In an informal talk in Shanghai last week, Douglas Red, principal financial adviser of Dutch banking group ING in China, said he was bullish on Chinese second-tier banks, but changes in the way they approach foreign investors will make them far more attractive.
Second tier banks constitute all the banks apart from the four big state-owned banks such as Bank of China, ICBC, Agricultural and Bank of China, said Red.
The second-tier banks are numerous and varied, however. Some, such as the city commercial banks, were set up from bankrupt rural credit cooperatives. China Merchants Banks and Minsheng bank are two leading second-tier banks, with Minsheng priding itself on being the closest thing China has to a private bank, he pointed out.
Many second-tier banks have been the object of investor attention. Private equity firm Newbridge Capital recently acquired a stake in Minsheng after failing to close a deal with Shenzhen Development Bank.
The International Finance Corporation (IFC), the financing arm of the World Bank, has invested in numerous second tier banks, such as Minsheng, Bank of Shanghai and Nanjing City Commercial banks.
But Red stressed that to attract top quality foreign investors, second-tier banks have to understand what it is foreign investors want to find out about.
He pointed out that despite many banks's desire to attract foreign investment, local banks often do not provide the right kind of 'image' or even basic information.
"Some times even the figures in the annual reports cannot be reconciled, while the English level is also some times inadequate," he said.
In addition, Chinese banks should learn to give potential investors a balanced picture of their operations.
"Quite often investors hear only the good news or the good aspects of a bank. However, investors are very aware of the problems in the banking system in China. They are not stupid. Therefore, Chinese banks should admit what is wrong with their bank, and then gain the investor's trust and admiration by explaining exactly what they plan to do about it," he added.
Trust in the management was a key factor foreign investors look at, said Red.
However, the upside is that since a lack of familiarity with foreign investors is wide-spread, and the standard fairly low, it would be easy for a far-sighted bank to accelerate past its competitors.
"In an inland province like Henan, a city commercial bank could easily become the best bank in the province by carrying out a few changes," he said.
However, there were also some more serious underlying problems Red added, especially in terms of how many banks are structured.
Too often, the bank branch is independent from the headquarters. That's because many branch managers answer directly to the president, who naturally does not have the time or the resources to ensure adequate supervision.
Many managers run their branches like 'little kingdoms,' and consequently have no accountability.
Lack of information within the bank between the branches was another problem.
That is especially because management information systems in different branches are incompatible with each other. It is rare to see a country-wide roll-out of an IT system.
Usually, it is the branches that make the decision on which IT system to use.
The lack of a comprehensive and effective IT system across the whole country means that information is often lacking.
"Often, the bank's annual report will have just one figure for the revenue or profitability of the period. But in order to improve the performance of the bank, it's also very important to get a breakdown of the profitability components - for example, how profitable corporate banking is compared to retail banking," said Red.
As a result of these organizational flaws it is difficult for the top leadership of the bank to carry out strategic planning.
"Strategic planning is a vital tool for steering the banks towards future targets. Based on the targets you can assess how well you are performing. If you are under-performing you can make the necessary changes," said Red.
Knowing the present value of future cash flows was also an important tool for local and domestic investors to value the bank, he added.
As regards the ownership question, and whether banks like Minsheng are intrinsically more likely to produce better results, Red said the most important thing was for the bank to operate according to commercial principles.
"As long as the board of directors has oversight, as long as the rule book is followed, as longs as loans are not made on the basis of relationships, but on commercial principles, it doesn't matter if the ownership is state or private," he said.
Red concluded that while there many problems in the sector, it was very encouraging that the Chinese government was so serious about reform.
Indeed, he even expected one or two of the weaker second-tier banks to be allowed to fail.
"Many of these banks believe their local government will always prop them up, however much money they lose. But I believe local governments will turn around one day and tell the local bank they cannot afford to bail them out," he said.
