UBS's China breakthrough

The competition to penetrate China's potentially enormous financial services market is shifting from the commercial banking sector to the securities industry, but the lack of clear ground rules is frustrating many would-be foreign suitors.

U.S. Treasury Secretary John Snow gave voice to this exasperation during a visit to China last month. Speaking in Beijing, he called on Chinese regulators to make the country's financial services market more open to and transparent for foreign firms. "China can quickly move forward with further liberalization of its financial services sector by allowing foreign securities firms to establish or acquire wholly owned subsidiaries and by expanding the scope of products that securities firms can offer," he said.

It's too early to tell if Snow's megaphone diplomacy will bear fruit, but his tactics stand in sharp contrast to the low-key approach recently adopted with striking success by UBS. In late September the Swiss bank won approval to take management control of Beijing Securities and acquire a 20 percent, $210 million equity stake in the firm.

UBS attributes its success with Beijing Securities to its compliant attitude. Unlike its rivals, which had pressed to take a 49 percent stake in mainland brokerage firms, UBS decided not to challenge the rules that prevail in China's banking sector, which set a limit of up to 20 percent for any single foreign investor buying into a Chinese bank and 25 percent for all foreign investors in any entity.

"We took the view, which goes to the heart of things, to work with the Chinese authorities," Rory Tapner, UBS's chairman and CEO for Asia-Pacific, tells Institutional Investor.

Subject to final approval from the China Securities Regulatory Commission, UBS has acquired a highly prized asset: an entity with a full suite of licenses that will allow the Swiss bank to underwrite and distribute equities and bonds and trade in the secondary market. "We have the opportunity to be a fully fledged player in a domestic market that is opening up rapidly but at the same time to retain control over our destiny," says Tapner. "This is all about building a platform for the future."

The agreement marked the biggest opening of China's securities market since last December, when Goldman Sachs won approval to establish a new investment bank with Beijing Gao Hua Securities and take a 33 percent stake in the venture. Morgan Stanley, meanwhile, owns 33 percent of China International Capital Corp., an investment banking venture with China Construction Bank that helped it win the mandate for China Construction's $8 billion IPO last month.

Although it is taking only a 20 percent equity stake in Beijing Securities, UBS will become the first foreign firm to gain management control over a Chinese investment bank -- a right that was approved by the State Council, China's highest decision-making body. The International Finance Corp., the World Bank's private sector investment arm, is buying an additional 5 percent; a consortium of mainland investors chosen by UBS will own 42 percent, and the Beijing city government will hold the remaining 33 percent.

Regulations have allowed foreign firms to hold no more than 33 percent in joint ventures and have limited their operations within China to underwriting; they are not permitted to distribute securities or trade in the secondary market. CLSA, the Asian investment banking arm of France's CrŽdit Agricole, and BNP Paribas Peregrine Securities have bought into such entities. China's securities industry, which lost an aggregate $1.8 billion last year, is in a horrendous mess, but the country's growing economic clout and massive capital needs offer great potential. As Xia Bin, director of the State Council's Financial Research Institute, puts it: "The future is very promising. Otherwise why would so many foreign companies want to participate?" The government hopes that the expertise of firms like UBS and Goldman will help whip the sector into shape.

Beijing Securities is a midsize brokerage with 600 employees and 27 branches. Losses on, among other things, proprietary trading led the firm to post a loss of $19 million last year. The deal with UBS neatly allows the Swiss bank to sidestep those businesses and handpick which Beijing Securities assets it will keep. The bank will take key Beijing Securities personnel and transfer 30 to 40 of its staff to the new firm. It plans to slash the Chinese firm's branches from the current 27 to between five and ten. "The structure eliminates the downside risk of the legacy items," says UBS Asia chief Tapner.

As for the task of turning Beijing Securities around, Tapner says: "It's not rocket science. We are building a franchise that positions UBS as the firm to go to across the breadth of investment banking and wealth management activities in China. We will concentrate on the smaller institutional market."

The bad news for Snow and UBS's competitors is that the authorities "regard this as a test case," says Tapner. If history is any guide, China might wait until it can assess Beijing Securities' performance before deciding on any broader market opening.