Banking in Asia: The End of Entitlement

CIAO DATE: 12/99

Banking in Asia: The End of Entitlement

May 11, 1999, Hong Kong

Speeches and Transcripts: 1999

Introduction

Dominic Casserley: This book is the result of a two-year research project by McKinsey supplementing the day-to-day experiences of our consultants across the region. You will no doubt be relieved to know that we are not going to try to summarize all this work into just 20 or 30 minutes. The book gives great detail on each country and each business line across Asia, including retail, corporate, investment, and private banking as well as trading and asset management businesses. It would be impossible to cover all this ground in such a short time.

Instead, we wanted to touch upon some common themes and implications for commercial and investment banks across Asia and here in Hong Kong.

The Changing Banking Markets of Asia

The population of Asia is about 3.2 billion. Probably less than half of these people have a bank account of any meaningful size, and only about 100 million Asian households have financial balances large enough to interest the leading multinational banks. Yet in 1997-98, the Asian financial crisis impoverished the whole region, both those people with and those without bank accounts. So, the banking industry permeates everyone’s life.

We believe that the 1997-98 Asian financial crisis marked a watershed in Asian banking and finance. This was not just because many banks, securities firms, and finance companies closed, merged, or effectively withdrew from the market, or because many people employed in financial roles in Hong Kong, Singapore, Tokyo, Bangkok, Kuala Lumpur, Jakarta, and other Asian cities lost their jobs, or because individual investors and institutions lost huge amounts of money in the declining Asian equity, bond, and currency markets. The crisis was a watershed because the way banks, securities companies, and finance companies earn profits in Asia will never be the same again.

It is important to note, however, that many of the trends that seemed to be triggered by the financial crisis were already underway in most Asian markets before the crisis struck. For instance, during the mid-1990s much of our work with our banking clients in Asia was focused on preparing for a more competitive environment that would unfold over the early years of the next decade. What the crisis did was to quicken the pace of regulatory and competitive change, compressing what most financial industry observers thought would take as long as 10 years into just two or three. Moreover, this stepped-up pressure to change came at a time when most Asian countries’ financial industries and banks were very weak. Thus, many players that might have managed a less ferocious transformation will not survive, or will be unable to survive alone.

In the 1980s and most of the 1990s, immense fortunes were made as commercial and investment banks funded “the Asian miracle.” In most Asian markets, a banking or securities license gave access to easy profits. So, even though the markets outside Japan were very small when compared with those of the US or Europe, many international bankers thought they had to be part of banking in Asia. The 1997-98 crisis brought these days of making easy money in Asia to an abrupt end. What was effectively the age of entitlement in Asian banking is over. In its place will emerge a revamped financial industry, requiring fresh formulas for success and resulting in a new competitive balance among domestic and global players.

First, however, let us say that we see great opportunities in the Asian banking markets over the next decade. In 1998, financial services in Asia generated US$210 billion in revenues; by 2010, we expect that total revenues will top US$450 billion. We expect the Asian banking markets to grow on average at 7% a year in real terms, which is faster than those in the West are growing, and Asian markets outside Japan will grow at closer to 10% a year. Across the world, as GDP per capita has increased, demand for financial services has increased faster than general economic growth. The same will apply in Asia in the first decade of the next century. In addition, there will be new service opportunities for banks: new retail opportunities to meet the needs of expanding and aging populations and more educated consumers; new corporate and investment banking opportunities to meet companies’ needs for hedging services and long-term funding. Banks will have many new opportunities to offer value-added services. Banking in Asia will be a great growth market.

If banking will remain a growth market in Asia, why do we see a whole new competitive environment, an end to the era of entitlement? Let’s look at three key businesses in Asia to get a sense of the drivers and nature of change. We’ll look at retail banking, corporate banking, and investment banking.

Retail Banking:The Masses will Enrich those who are Ready

Gregg Gibbs: Retail banking will be the largest banking segment in the next decade. It will represent nearly half of the US$450 billion in financial services revenues in the region we forecast for 2010. But retail banking will probably undergo the most change in the next few years of any banking sector. Why will retail banking be tougher in Asia in the next few years?

First, many markets that used to be protected, where foreign competition did not exist, are now opening rapidly to foreign competition. Most obviously, Korea, Thailand, and Indonesia have opened once closed markets, and other countries such as Japan and Singapore are in the process of making competition much more intense.

Second, domestic markets will be deregulated, and old protections unwound. Here in Hong Kong we can expect the interest rate cartel to be unwound, creating higher funding costs for the small banks that rely upon protected funds. At the same time, new competitors will compete more aggressively for business. We are getting the first taste of all this in the mortgage wars we are now seeing in Hong Kong.

Third, banks will face more demanding customers. Our research of Asian consumers suggests that nearly 50% are dissatisfied with the service they receive from their banks, and many would be prepared to switch if offered new opportunities. The experience of Taiwan in the 1990s, where the new banks introduced in 1991 have now built up nearly 20% market share from scratch, supports the fragility of existing banks’ retail franchises.

Fourth, banks will face competition from alternative products. We have seen in the United States and Europe how unit trusts or mutual funds can win savings away from the traditional banking deposits. Over the next decade we believe we will see the same trends in many Asian markets. Today, retail funds total about US$600 billion across Asia; by 2010 we expect them to grow to US$2-3 trillion, of which about two-thirds will be in Japan. This will leave about US$1 trillion of mutual funds outside Japan, much of which used to sit in bank deposits.

Finally, retail banking will become more expensive for banks. To meet the evolving needs of different segments of customers, to develop new products, and to introduce services like Internet banking and remodeled branches will all require a level of investment with which Asian banks are unfamiliar. Historically, banks in Asia have earned good returns partly because they were able to keep investments low, and because they did not face stiff competition. That era is over.

In summary, whereas in the past many banks across Asia have treated their retail customers as an easy source of deposits to fund corporate loans, in the future they are going to have to look at retail customers as do the best retail shops, as customers who require superb products and customized service, but from whom great profits can be earned if you get the formula right.

Corporate Banking: Big Profits Among the Risks

Gregg Gibbs: What about corporate or commercial banking? Corporate banking has been a huge market in Asia, and we believe it will remain so in the next decade.

However, corporate banking was already becoming a tough business during the 1990s, and we see many of the trends that underpinned the problems in this business continuing into the next decade.

First, the most attractive customers will be wooed by every local and international bank, so that the margins on serving them will be very fine indeed. Loan spreads of less than 100 basis points over matched opportunity funding costs will reappear in Asia.

Second, the capital markets will take away many interesting opportunities, so that banks will be left with the weaker credits that cannot access the capital markets.

Third, after the recent wave of bank failures, accompanied by the withdrawal of bank lines to many corporations, customers will be much wiser and will shop around their banking to a few banks and ensure that they have secure funding.

Finally, this sector will consistently provide “nasty surprises” in terms of credit losses for banks that are too active in it, or too aggressive in the lower-quality credit areas.

All in all, we believe that corporate banking success in the next decade will require a migration to a much tougher approach involving more products and thus, higher costs. These products will be targeted to meet the service needs of corporations in Asia, be they trade services or cash management or derivatives to hedge risks. In all cases, banks will need to segment their customers to understand which corporations they can serve, and use lending carefully to avoid losses and thus not undermine returns on equity. Fee income will be critical to supplement lending spreads for successful corporate banks.

Investment Banking: No Escape from Global Trends

Gregg Gibbs: If corporate banking will continue to be tough in Asia, surely then investment banking, which often steals the best customers from the corporate bankers, will be a bonanza. Unfortunately, only for a very few.

It is certainly true that investment banking markets will grow enormously during the next decade. We estimate that the total underwriting and advisory markets will expand strongly during the next decade, fueled by infrastructure funding needs, corporate balance sheet refunding, and more merger and acquisition activity in Asia. Unfortunately, by global standards, apart from Japan, Asia’s investment banking markets are and will remain small. Against that backdrop, we believe the markets will be hard work for all but a few.

The investment banking markets in Asia are already very concentrated. For instance, between 1994 and 1997, the top five equity underwriters in Asia outside Japan were familiar names: Goldman Sachs, Merrill Lynch, Morgan Stanley, Peregrine, and ING Barings. On average, however, these five generated annual fees twice those of the next five competitors, and 15 times those of competitors outside the top 10. With the high cost of staff, real estate, and travel the same for all competitors, the small competitors are being squeezed out of the investment banking game. Already, the global giants dominate the key Asian markets outside Japan, as they do in the US and Europe. Without a global product range, the ability to place securities globally, and the ability to hire the best talent, few investment banks will compete successfully. The transition to a global market has already happened in Asia.

Hence, local, smaller firms will be left to pick up the scraps. They will develop important franchises in niche areas, but in the overall scheme of things they will be small bit players in Asia compared with the global top 10.

This is already the case. There are no leading purely local investment banks left in Asia. The 1990s saw the disgraceful story of the decline of the Japanese banks as serious leading competitors outside Japan. Over the past few years, Barings, W.I. Carr, Peregrine, and Jardine Fleming have either become part of global firms or disappeared altogether. Today, there is no leading investment bank headquartered in Asia. There will not be any in the next decade either.

So, across Asia we see the next decade as a story in banking of resumed growth, but of far more demanding customers, open markets, and stiffer competition. The opportunities will be there, but they will be tougher to garner. Given this scenario, what choices will competitors face? How can they proceed? Let’s talk about the multinational banks, then the locals.

Three Choices for Multinationals

Dominic Casserley: Multinationals have three main strategic options in the face of the Asian opportunities and challenges: play it safe, dominate a product across the region, or become insiders in one or more countries.

Playing it safe is for those banks that do not see great opportunities in Asia, or cannot build the will at the corporate center to make more investments here at this time. So, second-tier US and Canadian banks are unlikely, we believe, to expand beyond their representative offices in key cities.

Dominating a line of business, like credit cards or trade finance across Asia, is a viable option for competitors lacking a large physical presence in many countries but having strong skills in their chosen markets. Some of the US credit card firms are trying to enter Asia this way through alliances with local banks. And Schwab, the discount broker, has entered the Hong Kong market aggressively through use of the Internet.

Becoming a true insider is for the bold firm that sees the opening of Asian markets as an opportunity to build new insider positions. Standard Chartered’s acquisitions in Thailand and Indonesia, Hongkong Bank’s foray into Korea, and ABN AMRO’s purchase of Bank of America’s retail businesses across much of Asia are all examples of bold players pursuing this path. The challenge here is to decide which countries to focus on, and the ability to handle far-flung, high-risk acquisitions is a must. Moreover, these bold players have to move quickly to grab the most attractive acquisition candidates, and must balance long-term opportunities with short-term credit and organizational management risks.

Four Options for Local Banks

Local banks have four key options.

First, they can refocus and reinvent themselves in the face of new competition and more demanding customers. But we believe they will have to be large and self-confident to pursue this route and win on their own.

Second, they can try to build scale through local, in-country mergers and alliances. This will be a tough process, involving complex operating issues and concerns over family face, but it is a viable route for those with the courage to break the mold.

Third, a few banks might form cross-border alliances with other Asian banks to build regional scale. Again, as many of these banks are family-owned it might be difficult to make this work. But DBS in Singapore is an example of a local Asian bank pursuing this approach through acquisitions in Hong Kong, Thailand, the Philippines, and Indonesia.

Finally, many local banks will recognize that they would be best served by linking with, or selling to, one of the multinationals. That will be the best way for many to get the best returns for their owners and the best services to their customers in a tougher environment. Bank of Asia in Thailand and Korea Exchange Bank are examples of banks taking this route, as well as those recently purchased by Standard Chartered and Hongkong Bank. All these selling banks, however, were wounded by the financial crisis. The hard next step will be for fully healthy banks to recognize that the future is clouded, and that selling when they are strong might be the best option. That, however, will take far-sighted leadership.

Implications for Hong Kong

What does all this mean for Hong Kong?

We see resumed growth in Hong Kong’s banking markets over the next few years, due to increasing population, wealth, and new needs of Hong Kong’s corporations. But many of the pressures of more open markets, deregulated pricing and interest rates, more intrusive multinational competitors, more demanding customers, and increased investment requirements will also play out in Hong Kong over the coming years. So, while we see resumed growth in the Hong Kong market, we also see:

1. Increased market share being taken by multinational banks. Already we have seen players like DBS of Singapore and GE Capital looking at buying into the market. Others will follow. 2. We also believe we will see consolidation—mergers or alliances—among the smaller banks, to share costs and to build the scale required to face more intense competition. Already, the Bank of China Group is considering consolidating its sister banks in Hong Kong. What is for sure is that Hong Kong cannot, indeed should not, avoid the trends sweeping across Asian banking. In fact, if the local Hong Kong banks do not modernize, Hong Kong will not have a preeminent banking industry in the region anymore.

Conclusion

In conclusion, commercial and investment banking in Asia in the 1980s and 1990s saw periods of great wealth creation and destruction. Those cycles will probably be repeated in the first decade of the 21st century, but what must be different for the winners of that decade is how they strive for profits. In an environment across nearly all businesses and geographies of more transparent information, more sophisticated customers, and more open competition, it will be necessary to manage all elements of every financial business with far more discipline than in the 1990s. At the same time, as this new environment exposes the weaknesses of some competitors, the eventual winners will need to be ready to make major acquisitions to secure their leadership positions. From the cozy world of protected markets, good margins, and few mergers or acquisitions in the 1980s and much of the 1990s, banking in Asia will become a competitive arena of narrower margins and consolidation in the first decade of the 21st century. The new era will mark the end of entitlement for all competitors in Asia.

Let us remember that while old-style banking may be under pressure, these changes are good for society at large. What will emerge from this process of change will be better run and stronger banks, with more diversified sources of income, less prone to succumb as many did in 1997 and 1998. This will bring stability to the region’s economies. Meanwhile, consumers and corporations will have more choice and more finely priced products. In economic terms, the cost of capital will decline for many users of bank services.

We should welcome this change, in fact hasten it.

Gregg and I made a presentation to a group of bankers in Taiwan a few days ago. The words of one senior banker sound right to me. He said to his colleagues assembled at the meeting that his greatest fear was that because Taiwan had largely avoided the 1997-98 financial crisis its banking industry would not reform and consolidate. That because of short-term success, Taiwan’s banks would miss the bigger picture, the inexorable end of the age of entitlement, and by 2005 would look like dinosaurs in a reformed banking industry in Asia. It is a warning that all sitting here in Hong Kong should take seriously too.

The 21st century is often positioned as the “Pacific Century.” Without an effective and efficient banking industry in Asia, it will be no such thing. Recognizing the real situation is the first step in creative change in any industry or organization. So, recognizing that the era of entitlement in banking is over will help create the banking industry required to give Asia the future it deserves.

Thank you very much.

Banking in Asia: The End of Entitlement was published in April 1999 by John Wiley & Sons (Asia).

Question & Answer

Question 1: I wonder if you could comment, perhaps using Hong Kong as an example of a local market, on the degree to which you feel the aggregate profits of the banking system will decline at least relative to assets as things become more competitive and as changes take place. I don’t have any statistics but my impression is that you have here in this town, excluding a few recent aberrations, you have almost every bank no matter how inefficient is making at least some profit and you have the more efficient or large market share players like HongKong Bank or Hang Seng Bank with extraordinary large profits relative to assets. How much of these easy profits of the past will go away through competition?

Dominic Casserley: I think we would see a similar cycle as you’ve seen in other deregulating markets, which is that aggregate profits in the industry leave aside the credit losses we’ve had which is a particular operation. But as you look over the cycle that aggregate profits in the industry will come under pressure for awhile, the smaller banks will be squeezed and there will be more aggressive competition against the leaders in the market. After a period of time however, the market will stabilize and total profits will increase, although return on assets will be lower than it has been in the past. In order to generate an attractive return on equity, therefore, people are going to have to manage those ratios much more carefully. So, I think there should be a curve—a downward curve for awhile and pressure on the industry. Then it will stabilize, but at a lower level than we saw in the 1970s, 1980s and early 1990s. We are just not going to see that level of margin in the banking industry in the future.

Question 2: I wonder, Dominic, if you could comment on the fact that one of the impediments of the financial system in Asia has been the lack of properly developed bond markets and I wonder if you could comment on the future of this bond market development.

Dominic Casserley: We see the development of a stable bond market in Asia as very important. Clearly the problems in the late 1990s around the Asian bond market are a serious setback. There are a number of things missing at the moment. First of all, there are no natural holders of Asian fixed income debt. There is simply not a large enough institutional investor group focused on that asset class. Building up local pension funds is going to be very important during the course of the next decade. We believe that there is very good news on that however; the savings requirements in Asia to fund the pension requirement of an aging population, plus the growth of more local insurance activity means that there will be more local assets seeking out fixed income products in the region.

The second thing that has to happen is that the quality of the issuance has to go up. We believe that the experience of the late 1990s, and some of the problems we saw in the fixed income markets will be a salutary lesson, and with more sophisticated institutional investors looking at these products, we can see it slowly developing during the course of the next decade. But we’ve got to get both sides in place. We have to get domestic institutional investors which will be a slow process during the course of the next decade, and we have to make sure the quality of the underwriting that is taking place is much higher than it has been. But I think, over time, we are relatively optimistic.

Gregg Gibbs: I would just add that one of the lessons coming out of the crisis was that corporations saw that all of a sudden their short term lending was no longer available for roll over—that relying on banks for a lot of 6, 12 and 18 month money isn’t really sufficient to meet your long term capital investment needs or your long term growth plans. I think corporate—whereas before they were quite willing to look at the reasonably well priced funds they received from their banks as the only way to fund themselves—will increasingly look for longer term funding. Pushing it out to three to five years and beyond. I think you’ll see from corporates probably a higher realization of the importance of capital markets than you’ve seen in the past.

Question 3: I was fascinated by the statistic that there are a hundred million households of interest and you’re projecting a doubling or tripling of that until the year 2010. Do you see that as a growing distribution of wealth or do you count on each of the hundred million households having two children or three children? That’s question one. Question two, in the small talk you couldn’t address it, but do you see that in your conjectures and predictions, a role for US banking deregulation? Will there be a major effect on your assessment if regulation of the financial services [industry] doesn’t go forward in the next two US Congresses?

Gregg Gibbs: The increase in the number of bankable households, attractive bankable households, comes largely from the increased distribution of wealth. Not so much because wealth will be reallocated, but because as the economies of Asia develop, you will see a greater number of people that come onto the radar screen. If you look at banking deposits as an example, the acceleration of banking deposits in the banking system grows very rapidly when GDP grows from $1000 to $5000. In the time of that growth from $1000 to $5000, you’ll see at the $1000 mark, bank deposits typically being about 15% of a country’s underlying GDP. When you get to the $5000 to $7000 mark, typically bank deposits represent up to 50% of GDP.

So what you have is the ability to save much more once you pass the basic threshold of subsistence. We think that is going to be a large part of the underlying growth in terms of the households that become interesting. They’ll just have a bank account of size that will be adequate to support profits. They will also have the minimum collateral to start to support some basic form of consumer lending.

Dominic Casserley: On your second question, on US banking deregulation, I don’t think we see that as a major driver of change here. For the very simple reason, which is that the number of US institutions that are playing a major role in most of the domestic markets today in Asia is a very limited number. The stakes at the table or the places at the table for play are being decided today. Over the next two or three years, the competitive environment for most of the domestic banking markets in Asia will be resolved. Because there is very clearly a deregulatory window within which the regulatory authorities in many markets are going to allow change to take place. And then we think they’ll start to . . . (unclear). . . again. The number of US banks who are going to take advantage of that opportunity has already been decided—very few, very few indeed. And so we don’t see the change in US regulatory environment vastly changing the way in which US institutions will act in this market.

Question 4: Although I didn’t read it directly, I understand that John Reed is purported to have said that internal studies by Citibank led him to conclude that Citibank had never made any money in the corporate banking business, in the history of the organization on a risk adjusted basis, before Sandy Weill reminded him that he really didn’t mean that. Do you have a view on that subject and why are you so particularly optimistic about corporate banking being a profitable business in the future in Asia?

Dominic Casserley: I think what we actually tried to paint was a picture that corporate banking has been and will continue to be a very tough business in Asia. I’ve looked at that business many times around the world, and for most players it does not return on a risk adjusted basis their cost of capital. So, usually it’s a wealth destroyer as a business. For a few players who are able to supplement their core lending product with a whole range of fee income products and other services, it does become an attractive business. We see that pattern continuing. That is, there will be continuing demand for these services, that there will always be banks who will convince themselves that this is the period in which they will actually produce superior returns. But when you look at the segment as a whole, it will probably not be very attractive.

There will be people at the high end, who will make money because of lots of high value-added services. And there will be some people who are very good at middle market lending, who will be able to make good fat margins and control the credit risks because they have incredible understanding of those credit risks. But when you look at the group as a whole, it is true in the past and it’s going to be true going forward, that corporate banking, when you adjusted for risk and you adjusted for cost of capital, it close to or destroys shareholder wealth. And that will continue to be true.

Question 5: I noticed however that you avoided speaking on China. If you could spend just a few minutes on your assessment of China.

Dominic Casserley: We see the banking situation in China as one of slow change. The market, when you examine it in more detail, is actually much more segmented than people realize. There obviously are the big four banks, and then the Bank of Communications is bank number five. But the last ten years, there have been a number of new venture banks put in place which are establishing and growing market share, penetrating new market segments, introducing new products. On the edges, and it’s really on the edges, are the multinational banks waiting to do something but having minute market share. Going forward, the realities of the reform challenge facing the Chinese government means that radical change in the banking industry is going to be very hard to put through, because of the special funding challenge that the banks have to keep the state owned enterprises (SOEs) funded. So we see a gradual process of change, where attempts are made to clean up the big four state banks to improve the credit underwriting processes on some of the new banks. But when you look at the banking industry in China, five to ten years from now it will have changed. But, the market share held by the big four and the Bank of Communications will still be dominant. And we will probably still have the vestiges of serious credit issues that the industry will be trying to unwind. So I am afraid, it’s a gradual process of evolution.