In May 2015, Forbes ranked Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, and Bank of China first to fourth in its list of top banks globally by asset size, market capitalisation, revenue and profit. It is hard to imagine that less than 40 years ago, none of these institutions existed. In 1978, China had only the People's Bank of China; central bank, policy bank, commercial bank and regulator all in one.
By 1998, the broad structure we know today was in place. The ”big four” state-owned banks were in operation. A number of joint stock commercial banks had been set up. Policy banks were formed in the 1990s. The PBOC was left with the central bank and regulatory function. Yet the structure could not cover significant weakness.
The Chinese reform, marked by pragmatism and willingness to learn from others' experience, enabled its dramatic development over the past few decades. Western trained returnees and foreign institutions can play important role. SOE and financial sector are closely intertwined in China. This applied in 1998; it is still true today.
China had no definitive, official non-performing loan statistics in the late 1990s. Estimates ranged from 20% to 50% for the ”big four”, an extraordinarily high ratio caused by directed lending by government, weak legal enforcement, and lax credit controls. As part of Premier Zhu Rongji's effort to clean up the banks, RMB270 billion of new capital was injected into the ”big four” in 1998. Each set up a “bad bank” or financial asset management company (AMC), and in 1999, RMB1.3 trillion in NPLs were carved out to the four AMCs. The ”big four” also went through a significant slimming exercise, cutting 10% to 30% of outlets and making more than half a million staff redundant. Importantly, financial sector reform went in parallel with SOE reform. SOE and financial sector reform must go hand in hand in China. This applied in 1998; it is still true today.
The 1998-99 round of reform bought some breathing space, but quickly proved insufficient. Something more radical, possibly involving external forces, would be required.
Of the ”big four”, Bank of China was the most international. Its presence in Hong Kong was large, but had a rather unusual set up. It operated with 12 affiliates, each with its own brand and network, loosely coordinated by a "Hong Kong management office". The Hong Kong operation suffered similar problems as in the mainland, particularly asset quality issues due to state-directed lending. However, the problem was not as severe given it was regulated by the Hong Kong Monetary Authority and subject to open market competition. We at UBS, where I served as head of the corporate finance group, believed a restructuring and IPO of the Hong Kong operation could be viable, and would be a good test case for the Bank of China Group and other Chinese banks.
In the initial dialogue with BOC and BOCHK, we focused on asset quality. It would obviously be better if the bank could be cleaned up and NPLs stripped out before the listing. However, the costs would have to be borne by the original shareholders, BOC and ultimately the Ministry of Finance. There would be trade off between cost and IPO valuation, but not a simple linear relationship, as IPO investors also had to be convinced the asset quality issue would not repeat itself. We spent hours discussing these topics with the BOC and BOCHK teams, drawing on experience from other countries. We shared UBS’s then-recent merger with SBC Walburg as a case study, as BOCHK faced a daunting task in integrating its 12 affiliates.
In early 2001, a beauty parade in Beijing was used to select investment banks to lead BOCHK's restructuring and IPO. In the usual Chinese way, the meeting was short and formal, without many questions. But due to the long interaction we already had with BOC and BOCHK, we knew we addressed the key issues. UBS was appointed alongside Goldman Sachs and BOCI, the investment banking arm of BOC, shortly thereafter. It was a big breakthrough for our China business, and a colleague shed tears of joy.
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Hank Paulson, then CEO of Goldman Sachs, addressed what was to follow in his memoir Dealing with China. The role was, he said, a combination of “policy adviser, management consultant and investment banker". I would add to that list IT consultant, HR advisor and much more.
By the time the merger came into effect in October 2001, the branch structure had been rationalised, back office operations centralised, and workflow and methods unified. To maintain discipline in lending, a new risk management system was introduced independent from business origination. Corporate governance and organisational structure were put in place in line with international standards.
The original target was an IPO at the end of 2001. That did not happen due to several unexpected events. Auditor Arthur Andersen was caught up in the Enron scandal in the US, though PricewaterhouseCoopers formally took over the audit when it absorbed Arthur Andersen’s Greater China business, and signed off the accounts with little delay.
Another major challenge also had a US angle but originated from the top of the BOC hierarchy.
During 2001, we became aware BOC was in talks with the Office of the Comptroller of the Currency, the US bank regulator, about past misdeeds at BOC’s New York branch. The misdeed was related to a questionable loan with which former chairman Wang Xuebing, who left in early 2000, was personally involved. In January 2002, BOC was fined by the OCC, and Wang was arrested. Commentators questioned whether BOCHK could list in such circumstances. Could effective controls and governance structures be put in place to prevent fraud and theft, given many irregularities besides this case? A number of ex-BOC managers, for instance, stole a staggering US$480 million from a Guangdong branch between 1992 and 2000. It was no surprise that, referring to the forthcoming BOCHK IPO, a January 2002 Bloomberg article concluded that “prospective investors in China's banks should heed the warning”.
Under pressure
By Spring, we all felt pressure to complete the IPO. Two major issues remained. First, what level of non-performing loans would the market accept? Having set up a specialised assets management department to focus on non-performing asset management and collection, existing NPLs would decline. With the overall restructuring, we were confident new loans would not suffer the same problems. Nonetheless, the starting NPL level would have a large psychological impact on potential investors and drag on earnings in the initial years. After much discussion, we targeted 8% NPL at the end of 2002. To reach that, BOC agreed to acquire roughly US$1 billion of NPL from BOCHK. Some institutional investors were put off by the high NPL level and lacked faith in the new system. They were proven wrong: by the end of 2005, the impaired loan ratio was 1.28%, and stayed below 1% for the next decade. This template of NPL carve out combined with a new risk management system, enhanced corporate governance and focused impaired asset management would be repeated on a much larger scale in mainland China.
The second issue was the listing venue. Previous major Chinese SOE IPOs had been dual listings in Hong Kong and New York. The argument was that the US listing regime was more rigorous and would attract better quality companies, resulting in stronger investor support. I always felt the marginal benefit of a US listing was not meaningful compared to the legal and accounting costs. Enron demonstrated there could also be fraud in the US.
Furthermore, in 2000, we led the Hong Kong-only IPO of MTR, the government owned Hong Kong railway operator. It was highly successful as local investors were familiar with the company. We were confident that with BOCHK’s equally high brand recognition, the success could be repeated. However, Goldman adopted an evangelical fervour in defending the need for a US listing. BOC chairman Liu Mingkang was sympathetic to our argument, but did not want to risk the success of the offering. After many rounds of discussion and memos, he went with Hong Kong only. BOCHK set a precedent and from then on, almost no Chinese SOE went for US listing.
During the marketing exercise, we naturally encountered doubts. A competitor issued a sceptical research report: the cover was a photo of a giraffe chewing leaves from a branch high above the ground, with the caption “high hanging vegetation” (as opposed to low hanging fruit). Nonetheless, the offering in July 2002 was a resounding success. Demand for shares was roughly five times the offering size. It was an important reference point for Liu, as it would give him and other Chinese leaders the confidence to pursue IPOs for other major Chinese banks.
Rocky start
BOCHK started life as a listed company in a rocky way. In 2003, CEO Liu Jinbao was detained in China for questionable loans. I had come to know him well through the IPO: he was flamboyant, high profile and not attentive to details. In roadshow meetings with investors, I translated for him and he would often deviate from the script. I took the liberty to put forward the correct version in English, and was caught out in New York by a fund manager who understood Chinese. His detention appeared to confirm the worst fear of skeptics. However, the disruption was temporary and BOCHK started to deliver strong results. By 2005, its return on equity would reach 18% compared to 12% in 2002, resulting in significant uplift in its share price.
Even today, after years of work to root out corruption, corporate leaders are continuing to fall from grace. Yet as BOCHK did back then, SOEs continue to shrug off the incidents.
Throughout the project, we worked closely with the Beijing-headquartered team of BOC who in turn reported to key officials. We met Premier Zhu Rongji to report directly the progress. Our team was led by Leon Brittan, who had joined UBS as a vice-chairman after stepping down as vice-president of the European Commission. He had led the EU negotiation with China on its accession to the World Trade Organisation, so discussion naturally centred on BOCHK and WTO. Zhu was sharp and articulate. It was clear that in his mind, these were major initiatives of the reform programme. On the one hand, a successful BOCHK IPO would pave the way for restructuring and IPO of Chinese banks. On the other, WTO accession was significant not just in opening up overseas markets for Chinese export, but also as a catalyst for reform of its state-owned industrial and financial sectors with the removal of protection over time.
The commitments China has now made to global climate change and RMB internationalisation could act as similar catalysts going forward.
David Chin joined SG Warburg in London in 1994 and moved to Hong Kong in 1996. After various mergers he remained with UBS, holding several senior roles and working on a string of high-profile deals before retiring as head of Asia investment banking in 2015.
