Cdn Banks Eye China

THE CHALLENGE: Canada's Big Five are small fry compared with many foreign rivals
THE LESSON: Target a niche, form partnerships, take the long view -- and then proceed with caution . . .

The Globe and Mail, Sinclair Stewart, Saturday, October 29, 2005

Rick Waugh has a little story he likes to tell about China. More than four years ago, before he was promoted to chief executive officer, Bank of Nova Scotia was approached by the World Bank with a proposal: Would it like to make a co-investment in Xi'an City Commercial Bank (XCCB), a coalition of more than 40 credit unions that had recently banded together under one corporate umbrella?

Xi'an, a city of more than seven million people in the heart of the Chinese mainland, is perhaps best known for its Terracotta Warriors, a stony legion of 8,000 life-sized sculptures that have been described as the eighth wonder of the world. What it isn't known for is stellar economic growth or the maturity of its banking system -- both of which the Chinese government and the World Bank have been attempting to change.

Scotiabank agreed to contribute $3-million (U.S.) for a 2.5-per-cent stake, and then work with XCCB to improve its governance practices and upgrade its accounting to international standards.

It sounded like the ideal opportunity: a cheap, low-risk, and straightforward segue into a Chinese market that was untapped by foreign rivals. But this is China, where attempts to transform the business culture, much less introduce Western notions of corporate governance and bookkeeping, are rarely straightforward matters. As it turned out, Scotiabank didn't sign the agreement until the fall of 2002, and then had to wait another two years before the investment itself was formally consummated.

"Four years," says Mr. Waugh, unfurling the fingers of his right hand to emphasize the point. "Four years to just close the deal. The Chinese, while their intents are right, have a long way to come on accounting standards, transparency, understanding shareholders' rights -- particularly minority shareholders' rights -- because they come from a culture of central planning. They've got a long way to learn."

The hurdles in Xi'an have hardly soured Scotiabank on China. The company has been laying groundwork here for 20 years, and now boasts representative offices in Beijing and Shanghai, as well as branches in Guangzhou and Chongqing. Along with Bank of Montreal, it has been the most active of the Canadian banks in pursuing growth in the world's most populous country.

Yet amidst the current helter-skelter environment of foreign investment in China and the litany of Western banks who have laid down billion-dollar bets in the past year, Mr. Waugh comes off as a voice of caution. He sees the obvious potential but he's wary of reaching too far, too fast. His experience with Xi'an city has taught him as much.

"In China, the road is going to be a very difficult one, through potholes and what have you, and you just don't know until you get there," he said. "For us, we're not counting on any material results for the foreseeable future. It is going to take longer than we think."

Canada and China are separated by several chasms, ranging from the geographic and the linguistic to the cultural and the political -- all of which can pose serious impediments to foreign expansion. Yet these barriers are quickly dissolving in the face of enormous opportunity. The numbers alone are enough to make any banker giddy: 1.2 billion people, $1.5-trillion in personal savings, and an economy chugging along at a 9-per-cent clip. The thinking is that as the Chinese get dragged into the global economy, they will begin acquiring the same kind of spending habits as Western consumers, creating an explosion in credit card usage, mortgages and lines of credit.

This combination of demographics and cordial business relations positions China as a natural place for expansion -- albeit cautious expansion.

"We have to focus on being a niche player in a very big market," conceded Mr. Waugh. BMO shares that view. It has branch offices in Beijing, Guangzhou and Hong Kong, along with a representative office in Shanghai. Foreign exchange trading is one of its biggest businesses here, and BMO is by far the largest Western player in the game, accounting for 70 per cent of the trading volume by foreign banks.

But like Scotiabank, its ambitions are realistic, if not modest. BMO realizes it could never compete with larger Chinese or U.S. rivals in personal banking, so it has focused its retail strategy on wealth management. It has a 28-per-cent interest in Fullgoal Fund Management Co. Ltd., a Chinese mutual fund company with more than $1.5-billion in assets under management. The fund industry is still in its infancy in China, evidenced by how much of the country's savings are deposited in bank savings accounts. However, BMO predicts that as much as $300-million (Canadian) in assets could be available for management in the next five to 10 years.

Tony Comper, BMO's CEO, preaches patience, but says the notoriously complex regulatory system in China is improving and things are beginning to move more rapidly.

"Frankly, we're not as interested in any short-run [potential] as we are in building a long-haul business," he said. "For our book, as opposed to taking just a pure equity investment in one of the commercial banks, this initiative . . . looks like one that is better suited to our capabilities and our risk appetite. The hallmark of the BMO approach to markets like this, and markets anywhere else, is a measured pace."

These banks may be moving with caution, but at least they're moving. The rest of the Canadian banks appear impervious to the China boom, and any steps they have taken to penetrate the mainland have been comparatively minor.

This shouldn't come as a complete surprise. BMO and Scotiabank have spent decades cultivating relationships with Chinese officials. More importantly, however, they can lay claim to proven growth strategies (Scotiabank in Mexico and the Caribbean, BMO in the U.S. Midwest).

This last point can't be overstated. Canadian Imperial Bank of Commerce, for instance, has made costly stumbles in the United States, both with its failed electronic retail bank and its accident-prone investment bank. Royal Bank of Canada has had growing pains recently in the U.S. Southeast, and while they have been less spectacular than those suffered by CIBC, they are serious enough to give the markets pause.

CIBC has a token presence in China, including representative offices in Beijing and Shanghai. However, it has essentially chosen to outsource its Chinese banking capabilities through a "business co-operation agreement" it struck recently with Bank of East Asia. The Hong Kong bank will provide CIBC clients with trade financing services and local currency accounts in China, but the Canadian bank will not receive revenue from the venture. RBC, meanwhile, has a representative office in Beijing.

That leaves Toronto-Dominion Bank, which has also resisted the urge to join the masses descending on China. Ed Clark has steered clear of China, instead devoting his two years as CEO to the U.S. retail market, first buying Portland, Me.-based Banknorth Group Inc., and then pulling off a merger of his discount brokerage operation, TD Waterhouse USA, with rival Ameritrade Holding Corp.

"Should we be sitting there and trying to get into China today?" he asked in a recent interview. "We came to the conclusion that what you have to do is what you're good at. You have to make money the way you know how to make money. So because of this historical legacy, Scotiabank has built a culture that is comfortable working in different cultures around the world. I'd rather make money for my shareholders doing what I [know how to do] than taking a shot at something I don't know how to do. Because it might be twice the rate of return, but I also could lose my shirt."

Maybe the cautious types are right. Maybe China is too raw and unwieldy, its reforms progressing too slowly, to justify anything more than a prudent, systematic approach to growth -- if anything at all. Maybe it's too risky to place a big bet on a banking system that is riven by bad loans and encrusted with bureaucratic management. But if these people are right, then a hell of a lot of high-powered bankers could be wrong.

The Chinese banking market has become the focal point of an unprecedented gold rush in the past year and a half, and Canadian banks are nowhere to be seen.

Witness the string of recent deals: HSBC shelled out $2.25-billion (U.S.) in late 2004 for a 20-per-cent stake in Bank of Communications; Bank of America then paid $3-billion for a minority stake in China Construction Bank; Royal Bank of Scotland, backed by some other investors, acquired 10 per cent of Bank of China for $3.1-billion; Semasek, a Singaporean conglomerate, also anted up $3.1-billion for a 10-per-cent stake in Bank of China, and committed another $2.5-billion for a slice of China Construction Bank. Even investment bankers are getting in on the act. This summer, Goldman Sachs said it would buy 10 per cent of Industrial and Commercial Bank of China for $3-billion, and UBS recently agreed to pay $500-million for less than 2 per cent of this bank.

Say goodbye to patience. The story here is one of mutual back-scratching: The Chinese banks, which are preparing for competition on the world stage when the country fully opens it doors to foreigners at the end of 2006, get exposure to best practices and management expertise, not to mention a much-needed dose of cash. The Western banks get access to huge distribution channels, which they can use to market their products to hundreds of millions of customers. They may also earn some lucrative fees for advising these Chinese banks when they begin launching initial public offerings on the stock market later this year.

Until recently, the 200 foreign banks operating in China controlled just 1 per cent of the country's $4-trillion banking system, according to UBS. However, if the deals continue at the current pace, this number could rise to 17 per cent in the next two years. A foreign bank can own up to 20 per cent of a Chinese bank, while a group of outside investors can own a maximum of 25 per cent combined.

Mind you, there are plenty of detractors. Chinese banks are legendarily opaque, and when they do offer a glimpse of their books, it's rarely pretty. The loan problems experienced by Canadian banks a few years ago barely register alongside the dysfunctional lending practices of their Chinese peers. So far, the Beijing government has paid a staggering $280-billion to bail out its banks since 1998, and will have to inject another $200-billion before the job is done, according to a report last month by the Organization for Economic Co-operation and Development. That is more than 30 per cent of China's GDP for 2004.

Jonathan Anderson, the chief Asian economist for UBS, believes the real story lies somewhere between the fear-mongers and the unfettered optimists. His argument is that, despite being an emerging market, China is a country that is severely overbanked. According to his calculations, commercial bank deposits account for nearly 200 per cent of the country's gross domestic product, while loans stand at roughly 130 per cent of GDP, both far in excess of banks in developed countries. Opportunities and risks still exist, he admits, but not nearly to the degree to which many believe.

"The truth of the matter is that China's financial system is neither an explosive minefield nor a beckoning gold mine," he wrote in a recent article, "but rather a profoundly middle-of-the-road investment option."

Five banks, five strategies

Bank of Montreal

Bank of Montreal's roots in China date back to the late 19th century, and today the bank remains one of the most expansive Canadian financial institutions on the mainland. BMO has branches in the capital of Beijing, as well as in Guangzhou and Hong Kong, and also boasts a representative office in Shanghai, China commercial centre. The bank is pursuing the retail market through its 28-per-cent stake in Fullgoal Fund Management Company Ltd., a mutual fund joint venture with a few Chinese partners. This summer, BMO became the first Canadian bank to be granted a licence to offer local currency services in China.

Canadian Imperial Bank of Commerce

CIBC has representative offices in Beijing and Shanghai, and once had a merchant banking partnership in Hong Kong with billionaire Li Ka-shing, Mr. Li sold his holdings in CIBC last year, however, and the two sides began dissolving their merchant bank. CIBC has been curtailing foreign expansion after experiencing troubles in the U.S., and China is no exception. Rather than undertake a more aggressive growth plan, CIBC struck a recent co-operation agreement with Bank of East Asia. The deal will allow CIBC customers to access Chinese trade financing and open local currency accounts through Hong Kong-based BEA.

Toronto-Dominion Bank

TD boss Ed Clark says he has no interest in chasing the Chinese dragon, and is instead focusing his external growth ambitions on the U.S. market. Through its TD Waterhouse brokerage, TD once had a small presence in Hong Kong, but that has since been shuttered. The bank has no beachheads on the mainland.

Royal Bank of Canada

RBC, Canada's largest bank, is one of the smallest in terms of its Chinese presence. The bank has capital markets operations in mainland China through its sole representative office in Beijing. RBC has applied to open a branch in the capital, and says it is committed t expanding its business with both government and financial services companies.

Bank of Nova Scotia

Along with BMO, Bank of Nova Scotia has the most entrenched Chinese presence of Canada's Big Five banks. Scotiabank, which has a reputation as the most international player in the Canadian banking sector, has representative offices in both Beijing and Shanghai, and has branches in the populous cities of Guangzhou and Chongqing. It recently partnered with International Financial Corp., a division of the World Bank, to acquire the small equity stake in Xi'an City Commercial Bank. Many American banks have attempted to crack the retail market this way, but this was the first time a Canadian bank made a director investment in one of its Chinese counterparts.

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Banking Reform in China

The Economist, 27 October 2005

It is a staggering thought: communist China now has a bank more valuable than Barclays, American Express or Deutsche Bank, financial institutions at the heart of Western capitalism. At more than $66 billion following its initial public offering in Hong Kong on October 27th, China Construction Bank (CCB) boasts a larger market capitalisation than any of these three. CCB's listing, which raised $8 billion from foreign investors for 12% of its shares, is the largest global flotation for four years, China's biggest and the biggest ever for a bank. CCB garnered another $4 billion ahead of its float by selling stakes of 9% to Bank of America and 5.1% to Temasek, Singapore's investment agency.

This is quite a transformation for a bank that was technically insolvent less than two years ago and which, despite a hastily applied commercial gloss, is still a government agency, plagued by bad debts and corruption so pervasive that just five months ago its then chairman was arrested for bribery. In private, China's leaders must be marvelling that they have pulled off this sale. Yet their ambitions are far greater. Bank of China (BOC), the second of the “Big Four” state banks, with foreign investors already aboard, is planning a $5 billion foreign listing in early 2006. Industrial and Commercial Bank of China (ICBC), the biggest, is appointing advisers for a $10 billion flotation late next year or in 2007. Many of the smaller joint-stock and city banks now too have foreign investors and are eyeing overseas listings.

Beijing is encouraging this rush to market as the most fundamental step in reforming the economy since Deng Xiaoping opened China to the world in the late 1970s. Since then, the country's banks have been almost wholly responsible for channelling the population's sky-high savings into industry and investment. Given China's failure to develop healthy stock and bond markets, bank assets have ballooned to almost 30 trillion yuan ($3.7 trillion) in 2004, or 210% of gross domestic product (GDP). That is the highest of any big economy, says Nicholas Lardy at the Institute for International Economics in Washington, DC: India is at 170%, Brazil 160% and Mexico 100%.

Sadly the banks have been disastrous middlemen, lending on government instruction without a view to their profits. They have poured money into wasteful infrastructure projects and kept broken state-owned enterprises (SOEs) afloat. Not only has this created huge non-performing loans for the banks themselves, but also because China's investment is so unproductive, it has to shovel ever more money into its economy to maintain its current growth. Already, China needs almost $5 of fresh capital to generate $1 of incremental output, a far worse ratio than Western countries and even India. In the first quarter of 2005, fixed-asset investment reached an incredible 54% of GDP, 10 percentage points above the household savings rate. No country can sustainably invest more than it saves and China must raise the productivity of its economy.

That is why overhauling its banks is so critical to securing the country's future growth. China's political leaders have an iron commitment to bank reform—a commitment backed with cash. Since 1998, Beijing has injected more than $260 billion into its banks via straight handouts and by allowing the Big Four to shift dud loans into separate state-backed companies. This is about twice what South Korea spent to restructure its banks after the 1997-98 Asian crisis and about what America needed to bail out its savings & loans industry. Mindful of the long paralysis of Japan's indebted financial system, China is pumping in funds before a financial meltdown. Weijian Shan, a director at Newbridge Capital, a private-equity firm which owns a controlling 18% stake in Shenzhen Development Bank (SDB), is impressed: “the government is taking the pain before it is too late, showing it understands that China's economic development depends on a healthy banking system.”

Beijing realises too that money alone will not do the trick. Since 1998 it has raised accounting, prudential and regulatory standards. Before then, the banks could book interest income for up to three years even if it was not being paid; now they can do so for only 90 days—the international norm. In 2002, the old lenient system whereby banks provisioned just 1% of their loans regardless of risk, was replaced by a five-tier classification tying the size of the provision to loan quality. Meanwhile, the central bank's decision last October effectively to lift the ceiling on commercial loan rates should, in theory, allow banks to charge more to riskier borrowers.

The biggest change, though, has been the creation of a central regulator, the China Banking Regulatory Commission (CBRC), carved out of the central bank in 2003. Headed by Liu Mingkang, a respected former president of BOC, the regulator is trying to shift the banks' focus from mindless loan and deposit growth to preserving adequate capital and generating decent returns on it. Lenders that do not meet a capital ratio of 8% of risk-weighted assets (as decreed by Basel I, a global standard) by 2007 face sanctions—including the removal of senior management. The regulator's 20,000 staff are trying hard to ensure compliance. “At every board meeting, the CBRC guy is right there taking notes and pounding the table,” says Stephen Harner, a former diplomat who now sits as an independent director at Hangzhou City Commercial Bank.

The rush for reform

All this has given an urgency to reform efforts. Almost all China's 128 commercial banks have introduced better governance, shareholding and incentive structures, and have added independent directors to their boards. Senior managers are investing in new risk systems and trying to change bad old habits such as having the same person make and approve a loan, a practice that encourages corruption.

The restructuring has been helped by a benign environment. China's economic boom fuelled annual loan growth of almost 16% over the past four years and deposit growth of 18% a year. Lending to consumers, which started only in 1997, has exploded, increasing 123 times to more than 2 trillion yuan ($250 billion) in seven years, says Merrill Lynch, an investment bank. Corporate loans still dominate, but mortgages, car and education loans now make up 11% of the total and 26% of new lending, says Mr Lardy (see chart 1).

Strong revenue growth and offloading bad debts on to the government has inflated bank profitability. Last year, China's 13 biggest banks made net profits of 90 billion yuan ($11 billion) and a decent-looking return on equity (ROE) of almost 11%, says Fitch, a credit-ratings agency. Over half came from CCB, the sector's poster child, which expects net profits of 42 billion yuan ($5.2 billion) for 2005. Though it is only the third-largest lender, aggressive management, leadership in mortgages and the number two position in debit and credit cards have helped it achieve an industry-leading ROE of over 25%.

Meanwhile, the headline non-performing-loan ratio reported by the CBRC fell to 8.8% of total loans by this June, down by half since the end of 2003. CCB looks much cleaner, with a ratio of 3.91%. It has stronger reserves, with loan-loss provisions of 64% of its bad loans compared with 15% average for its peers. Its listing prospectus says that loans to “new” customers (acquired since 2000) are one-third as likely to go sour as those to older clients, suggesting regulations are working. On this basis, CCB looks only a bit worse than developed-world banks.

Well, it would, if that were indeed the true picture. Independent estimates put bad debts at 20-25%, far exceeding official figures. The CBRC itself paints an alarming picture. In an internal report leaked to Shenzhen's Securities Times, the CBRC found system-wide bad loans actually rose this year, if a disposal from ICBC was excluded. It expects 30 billion yuan in new bad loans in 2005. And on October 14th having inspected 11 banks, the CBRC concluded that it is “common practice” for banks to ignore regulations and fail to monitor loans, and that bad-loan levels are “not accurately revealed”. Poor accounting means that the banks themselves are unsure of their bad loans. Others do not tell. Lai Xiaomin, head of the CBRC's Beijing office, admits that “when our banks disclose information, they don't always do so in a totally honest manner.”

That bad loans are rising, not falling—Fitch estimates by 8% in the first half of 2005 once government-funded write-offs are excluded—is not surprising. China's banks went on a lending binge between 2003 and 2004, partly to “grow out of” their bad loan problem. Many loans will go sour, as Beijing has moved to curb overheated sectors such as steel, cars and property. If economic growth slows, a new wave of bad loans will hit. In addition, banks carry alarmingly high levels of “special mention” loans, ranked as performing but where a borrower's circumstances have worsened. Even at CCB, these are 14% of the total.

Look at the books

A new surge in bad debts would be bad enough if Chinese banks had the earnings power to absorb them, but they do not. Behind the headline numbers, their basic profitability is very poor. An average net interest margin of 2.36% looks decent compared with the 1.5-2.5% in developed markets. But David Marshall, head of Asian financial institutions at Fitch, argues that Chinese banks need far wider margins to cover the risks typical of an emerging economy. Indonesian banks, for example, boast a 5% net interest margin and Indian banks 3.45%. Meanwhile, Chinese banks are too dependent on loan income. More stable income from commissions and credit-card fees is only 13% of total revenues, half the level at Indian banks and just one-third of Thailand's. And while costs at Chinese banks are low, at 45% of revenues, this reflects poor investment in training and IT, not better efficiency.

Put all of these factors together and the return on assets (ROA) generated by China's banks, at less than 0.5% last year, is the worst in Asia (see chart 2). Granted, they look better measured by ROE, but this too is deceptive. The excellent 25% CCB highlights in its prospectus is really 17% after adjusting for a tax break. More crucially, the sector's 11% reflects inadequate levels of equity (in other words, capital) rather than high returns. The industry has a capital-adequacy ratio of barely 8%. Mr Marshall argues that China's banks should be carrying capital of at least 15-20%, as banks in Indonesia do, to guard against unforeseen risk. If they did, their ROEs would drop to 5% or less—a much truer reflection of their innate level of profitability.

Two sobering conclusions follow. The first is that even a tiny deterioration in business conditions that either reduces margins or increases bad loans would wipe out earnings at China's banks. The second is that even if the economy remains good, the banks cannot generate enough internal capital to support their current levels of loan growth. Ryan Tsang at Standard & Poor's, a credit-ratings agency, estimates that to avoid more capital injections the banks have to generate an average ROA of 2.1%, almost five times current levels.

Clueless lenders

To close that gap will take a fundamental transformation of how Chinese banks operate. The banks simply do not understand how to price risk or spot a dodgy borrower. Neither flexible interest rates nor loan classifications can help if credit officers cannot tell good loans from bad. The current boom has led loan officers to believe the value of collateral always goes up.

The real battle for bank reform will be won or lost in the branches. While reforms have changed much at head offices, they are hard to enforce elsewhere. Guo Shuqing, CCB's new chairman, admitted shortly after he got the job, that “more than 90% of the bank's risk managers are unqualified”—a bold statement from a man wanting to list his company.

A pyramid of cards

These are massive organisations to turn around, after all. CCB alone has 14,250 branches and 304,000 employees. Their historic decentralisation makes them especially hard to control. In a book to be published in November, Wu Jinglian, China's most respected economist, notes that until a decade ago provincial branches of commercial banks borrowed funds directly from provincial offices of the central bank and lent them to local customers. They enjoyed “legal person status” and did not require authorisation from head office. Even today, big branches of ICBC have their own English-language websites—emphasising their independence. “Branch managers are kings in China,” concurs Frank Newman, an American who took over as chairman of SDB on behalf of Newbridge earlier this year.

At all banks there is a struggle between head office, which wants to centralise processes, and local staff who are in thrall to the demands of local officials and industrialists and who disobey their branch managers on whom they depend for their promotions at their peril. Unhelpfully, the branches are being monitored by a regulator that faces the same problems as its charges—too many unqualified staff spread too thinly. Han Mingzhi, head of the CBRC's international department freely admits, “we lack people who understand commercial banking and microeconomics. It is a headache for the CBRC.” The result is that it will take China's banks years to establish proper corporate governance, a genuinely commercial culture and hence decent profitability.

Meanwhile, strategic foreign investors are supposed to bridge the gap—with money, but especially with skills in risk management and advanced financial products. The lure of China's high growth and huge population has triggered an astonishing stampede, attracting some $18 billion in foreign direct investment in China's banks in one year. The first big deal was the $1.7 billion HSBC paid for a 19.9% stake in Bank of Communications (BoCom), the fifth-largest lender. Then came CCB. Since then, a consortium led by the Royal Bank of Scotland has put $3.1 billion into BOC, Temasek another $3.1 billion and Switzerland's UBS $500m, while Goldman Sachs and Germany's Allianz are investing in ICBC. Only Agricultural Bank, the Big Four bank with the deepest problems, has failed to attract a Western investor.

In return, the international banks get a cut-price entry ticket: Bank of America paid 1.15 times book value for its stake in CCB, which has now floated at almost twice book. They also gain access to a branch network and client list they could never afford to replicate, even after World Trade Organisation rules force China to open its domestic banking market fully from end-2006. Every deal is thus accompanied by a joint-venture in savings and insurance products and, of course, credit cards—the Chinese financial market that has every foreign investor salivating.

Only 12m of the 880m bank cards in China are genuine credit cards. So McKinsey, a management consultancy, predicts exponential growth from this segment, and profits of $1.6 billion by 2013. Yet McKinsey also notes that half of existing accounts are unprofitable. Chinese pay their bills in full each month, show little loyalty to brands and are unimpressed by foreign-backed offers. Ron Logan, head of HSBC's credit-card venture with BoCom, says acquisition costs are soaring as competition heats up, with everything from DVD players and holidays used to entice customers, further eroding profits. Jean-Jacques Santini of BNP Paribas, which just bought one-fifth of Nanjing City Bank, warns investors: “expect to lose money on credit cards for the first three or four years.” The only way for investors to make decent returns in the short term is by betting on a big rise in post-IPO share prices. Everything else they take on trust.

A very Chinese welcome

Meanwhile, given limited ownership rules, foreign banks can have only a modest influence on strategy or operations at their Chinese partners. Newbridge is an exception since it has won genuine management control of SDB, which is small and has a widely dispersed ownership. HSBC's vastly greater size compared with BoCom, means it might, in time, have a significant say. The rest are restricted to one or two board members each, while the appointment of senior management remains with the Communist Party. “Can China's banks be fully reformed while staying under government control? I doubt it,” says Mr Marshall.

To reform its banks properly, China must allow foreign takeovers. And its banks must be allowed to merge and fail. Yet even if Beijing raises cumulative foreign-ownership limits above the current 25% next year, as the CBRC expects, it is unlikely to relinquish control of a major bank. Worryingly, the CBRC seems ambivalent about foreign participation. Mr Han says he doubts the wisdom of raising the ceiling on foreign investment “if we don't get something in return”. Yet as banks in Poland and the Czech Republic discovered, preventing foreign takeovers simply delays bank reform and means more costly bail-outs. A stockmarket listing cannot really help while the state remains in charge: minority investors can do little to change poor corporate governance or influence strategy.

Instead, China is gambling on going it alone. By rushing poorly reformed banks to market and sucking in a bit of money and know-how (not to mention greater scrutiny) from foreign investors, it hopes to improve them sufficiently and sufficiently rapidly before the economy runs into a headwind. The size of that gamble should not be underestimated.

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Macquarie Bank

The Economist, 13 October 2005

The heady climb of an unusual investment bank

This week, for the first time in its 20-year history, Macquarie Bank held a board meeting in London, the first outside Australia, its home country. Allan Moss, Macquarie's chief executive, says that nothing should be read into the timing: the meeting had been planned for more than a year, and the bank owns lots of assets in Britain. Others are not so sure. In August, the bank said that it might bid for the London Stock Exchange, already the subject of attention from other European bourses. Rumours about the preparation of such a bid have been flying about since.

The idea fits Macquarie's unusual style. As well as offering conventional investment banking, fund-management and retail financial advice, the bank has been an eager acquirer, via funds and trusts, of firms and infrastructure. In Britain alone it made a string of purchases in the past 18 months, from a ferry operator to a gas distributor, to add to the M6 toll road and the two airports it already owned.

Macquarie has grown from two offices, in Sydney and Melbourne, into the manager of a portfolio worth A$89 billion ($67 billion) and the employer of 7,000 people in 23 countries. In the year to the end of March, it made a profit of A$823m, an increase of 67%, and the value of its portfolio went up by more than 40%. Its income outside Australia rose by 83%, and now accounts for almost 40% of the total.

The action rolls on. On October 4th Macquarie launched a new fund, to invest in media assets. It will be financed by an initial public offering that is planned to raise A$927m-996m. The stock market likes what it sees: the share price is almost 60% higher than in mid-April. This helps to explain why Mr Moss is Australia's longest-serving chief executive. Having clocked up 12 years in a land where the average boss lasts for about four, he reckons: “I'm probably approaching 250 years old.”

A rum choice of name

Macquarie was formed in 1985 from the Australian arm of Hill Samuel, a British merchant bank. It was listed on the Australian stock exchange 11 years later. The original team included both Mr Moss and David Clarke, now the executive chairman. They trawled history books to name their bank after a great Australian. “Remarkably,” says Mr Moss, “quite a number are not necessarily the sorts of people whom you would choose for the name of a bank, actually.” They settled on Lachlan Macquarie, an early 19th-century governor who brought order to the chaos of colonial Sydney, in which rum was often used as currency. The governor bought Spanish silver dollars, punched out the middles and thereby created two new coins: the punched-out bit and one with a hole, which became the bank's symbol. “It was the first Australian financial innovation,” says Mr Moss. “it was of great benefit to the community and it made money. It's a symbol we feel proud of.”

The bank is making money too—not least for its bosses. In 2004-05, Macquarie's top seven executives were paid a total of A$89m; Mr Moss's share was A$18.5m, mainly from “performance-related” fees added to his salary, making him Australia's highest-paid chief executive. The fees, he says, are “market rates for the work we do”. Macquarie, he notes, has raised A$17 billion in venture capital in the past 18 months, half at home and half abroad. Clearly, he says, clients have confidence in Macquarie's business model. A key strategic theme is “not being constrained by conventional views of what investment banks should do”.

This unconventional model took shape about ten years ago, when Macquarie won a tender to build the M2 toll road in Sydney by floating a company that would own the road; original investors have reaped a ten-fold return. Thereafter, Macquarie set up a series of listed funds covering toll roads, airports and communications: the media fund is the latest addition. Like its parcel of international property trusts, all have done well. The assets they own or manage range from a toll road in Chicago to a power company in Canada. The bank's image took a battering three years ago, after it paid almost A$6 billion for Sydney airport, when Virgin Blue, a low-cost carrier, accused it of reneging on an access deal. Virgin launched billboard advertisements with the bold slogan “Macquarie: what a bunch of bankers,” before the dispute was settled.

The common theme behind this disparate group of assets, says Mr Moss, is finding businesses that “have some protection from the full rigours of competition.” This means buying shopping centres, industrial properties, airports, toll roads and broadcast towers in locations that pretty much have the field to themselves: as more people want to use them, their revenue streams will keep on growing.

So far, this approach has worked exceptionally well. Could it come unstuck—because of a global downturn, say, or, as some critics suggest, simple hubris? Mr Moss counters that risk management is his most important job. Macquarie, he says, continually estimates what would happen if markets fell by as much as 40% in a day, and makes sure it is confident the bank would still be in good shape at the end of such a catastrophe. Such methods will continue to be needed if it is to steer clear of the grand visions that have sunk more flamboyant high-flyers.

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