Viewpoint: Rush for stakes in banks is leaving assumptions untested

The deal-making frenzy for stakes in Chinese banks has captured the attention of global banks. In the past two years alone, more than $20bn has been forked out for a relatively small slice of China’s rapidly growing financial services market.

However, it remains unclear whether investors will reap the longer-term strategic benefits they are hoping for. The paper windfalls earned by first movers from their initial investments are founded upon a number of assumptions, such as that China’s economy will extend its run of 8 per cent-plus annual growth for the next decade; that non-performing loans will drop to lower levels than today; or net interest margins will fall only modestly once the government liberalises interest rates on deposits and loans. However, an unexpected slowdown in the economy or even a gradual regulatory shift could test these assumptions.

On top of those risks, foreign investors have their hands tied by the 20 per cent ownership cap that puts the core banking businesses most in need of improvement outside their direct control. It is no surprise that most players are hedging their bets by investing heavily in organic growth options, such as setting up their own branch networks.

If they hope to extract value from their investments in Chinese banks, foreign investors will need to adopt innovative approaches that give them greater influence in the areas that matter most.

First, investors should focus on a few critical areas where they can have the biggest impact on shareholder value. Our analysis shows that upwards of 60 per cent of value creation – and downside protection – will come from getting the basics right, for example, implementing credit risk management systems in corporate banking, or protecting the balance sheet by adopting appropriate asset and liability management practices.

The remaining 30 per cent of value creation will come from defending growth opportunities in existing retail business lines. Critical will be defending the mortgage business and holding on to the deposits of the top 2 per cent of retail banking customers who account for more than 50 per cent of a bank’s total revenues and profits.

In spite of the popularity of new growth areas such as credit cards and unsecured personal loans, our analysis shows these lines will account for no more than 10 per cent of value-creation opportunities over the next 10 years for most medium-sized Chinese banks. For many who account for profits conservatively, these businesses won’t generate substantial profits for several years to come.

Second, even after the first investment has been made, it may be necessary to negotiate additional joint ventures that give a foreign investor effective control over high-impact but often neglected areas of the business, such as wholesale banking.Many joint ventures are focused on long-term growth opportunities such as credit cards.

Third, investors must create a structure where they wield genuine influence over the risk management organisation. It isn’t enough to appoint the chief risk officer or to write the manual on risk management. Investors should be actively involved in building and transferring risk management skills to their Chinese partner.

Finally, investors have to be prepared to over-invest in people. Transforming a Chinese bank is not a job for a handful of expatriate board members. A strategic investor should be ready to spend another $5m-$10m a year on people for up to five years (some of this could be shared with the local partner). Ideal candidates are senior executives fluent in Mandarin with banking experience in China and other markets. Since the supply of such people is still limited, secondments of senior Chinese executives to foreign postings for a few years could help banks cultivate the talent pool.

Some strategic investors are abiding by these principles; however, not all understand them and fewer wield enough influence with their partners to implement them. For foreign strategic investors in China, creating value will require deft deal-making and outstanding execution.

Emmanuel Pitsilis is head of McKinsey & Co’s financial institutions practice in greater China. Jeffrey Wong is an associate principal in McKinsey’s Shanghai office.