The coming bank consolidation

Top-rated Merrill Lynch bank analyst Keith Irving talks about the dramatic changes in Asian FIG scene.

FinanceAsia: Will the consolidation in Hong Kong be between the Hong Kong banks themselves or will it be from Singaporean/Australian banks?

Keith Irving: The first thing to say is that we are not bulls on the mega-consolidation wave in Hong Kong. We've had that opinion for some time. In the first instance, the franchises that remain available to potential foreign buyers are probably less attractive than the ones that have already gone. Basically the remaining large players, Hang Seng and Bank of East Asia seem unlikely to be available to a foreign majority owner. And with the smaller banks, you still have significant levels of entrenched family ownership. The fact that we see profitability decline in Hong Kong is not necessarily that relevant to family-owned banks which are not necessarily being run for profit reasons but more as prestige vehicles. So we're not bulls. When we do see activity, we reckon it will be less in-market consolidation than foreign entrants buying stakes. Even there we see limited opportunities.

Take HKCB, for example. Most people believe that will be bought at some point, probably by a mainland bank. The Mainland banks are probably still buyers.

Of all the smaller banks we cover, the one that looks most likely for a foreign approach is Wing Hang. The only reason I state that is that the family shareholding is not the largest single block. The largest single holding is BoNY with 25%. BoNY is not really a retail bank anymore so Wing Hang is no longer a core holding.

Some CEOs say that the families do see the writing on the wall. The longer it is left, the less they are worth.

There are two arguments against that. First is, most banks in Hong Kong continue to go gung-ho into the mortgage market. So the realization of the declining returns in the mortgage market is perhaps not as real as some would have you believe. There is still a belief that the return on the mortgage is low, that it opens the door to cross-selling other products down the road. That's an argument that a Hang Seng or HSBC can sustain. It's much harder for a smaller bank to sustain it.

I wouldn't get too excited by the idea that there is a growing willingness to sell banks. The issue is not necessarily so much retaining a shareholding interest, but also retaining management control. That's something a foreign buyer wouldn't want to allow.

Are Australian banks interested in Asia?

They're intellectually interested in Asia. They do not seem to be interested in a physical presence in Asia. We've seen ANZ downsize its Asian operations. Post the Commonwealth-Colonial merger, it is generally believed that the Commonwealth Bank is looking to sell the bulk of its Asian insurance operations.

But they are still involved in the corporate and wholesale business. Also, there is an interest in China. I believe the Commonwealth Bank is keen to keep hold of its China license in insurance.

The Australians have spent the last decade becoming more domestic animals and that has served them well. ROEs are in the 20% region, share price performance since 1994 has been good, and -- uniquely among the world's developed markets -- there still seems to be under-penetration of credit. The loans-to-GDP ratio is only 90% whereas in the UK and US it is typically 140%. That probably represents the deleveraging after the corporate crisis in the early 90s, but it does suggest there is room for loan growth to outstrip economic growth. Low growth of 7-10% is still quite achievable. And in addition, the banks have been moving into non-interest income streams.

The banks are now controlling about 70% of the wealth management inflows. That's a higher quality earnings stream, and should lead to a re-rating of the banks. The big four control about 80% of the banking market.

Is bancassurance going to be a successful model in Asia?

We do believe that long term, the prospects for non-interest income in Asia are extremely good. Asia is moving in the same direction as Australia, for example. You have a young, but ageing population. They're reaching the peak of their earnings power, and the financial crisis heightened the need to plan for the future. You can no longer rely on your children or the government to take care of you. Right now, most are adapting to a new economic reality: low inflation, low wage rises, stagnant house prices, lower job security. So right now they are not committing a big portion of their wealth towards asset management and insurance. That's a trend we see changing 5 years from now.

In some markets in Asia we're beginning to see that the bancassurance model is beginning to supplant the more traditional, tied agency model. The change is being driven by the accreditation of insurance sales forces and the low pass rates at the agency level, and partly because people trust their banks. A bank is also in a relatively unique position to sell something to its customer. You are talking about a retailing business. How many other retailers know how much their customers earn, whether they own their own house -- a whole myriad of information that most retailers would kill to get hold of. If this information is used properly, then the cross-selling opportunities are enormous. The problem is that most banks in Asia haven't invested sufficient amounts in customer relationship management and data mining. Again, that's where the Australian banks have spent a considerable amount of time and money.

The third point is that there do remain restrictions in some countries against bancassurance. For example, in Korea, a staff member is not allowed to sell insurance. Insurance can be sold in a bank branch, but it has to be done by an employee of an insurance company. That is expected to change. Taiwan has introduced a holding company act, but there are still barriers that exist to cross-selling. We do expect those to break down.

Are there legal issues in Asia about CRM and bank secrecy?

It comes down to whether you have the customer's permission. In most cases now, the banks are quite careful when they are opening accounts to allow information available across the group.

What about this whole issue of families owning banks in Asia?

Interesting question. Are families getting out of banking? It varies from market to market. And also the impact of globalization is different for different sized institutions. In general, I would say yes. The larger banks in Asia are likely to become more 'corporatized' in the coming years. But I still think there will a second tier where family ownership remains the dominant force.

Take Hong Kong. You are talking about institutions that were built from the ground up in the 1940s and have significant sentimental and emotional attachment. And when you look around Asia at the banking families, the bank itself is in some cases a very small proportion of their overall assets. Therefore, declining profitability of that institution is relatively irrelevant and their focus on deriving may not be that high.

Will Thai families be diluted?

Essentially, the families that were in control before the crisis are still in control. They have had to accept a degree of dilution but structures have been created that have allowed them to retain a greater degree of ownership than if we had had the same situation in the US. Or even in Latin American markets.

In theory, if Asia returns to its growth track, there will be a constant capital need. So yes, we'll continue to see dilution. But family ownership will continue to be important.

Thailand is the place where you've seen the most significant increase in foreign competition, with the arrival of ABN AMRO, UOB, DBS, Standard Chartered. Those foreign-controlled banks are now taking significant market share. ABN AMRO Bank of Asia has moved from being a small niche player before the crisis, paying a premium for deposits, to becoming the price setter in the market and effectively setting the deposit rate and growing its deposits at 1% per annum. So we do see a shift in the balance of power.

Do Japanese banks have any interest in Asia?

They might have some interest. They just don't have any money.

On the Taiwanese banking sector, some people compare it with Japan, and say if it not cleaned up there could be a similar lost decade.

There is a disturbing parallel between Japan and Taiwan. We don't believe that the problems in Taiwan are systemic in nature. We're looking at the NPLs in Taiwan peaking at 15%. They will be quite polarized between the state banks and the higher quality private banks, where they are provisioned. Arguably, the problem isn't big enough in some ways. At 15% NPLs, the cost of dealing with that problem is only 3% of GDP. Arguably it isn't disturbing enough to gain enough focus.

That's where the parallel with Japan is relevant. This problem could just be allowed to fester over a number of years, coupled with the fact that market is very fragmented -- where the second largest bank has a 6% market share -- means competition is intense.

With the new holding company law, we actually think the longer-term outlook for the Taiwanese banking sector is brighter than it has been for some time. We do foresee in-market consolidation. We do foresee greater foreign participation. The fact that a bank like Citigroup has paid $850 million for a stake in the Taiwanese financial services sector, its single largest cash investment in non-Japan Asia, should tell you something about the way a very bright group of management views Taiwan.

But with the legislative changes now in place, we don't anticipate further action till next year when the first financial holding companies are formed.