The acquisition of strategic stakes in China’s national, regional and city commercial banks remains a topic of keen interest to foreign investors. This is so even though, at the time of the author’s writing, foreign investment approvals for these types of investments seems to have been temporarily placed on hold following China’s restructuring of its central ministries and administrative bureaux in April this year. This restructuring included the formation of the China Banking Regulatory Commission (CBRC) to take over the regulation of banks and other financial institutions from China’s central bank, the People’s Bank of China (PBOC), which will remain in charge of monetary policy. The exact delineation of authority between the CBRC and PBOC may not be clarified until proposed revisions to the People’s Bank of China Law and the Commercial Banking Law of the PRC are passed by the National People’s Congress later this year. In the meantime, as one of its first regulatory acts, the CBRC has drafted a long-awaited regulation which should, for the first time, provide a clear regulatory basis for foreign investment in China’s banks (Bank Investment Rules). The draft Bank Investment Rules are currently before the State Council (the equivalent of China’s cabinet) and are expected to be issued in the near future.
This article deals with current regulatory issues associated with acquiring strategic stakes in China’s national and regional joint stock banks and city commercial banks (Mid-Cap Banks). This category excludes China’s four major State-owned commercial banks and the national "policy banks" on the one hand, and the smaller urban and rural credit cooperatives on the other (see Table 1). The use of the term "strategic stakes" in this article refers to equity interests of less than 25% in China’s Mid-Cap Banks. Table 2 sets out the status of reported strategic investments in Mid-Cap Banks to date.
The banking sector in China is, at least for the time being, a heavily protected industry. Foreign participation in this sector is permitted in a number of limited forms, although each such form carries significant restrictions both in terms of geographic operation and scope of business activities. Table 3 summarizes the different forms of foreign investment vehicles and their permitted scope of operations.
Under China’s WTO commitments, the restrictions on foreign participation in the banking sector are scheduled to be relaxed in incremental stages culminating in almost full access by 11 December 2006. However, even after 2006, the road to building an effective foreign bank presence in China will continue to be very difficult. Rules designed to "manage" the influx of foreign investors after 2006 look likely to delay the creation of a truly level playing field in the banking sector for many years (see Table 4). Thus, until 2006 and very likely beyond, there are a number of compelling reasons for foreign investors to consider acquiring strategic stakes in China’s Mid-Cap Banks:
- Acquisition of Domestic Branch Networks. The development of foreign branch networks from scratch is costly and also subject to significant regulatory hurdles. A strategic investment would allow a foreign investor to position itself for a future acquisition of a controlling interest in a Mid-Cap Bank, thus enabling it to indirectly acquire an existing branch network.
- Access to Restricted Business Activities. Unlike the restrictions placed on foreign investment vehicles, Mid-Cap Banks are not subject to the same constraints on business activities. A strategic acquisition prior to 2006 would allow a foreign investor to indirectly engage in banking businesses that are currently open only to domestic banks. Such indirect participation would also allow the foreign investor to monitor the development of these markets.
- Strategic Investment Opportunity. In contrast with China’s four major State-owned banks, the Mid-Cap Banks are generally perceived to have lower non-performing loan ratios and healthier balance sheets. While this is not true for all Mid-Cap Banks, many foreign investors believe that the introduction of advanced management and corporate governance practices to the more promising Mid-Cap Banks will significantly enhance their return on investment.
- Strategic Alliances: Developing relationships with Mid-Cap Banks could lead to "reverse business flows" where domestic clients of Mid-Cap Banks utilize the services of the foreign investor for investments outside China. There may also be follow-on co-investment opportunities in China with the major shareholders of Mid-Cap Banks.
The Mid-Cap Banks
The Mid-Cap Banks can generally be classified according to their geographic scope of operations. National banks, such as Minsheng Bank and the Bank of Communications, conduct business on a nationwide basis. The regional banks, such as China Merchants Bank and Shenzhen Development Bank, originally operated within provincial boundaries but have since expanded well beyond these areas. The city commercial banks, such as Bank of Shanghai and Nanjing City Commercial Bank, are generally permitted to operate only within the metropolitan boundaries of their native cities.
Size and geographic limitations present the greatest threats to the future growth of the Mid-Cap Banks. The city commercial banks (also known as "bonsai banks") are most at risk, as their inability to service clients beyond their native cities is proving to be a major handicap. Their attempts at strategic alliances with other Mid-Cap Banks have not been successful as their larger peers have not been eager to encourage expansion of the city banks.
Lending activities by Mid-Cap Banks are almost exclusively directed at corporate clients, despite efforts to shift their focus to the lucrative consumer credit market. The relatively small size of the Mid-Cap Banks poses a major obstacle to forays into the consumer market, so many Mid-Cap Banks are actively seeking ways to expand their capital base. A number of Mid-Cap Banks, such as Minsheng Bank, China Merchants Bank and Shanghai Pudong Development Bank have completed domestic A-share listings. Many other Mid-Cap Banks have announced their intentions to seek a public offering at some point in the future.
Structuring the Acquisition
The majority of Mid-Cap Banks are incorporated as joint stock limited companies under the PRC Company Law. Some of these banks, such as Minsheng Bank, have relatively diverse shareholdings, including both State and non-State ownership. Most, however, have fairly concentrated and predominantly State shareholdings.
Foreign strategic investments in Mid-Cap Banks to date have taken the form of direct purchases of new shares, or secondary purchases of shares from existing shareholders. Quasi-equity investments in the form of convertible debt have begun to appear in other sectors but further complicate the approval process. Preferred equity is not yet provided for under China’s company laws.
The aggregate size of any foreign strategic investment in the Mid-Cap Banks will be limited to less than 25% of the registered capital of the bank. The PBOC has traditionally held the view that any investment at or above 25% must take the form of a Sino-foreign joint venture bank. This type of investment is not viable for either the investor or target bank as it would effectively require the conversion of the Mid-Cap Bank into a different entity with significant operational restrictions. Therefore, all strategic investments in Mid-Cap Banks have been kept well below the 25% threshold. It also seems that the PBOC has placed a 15% limit on any single individual foreign investment in a Mid-Cap Bank.
Key Regulatory Approvals
China Banking Regulatory Commission
Given the recent number of highly publicized strategic acquisitions, readers may be surprised to know that foreign investment in PRC banks is actually prohibited under an official notice issued by the PBOC in 1994. The 1994 notice remains in effect today and there is, in fact, no formal regulatory basis for investments in Mid-Cap Banks. However, despite this prohibition, the PBOC has, in the past, selectively approved strategic acquisitions on a case-by-case basis.
The Bank Investment Rules that are currently before the State Council are widely expected to lift the blanket prohibition on foreign investment in Mid-Cap Banks and provide qualitative foreign investment criteria. While little is known about the proposed Bank Investment Rules, they should establish the CBRC as the approval authority with broad discretionary powers for all foreign investment applications. In the past, because such authority had not been delegated to the PBOC, each transaction had to be approved directly by the State Council, a lengthy and highly political process. The devolution of authority to the CBRC should lead to a more rule-based and predictable approval procedure.
Ministry of Finance
The purchase of shares in a Mid-Cap Bank from the State or from a State-owned enterprise will trigger mandatory State asset valuation requirements. Under rules designed to prevent the disposal of State assets at less than fair value, the acquisition of shares held by the State or a State-owned enterprise must be appraised by a valuer authorized to conduct State-owned asset appraisals in China. The results of the appraisal must then be verified and filed with the Ministry of Finance (MOF) (or its provincial counterpart), and the transaction executed at or near the appraised value of the shares.
If the shares are held by the State or a State-owned enterprise in a listed Mid-Cap Bank, then the transaction itself, not merely the results of the appraisal, must be approved on its merits by the MOF.
China Securities Regulatory Commission
The purchase of shares in listed Mid-Cap Banks requires special consideration. Foreign investors are currently prohibited from acquiring shares on China’s A-share markets unless the foreign investor has obtained Qualified Foreign Institutional Investor (QFII) status from the China Securities Regulatory Commission (CSRC). However, QFII status is only available to those foreign institutions engaged in fund and asset management activities, not for those seeking to make private equity purchases. Therefore, acquisitions of listed Mid-Cap Banks generally need to take the form of privately negotiated purchases from existing shareholders that hold non-listed "State-owned" or "legal person" shares.
Until recently, foreign investors were expressly prohibited from purchasing non-listed State-owned or legal person shares in a listed Mid-Cap Bank. The ban was effectively lifted pursuant to a notice issued by the CSRC, the MOF and the former State Economic and Trade Commission on November 4, 2002 (the 2002 Notice). The 2002 Notice is of major significance as it now provides a legal basis for the acquisition of these types of shares in A-share listed companies.
The 2002 Notice requires that the parties register any change in ownership of a listed company with the appropriate securities registration and clearing institution. In Shanghai, this institution is the local branch of the China Securities Depository and Clearing Corporation (or "Shanghai CSDCC"). Under guidelines issued by the Shanghai CSDCC, approval by the Marketing Department of the CSRC is required before the Shanghai CSDCC will register the share purchase.
State Administration of Foreign Exchange
As investments in Mid-Cap Banks have, to date, been made under ad hoc administrative exceptions by the PBOC, foreign investors have faced considerable uncertainty as to whether other government departments and administrative bureaux would recognize their investments. The State Administration of Foreign Exchange (SAFE) is one such department. In order to ensure that dividends and proceeds from the disposal of strategic investments can be remitted offshore in foreign currency, some foreign investors have sought specific approval of their investments by SAFE, even though such approval is not legally required. Concerns regarding this issue should be resolved with the promulgation of the Bank Investment Rules.
Important Structuring Considerations
Making a strategic acquisition in a Mid-Cap Bank requires special consideration of the unique industry risks facing China’s banking sector. Competition among the Mid-Cap Banks and with the national State-owned banks is fierce, and with the eventual market liberalization post 2006, many Mid-Cap Banks are not expected to survive. Consolidation in the industry leading up to 2006 is inevitable, and the CBRC will face immense pressure to relax the geographic and other restrictions currently imposed on the regional and city commercial banks.
Senior management of the Mid-Cap Banks will thus face important strategic business decisions over the coming years. It is therefore crucial that a foreign investor negotiate up-front effective means of participating in the decision-making processes of the Mid-Cap Banks. This may require negotiating with the bank’s major shareholders for minority shareholder protection rights such as board representation, management positions, veto rights, access to information, etc. Such negotiations will be difficult, especially for investments in Mid-Cap Banks that are preparing for listing. In those cases, it is no secret that the CSRC looks unfavourably upon negotiated shareholders agreements. The CSRC also resists any changes to articles of association that enhance the limited minority protection rights available under the PRC Company Law. In some deals, Chinese shareholders have played the CSRC’s stance on these issues to their advantage. It is therefore critical for the foreign investor to negotiate minority protection rights with the Chinese shareholders as early as possible, and enlist shareholder support to persuade the CSRC to accept proposed changes to the bank’s articles of association.
Foreign investors must also pay special attention to rules governing the disposal of their shares. There is not, at present, a liquid market for the disposal of a foreign investor’s interest in Mid-Cap Banks. Any disposal of shares to another foreign investor will likely entail virtually the same arduous regulatory process associated with making a new foreign investment. In the case of investments in listed Mid-Cap Banks, foreign investors cannot (at least for the time being) list their shares for sale on the A-share market during any subsequent public offering by the bank. While it is possible to seek a listing of shares on China’s B-share market, this is not an attractive option given the anemic state of the B-share markets. Furthermore, under the 2002 Notice, a mandatory twelve month lock-up period will apply after the foreign investor has acquired State-owned or legal person shares from an existing shareholder in a listed company.
Finally, valuation and pricing will pose major challenges for the strategic investor. Significant time and effort must be expended to assess the health of the Mid-Cap Bank’s loan portfolio, as lending practices have often suffered from undue influence by local governments and powerful shareholders. Pricing will also be difficult. In the case of listed Mid-Cap Banks, their listed A shares trade at valuations far greater than what strategic investors have been prepared to pay for their purchase of non-listed illiquid State-owned or legal person shares. Significant discounts negotiated by foreign investors in the past have been politically sensitive. In the case of Newbridge’s attempted acquisition of the listed Shenzhen Development Bank, it has been widely reported that pricing and valuation differences engendered sharp disagreements among shareholders on the viability of the investment. It is perhaps instructive that during IFC’s negotiation of its investment in Minsheng Bank, IFC was careful to emphasize its ability to bring more to the table other than new capital alone. IFC had for many years provided significant technical assistance to Minsheng Bank. Its offer of continued assistance, while not the only factor, greatly enhanced its efforts to persuade Minsheng’s shareholders to accept IFC’s pricing and its strategic role in the bank.
Table 1. China’s Banks
National State-owned Commercial Banks
Bank of China
China Construction Bank
Agricultural Bank of China
State-owned Policy Banks
China Development Bank
Agricultural Development Bank of China
Export-Import Bank of China
National Joint Stock Banks
Bank of Communications
China Everbright Bank
CITIC Industrial Bank
China Minsheng Bank*
Regional Joint Stock Banks
China Merchants Bank *
Industrial Bank (formerly Fujian Industrial Bank)
Guangdong Development Bank
Shanghai Pudong Development Bank*
Shenzhen Development Bank *
City Commercial Banks
Urban and Rural Credit Cooperatives
Roughly 300,000 nationwide
* Shares listed on China’s A-share markets.
TABLE 2. Reported Strategic Investments in PRC Banks to Date
China Everbright Bank
Asian Development Bank (3.03%)
China Everbright Holding (HK) (20.07%)
Bank of Shanghai
International Finance Corporation (7%)
Shanghai Commercial Bank (HK) (3%)
Nanjing City Commercial Bank
International Finance Corporation (15%)
International Finance Corporation (1.22%)
Xian City Commercial Bank
International Finance Corporation (12.5%)
Shenzhen Development Bank
Newbridge Capital (18%)
Not closed, pending dispute resolution
Shanghai Pudong Development Bank
Citigroup Inc. (5%, with options for up to 24.9%)
Announcement of intention to purchase
TABLE 3. Foreign Investment Vehicles in China’s Banking Sector
Form of Investment
Scope of Business
Restrictions on Activities
Foreign-Funded Financial Institutions
In the form of:
Deposits, loans, letters of credit, guarantees, foreign exchange settlement, interbank lending, bank cards, safe deposit boxes, credit investigations, sale and purchase of government bonds, bank business consulting
Foreign Currency Business:
(1) No geographic restrictions
(2) No client restrictions
Local Currency Business:
(1) Geographic restrictions - currently limited to Shanghai, Shenzhen, Tianjin, Dalian, Guangzhou, Zhuhai, Qingdao, Nanjing and Wuhan, with other geographic restrictions to be lifted in phases until full liberalisation by 2006;
(2) Client restrictions - currently limited to foreign individuals and foreign companies. Restrictions on Chinese companies to be lifted by 11 December 2003. All restrictions lifted by 2006
Fund Management Joint Venture Company
Establish and manage public investment funds
Limited to investment in PRC listed shares and government bonds. Mandatory 80:20 portfolio split between listed shares and government bonds
Maximum foreign ownership of fund management company capped at 33%, increases to 49% by 11 December 2004
Securities Joint Venture Company
Underwriting share and bond issues, brokering shares and bonds
Prohibited from brokering A shares
Prohibited from providing securities investment consulting or investment management services
Maximum foreign ownership of securities company capped at 33%
Qualified Foreign Institutional Investor
Portfolio investments by approved foreign financial institutions in A-shares, B-shares, government bonds
10% cap on QFII investment in any one listed company
20% cap on aggregate investments by all QFIIs in any one listed company
Quota restrictions on aggregate amount QFII permitted to invest in China (US$50-800 million)
Must entrust domestic banks (or branch of a foreign bank) as custodians of trust assets; entrust domestic securities companies to handle securities transactions
One to three year lock-up period for funds
Outward remittances cannot exceed 20% of the total principal and must be made at one (for closed-end funds) to three month intervals
TABLE 4. Stiff Regulatory Barriers to Entry Post 2006
- Excessively high working capital requirements: RMB100 million per branch which is several times higher than international standards. Effectively requires branches to be capitalized as subsidiaries.
- Unfavourable application of capital adequacy requirements: 8% capital adequacy ratio for RMB loans which conforms with international practice. However, the sum of this capital must be calculated separately at the branch level, significantly limiting local currency financing capabilities of foreign banks.
- Foreign currency lending subject to restrictive foreign exchange approvals: While there are no client restrictions on foreign currency activities in China, in order to borrower foreign currency funds, Chinese customers themselves must obtain pre-approval from authorities in charge of foreign debt management, namely the State Administration of Foreign Exchange (SAFE). SAFE approval is discretionary and procedures for obtaining approval are opaque.
- Interest rates on foreign currency deposits restricted: Foreign banks will have no discretion to set interest rates on foreign currency deposits less than US$3 million. As Chinese banks hold the vast majority of foreign currency deposits in individual accounts, foreign banks cannot offer higher interest rates to attract new customers.
Simon Cheong is a senior associate with the international law firm Freshfields Bruckhaus Deringer based in Beijing. Mr. Cheong was formerly seconded to the World Bank Group's International Finance Corporation where he advised on strategic investments in China's banking and insurance sectors. Mr. Cheong is qualified to practice law in New York, England, Hong Kong and Australia. The author also acknowledges the invaluable contribution of Mr. Leland Fong in gathering relevant laws and research materials in preparation for this article.