sun eu 1 may20 - economist.com › sites › default › files › special... · 1 the economist...

A survey of international bankingMay 20th 2006

Thinkingbig

Republication, copying or redistribution by any means is expressly prohibited without the prior written permission of The Economist

Banks the world over are scrambling to become larger, whether byorganic growth or by mergers and acquisitions, says Robert Cottrell.But how much does size matter?

most everywhere, big banks have beengetting bigger through mergers and acqui-sitions as well as through organic growth.Is there a natural limit to this process ofbank-eat-bank? Could the biggest bank oftomorrow be two or three or even tentimes the size of a Citibank or an HSBC to-day, and if not, why not? And who bene-�ts? It is not always the surviving bank’sshareholders. One-half of recent bankmergers around the world have destroyedshareholder value, says Philippe DeBacker, a partner in Bain & Co, a consulting�rm. In America it is medium-sized banksthat are prized most highly by the stock-markets, partly because investors expectthem to be bought dearly by the big banks.

One argument commonly used in fa-vour of mergers, in banking as in manyother industries, is the pursuit of econo-mies of scale in areas such as procurement,systems, operations, research and market-ing. But the gains from that in the mass pro-duction of �nancial services, though notnecessarily illusory, can be elusive. Thereis a sizeable literature of academic papersclaiming that economies of scale can beexhausted by the time a bank reaches a rel-atively modest size. A study of Europeanbanks in the 1990s, published by the Euro-pean Investment Bank, put the �gure forsavings banks as low as �600m ($760m) in

Calmer watersAfter decades of wrenching change, Ameri-can banks are now mastering new businessmodels. Page 3

The risk-takersInvestment banks are a race apart. Page 4

One Basel leads to anotherThe di�cult business of drawing up new international banking rules. Page 6

What single market?But western European banks are beginning todo more cross-border business. Page 7

Gone shoppingAustrian banks have led the way in easternEurope. Page 9

A land of limited opportunitiesRussian banks worth having are few and farbetween. Page 10

High livingBrazil’s banks charge startling rates to private customers. Page 11

Naturally giftedOverprotected it may be, but India’s bankingsector is going from strength to strength.Page 12

Proceed with cautionFinancial services in China are set for hugegrowth, but there is no easy way in. Page 14

Back in businessJapan’s banks have restructured and consoli-dated. Now they must �nd new ways ofmaking money. Page 16

A funny sort of privatisationThe future of Japan’s postal savings bank remains a mystery. Page 17

The limits to sizeWhen banks go wrong, the biggest come o�worst. But that doesn’t stop the scramble forgrowth. Page 18

The Economist May 20th 2006 A survey of international banking 1

1

Thinking big

BORROWING and lending has becomea fairly well-understood line of busi-

ness, and a fairly well-managed one mostof the time in most of the world. It is thebanks themselves that are volatile, shiftingshapes and strategies as furiously as theirregulators will allow them in their e�ortsto win markets and market share. In Chinathey are escaping state captivity by sellingshares to foreigners and stockmarket in-vestors. In Russia they are running wild,with balance sheets growing by 30-40% ayear. In Japan three new �megabanks�have eaten 11 old banks and are now di-gesting them. In central Europe foreignershave bought or built 80% of the top localbanks since the fall of communism.

In America the ten biggest commercialbanks control 49% of the country’s bank-ing assets, up from 29% a decade ago. Theyare pausing for breath now, after a longmerger binge encouraged by the deregula-tion of interstate banking and the removalof barriers between banks, insurance com-panies and securities �rms. Non-�nancialcompanies are not meant to own banks,but even that is now being tested by Amer-ica’s biggest retailer, Wal-Mart, whichwants a restricted banking licence.

This survey of commercial bankingaround the world is much preoccupied byquestions of size and of ownership. Al-

Also in this section

www.economist.com/audio

An audio interview with the author is at

www.economist.com/surveys

Acknowledgments and sources are at

1

2 A survey of international banking The Economist May 20th 2006

2 assets. More recent studies suggest farhigher thresholds, up to $25 billion.

Big banks might even dispute that thereis a limit at all. But at some point disecono-mies of scale will also start creeping in.Management will �nd it harder and harderto aggregate and summarise everythingthat is going on in the bank, opening theway to the duplication of expense, the ne-glect of concealed risks and the failure ofinternal controls. Something of that lastproblem a�icted the world’s biggest bankholding company, Citigroup, in 2002-05,when it was rocked by a string of compli-ance problems. America’s Federal Reservereacted by telling Citigroup to suspendlarge acquisitions, but lifted the order inApril this year when it judged that thecompany had got better controls in place.

Another argument commonly madefor mergers is based on economies ofscope, the proposition that related lines ofbusiness under the same ownership ormanagement can share resources andcreate opportunities for one another. Thebasic economy of scope common to al-most all banks is the taking of deposits onone hand and the making of loans on theother. The bank gets to re-use its deposi-tors’ money pro�tably. The skills and in-formation useful on one side of the busi-ness tend to be useful on the other side too.

But does the same hold good when a re-tail bank is paired with, say, a corporatebank, an investment-banking division, acredit-card processor, an asset-manage-ment operation, private banking (for richpeople), an insurance business or a foreignbranch network? These businesses alloverlap with one another to some degree,but so do lots of other businesses. Thefashion for industrial conglomerates cameand went 30 years ago. Will �nancial con-glomerates be any more enduring? The

bank holding companies that are buildingthem clearly believe so.

A third reason for banks to pursuegrowth through mergers and acquisitionsis one that is never used as an argument atthe time, but is universally recognised as afactor. It is managerial ambition (which in-cludes managerial error). Chief executiveswant the grati�cation of running a biggercompany, or they fear that their own com-pany will be taken over unless they grabanother one �rst.

Managers can argue that the businessenvironment is changing rapidly and thatbanks must seize the new market opportu-nities created by new technology or na-tional deregulation or economic globalisa-tion. Thus there is much talk in Europenow of a fresh wave of cross-border merg-ers and acquisitions within the 25 coun-tries of the European Union, encouragedby the single European currency, the deep-ening Single European Market and the en-largement of the EU into central and east-ern Europe. Shareholders may be the moreeasily persuaded because a takeover tendsto look good at the time. The buyer booksthe new revenues immediately and cutssome overlapping costs. The acquisitionpremium goes straight to goodwill. It isonly later that you �nd out whether thebusinesses are a good long-term �t.

And perhaps growth-hungry CEOs arewiser than their students and their criticsknow. The very big banks created in Amer-ica over the past ten years have not beenstellar stockmarket performers recently,but they may just be taking time to beddown and knit their management andcomputer systems more closely together.Their future results may transform the cur-rent wisdom about economies of scale.

Bigness may also have bene�ts not eas-ily captured in studies of �nancial perfor-

mance. One is the ability to place strategicbets on future markets, such as China,without putting the whole bank at risk.Another is regulatory capture, or the abil-ity of the regulatee to in�uence the regula-tor. The bigger the bank, the more likely itshome-country regulators and legislatorswill be to take its interests into accountwhen drafting new rules, and the morelikely they will be to judge it �too big tofail� in the event of a crisis.

Wait for itNot, of course, that banks these days foldas often as they used to, which is anotherreason why strong banks go shopping.Weak banks no longer fall into their laps, atleast in Europe and America. Banks fail lessoften, partly because external conditionshave been kinder. Developed economiesaround the world have become more sta-ble over the past 20-30 years, save for Ja-pan in the 1990s. Big shocks in the �nancialmarkets have become rarer and bettermanaged. Recent medium-sized shocks,such as the downgrading of General Mo-tors’ credit rating last year, have been rela-tively easily absorbed. The �nancial mar-kets have moved, you might say, frombeing a source of shocks to being shock ab-sorbers too.

Such stability may engender its own in-stability if it encourages everyone to takeon more risk in the belief that disasters areless likely to happen. But give credit, untilthen, where credit is due. Benign economicconditions have encouraged stable banks,and vice versa. Bankers and regulators inmuch of the world have arrived together ata pretty good model of how commercialbanks ought to be run. Pressured by the de-

How the mighty have grownWorld’s top ten banks by assets*, $bn

2004 1995 1985

UBS 1,533 Deutsche Bank 503 Citicorp 167

Citigroup 1,484 Sanwa Bank 501 Dai-Ichi Kangyo Bank 158

Mizuho Financial Group 1,296 Sumitomo Bank 500 Fuji Bank 142

HSBC Holdings 1,277 Dai-Ichi Kangyo Bank 499 Sumitomo Bank 135

Crédit Agricole 1,243 Fuji Bank 487 Mitsubishi Bank 133

BNP Paribas 1,234 Sakura Bank 478 Banque Nationale de Paris 123

JPMorgan Chase 1,157 Mitsubishi Bank 475 Sanwa Bank 123

Deutsche Bank 1,144 Norinchukin Bank 430 Crédit Agricole 123

Royal Bank of Scotland 1,119 Crédit Agricole 386 BankAmerica 115

Bank of America 1,110 ICBC† 374 Crédit Lyonnais 111

Source: The Banker *Mitsubishi-UFJ Financial Group was formed in October 2005 with assets of $1.71trn †Industrial & Commercial Bank of China

1

A decade of dealsTop ten bank mergers and acquisitions since 1995

Deal valueTarget Acquirer/year $bn

UFJ Holdings Mitsubishi Tokyo 59.1 Financial Group/2005

Bank One JPMorgan Chase/2004 56.9

FleetBoston Bank of America/2003 47.7Financial

BankAmerica NationsBank/1998 43.1

Citicorp Travelers Group/1998 36.3

MBNA Bank of America/2005 35.2

NatWest Royal Bank of 32.4 Scotland/1999

Wells Fargo Norwest/1998 31.7

JPMorgan Chase Manhattan/2000 29.5

Sakura Bank Sumitomo Bank/2000 25.8

Source: Dealogic

2

1


2

THE introduction to this survey sug-gested two basic reasons why banks

merge. The �rst was the hope of increasingshareholder value through economies ofscale or scope. The second was to gratifymanagers who wanted to build an empire,or wanted to avoid being taken over in an-other bank’s empire-building. In theAmerica of the past decade or so bankmanagers were more than usually free topursue empire-building ambitions be-cause there was so little certainty wherethe industry was heading. Claims thatthey would increase shareholder valuewere hard for outsiders to dispute.

The strategic bets were being placed byguesswork because four big structuralchanges threatened to make earlier mod-els of commercial banking obsolete: �rst,the growth of the capital markets, gather-ing pace through the 1980s; second, the ar-rival over the same period of powerfulnew information technologies; third, thederegulation of interstate banking by theRiegle-Neal act of 1994; and fourth, the re-moval of barriers between banks, insur-ance companies and securities companiesby the Gramm-Leach-Bliley act of 1999, al-lowing the formation of diversi�ed �nan-cial groups. These changes produced awave of big mergers among Americanbanks from the mid-1990s onward. Thebigger the bank today, the more likely it isto be wildly di�erent from what it was ten

or 20 years ago. JPMorgan Chase, Amer-ica’s third-biggest bank by market capital-isation, is the product of mergers among550 banks and other �nancial institutions,including 20 in the past 15 years.

Only now, after 30 years of bone-shak-ing structural change, during which the to-tal number of bank holding companiesand thrifts (or mortgage companies) hashalved, has the pace of consolidationslowed. More banks are being created totake the place of some of those eaten up inmergers and acquisitions. The total num-ber of banks seems to be stabilising ataround 8,000, more than 90% of them

small local ones with assets of less than $1billion. No bank has failed since June 2004,an historic record, says the Federal DepositInsurance Corporation (FDIC), which in-sures deposits at banks and savings associ-ations. One reason is that 2005 was the�fth consecutive year of record pro�ts forAmerican banks. Last year they made $134billion, 9.6% more than they did in 2004.Return on equity, or pro�t as a percentageof capital�the key measure of a bank’spro�tability for its shareholders�fellslightly, but remained close to 60-yearhighs. It was down mainly because bankswere making so much money that theycould a�ord to plough capital back intotheir balance sheets, boosting their capital-to-asset ratios to the highest levels seensince 1939.

The capital markets have proved a con-tainable threat. They did take market shareaway from the banks: between 1974 and1994, the proportion of non-�nancial debtadvanced by America’s commercial banksdeclined from 30% to just over 20% (seechart 3). But since then the banks’ share hasheld steady. And because American bor-rowing and lending was increasingsharply over that period, the amount ofcredit provided by the banks kept growingin absolute terms at roughly the samespeed as the economy as a whole, evenwhile their market share was shrinking.

The growth of capital markets also

Calmer waters

After decades of wrenching change, American banks are now mastering new business models

3Holding their own US banks’ non-financial debt and market share

Commercial banks’ share of non-financial-

sector debt, %

Ratio ofnon-financial-sectordebt to GDP

Source: FDIC

1.0

1.2

1.4

1.6

1.8

2.0

15

20

25

30

35

40

1952 60 70 80 90 2002

mands of the capital markets for eciencyand predictability, they have also beenpretty good about sticking to the rules andso avoiding catastrophic mistakes.

A version of that modern bankingmodel is enshrined in a new set of rules,running to about 700 pages, that tell bankshow they should weigh their risks, andhow much capital they should keep onhand in case things go wrong. Big banks inmost developed banking markets will beadopting the new rules, known as Basel 2,starting with the European Union nextyear. But America is hesitating. Some crit-ics there think that the Basel 2 rules are atonce too lax and too complicated; othersthink they discriminate too much betweenbig and small banks.

One safe prediction is that Basel 2 and

its risk-modelling methods will makebanks even harder to understand thanthey are already. Ask a banker to explainrisk management or credit derivatives orcapital allocation to you, and the algebrawill soon be spilling o� the blackboard.The opacity of banks may count againstthem with investors. Mercer Oliver Wy-man, a strategic and risk-managementconsultancy, says that publicly listed �-nancial-services companies around theworld were valued last year at an averageof 14 times their pro�ts, against a multipleof 18 for non-�nancial companies. But thediscount has been shrinking, suggestingboth that investors have got more optimis-tic about relative growth prospects for �-nancial services, and that they think bank-ers have got better at banking, turning it

into a generally less risky business. This survey broadly agrees on both

points. It considers the state of compe-tition and consolidation in the developedmarkets of America, Europe and Japan. Itlooks at the big emerging markets ofChina, India and Russia, where the globalwinners and losers of the future may bedecided. (China alone may account forover 25% of new global demand for �nan-cial services in the coming �ve years, saysAlain LeCouedic, a partner at Boston Con-sulting Group.) It pauses to consider the in-tricacies of Basel 2, the virtues of pure in-vestment banks and the cost of a Brazilianoverdraft before drawing a conclusionwhich can be brie�y summarised here:better banks tend to get bigger, but biggerbanks are not necessarily better. 7

1


2

THE bigger the commercial bank, thebigger the investment-banking opera-

tion it is likely to have under its wing, un-derwriting stocks and bonds, advising onmergers and acquisitions, and trading insecurities and commodities both on thebank’s own account and on those ofother institutions. This is where the bankdoes its main business with big corpora-tions, which have moved more and moreof their borrowing to the capital marketsover the past two or three decades. Citi-group had the biggest investment-bank-ing revenues last year of any institutionsave for the biggest of the pure invest-ment banks, Goldman Sachs.

The pure American investment banksare a well-matched and well-consoli-dated bunch. There are �ve in the top tier:Goldman, Morgan Stanley, Merrill Lynch,Lehman Brothers and Bear Stearns. Allbegan this year with record or near-recordpro�ts. Goldman Sachs reported a 39% re-turn on equity in the �rst quarter, the oth-ers from 19% to 27%.

By Goldman’s reckoning, it was aquarter when everything came right. Da-

vid Viniar, the �rm’s chief �nancial o-cer, said the conditions in most main�nancial markets were the best in 25years. But as to exactly what it was thatGoldman did so pro�tably, nobody couldbe sure. More than half the �rm’s reve-nues were accounted for by a single line,labelled �FICC�, for trading in �xed in-come, currencies and commodities.

Goldman and the other big invest-ment banks have worked furiously hardto ensure that their risks are as ecientlyhedged and as �nely priced as manage-ment and mathematics will allow. Risk-taking is their core business, the thing thatthey get paid for�unlike retail banks,whose core business is distribution.

But if you make a 39% return on equitywhen everything goes right, what ifthings go wrong, and a hedge fund or twoblows up in your face? Such worries helpaccount for the relatively lowly valuationof the pure investment banks in the stock-market. Early this year they were pricedaround 11 or 12 times earnings and 2.5times book value, not far out of line withmuch less pro�table commercial banks.

Given the much bigger market capitalisa-tion of the largest commercial banks, theoverlap of business lines and the propen-sity of commercial banks to merge insearch of new economies of scale andscope, is it only a matter of time beforethe big commercial banks start buying upthe investment banks too?

Not necessarily. One reason is that thecommercial banks are trying to reducethe volatility of their earnings, not in-crease it. Another is that the pure invest-ment banks are packed with very highlypaid, headstrong individuals who wouldbe hard if not impossible to accommo-date within any other company’s culture.The average pay and bene�ts at Goldmanfor all employees, right down to driversand doormen, in the �rst three months ofthis year alone worked out at $220,000per head, more than twice what a bigcommercial bank pays its average em-ployee for an entire year. To graft a Gold-man or a Lehman on to a commercial-bank culture would threaten chaos.Which is not to say that, sooner or later,somebody might not try it.

Investment banks are arace apartThe risk-takers

created new opportunities for the com-mercial banks. They could securitise andsell o� loans, taking arrangement feeswithout tying up capital. By 2001 roughly18% of their non-interest income camefrom selling and servicing securitised as-sets. With the collapse of the wall betweencommercial banking and underwriting inthe late 1990s, commercial banks couldplunge into investment-banking markets.

Predictions in the 1990s that bankswould lose their retail customers to in-ternet-based competitors were also wideof the mark. Branch networks have provedto be indispensable as the place where cus-tomers go to open accounts and wherethey can most easily be charmed into buy-ing more services. In America the numberof branches grew by 2.5% last year, andbanks have also been spending heavily toimprove existing branches. The biggest in-ternet-only deposit-taker in America, ING

Direct, positions itself explicitly as anadd-on service for people who alreadyhave a conventional bank account else-

where. Investment in branches may getless attractive if the yield curve stays �at,reducing the pro�t a bank can make bylending its depositors’ money on to long-term borrowers. Even so, any Americanbank with branches to sell has been �nd-ing a queue of willing buyers.

The next lot of worriesThere are still fears that new competitorswill eat the banks’ lunch. The use of mo-bile telephones for payments might openthe way for telephone companies to com-pete with banks in holding balances andrunning payments systems. But thatwould be a big departure for the phonecompanies. They would need to take onand manage much more �nancial risk, andaccept new regulatory burdens. That mayyet happen; but more likely, they will turnto banks to do the job.

Another current worry among Ameri-can banks is the e�ort by Wal-Mart, theworld’s biggest retailer, to get a licence foran industrial loan company, a state-char-

tered institution which is a bank in all butname. Small banks fear that a Wal-Martbank would put them out of business. Bigbanks fear losing big companies’ pay-ments business if Wal-Mart gets its wayand other �rms follow suit.

The big banks are right to worry aboutWal-Mart. The small banks may be overdo-ing it. Most Americans already have achoice of banks, big and small, withindriving distance. They might use a smalllocal bank because they value the proxim-ity, the personal service and the localroots, and are unlikely to turn to Wal-Martfor those qualities. In any case, Wal-Martshould have the chance to compete. Thehistoric separation in America betweenbanking and commerce re�ected the fearthat an industrial company would drainthe money from any bank allowed to fallunder its sway, and manipulate its lend-ing. But that is what regulators are there toprevent. And if securities houses and in-surance companies are free to tie up withbanks, as they have been since 1999, it is

1


2 hard to see why supermarkets or anybodyelse should be treated less favourably.

A third worry for American banks is the�attening of the yield curve, which is an-other way of saying that short-term inter-est rates have risen almost to the level oflong-term ones. That makes it muchharder for banks to extract a pro�t fromtheir basic strategy of borrowing shortfrom their depositors and lending long tocompanies and housebuyers. Worse still, a�at or inverted yield curve often presages arecession. That would mean demand forloans would grow more slowly, existingborrowers would have less money for re-payments, and assets used as loan collat-eral might fall in value. Banks would haveto make more provisions against theirloans, cutting into pro�ts.

Not like the bad old daysYet these are tri�es when compared withbusiness conditions of 15-20 years ago. Thesky above the banks may not be a perfectblue, but the clouds are smaller and thevisibility is better.

Each of the big banks at the top of theindustry has its own distinctive mix ofbusinesses; all have moved some distancefrom the traditional banking strategy ofholding assets on the balance sheet. Theysecuritise loans and sell them on in thecapital markets, or syndicate them to otherbanks, blurring the distinction betweenbank as lender and bank as trader. KenLewis, chairman and chief executive ofBank of America, says that he and his col-leagues are �marrying our huge distribu-tion network for originating loans with ca-pable capital-markets distribution, or, toput it more simplysaying ‘yes’ to morecustomers, and getting those loans thatwould not otherwise �t our risk para-meters into the hands of investors who ac-cept that risk at an appropriate yield.�

In the past decade big commercialbanks have also become buyers and sell-ers of derivatives, such as credit-defaultswaps and interest-rate swaps, sometimesin terrifying volumes, both for pro�t and tohedge their other assets and liabilities. Thebillions and trillions involved in deriva-tives trading are liable to worry outsiders,though the banks claim to be in control ofthe situation. True, the net position of abank in the derivatives market may not bea very big number by the standards of itsbalance-sheet totals at any one time. Thereal danger here is that, given the volumeof gross trading over time, any managerialor operational failing could very quicklysnowball into a much bigger problem.

The big banks have learnt to love theirretail customers, all the more so becausetheir big corporate borrowers have movedso much of their borrowing to the capitalmarkets. Between 1984 and 2004 commer-cial and industrial lending shrank from38% to 18% of American banks’ loan books.Over the same period, residential mort-gage lending rose from 12% to 31%.

Retail banking customers, includingsmall businesses, provide just over half ofcommercial banks’ revenues. Getting andholding a customer’s demand deposit ac-count is only the start of a long campaignto sell other products and services, rangingfrom asset management and credit cards tomortgages and safe-deposit boxes. WellsFargo, widely considered to be among thebest of America’s big retail banks, pushedup the average number of products it sellseach customer from 4.6 at the end of 2004to 4.8 at the end of 2005, and in the longerterm hopes to sell each of them at leasteight. Online banking has become a newand more pro�table way for the banks toserve their existing customers, rather thana threat to their existence.

By selling products for which they cancharge fees, rather than merely makingloans and holding them, banks can reducetheir reliance on interest income, gener-

ated by charging more to lend money thanthey pay to borrow it. The bigger the bank,the more fee income it usually has. At Citi-bank, fee income amounts to almost halfof all revenues; for a one-branch savingsbank, the �gure will be tiny. That ought tobe working to the big banks’ advantage.The di�erence between the average cost ofa bank’s funds and the average return onits loans and investments is low by historicstandards, and getting lower.

A puzzle here is that the size of a bank,and the diversity of its income, impressesthe stockmarkets less than you might ex-pect. Roughly speaking, the bigger and themore complicated the bank, the smallerthe premium over book value which itcommands in the stockmarket. Citigroupand JPMorgan Chase have underper-formed the Dow Jones Industrial Indexover the past �ve years. Bank of Americahas outperformed it, but still trades at �a30% discount to the sum of its parts�, saysone expert.

One reason may be that the �nancialengineering which produced these verybig banks is taking time to bed down, andthat in a few more years the economies ofscale and of scope will come through.There are patchwork quilts of inheritedand incompatible computer systems to in-tegrate; huge workforces to rationalise andmotivate; and research to be done onwhich products and services will cross-sellto which new customers.

Why investors hold backBut even then, two basic problems will re-main. One is that investors tend to shunopacity, and big diversi�ed �nancial insti-tutions will always be intrinsically hard tounderstand. A second problem is that non-interest earnings, especially those fromtrading, are seen by investors as more vola-tile than interest earnings, and, as a generalrule, the more volatile the earnings, thelower the valuation of the company.JPMorgan Chase’s chief executive, James

Increasingly handsome

Source: FDIC

US commercial banks’ return on equity, %

8

4

0

4

8

12

16

+

–

1934 50 60 70 80 90 2004

4

1


2

AS BANKS get bigger, they also becomesmarter. That, at any rate, is the theory

underpinning a new set of rules on risksand capital for banks around the world,formally called the �International Conver-gence of Capital Measures and CapitalStandards� and informally �Basel 2�. Thecode has been drafted by the Basel Com-mittee on Banking Supervision, an o�-shoot of the Bank for International Settle-ments (BIS), which supports and co-ordin-ates the work of leading central banksaround the world. It is a gentlemen’s agree-ment among leading regulators which allcountries with international banks are en-couraged to adopt, but which relies on na-tional law for its implementation.

One striking feature of Basel 2 is itsprinciple that banks should have the op-tion to decide for themselves where theythink their big and their little risks lie, andthen to allocate their capital accordingly,subject to national regulators’ rules andnational laws. Another feature is that itwill probably allow many big banks to re-duce the capital needed for their currentbalance sheet, in some cases quite sharply.

Europeans, by and large, are keen to geton with it. The European Union has passedlegislation to implement Basel 2 next year.Americans, by contrast, are worried onthree counts. First, they think the rules aretoo slack, allowing banks to reduce capitaltoo far. Second, they reckon that Americanbanks will not be able to implement therules reliably without at least another fouryears’ practice, if ever. Third, they fear thatthe rules will give the biggest banks toomuch of an advantage over small banks.

Those worries have persuaded Amer-ica to adopt Basel 2 later and more gradu-ally. International banks with headquar-

ters in America and subsidiaries in Europe,and vice versa, can only guess how theywill reconcile European and American reg-ulatory requirements when the EU worksto Basel 2 rules and America does not.

The Basel rules have their origin in thefailure of Germany’s Herstatt Bank in 1974.Herstatt defaulted on contracts with banksoverseas, highlighting the need for moreinternational co-operation among bank-ing regulators. The Basel Committee pub-lished its �rst �Basel Capital Accord�, nowknown as Basel 1, in 1988.

Recognising that some loans and in-vestments were less risky than others, theBasel rules �weighted� them accordingly.For example, all loans to companies wereassigned a weighting of 100%, but loans tobanks in rich Western countries had a riskweighting of just 20%. A bank which had$8m in capital and lent $100m to compa-nies was at the limit of its lending capacityif it observed the minimum capital re-quirement of 8% recommended by the Ba-sel Committee. But a bank which lent onlyto other banks could lend $500m beforereaching its limit.

A bigger, better rule bookThese Basel 1 rules soon came to be seen asmuch too crude in the way they weightedrisks, with one category for all corporateloans, another for all sovereign loans andso on. Work on a new and more �exibleframework, Basel 2, started in 1996, and adraft was published in June 2004. The newcode was designed for internationally ac-tive banks. In America, this may meanonly ten to 20 banks. In the European Un-ion all banks will have to implement Basel2, so that they can be treated equally, asEuropean law requires.

Basel 2 invites banks to choose be-tween two approaches when calculatingcredit risk and capital allocation. The sim-pler method, the so-called �standardisedapproach�, is designed for smaller bankswith less sophisticated risk-modelling andrisk-management systems. It requiresbanks to use the risk assessments providedby accredited credit-rating agencies whengiving a risk weighting to their loans andinvestments.

Bigger banks with more sophisticatedrisk-modelling and risk-management sys-tems can opt for what Basel 2 calls the �in-ternal ratings-based approach�, or IRB. TheIRB allows a bank to use its own internalhistoric data to calculate the riskiness of itsloans and investments. To do this calcula-tion, the bank needs to be able to estimatethe probability of default within one yearfor each borrower; the bank’s potential ex-posure at a default; the bank’s potentialloss from a default; and, in the absence of adefault, when the borrower will repay.

In addition to these risks of default, Ba-sel 2 requires banks to provide capitalagainst what it calls �operational risk�,meaning the risk of losses from crashingcomputer systems, natural disasters orrogue traders. But here calculation shadesinto guesswork.

In allowing banks to do more of theirown risk assessment under IRB, the Baselrules rely on national regulators to ensurethat banks are up to the job and are doing itdiligently. That is a tall order, at least ini-tially. National regulators also need tolook out for problems which may not beeasily caught by assessment of default riskalone. A bank with a very large portfolio of�xed-interest securities and derivatives,for example, would lose a bundle if inter-

One Basel leads to another

The di�cult business of drawing up new international banking rules

Dimon, hopes he can bring down the vola-tility of trading earnings. That would bequite a trick to pull o�.

It is hard to imagine further mega-dealsthat would make the biggest Americanbanks even bigger�but then the same wastrue ten years ago. And besides, as of April,Citigroup has been back in the game. Itschairman, Charles Prince, bantered at aconference in February that �we are morelikely to be ready to do JPMorgan in a few

years than JPMorgan will be ready to do Ci-tigroup,� although, he insisted in his nextbreath, �it’s not likely that either one willhappen.�

Alternatively, you might think thatJPMorgan Chase would be better balancedwith a global retail network, in which casea merger with HSBC would be the possiblebig-bang solution. Or that the pure invest-ment banks are relatively cheap, and thatsooner or later a commercial bank is going

to experiment with buying one. But far more likely, in the near term at

least, is that America’s big banks will aimto go on growing by buying small and me-dium-sized banks, extending their branchnetworks and capturing more of the retailcustomers that they have learnt to serve sopro�tably. In the meantime, they can befairly sure that nobody else is going to takethem over against their will. To that extent,they have won their strategic bets. 7

1


2 est rates went the wrong way. The Basel 2 rules count on �market dis-

cipline� to do some of the work of keepingbanks in line. Banks must publish detailsof their assets and liabilities and of themodels they use to calculate credit and op-erational risk. As George Kaufman, profes-sor of �nance at Loyola University in Chi-cago, has pointed out, this is not reallymarket discipline, but transparency anddisclosure. If regulators wanted to increasemarket discipline, they could do so byabolishing deposit insurance, whichwould make depositors think more abouttheir choice of bank, or by requiring allbanks to issue publicly traded subordi-nated debt.

America’s hesitations over Basel 2 wereincreased by a study last year of how itsbanks might calculate current risks andcapital requirements using Basel 2 rules.On average, the banks thought that apply-ing Basel 2 rules would allow them to de-crease their regulatory capital by 15%. Theyreached that conclusion using calculationsof risk falling �well short of the level of reli-ability that will be necessary to allow su-pervisors to accept those estimates for risk-based capital purposes�, said John Dugan,America’s Comptroller of the Currency,whose job includes bank regulation. Dif-ferent banks gave weightings ranging from5% to 80% for seemingly identical risks.

And even if banks manage to standar-dise their calculations, the Basel 2 ruleswill still be a cause for concern, accordingto Donald Powell, the FDIC’s chairman. Itsformulas for regulatory capital, he told theSenate, �are inherently calibrated to pro-

duce large reductions in risk-based capitalrequirements�, implying �a far lower stan-dard of capital adequacy than we have inthe US today�.

A third concern among America’s thou-sands of small banks has been that Basel 2would give big banks an unfair advantage.Big banks using the IRB approach wouldbe updating their risk calculations secondby second, laying o� assets that tied up alot of capital and adding ones that tied upmuch less. Small banks without the sameinformation systems, and without thesame scale and diversity of assets in whichto trade, might end up with a concentra-tion of the worst-priced risks without evenknowing it.

To allow more time to deal with theseconcerns, America plans to implement Ba-sel 2 only from 2008, and with a three-year

transition period. No American bank willbe allowed to use Basel 2 as a reason for re-ducing its risk capital by a total of morethan 5% before 2009, 10% by 2010 and 15%by 2011. Small banks will get a new set ofrules more �exible than those of Basel 1but much less complicated than those ofBasel 2, including more categories of risk,more use of external credit ratings andmore scope for using collateral and guar-antees to reduce risk weightings.

American regulators will also reservethe right to keep a basic minimum equitycapital ratio for all banks, currently set at4% of assets regardless of risk weighting,and they will go on prodding banks tokeep their capital levels well above anystatutory minimum. Most banks do that al-ready in order to impress customers andshareholders as well as regulators. The ar-gument here is that capital signals thetrustworthiness of a bank. Having lots of iton the balance sheet keeps down thebank’s cost of funds. Certainly, interna-tional comparisons suggest that high capi-tal ratios have done no harm to Americanbanks’ pro�ts in recent years (see chart 5).

America returned to strict capital re-quirements for all banks in 1984, after Con-tinental Illinois, the country’s seventh-big-gest bank, lost half its funds overnight.Until then, the biggest banks had not beensubject to any minimum capital require-ment, in the belief that they could betrusted to manage their own balancesheets. Times have changed, and bankstoo. But Americans can be forgiven if theyworry that banks, at any rate, have notchanged enough. 7

Beauty paradeLarge banks’ capital ratios and profitability 2002, as % of total assets

Equity capital Pre-tax profits

Country 2002 2002 2000-02

United States 6.34 1.66 1.67

Spain 5.07 0.93 1.15

Australia 4.91 1.49 1.61

Italy 4.68 0.48 0.81

Britain 4.49 1.11 1.34

Canada 4.32 0.61 0.3

France 3.94 0.58 0.72

Japan 3.15 0.04 -0.25

Germany 2.63 0.05 0.29

Switzerland 2.18 0.08 0.49

Source: FDIC

5

EVEN in Frankfurt the bankers have aspring in their step. A cyclical recovery

in the German economy and in Germanbanks’ pro�tability has been under waysince mid-2005. Deutsche Bank, Ger-many’s biggest, reported a return on equ-ity of 25% last year, up from 16% in 2004,helped by a very good year in its big invest-ment-banking operations. Merrill Lynch,an American investment bank, predicts anaverage 18% return on equity for big pub-licly listed European banks this year. If so,that will mark the ninth straight year ofstrong pro�tability for the industry.

Like American banks, European bankshave bene�ted from benign external econ-omic conditions. Unlike American banks,they have held their ground pretty wellagainst the capital markets as providers of�nance to big corporate borrowers. Ac-cording to �gures compiled by the IMF, thetotal assets of European banks amountedto $28 trillion in 2004, two-and-a-halftimes the total value of the market in priv-ate-sector debt securities, and three timesthe capitalisation of Europe’s stockmark-ets. In America, by contrast, the sum ofbank assets was $8.5 trillion, roughly half

the size of the market for private-sectordebt securities and half the capitalisationof the country’s equity markets.

The European Central Bank calculatesthat the cost of bank borrowing has beenvery close indeed to that of market-baseddebt over the past �ve years, and oftenslightly below it. Last year non-�nancialcorporations in Europe increased theirbank borrowings more than twice as fastas they did their issues of debt securities.Analysing past data for bank lending andprivate debt issues in the euro zone, twoeconomists, Fiorella De Fiore of the ECB

What single market?

But western European banks are at last beginning to do more cross-border business

1


2 and Harald Uhlig of Humboldt Universityin Berlin, concluded that banks do propor-tionately more lending to companies inEurope because it is harder for the public atlarge to get reliable information about thecreditworthiness of borrowers. The impli-cation is not so much that banks are betterat their job in Europe, rather that capitalmarkets are less ecient. An alternative ar-gument might be that European bankshave been underpricing their corporateloans, but that view is contradicted, at leastfor recent years, by low rates of defaultsand provisions.

Helped by consolidation within Eu-rope and by acquisitions in America, Eu-rope’s banks have gone on getting biggerover the past 10-15 years, in some waysmore strikingly so than their Americancounterparts. The biggest American bank,Citigroup, has capital equivalent to about1% of America’s GDP. The biggest Dutchbank, ING, is at 6.5% of Dutch GDP. Thebiggest Swiss banks, UBS and CreditSuisse, each have capital equivalent toabout 13% of Swiss GDP. As Jean Dermine,professor of banking and �nance atFrance’s INSEAD business school, pointsout, the bail-out of Crédit Lyonnais costFrench taxpayers twice the bank’s pub-lished capital in 1991. Not that any bigEuropean bank is going to repeat that spec-tacle, but the biggest European banks nowreally are too big to fail.

However, Europe’s banks have not gotbigger in quite the way that has long beenpredicted. Despite all the laws and rulesenacted since the mid-1980s to give theEuropean Union a single market in goodsand services, including banking and �-nance, banks have obstinately gone on get-ting bigger within their home countries.They have merged at home much more en-

thusiastically than they have merged orbranched or sold services across borders.

This is not to say that the single marketand other EU legislation has had little ef-fect. It has encouraged and forced wide-ranging deregulation of banking and other�nancial services and removed interest-rate controls, capital controls and barriersbetween banking and insurance andstockbroking. This deregulation helpedbring about a huge expansion in the ratioof banking assets, says Mr Dermine. In theNetherlands, the ratio of banking assets toGDP more than tripled between 1981 and2003. In Britain, a centre for internationalbanking, it almost quadrupled.

In the �ve years after Europe launchedits common currency in 1999, the value of�nancial-industry mergers within the EU

was roughly equal to that within America,at �500 billion against �580 billion, evenwithout much in the way of cross-borderacquisitions. Given the smaller size of Eu-rope’s markets, that implies a wave ofEuropean consolidation at least equal tothe American one provoked by theGramm-Leach-Bliley act of 1999, whichbrought down barriers between bankingand insurance and securities companies.

Now there are signs that big cross-bor-der bank mergers in Europe may be gettingeasier, or at least more attractive. The pastthree years have seen three of Europe’s big-gest such deals to date, and the �rst to takeplace between big banks from big coun-tries. Oddly, this has come just as the po-litical momentum behind European inte-gration has been slowing in all countries,

halting in most and even reversing insome, such as France and Poland.

One reason banks may be lookingabroad more now is that consolidation intheir home markets has started to reachnatural limits. Between 1990 and 2004 themarket share of the top �ve banks rosefrom 26% to 54% in Italy; from 35% to 46% inSpain; from 52% to 66% in France; from 66%to 82% in Britain; and from 78% to 89% inthe Netherlands, according to Boston Con-sulting Group. Germany is something ofan outlier, with the top �ve banks holdingjust 22% of the market, but much of thatmarket is in the hands of public-sector andco-operative banks immune to privatetakeover. The concentration of some typesof retail banking is much higher still.Across all EU countries, the top three mort-gage banks in each country have, on aver-age, two-thirds of the market there.

Open SesameAnother reason for banks to look abroadmay be that even protectionist govern-ments in Europe are losing the politicalwill, or the legal certainty, needed to de-fend national banking sectors. When theEuropean Commission asked banks earlylast year why they did not attempt morecross-border acquisitions, one of the mostcommon replies was that they expectedpolitical interference in takeover bids. Andindeed, when two foreign banks, BancoBilbao Vizcaya Argentaria (BBVA) of Spainand ABN Amro of the Netherlands,launched bids last year for two Italianbanks, Banco Nazionale del Lavoro andBanca Antonveneta, the Bank of Italy triedto frustrate them by promoting rival do-mestic bids. But under pressure from theEuropean Union and from business lob-bies, it gave up and its governor resigned.The banks went to foreigners. ABN got An-tonveneta. BNL was bought this year byanother foreign bank, BNP Paribas ofFrance, after BBVA had dropped out.

BNP Paribas’s chief executive, BaudoinProt, said later that his bank had swoopedinto the bid battle because it believed thatcross-border consolidation among Euro-pean banks was under way, there were�limited partners� and the barriers to suc-cess were high. He was pleased to havetaken BNP Paribas into a �relatively exclu-sive club of banks with retail networks inmore than one European country�.

Mr Prot’s words were not withoutirony, because even now it would take avery bold foreigner to think of launching ahostile bid for any big French bank. Evenso, the Italian drama must have had some

Home and abroad

Source: PricewaterhouseCoopers

Value of mergers and acquisitions amongEuropean banks, ¤bn

6

0

20

40

60

80

100

120

1996 97 98 99 2000 01 02 03 04 05

European domesticCross-border outside EuropeEuropean cross-border

7Love thy neighbourTop ten European cross-border bank mergersand acquisitions since 1995

Deal valueTarget Acquirer/year $bn

HVB Group UniCredit/2005 22.3

Abbey National Banco Santander 16.8 Central Hispano/2004

Générale de Fortis Group/1998 12.7Banque

Banca Nazionale BNP Paribas/2006 11.0del Lavoro

Crédit Commercial HSBC Holdings/2000 10.7de France

Banca ABN AMRO/2005 7.2Antonveneta

Bank Austria HVB Group/2000 6.7

Merita Nordbanken/1997 4.7

Banque Bruxelles ING/1997 4.7Lambert

Unidanmark Nordic Baltic Holding/2000 4.6

Source: Dealogic


2 demonstration e�ect across Europe in ad-dition to its impact on Italy. The chances ofsuccessful political interference must nowbe lower than they were, so long as banksare big and bold enough to face upsquarely and publicly to governments.

The segmentation of European bank-ing cuts deepest where the banks are mostvisible, in their retail operations. The capi-tal markets, trading in debt issues, equitiesand credit derivatives, have become wellintegrated since the launch of the commoncurrency, partly because so much of therunning has been made there by Ameri-can investment banks operating out ofLondon with a Europe-wide mandate. Bigloans cross borders easily too, because bigborrowers shop around and becausebanks syndicate (ie, divide up) the loansamong themselves. The European marketin syndicated loans expanded by 35% lastyear, almost twice the global growth rate.

Retail banking has been con�ned muchmore within national borders, mainly be-cause governments have insisted on regu-lating it heavily, ostensibly to protect smallsavers. Banks have worried whether theywould appeal to foreign customers, andwhether foreign tax laws or foreign regula-tors would trip them up.

The �rst of the recent big cross-borderbids, by Banco Santander of Spain for Ab-bey National of Britain, may have helped

to ease some of the banks’ fears. Britishcritics mocked Santander’s ambitions, butthe Spanish bank has done well with thedeal. Last year it cut Abbey’s costs by£224m, equivalent to almost 10% of reve-nues. Trading pro�ts rose by almost one-half. Santander expects more productivitygains from integrating computer systems.

The truth which Europe may now be inthe process of discovering, or admitting toitself, is that there are very few nationaldi�erences in what people want from theirbanks. Everyone wants safety, reliability,convenience, courtesy, clarity and, subjectto all this, a good return. It is also common

to �nd a �home bias� among householdswhen it comes to placing their savings.They want to be sure they can get attentionwhen something goes wrong. But a foreignbank with a well-run local branch can pro-vide this better than a local bank with anawful call centre half way round the globe.

The more that local banks are hollowedout by outsourcing and o�shoring of cus-tomer services and back-oce work tolow-wage countries in Asia and easternEurope, the weaker the economic argu-ments against cross-border mergers willbecome. A foreign �rm may have troublestang call centres with people who canspeak Danish or Slovak: some things willhave to stay local. But once a mortgageloan or a credit card has been sold, the eco-nomics of servicing it will be the samewherever it originated.

So what will happen if banks, per-suaded at last that cross-border mergerswork, all pile into the market at once?Prices, already high, will rise further, asthey have done in eastern Europe (seebox). That will be good for shareholders intarget banks, but perhaps worrying for thebanking system as a whole, especially ifbanks overpay with capital taken o� theirbalance sheets thanks to Basel 2. Europe’sleaders have spent years talking up theneed for banking integration. Success mayyet see them trying to talk it down again. 7

SINCE the collapse of communism, for-eign banks have bought up roughly

80% of all the banking business in thenew central European member countriesof the European Union. With hindsight,those that bought early now look veryclever. The markets are still relativelysmall, but growth rates are high, and soare pro�t margins.

The surprise is who got in �rst. Ger-many was the region’s biggest tradingpartner, but German banks were busy athome with the shocks and costs of uni�-cation. They left central Europe to theirsmaller Austrian neighbours. Rai�eisen, aco-operative banking group, went intoHungary in 1987 and was in seven morecountries by 1998. Hard on Rai�eisen’sheels came Creditanstalt and Bank Aus-

tria, which merged in 1997 (only to bebought in 2000 by HVB of Germany,which last year was bought by UniCreditof Italy). A third Austrian bank, Erste,joined the fray with its purchase in 2000of Ceska Sporitelna, a Czech bank.

As the Balkan wars subsided, morecountries became bankable. Rai�eisenbought into Bosnia in 2000, Serbia in2001 and Albania in 2004. But by nowother foreign banks were in the race, chas-ing a dwindling number of prospects,and prices spiralled upwards. Last yearRai�eisen paid more than four timesbook value for a bank in Ukraine, BankAval; and Erste paid 5.8 times book valuefor a Romanian savings bank, BancaComerciala Romania, beating o� �veother bidders.

�We are operating in markets with as-set growth of 40%, sometimes 50%, ayear,� says Herbert Stepic, chief executiveof Rai�eisen International Bank, �andwhen you apply this to the valuationmodel it is not so hard to understand whybanks are purchased at these price lev-els.� Others are less sure. �If you pay �vetimes book value, that requires extremelyhigh expectations about key criteria,�says Wilhelm Nuese, a director of Com-merzbank. �There must be a businessmodel in place, economic growth, cus-tomer growth, pro�t growth. In Ukraineyou would need [economic] growth of7-8% a year for the next 12 years , andpresent growth averages less than 4% an-nuallyAre these prices reasonable? Ifyou ask me, they are not,� says Mr Nuese.

Austrian banks have led the wayin eastern EuropeGone shopping

1


IF A big bank in America were growing atthe same speed as the whole Russian

banking system in recent years, the inspec-tors would be all over it. The Russian sys-tem’s total assets in nominal terms ex-panded by 37% last year, corporate lendingwas up 31%, retail deposits were up 39%and consumer lending almost doubled forthe third year in succession. �The story inRussia is one of real growth and real poten-tial. By any conventional measure, Russiais way underbanked,� says George Car-dona, a former HSBC executive who re-cently joined the board of MDM, a Russianprivate bank. Even Sberbank, Russia’shuge but slow-moving state-owned sav-ings bank, has roughly tripled its total as-sets and increased its loans to customerssixfold in the past �ve years.

In many ways such growth is good.After struggling through the chaotic 1990sand touching bottom with a big currencydevaluation and a debt default in 1998, thewhole Russian economy now has to makeup for lost time. Russia’s banking assets atthe end of 2004 were equivalent to 45% ofGDP, compared with a range of 55-120% inPoland, Hungary, the Czech Republic andthe Baltic states. The mortgage market inRussia is in its infancy, with outstandingloans worth perhaps $2 billion in total. Itcould be ten times that amount by 2010,says Natalya Orlova, an economist withAlfa Bank in Moscow.

In other ways, such growth is worrying.It tends to mean that credit quality is fall-ing. Banks are lending more and more toborrowers that they know less and lesswell. Fast growth also puts pressure onbanks to keep up their capital ratios. Untilrecently Russian banks could �nd the capi-tal they needed mainly from retained pro-�ts. But now, according to Fitch Ratings, acredit-rating agency, pro�ts are no longerquite enough to do the trick. The bankingsystem’s regulatory capital (measured as ashare of total assets) declined by almostthree percentage points between the �rstquarter of 2004 and the third quarter of2005. It remained comfortably above the10% capital ratio �xed by the central bank,but some institutions were getting close tothat level and had to rein in new lending.

To go on getting bigger, Russian banks

need more money from outside investors.Given the shallowness of the country’s do-mestic capital markets, that means raisingmost of it from foreign investors, by sellingthem equity or subordinated debt. Or, in-deed, entire banks.

This year Austria’s Rai�eisen Interna-tional Bank, which has been operating inRussia since 1996, paid $550m for Impex-bank, a Russian bank specialising in retailbanking and consumer �nance. This dealgives Rai�eisen 190 new branches acrossthe country, plus 350 consumer-�nanceoutlets in supermarkets and shopping cen-tres. Nicholas Tesseyman, deputy directorof the Moscow oce of the European Bankfor Reconstruction and Development, callsthe Impex deal �the �rst signi�cant acqui-sition by a foreign player in the bankingsectorUp until now they have been tinydeals, acquisitions of shell banks or green-�eld projects. This is something that maybreak the mould.�

Banks everywhere, and nothing to buyForeigners who want to buy a Russianbank may think that they have plenty fromwhich to choose. The central bank re-corded 1,199 licensed banks at the end ofJanuary 2006�one for every $550m ofGDP, compared with one for every $1.4 bil-lion in America. But that raw number ismisleading. All but 100 or so of Russia’s

banks are tiny, or dormant, or are �pocket�institutions serving the needs of at mostone or two controlling shareholders. Anyself-respecting business group wants a li-censed bank as its corporate treasury, be-cause under Russian law it is much moretax-ecient for companies to lend or bor-row money via a bank than directly.

Discard the dormant, the captive andthe pocket banks, and the picture changesdramatically. There are very few banks inRussia serving a wide range of customers.The state-controlled savings bank, Sber-bank, accounted for 26% of all the assetsand liabilities in the country’s banking sys-tem at the end of 2005, including 54% of allretail deposits. The second- and third-rank-ing banks, Vneshtorgbank and Gazprom-bank, are also state-controlled. Togetherwith Sberbank, they accounted for abouttwo-�fths of total assets. The four biggestprivately owned Russian banks, Alfa Bank,MDM, Rosbank and UralSib, have about8% of the market between them. There are42 foreign-owned banks which betweenthem have about 7% of the market, withRai�eisen and Citibank the most visible.Most of the remaining top 100 are verysmall banks with regional or industrialniches, a handful of corporate customersand big ideas.

�Almost every Russian bank that youmeet will tell you that its ambition is to bein the top 30 or 40 Russian banks, and todevelop retail business, and to expand intothe regions,� says Mr Tesseyman, whomeets plenty of them. These are admirable

A land of limited opportunities

Russian banks worth having are few and far between

Rising star

Source: Thomson Datastream

*Morgan Stanley

Capital International

Sberbank’s share price v MSCI* emerging-market banks, Jan 2000=100, $ terms

0

1,000

2,000

3,000

4,000

5,000

2000 01 02 03 04 05 06

Sberbank

8

MSCI emerging-market banks

1


2 aims, but clearly they are not going to beachievable by all banks. The alternativeambition�and perhaps the real aim of ev-ery private bank in Russia bar one ortwo�is to sell out to foreigners at a fancyprice. Now that Impex has sold for almostthree times book value, sellers of the big-ger private banks are going to be arguingfor four times or more.

How about a listing?For larger private banks, fancy prices mayalso be available through the stockmarket.Sberbank has enjoyed a long run as theonly listed Russian bank stock with any li-quidity. Its shares have been much in de-mand, tripling last year (see chart 8, previ-ous page). That left Sberbank trading at 20times historic earnings this year, much

higher than most commercial banks.Other Russian banks want to follow if themarkets hold up. Analysts say that Ros-bank may go this year, and that Vneshtorg-bank and Gazprombank, both state-con-trolled, may list minority stakes next year.

Buyers will have to proceed with cau-tion. Russian assets are no longer cheap,and Russian banks are moving targets.Loan portfolios are growing fast, but thereare not nearly enough data to model therisks, and such few as are available havebeen collected during an economic boom.Credit quality may look very di�erentwhen a downturn hits. At best, says Rich-ard Hainsworth, who runs a bank credit-rating agency called RusRating, �we canlook at the experience of other countries,we can make the assumption that the Rus-

sian population will behave in a similarway, but that assumption is tendentious,to say the least.�

Nor is the Russian government’s be-haviour all that easy to predict. In principleit welcomes free enterprise and foreign di-rect investors. In practice it hates any lossof administrative control over industries itconsiders of strategic value. One issueholding up Russia’s bid to join the WorldTrade Organisation has been the govern-ment’s refusal to ease restrictions on for-eign bank branches.

Russia’s protectionism would be moredefensible if there were already so muchscale and diversity and competition with-in the banking industry that the entry ofmore big foreign players would make littledi�erence. But Russia is not even half way

THE pro�t of $5.5 billion reais reportedfor 2005 by the biggest private bank in

Brazil, Banco Bradesco, was the highestever made by a Latin American bank. Itimplied a return on equity of 32%, makingBradesco twice as pro�table as the aver-age European or American commercialbank, and more pro�table than a WallStreet investment bank in a good year.Bradesco’s 80% growth in pro�ts was allthe more impressive in a year when theBrazilian economy grew by only 2.3%.

Bradesco attributed the good resultmainly to cost control and loan growth.Loans to clients rose during 2005 from34% to 39% of total assets, leaving lessmoney parked in government securities.

But the leap in pro�ts for Bradesco andother Brazilian banks will reinforce long-running grumbles in Brazil that banksthere, as in many other Latin Americacountries, charge far too much for theirloans, especially to private borrowers.Banks’ net interest margins in the regionare about half as high again as in the restof the developing world. Many analystshave asked why, and drawn a blank frommost of the usual suspects. Banks in LatinAmerica do not di�er markedly fromthose elsewhere in the developing worldin terms of their size, or the volatility oftheir macroeconomic environment, or inthe tax burden they bear.

Nor, in Brazil, is there an obvious lackof competition. Five banks share just overhalf the market, a similar ratio to that inmuch of western Europe. Yet some lend-ing rates are eye-watering. A monthly sur-vey of interest rates compiled by aBrazilian trade union, Anefac, found thatthe average monthly interest rate on abank overdraft in February was 8.19%,equivalent to a compound annual rate of157%. If you borrow on a credit card, youpay 10.24% a month or 222% a year.

Brazil has a history of high in�ation,which used to mean that interest rateswere vertiginous, and so were banks’margins. But in�ation is supposed to be

well under control now and might evendrop below 5% this year. That made thecentral bank’s benchmark interest rate of15.75% in April no bargain, but no excusefor three-�gure overdraft rates either. Arethe banks colluding?

Joao Manoel Pinho de Mello, a profes-sor at Pontifícia Universidade Católica inRio de Janeiro, says it may look like collu-sion, but he suggests a market-based rea-son, adverse selection, as one reason whypersonal rates have stayed so high. Bor-rowers prone to default, he says, may bedisproportionately sensitive to changesin interest rates. A bank will not rush toundercut its competitors if an o�er ofcheaper overdrafts merely brings it alarger share of deadbeat customers.

And, to be fair, there are cheaper waysfor Brazilians to borrow. Workers can getmuch lower interest rates through em-ployer-sponsored schemes, with repay-ments deducted from their wages.Borrowing of this sort has been increas-ing much faster than direct personal lend-ing in recent years.

But even taking these cheaper loansinto account, the banks’ average spreadon a personal loan earlier this year was44%, about three times that on a corporateloan. If banks in Brazil are serious aboutbuilding up their retail business, thisneeds to come down.

Brazil’s banks charge startlingrates to private customers High living

A world of difference

Source: Banco Central do Brasil

Brazil’s banking spread, non-earmarked credit, %

9

0

10

20

30

40

50

60

2001 02 03 0504

Individuals

Total

Corporate

1


2 there. The �nancial system functions bet-ter than it used to, but not nearly wellenough.There is no long-term rouble debtto speak of. Short-term lending rates arehigh. Many regional banks in e�ect havemonopolies in local markets, thanks to of-�cial backing, the IMF said last year. Assetsare highly concentrated on a few large bor-rowers and related lending is common, re-�ecting the structure of an economywhere a handful of business groups repre-sents close to half of GDP.

That concentration of ownershipmakes Russia a paradise for investmentbankers chasing big-ticket clients: thecountry has perhaps 20 companies with anet income above $1 billion, against four or�ve in India. A proposed share issue for aRussian state-owned oil company, Ros-neft, could be the biggest ever initial publico�ering from an emerging market. Interna-tional investment banks are racing to in-crease their presence in Russia. Late lastyear Deutsche Bank paid a reported$420m for 60% of UFG, a Moscow invest-ment bank, after buying 40% in 2003. Butfor the commercial banks, concentration

of ownership just makes life dicult. Theyvery quickly get to their limits for any oneborrower, at which point they have to stoplending or circumvent the law. If Russiahad more big banks, the needs of its bigcompanies would be better served andtheir risks more widely spread.

The �nancial system, like the rest of theeconomy, has become more robust sincethe shambles of 1998. There is far moremoney around. The government is rich.The administration runs more e�ectively.But a mini-panic swept some banks com-paratively recently, in mid-2004, and it isnot hard to imagine something on thatscale being repeated. Two private bankssu�ered runs. One of them, Gutabank, sus-pended operations. A state-owned bank,Vneshtorgbank, subsequently took it overat a token price.

The 2004 panic was encouraged by alack of public con�dence in banking regu-lation and in banking stability. In a bid toallay fears about the second, the govern-ment began to introduce deposit insurancelast year. But the insurance provision hasnot been accompanied by an obvious im-

provement in the quality of bank regula-tion, so the main result may be to increasethe moral hazard both that banks will usetheir depositors’ money rashly and thatdepositors will have less reason to choosestrong banks over weak ones.

The best thing for Russia’s banking sys-tem would be a break-up and privatisationof Sberbank, but the country’s botchedsales of industrial companies in the 1990shave made that option unthinkable. So,too, has Russia’s political course. It has be-come a far more statist country since Vladi-mir Putin took power in 2000. If a sale ofminority stakes in Vneshtorgbank andGazprombank does indeed go ahead, itwill suggest that Russia thinks market dis-cipline can help raise the transparency andeciency even of state-controlled banks.That is a good thing. The bad thing is thatthese state-owned banks look set to stay astop dogs of the banking system. If privateand foreign banks somehow manage toeat substantially into the dominant posi-tions of Sberbank, Vneshtorgbank andGazprombank, the state, on present form,will help them bite back. 7

WHATEVER it takes to be good at bank-ing, India has it by the bucketload at

every level. Look at the number of Indianexpatriates holding down whizz-kid jobsat investment banks in London and NewYork, at least until they are lured back by in-vestment banks in India itself. Look at thegrowing proportion of back-oce workthat foreign banks are moving to India byo�shoring and outsourcing. It is not onlythe basic payments and call-centre choresthat get moved to India these days. Latelast year JPMorgan Chase said it plannedto move one-third of the processing of itsforeign-exchange trades and of its creditderivative contracts, having alreadymoved some of its �nancial research andanalysis. By 2007 it expects to have 9,000employees in India, up from 5,000 now,one-quarter of them working for its invest-ment-banking division. Deutsche Bank,UBS and others are making similar moves.

Look, too, at the bold growth strategiesof the new private banks that have �our-ished since India began relaxing the state’snear-monopoly on the banking system in

1992. They have munched into the marketshare of the remaining state-owned banks,as you would expect. Less predictably,they have nibbled away at the marketshare of foreign banks too�partly becausethe foreigners have been more tightly regu-

lated, but also because the new Indianbanks have been dauntingly good at sell-ing themselves and at keeping down theircosts. The biggest of them, ICICI Bank,managed a return on assets and a pro�t peremployee last year almost identical withthat of Standard Chartered, the biggest ofthe foreign banks. At the same time, its de-posit base, and its loan portfolio, grewmuch faster.

The foreign banks have every right tofeel mildly annoyed with the Indian gov-ernment, which has kept them on a leashmuch shorter than that of their Indiancompetitors. For all the reform and deregu-lation across much of the Indian economysince the �nancial crisis of 1990-91, thegovernment still has no plans to let for-eigners buy Indian banks (except as dis-tress sales) until at least 2009, and there isno certainty that it will happen even then.In the meantime the 31 foreign banks ac-tive in the market are guaranteed the rightto open no more than 12 branches a yearbetween them.

The foreigners have been consoled by

Naturally gifted

Overprotected it may be, but India’s banking sector is going from strength to strength

Private passion

Source: Boston Consulting Group

*Founded after 1994†Forecast

Indian bank assets by type of bank, % of total

0

20

40

60

80

100

1995 2000 05 10†

Nationalised banks

State Bank of India

Old private sector

New private sector*

Foreign banks

10

1


2 the formidable growth of the bankingmarket as whole. Total assets have dou-bled in the past �ve years. Consumer lend-ing alone has been growing by an averageof 40% in each of the past �ve years,enough to keep the foreign banks’ assetsand pro�ts growing handsomely despite aslight loss of market share.

By restricting the expansion of foreignbanks, and so limiting the competition toprovide banking services to Indian cus-tomers, the government has kept businesscosts unnecessarily high. Even so, to judgefrom the development of the banking sec-tor, this is one of those rare occasionswhen it is tempting to claim that a touch ofprotectionism has had its bene�ts. It gavethe Indian private banks the space to learnhow to grow, and to gain con�dence asthey went. The biggest of them, ICICI andHDFC, burst forth with mass-market low-cost national business models that pittedthem directly against the big state-ownedbanks, perhaps forcing competition onthem more e�ectively than any foreignbanks might have done.

The wonders of competitionAs a result, �competition induced by thenew private-sector banks has clearly re-energised the Indian banking sector as awhole,� in the words of Rakesh Mohan,deputy governor of the Reserve Bank ofIndia, the central bank. In the �ve years to2004, operating costs at India’s public-sec-tor banks fell from 66% to 45% of revenues.Return on assets, a measure of pro�tabil-ity, rose from 0.57% to 0.89%. Non-per-forming loans fell from 14% of the loanbook to 5.5%. All this was done with a rela-tively modest contribution of state funds,less than 1% of GDP in all, to recapitalisethe public-sector banks, o�set by invest-ment gains, as minority stakes in public-sector banks were sold on the stockmarketand the shares rose in value.

As in so much of Asia, the fastestgrowth was in consumer lending. Thatwill remain one of the most buoyant mar-kets in India, thanks to favourable demo-graphics, changing cultural and consump-tion patterns, higher purchasing powerand the spread of �nancial services out-side the big cities. Fitch Ratings calculatesthat retail lending as a share of all banklending in India has risen from 11% to 24%in the past �ve years. But relative to GDP itremains fairly low by world standards, at10%, against 13% in China, 50-60% insmaller Asian economies such as Malaysiaand Singapore, and 80-100% in rich coun-tries such as Britain and America.

One big winner from the growth of re-tail lending has been ICICI Bank, the big-gest of the new private banks. Founded asa state development bank in 1955, itformed a commercial banking subsidiaryin 1994. The development and the com-mercial bank made separate o�erings oftheir shares, then merged again in 2002.Retail banking currently accounts forabout two-thirds of the balance sheet. �Wewere the �rst to identify the changes in theeconomy, we could ride the curve,� saysVishakha Mulye, ICICI Bank’s chief �nan-cial ocer.

In the past four years, ICICI Bank hasalso been busy expanding internationally.It has branches or subsidiaries in 12 coun-tries, aiming its services mainly at Indiancommunities overseas but sometimes�nding that they attract a much wider cli-entele. Last year ICICI Bank launched a di-rect-banking service in Britain, o�ering adeposit rate half a percentage point abovethat of its main rivals, which the bank saidwas made possible by the low cost of op-erating the service from India. Demandwas so strong that it swamped ICICI

Bank’s computers. Hard on ICICI Bank’s heels comes

HDFC Bank, India’s second-largest privatebank, which was spun o� from a govern-ment-owned mortgage institution of thesame name in 1994. HDFC Bank thinks ofitself as being a touch more selective thanICICI Bank. �When the market is growing,you can say, ‘I will grab market share and Iwill �gure out along the way how to makemoney from it,’ or you can say, ‘I can pickand choose, and still grow,’ and we haveopted for the second,� says Paresh Suk-thankar, HDFC Bank’s country head ofcredit and market risk. HDFC reported netnon-performing loans equal to just 0.24%of the loan book in its last published bal-

ance sheet, against 1.65% for ICICI Bankand 3.84% for the banking system as awhole. But those are low �gures for fast-growing banks, all the more so in a bank-ing system where three-quarters of the as-sets are still in the hands of government-controlled institutions that are vulnerableto ineciency and political interference.However good Indian bankers are at theirjobs, their loan books could still show upsome nasty surprises if and when theeconomy turns down.

A perfect moment for reformFor the moment the economy is buoyant,to the point at which India has displacedeven China as the favourite big storyamong foreign investors. Now would be aperfect moment for the government topush India’s banking reforms further, byselling down state shareholdings and byencouraging further consolidation. Thebanking system would evolve from a largenumber of small banks to a small numberof large banks. A �rst step in that directionwould be some arranged mergers amongthe country’s 28 public-sector banks, end-ing up with three or four banks big enoughto thrive independently or to fetch a fancyprice from Indian or foreign buyers.

The main opposition to further consoli-dation even along these lines comes fromIndia’s trade unions and their political al-lies who fear that it would cause job losses.But much of that fear may be misplaced,says Janmejaya Sinha, a vice-president ofBoston Consulting Group, at least as re-gards branch closures. The problem in In-dia is one of too few bank branches, nottoo many, especially outside the big cities.

With a stable of big, strong domesticbanks, India could be much more relaxedabout lowering the remaining barriers toforeign entry. That would bene�t the econ-

1


2

BIGGER may sometimes be better inbanking, but ownership matters too.

Whatever the size of a bank, it will usuallyperform worse in government hands, be-cause governments are generally less moti-vated than private shareholders are, andless good than market forces are at collect-ing and digesting information. Besides,they have lots of other things to do. Thereare bound to be con�icts of interest andlapses of concentration. The bigger thestate-owned bank, the bigger the mistakesit is liable to make.

China has paid dearly for the mistakesof four big new commercial banks whichthe government carved out of the old com-munist banking system in 1994-95. Bewil-dered by the rush to capitalism, the bigstate banks were soon making two badloans for every three good ones. The gov-ernment set about cleaning them up in ear-nest in 1999, taking loans equivalent to 17%of GDP o� their books.

When that failed to change the banks’ways, the government was forced to take anew and more radical tack. In 2003 it said itwould recapitalise two of the four, theBank of China (BOC) and the China Con-struction Bank (Ccb), using $45 billionfrom state reserves. Then it would bring inoutside investors, who might know howto change the banks in ways that the gov-ernment did not, and it would �oat minor-ity stakes in the banks on the Hong Kongstockmarket, in the hope that market disci-pline could also play its part.

Last year a similar plan was announcedfor a third bank, the Industrial and Com-mercial Bank of China (ICBC). This restruc-turing may cost up to $80 billion, saysRichard Podpiera, an economist with theInternational Monetary Fund. Last to

come will be a clean-up at the fourth bank,the Agricultural Bank of China, which issaid to have the lowest credit quality, theleast ecient operations and the lowestdegree of transparency of any of the four.The bill there may be the highest of the lot.

Early birdsIf China’s banks had dug themselves intosome scarily deep holes, foreign investorsproved remarkably keen to jump in along-side them and help them dig their way outagain. From the moment the governmentbegan talking of selling stakes in CCB andBOC, a queue of foreigners formed to buy.The same happened when it added ICBC

to the list in 2005. So far China has collected more than

$20 billion for stakes in banks some ofwhich would have been unsellable at anyprice seven years earlier. These were bigand risky investments by anybody’s stan-

dards, but in some ways they have startedto look like bargains already. The govern-ment began by selling shares to direct in-vestors at about 1.2 times book value.When 12% of Ccb was �oated in HongKong last year, investors on the stockmark-et were willing to pay almost twice bookvalue. That implied big paper gains for thedirect investors in Ccb and left some inChina grumbling that the banks had beensold too cheaply.

Not so. It was the arrival of direct inves-tors that raised the perceived value of thebanks. The foreigners were expected to im-prove the management and the corporategovernance of the banks to the bene�t ofall shareholders. The readiness of big insti-tutions to risk their capital was taken as asign that there were no more huge horrorsleft lurking in the banks’ loan portfolios.Their presence was essential to getting thepublic listings moving at all.

Proceed with caution

Financial services in China are set for huge growth, but there is no easy way in

Piling inTop ten recent foreign investments in Chinese banks

Deal valueDate Target (% purchased) Acquirer (nationality) $m

Aug 2005 Bank of China (10.0) Royal Bank of Scotland (Britain), 3,100 Merrill Lynch (US), Li Ka-shing (Hong Kong)

Jun 2005 China Construction Bank Corp (9.0) Bank of America (US) 3,000

Dec 2005 Guangdong Development Bank* (85.0) Citigroup (US) and others 3,000

Jan 2006 Industrial & Commercial Bank of China (7.0) Goldman Sachs (US) 2,580

Jun 2005 China Construction Bank Corp (5.1) Temasek Holdings (Singapore) 2,466

Aug 2004 Bank of Communications (19.9) HSBC Holdings (Britain) 1,745

Sep 2005 Bank of China (5.0) Temasek Holdings (Singapore) 1,550

Jan 2006 Industrial & Commercial Allianz (Germany) 1,000 Bank of China (2.5)

Mar 2006 China CITIC Bank (19.9) CITIC (Hong Kong) 714

Sep 2005 Bank of China (1.6) UBS (Switzerland) 500

Source: Dealogic *Subject to regulatory approval

11

omy through increased competition. Itwould also be good for Indian banks, or atleast for those that rose to the challenge. Itwould let them prove to themselves thatthey are every bit as good as the best for-eign competition, and they would be lesslikely to be denied market entry by othercountries on reciprocity grounds. Thestage would then be set for decades ofgrowth in which Indian banks would be-come powerful players, �rst in other Asian

markets and then across the world. That may sound far-fetched. But as ba-

sic banking becomes more of a commod-ity business, the winners will be the banksthat can do it most cheaply. India has thenecessary skills at the keenest prices. For-eign banks can move only so many of theiroperations there, but Indian banks have allof them there already, at costs far belowtheir developed-country rivals’.

If Indian banks want to expand over-

seas, they still have to resolve the reputa-tion issue. Customers in Europe or Amer-ica might hesitate to rely on a bank (and abanking regulator) in Mumbai to preservetheir savings. But such things can change.After all, Western consumers once mockedthe idea of Japan as a carmaker, yet Japansoon proved them wrong. India might pullo� the same trick in �nancial services. But�rst its government has to get out of theway and give the bankers a chance. 7


2 As for the foreigners, they have got afoothold in a huge market just as the con-ventional wisdom has been shifting in itsfavour. For any �nancial institution withglobal pretensions, the perceived risk nolonger lies with getting into China, it lieswith daring to stay out.

The calculations on both sides mayhave worked out well in the short term,but that leaves two big questions open forthe long term. The �rst is whether the cur-rent optimism about future growth in Chi-nese �nancial services is well founded.The second is whether, even in a growthmarket, these big state banks are the bestchoice for foreign investors.

On the �rst of those points, the answeris a �yes� that gets more con�dent the lon-ger the view that you take. Goldman Sachsforecasts that the number of people inChina with incomes over $3,000 a yearwill rise tenfold between 2005 and 2015.China’s government, though it has proveditself capable of huge policy errors in thepast, is getting steadily more con�dentabout allowing market forces to helpshape the economy, including, at long last,the �nancial-services sector. If things gotolerably well, say the consultants at Bain,total banking assets in China in 2010 willbe twice what they were in 2004. The mar-ket for insurance will almost triple, and as-sets under management will increase six-fold (see chart 12).

There could be hiccups, or worse, alongthe way, however. David Marshall, re-gional head of �nancial institutions forFitch Ratings, says that a sharp slowdownin China’s economic growth could lead tolosses of 10% of bank loan books. A seri-ous recession could well mean a bankingcrisis in which credit losses overwhelmedthe banks’ still-slender capital bases.

The downside riskAs to whether the big state banks o�er thebest way for foreign banks to capture thisformidable growth, the evidence is moreequivocal. The biggest contra-indicator isthat HSBC and Citigroup, two big foreignbanks which know China well and whichhave huge experience of building up for-eign operations, have chosen other routesinto the market.

Citigroup paid $70m for a 4.6% stake inChina’s eighth-biggest bank, Shanghai Pu-dong Development Bank, in 2002. It is nowin the process of raising that stake to 19.9%.It is also leading a consortium of foreignerso�ering to pay $3 billion for 85% of Guang-dong Development Bank, another me-dium-sized bank from China’s prosperous

south, a deal that will require China’s lead-ers to waive their rule that foreigners can-not own more than 25% of any bank.

HSBC has also chosen to put its eggs insmaller baskets. In 2004 it paid $1.75 bil-lion for a 19.9% share in Bank of Communi-cations (BoCom), which is China’s �fth-biggest bank but which has only one-eighth the number of branches and sta� ofICBC, the biggest state bank. In addition,HSBC is building up a branch network thatcurrently stretches to 12 main branchesand eight sub-branches. It also has stakesin a municipal bank, the Bank of Shanghai,and in an insurance company, Ping An.

If HSBC, one of the world’s biggestbanks, with all the advantages that its Chi-nese roots bring it in terms of geography,language and culture, sees BoCom as theright size of partner, are other foreign in-vestors over-reaching themselves by pair-ing up with banks �ve times BoCom’s size?

The short answer is that the foreignerswill probably not have a huge impact onthe state banks, whatever the early buzz. Atmost they can seed the Chinese bankswith a few good ideas and a few good peo-ple, and hope that these take root and�ourish. They can also make a fuss if theysee things going badly wrong inside thebanks. And that may be enough for them.After all, they want other things out of therelationship too.

They get access to the state banks’ hugebranch networks as distribution channelsfor their products. They can guide the de-velopment of narrow but pro�table linesof new business such as credit cards. Theyget, or so they hope, a closer relationshipwith the government that will help themobtain other licences in the future, for ex-ample in insurance and in brokerage. Soany further capital gain on their invest-ment will be a bonus.

The state banks, in short, may never getmuch better at their basic business of bor-

rowing and lending than they are already,which is to say, not much good at all. Thatmatters less as long as a rising tide ofgrowth and modernisation in China is lift-ing all ships. But with a 60% market share,six layers of management between headoce and branch level, huge sta� numbersand very little experience of lending onstrict commercial criteria, the state bankswill �nd it hard to grow, let alone to mod-ernise, as fast as their smaller rivals.

When the capital markets wake upThey are already losing good business tosmaller joint-stock banks. They will losemore good business when (and if) Chinaeases its restrictions on foreign banks bynext year, in line with its commitments tothe World Trade Organisation. And theywill lose more business still when China atlast gets round to modernising and open-ing up its capital markets. The lack of de-velopment in this area in the past decadehas left the banking sector with a near-mo-nopoly on corporate lending. Banking as-sets are very high by international stan-dards, at 210% of GDP in 2004. Morecompetition is needed from the capitalmarkets if China wants to build a modernmarket economy.

The capital markets need time andmoney to get on their feet, just as the bank-ing sector did. The majority of China’s 130or so securities companies were left tech-nically insolvent after a decade of ill-man-aged speculation. But the capital markets’turn must come. When they start to attractmoney away from the banks, what nowlooks like a high-growth, high-marginbanking industry will look much more likelow-growth and low-margin, at least foraverage and below-average performers. Sothe strategic investors who paid 1.2 timesbook value to get into the big and slow-moving state banks probably got the priceabout right. Later buyers, beware. 7

Watch it growChina’s financial-services industry, $bn

Source: Bain & Company *Forecast

BankingBalance sheet totals

InsurancePremiums

Fund managementAssets under management

20000

2004 2010*

2,500

5,000

7,500

10,000

12,500

20000

2004 2010*

50

100

150

20000

2004 2010*

100

200

300

400

DepositLoan

Non-lifeLife

12

1


FOR a society so given to miniaturism,Japan is powerfully attached to gigan-

tism in banking. In a study of the bankingcrisis and economic slump that gutted Ja-pan in the 1990s, Akihiro Kanaya and Da-vid Woo, economists with the Interna-tional Monetary Fund, say that part of thecause was the �persistent focus of bankson market share�. The banks pursuedgrowth for growth’s sake, making newloans at the peak of property and stock-market bubbles in 1989-90 when thatmeant taking on riskier and riskier cus-tomers at lower and lower margins.

When those loans went bad, the weak-est banks collapsed, but only after theyhad made another lot of bad loans in thehope of growing their way out of trouble,postponing a banking recovery by anotherhalf-decade. From a high point in 1986,when they accounted for a quarter of theJapanese stockmarket’s capitalisation, to alow point in 2003, when they spoke forless than 3% of it, the banks have had a gru-elling ride. Their lending contracted byone-third, and familiar names disap-peared in a wave of mergers and bail-outs.Eleven of the country’s biggest commer-cial and development banks, some ofthem among the largest in the world, con-solidated into three �megabanks�.

Industrial Bank of Japan, Dai-Ichi Kan-gyo Bank and Fuji Bank were among thebig names subsumed into Mizuho in 2000;Sumitomo Bank and Sakura Bank fusedinto Sumitomo Mitsui in 2001; and in Janu-ary this year Bank of Tokyo-Mitsubishiand UFJ, both the product of earlier merg-ers, completed a merger which once againgave Japan the biggest bank in the worldby total assets: Mitsubishi-UFJ FinancialGroup, or MUFG, with a balance-sheet to-tal of $1.7 trillion, slightly more than that ofAmerica’s Citigroup.

That has made MUFG cock of the walk,ahead of Mizuho with $1.46 trillion in totalassets and Sumitomo Mitsui FinancialGroup with $900 billion. These banks areeven bigger than the biggest banks of thepre-crisis days. But are they any better?

The stockmarket certainly seems prettykeen on them. Bank shares have multi-plied in value since the low point struckthree years ago. But the big banks’ pro�t-

ability remains low by international stan-dards, and their strategic direction is un-clear. They are run by a generation ofmanagers who got where they are todayby managing shrinkage, not growth.

Not only do the banks have to growagain, they have to grow in new directionsif they want to boost their pro�ts to inter-national standards. They now have to dowell as retail banks, a line of business inwhich they have been relatively weak butwhich is the least volatile and most pro�t-able area of banking in most rich coun-tries. Whereas HSBC gets more than 60% ofits pro�ts from retail banking and Citi-group more than 70%, the �gure for Mi-zuho is about 42%, for SMFG 15% and forMUFG 16%, says Naoko Nemoto, an ana-lyst with Standard & Poor’s.

The blockage in Japan looks like one of

supply, not demand. David Atkinson, ananalyst with Goldman Sachs in Tokyo, cal-culates that the big banks have only 2,700branches between them in the whole of Ja-pan. One carmaker alone, Toyota, has al-most twice as many dealerships. Dividethe sales sta� of Japan’s major banks bythe customer base, says Mr Atkinson, andthere are only enough sta� for at most 55minutes of personal contact with each cus-tomer each year, allowing for about twotransactions of modest complexity. Bycontrast, the average customer of an Amer-ican retail bank expects to conduct two orthree branch transactions per month.

Newer, nimbler banks have been seiz-ing the opportunity. They include ShinseiBank, re-born from the Long Term CreditBank of Japan, which collapsed in 1998and was bought two years later by foreigninvestors. Its retail banking business hasattracted 1.6m customers from a standingstart in 2001. A survey by the Nihon Keizai

Shimbun newspaper ranked Shinsei thebest bank in Japan for customer servicelast year, followed by Sony Bank, an in-ternet bank launched by the Sony group�ve years ago.

The biggest network of them allThe big Japanese banks had even less in-centive to develop retail networks whilethe state-owned post oce savings banko�ered a cheap alternative. But the savingsbank, by some measures the biggest �nan-cial institution in the world, is now due tobe privatised. Its long-term future is not yetclear (see box, next page). It scarcely mat-ters, however, whether Japan’s big banksexpect the privatised postal savings bankto be a Godzilla-sized competitor in 12years’ time, or whether they foresee itsdwindling from a major to a minor com-petitor. Either possibility ought to be fo-cusing their minds on the need tostrengthen their own retail business. Sotoo should the prospect of rising short-term interest rates, after years of zero rates.Even allowing for a rise in deposit rates aswell, banks should be able to get a betterreturn from loans than they have been do-ing in recent years.

There are signs that the big Japanesebanks have indeed been looking ahead to

Back in business

Japan’s banks have restructured and consolidated. Now they must �nd new ways of making money


2 such things. Moving, as often, in convoy,they have been buying into �nance com-panies which operate credit cards andwhich lend money at high interest rates topeople with poor credit histories. Thismay yield some short-term pro�ts, but thebanks would be eccentric to put too muchlong-term emphasis on this limited marketwhen they have so many better-heeledcustomers of their own to whom theycould be selling loans. Very probably theyhave that in mind, and they are buying �-nance companies to help them under-stand better how the process works. Fine,though they might acquire the sameknowledge more cheaply by hiring a con-sulting �rm or buying a book.

Building up a branch network can bean expensive and time-consuming pro-cess. Mr Atkinson thinks that in the longterm MUFG could reasonably aim for1,500 branches, or two-thirds more than ithas at present. It sounds a lot, but whatother option does MUFG have? It has hugeassets but relatively low pro�ts. If it wants

to be valued in the stockmarket at any-thing like the size of its global rivals, retailexpansion is the only large-scale optionreadily available to it, and to its rivals too.

And perhaps then, with more provenretail expertise at home, Japanese bankswill become a touch more visible abroad,where after the retrenchment of the pastdecade they are at present hardly visible atall. Which is not to say they are entirely ab-sent, but that their business is mainly in �-nancing Japanese investments and Japan-related trade. As India’s economy boomedlast year, lending there by Japanese bankstripled to $4.3 billion. But China in particu-lar must present a frustrating spectacle. Itsbanking system has opened to foreign in-vestment, the potential is immense, West-ern banks are piling in�yet Japanese banksare standing on the sidelines.

The timing has been bad for them, be-cause they mostly still need to repaymoney which the government lent themduring the banking crisis. Until they have�nished doing that, they can hardly start

throwing money around elsewhere. Thepolitics are touchy, too. Japan’s pre-1945empire casts a long shadow. Relationswith China have become more fractiousduring Junichiro Koizumi’s term as primeminister, partly because his visits to the Ya-sukuni war shrine in Tokyo have causedangry protests in China, and partly be-cause Japan is seen as an ally of China’sgreat new rival, America.

Even if the political climate improvesand when Japan’s banks have paid o� thegovernment, they need to have a bankingmodel worth exporting, whether to Chinaor anywhere else. Such things can be builtfrom unlikely beginnings. Think how use-less British banks were at retail in the1960s, and how much better they are now.Japan has formidable traditions of massproduction and of personal service. Putthem together, and a great retail bankingsystem could be built on that foundation�equal to the corporate banking system ofwhich the Japanese were justly proud formost of the 20th century. 7

SMALL savers across Japan can huntdown a bank branch, or they can let

the postman come to them, collect theirmoney and put it in the postal savingsbank. Until next year they also have thebene�t of an unconditional governmentguarantee on deposits. During the bank-ing crisis of the 1990s savers shifted theirmoney to Japan Post en masse, causing itsdeposits to double.

Now the commercial banks are backto normal, and the government is movingto privatise the postal savings bank. Butnobody knows yet whether this willcreate a giant new competitor for thebanks, or whether it will give them newmarkets to cannibalise.

In broad economic terms, the postalsavings bank has done Japan question-able good. It was a safe harbour for saversin the 1990s and so perhaps averted aneven bigger panic. But if it had not beenthere, perhaps the Japanese banks wouldhave got into retail banking earlier anddiversi�ed their business, making theirlending less concentrated and the crashless severe. The postal savings bank has

also served the state as a captive buyer ofgovernment bonds and as a direct cash-cow for other government agencies andprogrammes, keeping some spending outof the hands of the parliament and mak-ing the government budget for each yearlook much better than it was.

A step in the right directionA �rst partial reform in 2001 ended the di-rect use of the postal savings system forpolicy lending by the government. Butthe savings bank remained a very bigbuyer of Japanese government bonds,holding about 30% of the entire stock, andof bonds issued by the same governmentagencies which the savings bank used tofund directly. All the same, the processhas introduced more transparency anddiscipline, and has helped to prepare theway for further reform: the privatisationof the whole post oce, which is due tobegin next year.

The four main components of the postoce will be put into separate compa-nies: the savings bank; a life-insurancebusiness; the network of 25,000 post-of-

�ce branches; and the mail-delivery sys-tem. But they will remain under a singlestate holding company until 2017. Then,as the law currently stands, the govern-ment will have to divest itself entirely ofthe savings bank and the insurance busi-ness, though there is nothing to stop it re-purchasing them immediately if it haschanged its mind about the sale by then.

If that sounds a funny sort of privatisa-tion, it is all the funnier because seem-ingly nobody, unless this is a verywell-kept ocial secret, knows how thesavings bank is going to operate from2007 onwards, even while it is still understate management. It could be left todwindle as a minimum service for peoplewith no alternative, or it could be man-aged energetically as a rival to the banks.The only thing on which there is generalagreement is that nothing should be doneto frighten away depositors. If they pulledout their money in a rush, that wouldforce the savings bank to raise money byselling securities, including its huge gov-ernment bond positions, sending thebond markets crashing.

The future of Japan’s postalsavings bank remains a mysteryA funny sort of privatisation

O�er to readersReprints of this survey are available at a price of£2.50 plus postage and packing. A minimum order of �ve copies is required.

Corporate o�erCustomisation options on corporate orders of 500or more are available. Please contact us to discussyour requirements.

Send all orders to:

The Rights and Syndication Department26 Red Lion SquareLondon WC1r 4HQ

Tel +44 (0)20 7576 8000Fax +44 (0)20 7576 8492e-mail: [email protected]


Previous surveys and a list of forthcoming

surveys can be found online

www.economist.com/surveys

TO SAY that bankers are getting better atbanking is to say that they are getting

better at information technology, andhigher mathematics, and retailing, andmarketing, as well as at hiring and manag-ing people who are specialists in thosethings. Risk management, the rock onwhich any contemporary bank rests,scarcely existed as a profession outside theinsurance industry until the 1970s.

The ruthless scrutiny of capital marketsand regulators has been good for bankingbut hard on bankers. It means that themodern banker, even (and especially) thebiggest boss of the biggest bank, must be adetails man. The bank is a vast machine,and he is its chief engineer.

Ken Lewis, boss of Bank of America,downplays even his importance as a strat-egist. The things that make Bank of Amer-ica special, he says, are �franchise�, or mar-ket position; �execution�, or operationale�ciency; and track record. Beyond that,he told an investor conference in February,�we believe strongly that there are no un-ique strategies in �nancial services.�

Nor unique products, to judge from aletter to shareholders written earlier thisyear by James Dimon, JPMorgan Chase’sboss. The bank’s job was to deliver theright bundle of products at the right price,he said. �Where the products are ‘manu-factured’ is of little interest� to customers,he said. That is a fair claim to make so longas the product proves reliable. If it goeseven a tiny bit wrong, then where andhow it is manufactured suddenly starts tomatter very much indeed.

This survey began by asking whether,as banks grew and as banking systemsconsolidated, there was a natural limit totheir size. The short answer is that no bankcan be too big, so long as there is enoughfree competition to keep it on its toes. If

banks are right about economies of scale,and if management and information sys-tems can keep pace, then why shouldbanks not go on consolidating until onlythree or four or �ve of them are left, withthree-quarters of the market betweenthem, in a given country, or a given conti-nent, or indeed the world?

The problem is that banks do go wrongfrom time to time, and whenever that hap-pens, size turns out to be their worst fea-ture. The bigger a troubled bank, the lesscredible a government’s claim that it willnot intervene, the harder to manage thefailure, and the bigger the �nal bill to tax-payers. Even without a crisis, a bank is get-ting too big for comfort if regulators startmaking their rules around it. That sti�esnew competition and provides room forrisk to grow. So even if economies of scalewere in�nite, bigger banks would not al-ways be better banks.

One answer might be for countries to

cap the size of any bank as a share of GDP.The �gure would di�er from country tocountry, depending on the appetite forpublic spending, the place of �nancial ser-vices in the economy and the desire to ac-commodate national champions. The capfor America might be 1% of GDP for anyone bank’s capital, beyond which it mightgrow organically but not by acquisition.That would be no more intrusive than thecurrent American rule stopping any onebank gaining more than a 10% marketshare of deposits by acquisition, a limit al-ready touched by Bank of America.

But that last factor aside, there is no ob-vious limit to consolidation currently insight, only supply and demand. In Febru-ary Charles Prince, Citigroup’s chairman,o�ered his view of the future: �Nobodywants to sell. Everybody wants to buysomething. Any bank holding company ofsize is in the acquisition mode, not the sell-ing mode. It’s just as simple as that.� 7

The limits to size

When banks go wrong, the biggest come o� worst. But that doesn’t stop the scramble for growth

Future surveys

Countries and regionsPakistan July 8thFrance October 28th

Business, �nance and economics and ideasBusiness in India June 3rdLogistics June 17thClimate change September 9thThe world economy September 16thTalent October 7thTelecoms October 14th

sun eu 1 may20 - economist.com › sites › default › files › special... · 1 the economist...

Documents