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CHINA BANKING - A New Man in China

Frank Newman, the rare foreigner to run a Chinese bank, has a bold rehab. Will it work?

In June 2005, shortly after he took over as chairman and CEO of Shenzhen Development Bank, Frank Newman telephoned human resources chief Zhao Na and asked her for the salaries of the bank's 18 city managers.

"I can't do that," she responded. "I just don't have the information."

"But can you get it?" Newman demanded.

"No," Zhao replied. "The only way I can get it is if I call each branch manager and ask how much he gets paid."

Newman had seen a lot in his 38-year career as a banker, which included a two-year stint as deputy U.S. Treasury secretary, but nothing prepared him for the mess he found when he took charge of the $31 billion-in-assets Shenzhen, a struggling, midsize player in China's rapidly transforming banking industry. Recruited by TPG Newbridge Capital, the Asian arm of Texas Pacific Group, after the private equity firm became the first foreign outfit to acquire control of a local bank, Newman found Shenzhen short of capital and saddled with more bad loans than most other big Chinese banks. Its branches operated like renegade subsidiaries that only occasionally deigned to send to headquarters sparse financial data. "If you ever added them up, they certainly didn't make the actual total," says Newman.

As for day-to-day operations, the 63-year-old banker just smiles in disbelief. "It's not that processes were weak," he says in a recent interview in his office at the bank's headquarters in downtown Shenzhen, just across the border from Hong Kong. "There just weren't any processes for a lot of things that are normal in a bank or corporation."

Newman wasted little time getting down to work. Over the past 20 months, he has pursued a program of reforms more sweeping than anything he ever attempted in his years as a leading fix-it man of the U.S. banking scene, which included major roles at Bank of America and Bankers Trust Co. He centralized credit controls to stanch the hemorrhage of loan losses and imposed a strict code of conduct designed to stamp out illegal or unethical behavior and improve customer service. And those officials whose salaries couldn't be determined? Newman purged Shenzhen's top ranks, removing eight of the top ten executives and half of the 18 city managers, replacing them with a cadre of veteran foreign bankers and reliable locals.

Having gotten a grip on management, Newman revamped Shenzhen's strategy to increase emphasis on China's booming consumer banking market, striking a deal with GE Money, the consumer finance arm of General Electric Co., under which the U.S. company agreed to pay $100 million for a 7 percent stake in the bank and to help Shenzhen develop its mortgage lending and credit card businesses. Newman, meanwhile, sharpened the corporate lending that still makes up the vast majority of the bank's assets by focusing on lending to smaller companies and trade finance.

Those changes are already producing dramatic results. Shenzhen Development Bank's net profits nearly tripled in the first nine months of 2006 from a year earlier, to 890 million yuan ($113 million), and its aftertax return on equity rocketed to 21.4 percent, compared with 6.7 percent for all of 2005. Retail lending surged 64 percent in the first nine months, and retail deposits grew by 16 percent. In January the bank predicted that net would total between 1.2 billion and 1.4 billion yuan for all of 2006, compared with 311 million yuan in 2005.

"It's the fastest turnaround I've been involved in," exults a beaming Newman. "There's a lot of work still to be done, but we've come much further in the first 20 months than I've seen before."

It's an impressive start, but Newman still faces huge challenges. Shenzhen's third-quarter results were flattered by comparison with those of a very weak year-earlier period, according to Charlene Chu, a Beijing-based analyst at Fitch Ratings, who says, "These results are probably not repeatable." May Yan, a Hong Kong­based analyst at Moody's Investors Service, is even less sanguine. The bank remains debilitated, she says, by "limited profitability, poor asset quality, inadequate capital, as well as weak internal controls." Moody's gives the bank a deposit rating of Ba3/NP, meaning the bank is of questionable to poor credit quality and has an uncertain capacity to repay short-term deposit obligations. By contrast, the agency rates Bank of China A2/P-1, indicating good credit quality despite susceptibility to impairment over the long term. Fitch rates Shenzhen D/E, saying it has concerns about the bank's profitability, balance sheet integrity, management and prospects.

Newman says the ratings fail to reflect the progress Shenzhen has made. "Some of the rating agency write-ups look like somebody made a mistake and they pulled out the report for 2004 and forgot to update it," he says. "This is our bank they're writing about in 2006? This bank just earned the highest return on equity in the third quarter of any bank with published statements in the entire country."

Shenzhen also remains short of capital, which is constraining its ability to grow. The bank needs the $100 million from GE but can't complete the deal because of a dispute between TPG Newbridge and the Chinese authorities over reform of the bank's shareholding structure, a legacy of the institution's state ownership that leaves TPG Newbridge with nontradable shares. Newman has no say in the dispute.

Still, investors have been positive at a time of overall buoyancy in Chinese banking stocks. Shenzhen's A shares have surged 344 percent since the end of 2005, to trade at more than 21 yuan ($2.70) apiece in mid-February, or 29 times trailing earnings. China Construction Bank's shares rose 65 percent during the same period and were trading at a price-earnings ratio of 21; Bank of China's shares have risen 24 percent since their July listing and trade at a P/E of 29, while Industrial and Commercial Bank of China's shares have jumped 35 percent since their October listing and trade at a P/E of 32.

Many investors remain wary, however, saying the gains have left bank stocks, including Shenzhen, overvalued. "I am not saying Chinese banks are not great growth stories on the China play, just that you have to pay a premium to join in," says Brook McConnell, president of Hong Kong­based fund manager South Ocean Management.

Turning around Shenzhen Development Bank is difficult enough from a management perspective. What makes the job even more daunting is the cultural aspect. Newman is the first foreigner to run a domestic bank in China since the Communist revolution in 1949 and is the only one of Shenzhen's top managers who doesn't speak Mandarin.

"Think about it," says CFO Wang Bomin, who Newman recruited from Taiwan's Taishin Bank. "He's a foreigner here speaking English. All 14 people at a senior management meeting are Mandarin speakers, and when you say something they pick up their headsets. When they say something you pick up your headset. How do you manage this culture shock? You need a very tough mind."

Newman calls the headsets "just a tool I have to use" and plays down suggestions of a cultural divide. "I listen to what the local executives say because they have the best information and market knowledge," he says, "but I am not afraid to be responsible and make decisions."

Executives say Newman bridges the cultural gap with hard work and force of personality. "A senior guy like him should be having a good time somewhere, but even though he is so senior, he can still put formulas in Excel himself," says Wang. "He's a bank repairman who rolls his sleeves up. This bank is really lucky to have him."

Newman acquired a taste for the cultural issues faced by foreign investors in Asia when he served on the board of Korea First Bank, which TPG Newbridge acquired from the government in 1999 and sold to Standard Chartered Bank in 2005. That experience, as well as Newman's track record -- recruited from the Treasury in 1995 to rescue Bankers Trust from a derivatives scandal, he sold it to Deutsche Bank for $9 billion in 1999 -- is why TPG Newbridge picked him to run Shenzhen, says David Bonderman, the firm's founding partner.

"Not speaking Chinese was obviously not a plus, but much more important in our view were his banking skills and the personality to deal with different people and government and other agencies in a congenial way," he tells Institutional Investor. "Frank is an easygoing guy who can do that in many different cultures."

Being an outsider also has some clear advantages given Shenzhen's troubled past, Bonderman says. "You had a bank that had outstanding issues about loans to friends and this faction and that faction, and you wanted somebody who was above all that," he explains.

Certainly, Newman has been making a favorable impression. China Central Television, the national network, named him joint "economic personality of the year" in 2006, alongside China's richest person, paper manufacturing tycoon Zhang Yin, and Yu Pengnian, a Hong Kong­based businessman who donated $250 million to an eye charity in Tibet. Newman is the only foreigner ever to be so honored.

So what possessed Newman, who received a reported $100 million severance payment when he left Deutsche in 1999, to come out of semiretirement and accept a job in Shenzhen, a polluted, crime-wracked industrial city. The answer, he says, is simple. "If I hadn't wanted to do something very dramatic in a market that is changing very rapidly, I wouldn't have come to China in the first place."

It's not hard to see why the authorities allowed a foreigner to take charge of Shenzhen Development Bank. The smallest of China's top 15 commercial banks, Shenzhen has proportionally one of the biggest bad-loan portfolios, a legacy of politically directed lending. Many of its clients -- mainly small and medium-size enterprises in Shenzhen and Guangzhou -- were badly hit by the Asian crisis in 1997.

Believing that bringing in outside help was the only way to save the bank, the Shenzhen government invited TPG Newbridge to buy its controlling 17.9 percent stake in the bank for $150 million in 2002. Closing the transaction took more than two years, however, as chairman Zhou Lin opposed the deal and dismissed TPG Newbridge's transitional management team in May 2003. The U.S. firm filed a lawsuit in Texas alleging that Zhou had conspired with Taiwan's Chinatrust Commercial Bank to undermine its binding contract with the Shenzhen authorities. TPG Newbridge succeeded in taking control in late 2004, but bad loans surged anew during the legal turmoil.

By the time Newman, who was initially appointed an independent director in December 2004, took charge in 2005, fully 11.4 percent of loans were nonperforming, and the bank's capital amounted to only 2.3 percent of assets. By tightening credit controls on new loans, Newman succeeded in reducing the NPL ratio to 8.3 percent by the end of June 2006, but that remains well above the Chinese average of 7.5 percent and is far worse than those of such leading institutions as Bank of China and Industrial & Commercial Bank of China (just over 4 percent), China Merchants Bank (2.3 percent) and Bank of Communications (2 percent).

Newman's first task was to stamp his authority on the bank. He assembled an experienced team he could trust, recruiting Wang as chief financial officer and Simon Lee, a banker who had worked at Crédit Agricole Indosuez, American Express and Citic Ka Wah Bank in Hong Kong, as chief credit officer. Other new hires included financial controller David Choi from Ernst & Young in Hong Kong, and head of wealth management Wilson Chu, previously with Citigroup in Taiwan.

"There are some other institutions [in China] where it's just not clear that somebody has the authority to make a decision and just say this is the way it's going to be and make it happen," Newman says. "I had that authority, and I just did it."

At the same time, Newman wanted to ensure that Chinese deference to authority didn't stifle debate. He set up weekly strategy meetings and went out of his way to solicit the views of senior managers. "I couldn't be in a position of saying, 'We're going north,' and everybody else in the room thinks we should be going south but nobody wants to say anything," he says.

To get staff focused on performance, Newman overhauled the bank's incentives. Bonuses had been virtually automatic: "You got paid 100,000 renminbi a year, and 60 percent of it would be called your salary and 40 percent was your bonus," he explains, "but you got 100,000 a year whether you did a good job or a bad job or didn't even show up at the office."

Under the new system senior executives and branch managers are compensated like investment bankers, "where the big opportunity is the bonus," says Newman. Branch managers' pay is linked to the profitable growth of commercial and retail loans, deposits and fee business.

Newman says staff like the idea of pay based on measurable performance "because it is less subject to the whims of individuals and there is less risk of abuse or favoritism," which are problems in state-owned companies. "Most Americans don't realize this is really a capitalist system," he notes. "People are highly motivated by incentives."

The new style has gone down well. Investor relations chief Huang Ying argues that Newman's leadership gives Shenzhen a significant advantage over other Chinese banks with foreign strategic investors. "All the other foreign banks with equity stakes in Chinese banks act as consultants, and the local banks can follow their advice or just ignore it," he says. "We are the only bank in China controlled by the shareholders, and now we are managed by professional bankers, not politicians."

Samuel Chen, a Hong Kong­based China banking analyst at JPMorgan Chase & Co., agrees. "The bank's key attraction is its Newbridge involvement and an experienced foreign professional management team, which is delivering a turnaround," he says.

Once he had established a firm grip on the bank, Newman turned his attention to retail, the hottest area of the Chinese market. With consumer banking head Liu Bao Rui, Newman created dedicated teams to push mortgages, credit cards, car loans and personal finance. (Mortgages had been a part-time job for the bank's corporate loan managers.) He also struck alliances to develop products.

Although Newman hasn't been able to complete his deal with GE, the U.S. company has already been advising Shenzhen on ways to penetrate the consumer market, including a pilot mortgage project in Guangzhou. The initiative introduced new products such as a biweekly payment mortgage and an offset account mortgage, which allows customers to use account balances to reduce their mortgage debt. The pilot also focused on accelerating loan approvals, adopting a GE process dubbed "time to yes," or TTY. The effort appears to be paying off: The average wait for a mortgage approval has been slashed to two days from ten previously.

"Acronyms like TTY and KYC [know your customer] are becoming part of the regular vernacular at Shenzhen Development Bank," says Michael Barrett, Shanghai-based head of GE Money. "It means that customer focus is becoming part of the SDB culture."

Mortgage lending grew fivefold in the first ten months of 2006 compared with the same period a year earlier. Liu is now rolling out the mortgage program nationally and expects to have dedicated mortgage teams in all of Shenzhen's branches by the third quarter of 2007. The bank aims to boost its mortgage volume by 50 percent this year.

The latest new initiative with GE is the launch of a co-branded credit card with Wal-Mart (China) Investment, a subsidiary of the U.S. retail giant that operates 71 stores in 34 Chinese cities. The bank hasn't disclosed any details about the number of cards or amount of credit outstanding and says the venture isn't expected to produce any profits for two years, but executives are counting on the card to promote Shenzhen's brand across the country.

Thanks to those initiatives, retail lending surged 64 percent in the nine months ended September 2006, to 175.5 billion yuan; that represented 15 percent of Shenzhen's overall lending, up from 8 percent in 2003. Liu says his target is to boost that share to 40 percent within five years. By comparison, China Minsheng Banking Corp. boosted its retail lending by 21.2 percent in the first nine months of 2006, to 431 billion yuan, and Bank of Communications increased its lending by 18 percent, to 895.5 billion yuan.

Newman has also moved to develop Shenzhen's wealth management business. Chu, the division chief recruited from Citigroup, has been pushing a new line of principal-guaranteed structured products named Jucaibao, which offer higher returns than term deposits. The bank sold 6.7 billion yuan of investment products in 2005; sales slowed in 2006 (the bank hasn't reported figures yet) as a hot stock market captured investors' attention.

Notwithstanding the retail thrust, corporate lending still accounts for the vast bulk of Shenzhen's business, and Newman has moved to improve credit quality and boost profits. He curbed the authority of branch managers and centralized credit controls under Lee, the chief credit officer. The bank has also been increasing its emphasis on trade finance and medium-size companies. Newman insists that no loans extended since TPG Newbridge took over Shenzhen have turned bad.

Analysts acknowledge the improvement but remain concerned about credit quality. "Continuous aggressive loan growth and the legacy of lending to support economic development have eroded asset quality and exerted significant pressure on capital," says Moody's Yan. Despite Shenzhen's reforms, she adds, "meaningful improvements in its financial strength remain a challenge." Even Newman concedes that past mistakes are acting as a brake on growth. "We're growing as rapidly as we want to grow given our concern about credit quality," he says.

Newman's biggest challenge going forward is figuring out how to bolster his slender capital base. Retained earnings pushed up the bank's capital to 3.6 percent of assets at the end of September from 2.3 percent when Newman arrived, but that is well below the 8 percent minimum required under the Basel accord. All of the other eight listed banks in China meet or exceed the 8 percent target, led by China Construction Bank, with a capital ratio of 13.5 percent.

The $100 million investment from GE would raise Shenzhen's capital ratio to 4 percent, which in turn would allow the bank to raise additional capital by selling subordinated debt. That deal remains conditional on a revision of Shenzhen's shareholding structure, however.

In the spring of 2006, the China Securities Regulatory Commission required all listed companies to convert their nontradable shares to tradable ones and to compensate existing holders of tradable shares for their consequent dilution. The move lit a fire under the domestic A-share market, which had been depressed for several years by concerns about the potential release of nontradable shares.

At most companies owners of nontradable shares are state enterprises that received them for free from the government; they typically own about 70 percent of outstanding shares. Shenzhen Development Bank is unique, however. Nontradable shares represent only 28 percent of the outstanding stock, with the key nontradable holders being TPG Newbridge (17.9 percent), electronics firm SZ Zhongdian Investment Co. (3.2 percent) and Haitong Securities (1.7 percent). Complying with the CSRC mandate would require the agreement of several parties rather than a single government entity and would mean a minority of shareholders would pay compensation to a majority.

TPG Newbridge is not keen on the idea that it should compensate other shareholders. Says Shan Weijan, Asian head of TPG Newbridge, "I am against expropriation of anyone's property rights, whether populist or not." In July the firm and other nontradable holders did offer to pay 0.48 yuan in cash for every ten tradable shares outstanding -- or the equivalent of $20 million in total -- but the offer was rejected by the bank's 600,000-odd shareholders.

TPG Newbridge has yet to submit a new proposal, and shows little inclination to open up its wallet. "We'd like to reach a resolution, and we'd like to reach it sooner rather than later, but we won't do anything that is fiscally irresponsible, and we will do what is best for the shareholders," says Bonderman. "Our position is that the CSRC has to understand that it's a situation where we own less than 20 percent of the bank and you're going to have a different solution from one where somebody owns 85 percent of the bank."

Assuming an agreement is reached and the GE deal goes through, the bank will be allowed to issue subordinated debt to raise its capital ratio to 6 percent. That would still leave the bank short of the 8 percent Basel threshold. "It will still be 2 percentage points below the regulatory requirement, still below every other bank we cover on the commercial side," says Fitch's Chu. "They still face an issue there."

Newman appears to have some options, however. Shenzhen announced as part of its third-quarter earnings report that it had been approached by investors wanting to buy a stake in the bank. Chinese media reports suggest that one potential investor is Shenzhen-based Ping An Insurance. The bank also confirmed in June that it had talked to Lehman Brothers Holdings about a possible investment, but the firm would be limited to a 1 percent stake because of the 25 percent cap on foreign ownership in domestic banks. Either way, CFO Wang says, "we can piece together a bit of this and a bit of that. I don't see any problem getting from 6 percent to 8 percent."

Newman also remains sanguine. He says the only thing the bank cannot do because of its inability to meet capital requirements is open branches in new cities. "In the meantime, the business is growing very rapidly, and the China Banking Regulatory Commission is very happy to see the improvement in earnings and the earnings retention strength building," says Newman. "When you have over 25 percent annualized return on equity, you can grow without needing new capital."

Interview

Frank Newman on banking, culture and Deng Xiaoping

Frank Newman was enjoying semiretirement in New York in April 2005 when he was asked to take the helm of Shenzhen

Development Bank, which is controlled by Fort Worth, Texas­based private equity firm TPG Newbridge Capital. Never mind that he didn't speak a word of Mandarin and had never lived outside the U.S. Newman had been getting a taste of the challenge since December 2004, when he became an independent director of Shenzhen.

"It really sounded intriguing," he says of the offer to become chairman and CEO. "It didn't take me all that long to say, 'Sure, let's see if we can work that out.'"

So far the move is working out just fine. Shenzhen's earnings and stock price have soared over the past year as Newman has taken the lessons he learned in the late 1980s as CFO of Bank of America and in the mid-'90s as CEO of Bankers Trust -- such as centralizing credit controls and using incentives to motivate staff -- and adapted them to China's dynamic economic and political climate.

In a recent interview in his Shenzhen office with Institutional Investor Hong Kong Bureau Chief Kevin Hamlin, Newman discussed the management and cultural lessons he has learned so far.

Institutional Investor: You took on some big challenges at Bank of America, Bankers Trust and the U.S. Treasury. How does Shenzhen Development Bank compare?

Newman: It is not the biggest in sheer size, but it's the most complex. It's complex because things are changing so rapidly in China. The fact that you've got rapid economic growth is very good, but it does mean you've got changes going on. The legal system is still developing, the regulatory system is still changing, and there are big cultural differences.

Sometimes the cultural issues are very complex because human beings are very complex. I've learned that I cannot make assumptions about the way people will interpret things. I need to get feedback about the way people view a particular issue because they come from different backgrounds.

Can you provide an example of these cultural complexities?

In our weekly strategy meeting, which brings together roughly the top ten people in the bank, I was worried at first -- maybe this sounds like I'm making a joke -- that I was going to be treated with too much respect. I am the chairman, I am older and there is a cultural tendency in China to show respect, which is great because everybody likes to be treated with respect. But I couldn't be in a position of saying, "We're going north," and everybody else in the room thinks we should be going south but nobody wants to say anything. One of the key things was to actively encourage discussion of issues so that the meeting became a real forum for different views to come out.

How did you get employees to open up?

I asked them a lot of questions. It would never have worked if I had said "I think we should go north, does anyone have a different view?" So I had to come in and say, "You know, there are a lot of trade-offs and I'm trying to decide on this issue whether we should go north or northwest. [Consumer banking head Liu] Bao Rui, what do you think?" It took a while to get there, and I had to really work at it and make sure the people really knew that I was very comfortable with it and wanted to have a real discussion.

How do you convince employees to make changes?

One thing we've used over and over again is a very famous quotation by [former Chinese leader] Deng Xiaoping: "It doesn't matter whether a cat is black or white as long as it catches mice." We're not trying to do our operations in a Chinese way or in an American way or in a British way or in a Japanese way or whatever. We're just trying to decide what works best for our bank, for our customers in our particular circumstance. People have picked up on that quite well.

Has your experience as deputy U.S. Treasury secretary helped you?

There's a lot of stuff that came out of the government experience that is applicable here. The government has a big role in what goes on in China, there's just no question about it. I tell some of my friends back in New York that it took me a while to find out how little I really knew about China. One of the great misimpressions is that this is a monolithic central government that controls everything. It's just not the way it is. The cities have a lot of power, different agencies too. You have to deal with multiple organizations.

Is turning around Shenzhen Development Bank similar to the job Newbridge did at Korea First Bank?

No, they are different in some significant ways. At KFB the government had already taken out a lot of the bad loans; capital was fine. But the basic operations of the bank were not very profitable. The ratio of cost to income was way too high, and the unions were very, very strong. Here we've had a big NPL challenge, a big capital challenge, but the basic banking business was already profitable, and the cost-to-income ratio was perfectly respectable, though it is getting better.

The cultures, the people, are different. One of the things I was particularly pleased about here is that the people seem to accept me and my leadership very well. There are a lot of smart people here and instead of rejecting this foreigner who came in, they basically said, "If somebody is coming in here and actually knows how to run a bank better, that is great. We'll let him point us in the right direction."

How do you communicate key messages to staff?

We have a regular weekly senior management meeting. Quarterly, I give a report both in writing and in public appearance. So in this building we will get together 500 or 600 people plus video connections to all the branches. I, plus CFO Wang Bomin, usually will give a financial report and Liu will give a retail report. We give them real information, not just spin, talking about the direction the bank is going in.

What is the potential of the co-branded credit card with Wal-Mart?

It's not going to make money in the first year because you have to build up the accounts, but eventually it will make money. We hope that once we have some experience that we can do a similar kind of program for other retailers.

There's also the advertising benefit. I visited a big Wal-Mart store in Shenzhen recently. One of the first things you see when you walk into the store is a very nicely designed booth advertising this card, and you see SDB all over the place in blue and white. How much is that worth when you are trying to build a retail business? It's hard to put a number on it, but it's valuable.

Are you content with the current speed of growth?

Right now we're growing as rapidly as we want to grow given our concern about credit quality. Retail lending grew 80 percent in the past 12 months; that's pretty fast. There's also a complication right now because macro-economic policy is to not have lending grow too fast. If we wanted to grow at 30 percent a year in our lending, I don't think the People's Bank of China would let us at the moment no matter how much capital we had because it is trying to control the rate of growth in the country.