DBS: Randy for China expansion?

Hong Kong is in a funk, but could the Closer Economic Partnership Agreement (CEPA) provide a boost to the right bank? Randy Sullivan, CEO of DBS (HK) discusses.

What's your take on the banking environment for the rest of this year in Hong Kong?

Sullivan: Ever since 2002, we've seen very high levels of credit card defaults and bankruptcies, but these high levels could see some improvement. There are two types of bankruptcies. One is households that have suffered financial problems recently. The other group is the one which has had financial difficulties for a long time and exploited the recent relaxation of the bankruptcy rules. This states that their record will be washed clean after four years instead of seven previously. But the growth in the numbers of the second group is receding.

The other important factor is the property market. There have been some signs since June and July that the market is picking up. But the Hong Kong market can be very volatile, both on the downside and on the upside, and once the process gets started it quickly gains momentum. In addition, the affordability of the property market has never been greater. According to one property affordability index, the cost to service an average mortgage has fallen from 130% of an average household's income to just 30%. That's a massive shift and sooner later that will feed through into better sales.

In fact, it's amazing that throughout this whole period, the banking industry has remained so healthy. Banks are still profitable, and return on equity is medium to high single digits. We are around 9-10%.

How about the Closer Economic Partnership Agreement? What impact will that have?

Of course, it's a positive, which will improve market access for local banks. But the crucial issue is investment. The bottom line of banks whose sole market is Hong Kong will suffer, especially if they're investing in China at the same time. They may be forced to take a very incremental approach to investment in China, which rather nullifies the benefit of CEPA as an accelerated version of WTO. Having the required capital, risk management systems and IT - these all take a certain minimum level of resources. That makes the acquisition of Chekiang First by Wing Hang bank the sensible thing. It (CEPA) doesn't make any difference to us, since we're over $20 billion in total assets thanks to our acquisitions. What does make a difference to us is waiving the requirement to have a rep office for two years before upgrading to a branch, and calculating the profitability of the bank as a whole, rather than just of the branch, which wants to move into RMB business.

How will it influence the speed at which you can open more branches? After all, you can only open one branch a year, with or without CEPA.

It means we can open a new branch and offer RMB services in two years, compared to five years for a non-CEPA bank. But yes, CEPA doesn't remove the geographic restrictions regarding the number of cities, which open per year for RMB business to foreign and CEPA banks.

One has to distinguish between the part of the WTO schedule which permits an opening up of the full range of RMB and forex services to Chinese companies and individuals by foreign banks and a separate, geographic schedule which determines in which cities foreign banks can operate.

Yes, CEPA helps with the former, but not with the latter. And there will be other restrictions holding back foreign banks, such as the extent to which foreign banks can use the interbank market to fund themselves. Foreign banks can currently only borrow 150% of their total asset value, and a law is being discussed that a maximum of 40% of their loan requirement can come from the interbank market, with the rest to come from deposits. That's hard to achieve if you can't take deposits.

Do bankers tend to obsess unnecessarily over the number of branches they can open, given the importance of technology?

For sure, it's pointless to compete head-on with the local banks. What's more important is quality: opening the right branches in the right places. And foreign banks are helped by their ability to link up via technology.

Will CEPA benefits increase the attractiveness of Hong Kong banks as take over targets?

It should do so, but if you look at many big players who are interested in moving into China, their strategy is based around wholesale -institutional banking, for which you don't need an enormous amount of branches.

What's striking is that you paid 3.3x book for a Hong Kong bank back in 1998, but Wing Hang Bank only paid 1.22x book for Chekiang First. Does that imply the market isn't recognizing a China premium in Hong Kong banks? What does this say about the value of banks in Hong Kong at the moment?

Every transaction has its own dynamics. One shouldn't extrapolate from just one deal. Anyway, there's been a downward adjustment in the price because the economic environment is far worse now than it was then. The second factor is the size and scale of the bank. With a small bank, you get a much lower price to book value. Chekiang First is quite a small bank. Thirdly, the realization is sinking in that small banks don't have much place to go. Their scale is too small to generate the revenue you need to invest in products for which you get fees. In a mature banking system, simply making money off your interest spread is not enough. You have to invest in treasury products and IT systems to increase your margins.

What is your China strategy? What is your advantage?

We will be following our existing customers into China - middle market and SMEs. We have around 40,000 customers in that segment, almost all of them active in China. Our advantage lies in our IT platform, our treasury products, our management capabilities and our credit rating. We don't totally rule out an acquisition, but it's not our top priority. Our Beijing and Shanghai branches will focus on institutional banking, but in the Pearl River delta we will be looking at commercial or retail banking. That's the core of our bank in Hong Kong.

Are you apprehensive about the level of investment that expansion into China will require? And do intend to acquire any more Hong Kong banks?

Not really. We have the size and the scale. It's a tradeoff between the reasonable returns we expect over the medium term and the cost of setting up in China. As for acquiring more banks, we have already bought quite a few. That should suffice.

Will your appetite for M&A in Hong Kong be repeated in China?

We are very excited about the Chinese banks, but we have already been there for some time. Dao Heng had branches there as far back as the 1930s. I think we will be very measured and calibrated in further entering this market. It will be very much on a risk-adjusted basis.

It doesn't look as if you will be competing against Citibank and HSBC.

Depending on their strategy, they could be competition from time to time in selective markets, rather than full on. They have their MNC customers and we have our smaller, family-run SMEs or entrepreneurial businesses.

Who do you see yourself stacking up against in China? The state banks, the city commercial banks, or the shareholding banks?

Competition will come from a lot of different areas. We will need to produce a range of top class services, some of which at any given time will compete with all of the above.

You recently went through a re-branding exercise and folded the names of all your Hong Kong acquisitions into the brand DBS (HK). What's changed?

We have a fresh new look! Now we can start to reposition ourselves using our higher profile, our larger size, our strong credit rating and our ability to create and distribute more sophisticated products to move into priority banking and wealth management.

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