agricultural Bank of China, Bank of China, CCB and ICBC. The giant mainland banks, in turn, are equally unwilling to be subsumed by their international competitors. By taking partners like BofA -- and potentially RBS, Goldman and Allianz -- China's banks figure they can have their cake and eat it: They get the capital and knowledge transfer they desperately need while maintaining control of their destinies.

Lewis says his move was inspired in part by recent internal research that showed that China's Big Four had such strong customer loyalty that "it would be more advantageous to join them, as opposed to competing head-on with them."

After many meetings with China's regulators and senior government officials, Lewis had also become convinced that "the Chinese realized that they were not going to achieve the things they wanted to achieve with the economy if the banks were not successful -- and successful meant being internationally competitive."

China's banking system certainly needs reform and support. Since 1997 the government has spent $257 billion bailing out the country's dilapidated banks. The recapitalizations of CCB and Bank of China are thought to be complete, but Simon Ho, an ABN Amro banking analyst in Hong Kong, estimates that at least $220 billion more will be needed to fully recapitalize the banking sector. He also reckons that industrial overinvestment could cause more bad loans to surface in coming years.

CCB is by any measure a huge bank: It has 14,500 branches, 12,500 ATMs and 136 million retail accounts. It holds a 12 percent share of total loans and a 13 percent share of China's deposits, and it is one of the largest providers of residential mortgages in the country. CCB serves 92 of the top 100 business enterprises in China.

Lewis says he preferred CCB in part because it is, in his judgment, further along with its reforms than China's three other megabanks. "We'll see that play out in the fact that their IPO will be first," he says. "That they've gotten far enough along that they can go to the public markets is the ultimate proof."

For 2004, CCB reported profits before write-offs of $6.2 billion, up 33.9 percent from 2003. The bank received a $22.5 billion capital injection from the government in late 2003, and last summer state-owned Cinda Asset Management paid 30 percent of the face value for $15.6 billion of the bank's bad loans. CCB's capital adequacy ratio now stands at 9.4 percent, its nonperforming-loan ratio at 3.7 percent and its loan-loss provision at 70 percent, estimates Ho.

In Lewis's opinion, CCB is more like BofA than the other three big Chinese institutions because, like the U.S. bank, it is "very focused on consumer, small-business and middle-market customers." The rapport Lewis established with chairman Guo and president Chang Zhenming was another big plus. "We had wanted to look them in the eye and see that we had a cultural fit," says Lewis. "I was very impressed in terms of their sincere desire to make CCB do the things necessary to make it competitive in an international sense."

Still, skeptics in the banking communities of Beijing and Hong Kong predict cultural problems between the two banks. Though BofA will send 50 executives to CCB to advise on corporate governance, risk management, information technology, financial management, human resource management, retail banking and global treasury services, local bankers say BofA's lack of experience in China portends complications.

Lewis dismisses such concerns, pointing out that "there's always a reservoir of employees [at BofA in the U.S.] who know the culture and speak the language." He insists that BofA bankers will "roll up their shirtsleeves and work alongside the people of CCB to win in the marketplace. This is a bet on China through China Construction Bank."