Foreign banks less influential than expected

Some have asked me: "Why is it that foreign banks are not as competitive as we thought after they entered China two decades ago?"

When China officially joined the World Trade Organization in 2001, it was widely believed that foreign banks would disrupt the Chinese banking sector once they were given access to the domestic market. Nearly two decades later, however, we discovered that foreign lenders in China are not wolves. The catfish effect we expected foreign banks to have on their Chinese counterparts did not appear either.

The catfish effect refers to the motivating effects of strong competition on weaker individuals.

One of the reasons is that foreign banks are restricted by their scale in China, which means their market shares in the country are very small.

The China Banking and Insurance Regulatory Commission said that by the end of the first quarter, foreign banks had established 41 locally incorporated banks, 115 branches and 149 representative offices in China. Total assets of foreign lenders in China reached 3.58 trillion yuan ($511.2 billion), while total assets of commercial banks in the country stood at 251.84 trillion yuan.

After the 1997-98 Asian financial crisis, a series of events caused huge losses to foreign banks that entered China, so they reduced their overseas business to meet capital adequacy ratio requirements and took an asset-light approach to business expansion overseas, such as being lead bond underwriters but not themselves holding bonds.

As a result, they invested a limited amount of capital in the legal entities they set up in China. Restricted by CAR requirements on their head offices, their legal entities in China often have limited capacity for asset expansion.

Over the same period, Chinese banks underwent fast-track development. Now, several of the country's largest banks by assets make the list of the top 10 banks worldwide. Under these circumstances, foreign lenders cannot make a widespread impact on the China market.

It is also worth noting that foreign banks' understanding of market risks does not always align with China's unique market conditions. They often claim risks in the Chinese banking sector are huge because domestic lenders offered a large amount of loans to less-efficient State-owned enterprises and local government financing vehicles. In their view, banks should issue more loans to more efficient private companies that have clearly-established ownership structures.

But it turns out that the assets considered risky by foreign banks have actually become quality assets for domestic lenders, whereas the areas which they believe bank loans should flow into have become major areas of nonperforming assets. Therefore, foreign banks are not as good as their Chinese counterparts in terms of identifying and controlling financial risk in China.

However, foreign banks' strengths in certain financial sector activities－such as foreign exchange transactions, bonds and derivatives－are far beyond that of their Chinese counterparts.

Despite their good performance over the areas, there is limited room for them to play an active part in China's financial market as it is not yet fully developed. Their sizes also restrict them from playing a bigger role in the domestic financial market.

Moreover, mechanisms of decision-making within foreign banks are not suitable for the China market. Many foreign banks adopt a vertical approach that has a top-to-bottom management arrangement.

Head offices of foreign banks have a clear risk appetite and clear customer strategies. These are often divorced from the reality of the Chinese market. A lot of business that foreign banks consider to be of good quality in China does not meet their head offices' requirements for access, and they have to repeatedly communicate with relevant departments on specific business conditions.

With the implementation of the Basel III standards, bank management has become increasingly standardized and complicated. A single business not only needs to receive approval from higher-level management, but also needs to get a nod from relevant departments at the same level, which means a lot of communication up and down.

Foreign banks abide by these rules rigidly in this regard. In other words, they are more bureaucratic than Chinese banks.

For example, almost all banking businesses are related to legal affairs. If a foreign bank in China prepares to issue a loan, the department of legal affairs at the same level must review the loan and issue an opinion. When the approval process moves on to the bank's head office, the department of legal affairs at the head office will also review the loan and communicate with the legal affairs department in China if any questions arise. But it is difficult for communications in this regard to go smoothly because Chinese laws, policies and regulations are quite different from those of other countries.

We have also seen a reversal of advantages of foreign banks and their Chinese counterparts in technological and innovation capabilities.

Fifteen years ago, foreign banks were well ahead of Chinese banks in terms of technology and business innovation. But after 2005, Chinese banks made tremendous progress in technology investment and application and business innovation. They surpassed foreign lenders in these areas by drawing on the advanced experience of foreign banks and taking advantage of the momentum of rapid development of the domestic economy and ongoing globalization.

This is in part because the mechanisms of decision-making at foreign banks require the banks to conduct feasibility studies and calculate returns on investment and potential risks accurately before upgrading their systems or developing a new product.

Chinese banks, on the contrary, will start developing a product or a system after performing simple calculations, as long as there is market demand.

The decision-making process of foreign banks has restricted their capabilities and innovation speed. In addition, business innovations made by foreign banks' head offices usually do not meet China's market demand, and innovative business models developed by foreign banks in China often aren't accepted by their head offices.

In previous years, Chinese market entities and clients looked at foreign banks－especially well-known large global financial institutions－with admiration. But as time went by, various factors have led to a decrease in market recognition of foreign banks.

First, not all foreign banks that entered China are well-known to locals, and many are not from developed countries. Due to the uniqueness of the banking sector, customer trust is key for banks to build long-lasting business success. What is behind customer trust is not only the strength of a bank but, more importantly, the status and reputation of the nation where the bank hails from.

Second, both the Chinese economy and domestic enterprises have undergone rapid development over the past 20 years. Foreign banks cannot fully meet domestic demand as their business and product innovation capabilities are relatively limited.

Third, foreign banks stick to rules and handle business in a complicated way, which inflates costs. In contrast, Chinese customers are used to enjoying free or low-cost financial services, so they are less likely to accept higher charges from non-local counterparts.

Finally, large-scale losses on failed wealth management products have damaged the admiration by Chinese clients of foreign lenders.

In the above analysis, I want to demonstrate a universal phenomenon regarding banks' cross-border operations rather than show how poorly foreign banks perform in China. In a number of aspects including financial product innovation, business model innovation, staff training and management, internal process management and marketing, there is still a lot for Chinese banks to learn from their foreign counterparts.

I also want to say that how well foreign banks perform in China has something to do with the level of China's opening-up. But it also has more to do with their business strategies and capabilities. It is unnecessary for China to open up in a way that treats foreign banks as VIPs.

Currently, restrictions imposed by China on foreign banks are very few compared with other countries, in my opinion.

Ultimately, opening-up does not simply mean giving foreign institutions access to the China market. Policymakers should pay more attention to the construction of a more open market overall.

The writer is vice-president of the Shanghai Finance Institute.