FUTURE OF BANKING : FRAGILE GIANTS KEY TO WESTERN HOPES / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

September 13, 2011 7:25 pm

Future of banking: Fragile giants key to western hopes

By Patrick Jenkins, Simon Rabinovitch and Joe Leahy

 

 

The attractions of the fast-growing markets that seemed so promising after the financial crisis now look increasingly hard to sustain

The advice from Pan Gonsheng was typically forthright. Presenting stellar results from Agricultural Bank of China a few weeks ago, the lender’s vice-president felt every reason to be bullish.

He was talking about Chinese institutions, rather than the downtrodden stocks of their western equivalents – and similarly upbeat sentiment has surrounded other big emerging market banking sectors, notably Brazil’s, over the past couple of years.

 

The financial crisis that gripped much of the globe three years ago has morphed into a sovereign debt crisis with a second round of knock-on effects for the banks of Europe and the US. In the mean time, the performance of their peers in the high-growth “Bric” economies of Brazil, Russia, India and China – particularly Brazil and China, which have shown healthy growth trends – has been thrown into sharp relief.

Domestic banks there have boomed. And foreign banks – from HSBC to Santander to Citigroup – have pushed hard to expand in those markets, drawn not only by the growth outlook, but also by the fact that such economies, less affected by the global crisis, have generally taken a softer line on the regulatory reform drive constraining profits in the west.

Lately, though, there is evidence that the momentous pace of the banks’ growth story is proving hard to sustain. The exhortation from Agbank’s Mr Pan was as much an attempt to shore up a 20 per cent slump in Chinese banks’ share prices this year as a triumphant cry of faith in a booming market. Sceptics are starting to ask: will it all end in tears?

The rapid development of Brazil and China in the past decade or so has depended on a dramatic expansion of their banking sectors, which has in turn depended on the rapid evolution of a once chaotic lending market.

Speed read

● Solid record Brazil’s stable economic management, new lower middle class and increases in wages have helped to create one of the strongest financial sectors in the emerging markets
● State still in charge Beijing remains Chinese banks’ majority owner, but listings have forced the lenders to become more transparent
● Difficult debt Credit rating agency Fitch has warned that more than half of new loans in China since 2008 have gone to the property sector or local governments, both of which may struggle to repay

Paulo José recalls how credit came to Brazil, paving the way for a functioning property market. The veteran property broker says the crucial change came in 1997, when a law was passed allowing lenders to reclaim property from defaulters. At the same time, policymakers began trying to reduce runaway inflation, creating scope in the long term for a gradual reduction in interest rates.

The country’s mortgage market was born.
In a little more than a decade, Brazilian mortgages have grown from virtually zero to 17 per cent of household debt, or about 4.5 per cent of gross domestic product, and have become a driver of the economy. “Before, when inflation was galloping along, it was very difficult for people to get financing.

It was absurd, crazy,” recalls Mr José, who operates in São Paulo’s elite Jardins district. “Today things have stabilised.”

This is just one illustration of how Brazil’s banking industry, and its economy, has changed in the past decade. The country’s record of stable economic management, solid growth, the creation of a new lower middle class and wage rises have helped to produce one of the strongest financial sectors in emerging markets. In the early 1990s, inflation was measured in thousands of percentage points. Today, it is in single digits.

Brazilian banks boast capital adequacy ratios among the world’s highest, with tier one that is on average equivalent to 17 per cent of their risk-weighted assets. Their profitability is the envy of western peers.

A similar story – with a little more government influence – has evolved in China. From virtual insolvency a decade ago to their emergence as the world’s biggest financial institutions, flush with double-digit profit growth and supremely healthy balance sheets, Chinese banks could be forgiven for having a swagger in their step.

Again, the foundations were laid in the late 1990s, when Beijing injected $100bn into the biggest state-owned banks and hived off their non-performing loans to asset management companies. This helped transform them from creaky relics of Soviet-style central planning to leaner businesses with a sharper commercial focus. In a drive for efficiency, they slashed branch numbers and laid off hundreds of thousands of employees. With gleaming new headquarters and enlarged cash machine networks, they began to resemble banks anywhere in the developed world.

The culmination of this metamorphosis was a wave of initial public offerings that began in 2005. The government remains the banks’ majority owner, but the listings forced them to become more transparent – and also to answer to private shareholders, a move intended to further propel the reform process.
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The theory has been proved right – up to a point. The growth of internet banking, credit cards and an array of investment products for savers reflects intensifying competition. But Chinese banks still derive about 70 per cent of earnings from cushy net interest margins that Beijing delivers on a silver platter by setting a floor on lending rates and a ceiling on deposit rates, allowing them to borrow cheaply and lend expensively. And a lending explosion in the past three years – with the state using banks as intermediaries to administer an enormous fiscal stimulus – acted as a reminder that the government, not the market, is their ultimate master.

Total loans in China are nearly 80 per cent higher than before the crisis, according to central bank data. Yet that growth has largely come under orders from Beijing to turn on credit taps. That, say bears, could lead to their undoing – and is a significant reason why jittery investors have come to see Chinese banks as frail giants.

Of the leading credit rating agencies, Fitch has sounded the alarm most loudly, warning that more than half of all new loans since 2008 have gone to the overheated property sector or to indebted local governments, both of which may struggle to meet repayments.

“There is a high likelihood we will see some asset quality deterioration in the next few years,” says Fitch’s Charlene Chu. “How severe this deterioration is and whether sovereign support will be required remain to be seen.”

An indication of waning investor confidence in the direction of reform came last month when Bank of America sold a 5 per cent stake in China Construction Bank, the country’s – and the world’s – second-largest lender by market value. Sources close to the deal said Bank of America – under pressure at home to shore up a troubled balance sheet – struggled to entice foreign institutions and ended up selling most of the position to Chinese state-owned entities. A few years ago western buyers would have been queuing up to secure such a prized asset.

Doom-laden predictions have been directed at Brazil, too, with the country’s rapid growth returning this year to more normal levels after a fiscally induced high in 2010 of 7.5 per cent amid a determined revival of inflation.

Hedge fund managers Paul Marshall and Amit Rajpal of Marshall Wace argue that Brazil’s credit market is heading for a US-style crisis. “We are currently at risk of transitioning from a boom to bust,” they wrote in July. They argue that debt repayments consume nearly 28 per cent of household disposable income, while the US consumer was spending 14 per cent on debt when the subprime crisis hit in 2008.

They also point to Brazil’s high interest rates – which average 47 per cent but are as much as up to 205 per cent on one type of credit card loan – increasing default rates and troubles in some smaller banks. Indeed, loan defaults hit a 17-month high in July, with loans in arrears for 90 days or more rising to 5.2 per cent of outstanding credit compared with 5.1 per cent in June. (In the US before the crisis, the proportion of defaulted loans exceeded 10 per cent.) The default rate for individuals climbed to 6.6 per cent of loans in July, up from 6.4 per cent in June while that for companies was unchanged at 3.8 per cent for the third month.

“Since a couple of years back, it’s been really easy to borrow money,” says Serlina, a maid at a wealthy home in the city of Salvador in Brazil’s booming north-east, whose brother and sister-in-law have ended up on credit agency blacklists as defaulters. For the poor, the problem arises when an unexpected expense, such as a medical emergency, forces them to delay a payment. “Most people spend all of their spare income on debt,” she says.

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But a host of commentators rejects “simplistic” comparisons between Brazil and the US, arguing that the rise in defaults in Brazil is part of the natural credit cycle as economic growth moderates and the central bank raises interest rates – by 175 basis points this year – to contain inflation. Defaults, they argue, remain well below the country’s highs in 2009 and in line with long-term trends.

“In Brazil, it is true that credit is expanding at high rates, but the basis and the dynamics of this growth is built on sound fundamentals,” domestic fund house Dynamo argued in a recent investor note. The firm is a long-term investor in Brazilian market leader Itaú Unibanco, also Latin America’s largest private-sector bank.

For one thing, the US bubble was built on overlooking risk that fed into asset prices – particularly property – with consumers able to borrow at inordinately low rates. In Brazil, the opposite occurs. High interest rates charged by banks mean risk is properly accounted for, limiting borrowers’ ability to amass debt. The economy also has a long way to go to reach even the credit penetration of Latin American neighbours such as Chile, where private sector credit is 70 per cent of GDP. In Brazil, the level is 47.3 per cent, up from 26 per cent in 2002.

That said, some question whether credit in Brazil can continue to grow so rapidly. Tony Volpon of Nomura argues that longer maturities and lower interest rates will be necessary to sustain more rapid credit growth.

Shares in Itaú, one of the worst stock market performers among Brazil’s banks, have slumped 33 per cent this year. They were dragged down by worse-than-expected bad debts in its small business unit that spooked investors. “We see Brazilian consumers who are already overextended, vulnerable to any unexpected shocks to credit availability and income growth,” says Mr Volpon. However he also says: “We expect no credit ‘bubble’ in Brazil.”

China is hoping for a similarly soft landing. Jim Antos at Mizuho Securities takes pride in being the “most negative analyst on Asian banks in the world”, with no “buy” recommendations on any Chinese lenders. Nevertheless, even he is dismissive of the idea that China is on the verge of a homegrown credit crisis. “They need to maintain social stability, and that is the underlying driver of so many things relating to the banking sector,” Mr Antos said. “They are going to have a very quiet bail-out of the weaker institutions.”

But whether the landings are soft or hard, any sustained slowdown or backfiring of credit booms in Brazil and China is bad news for western banks looking to emerging market growth to offset to struggling business prospects back home.

There is a new-found caution, says one European bank chief executive with long-standing ambitions in both markets. “The big momentum has gone. There is a sort of bubble and some issues now need to be addressed, particularly around non-performing loans.” Nonetheless, he concludes: “We still want to be there.”

Ambitions thwarted by red tape and competition

Markets such as Brazil and China may boast obvious attractions, yet so far international banks have notched few successes there.

In Brazil, only Spain’s Santander has a leading position, thanks to its opportunistic acquisition of the local business of ABN Amro just as the financial crisis set in. HSBC, by contrast is a second-tier player in Brazil. Like Santander’s Spanish rival BBVA – which despite a commanding presence across Latin America is absent from Brazil – the UK-run bank has been frustrated by an inability to grow by acquisition in a highly consolidated market.

Foreign incursions into China have been mired by a thicket of regulations and increasingly tough competition from local rivals. As a result outsiders’ market share was just 1.8 per cent last year.

On the ground, HSBC, Standard Chartered and Citigroup have the biggest branch networks. Among the investment banks, foreigners have fought for a slice of the domestic action through minority stakes in joint ventures (as dictated by law), though returns are limited. UBS, Goldman Sachs and Deutsche Bank are the leading foreign players, according to Dealogic.

Traffic is equally slow in the other direction. In both China and Brazil even the strongest banks have done little or nothing in the good times to diversify away from their home markets.

Itaú of Brazil has made some moves abroad but mostly into neighbouring Chile, Argentina, Paraguay and Uruguay.

China’s cash-rich banks are urgently hoarding capital in case non-performing loans do spike. Like their Brazilian counterparts they do not want to dilute fizzy growth at home with low-growth western acquisitions. Many still remember the experience of China Investment Corp, a sovereign wealth fund, which made big investments in Blackstone Group and Morgan Stanley – just before the financial crisis.

The roster of M&A is thin. When Industrial and Commercial Bank of China, the nation’s largest lender, last month bought the Argentinian arm of South Africa’s Standard Bank for $600m – hardly a blockbuster – it was the second-biggest foreign acquisition ever made by a Chinese bank.

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Copyright The Financial Times Limited 2011