In-Depth Integrative Case 1

      HSBC in China Introduction After years of negotiations, China finally acceded to the World Trade Organization (WTO) in December 2001 (see Exhibit 1). This development was a significant milestone in China’s integration with the global economy. One of the most important and far-reaching consequences was the transformation of China’s financial sector. China’s banking, insurance, and securities industries were long due for a major overhaul, and the WTO requirements guaranteed that the liberalization of China’s economy would extend to the important financial sector. China’s banking sector had become a casualty of the state. Banks and other financial institutions haphazardly extended loans to state-owned enterprises (SOEs) based not on sound credit analysis but favoritism and government-directed policy. As a consequence, crippling debt from bad and underperforming loans mounted, with no effective market disciplines to rein it in. China recognized that opening up the banking sector could bolster its financial system. Foreign management would help overhaul the banking sector and put the focus on returns, instead of promoting a social agenda. This fiscal agenda would ultimately lead to a stronger and more stable economy. Yet after years of direction from the state, Chinese bank managers did not have the necessary skills to transform the banks on their own. Guo Shuqing, shortly after being promoted to chairman of China Construction Bank, admitted that, “more than 90% of the bank’s risk managers are unqualified.”1 Immediately upon accession to the WTO, China’s banking sector began to open to foreign banks. Initially, foreign banks were allowed to conduct foreign currency business without any market access restrictions and conduct local currency business with foreign-invested enterprises and foreign individuals. In addition, the liberalization of foreign investment rules made Chinese banks attractive targets for foreign financial institutions. Sweeping domestic changes have followed. Strong emphasis has been placed on interest rate liberalization, clearer and more consistent regulation, and a frenzy of IPOs of state owned banks has followed. It was in this context that HSBC rapidly expanded its presence in China. Exhibit 1 China’s WTO Commitments General Cross-Sector Commitments 3 Reforms to lower trade barriers in every sector of the economy, opening its markets to foreign companies and their exports from the first day of accession. 3 Provide national treatment and improved market access to goods and services from other WTO members. * Special rules regarding subsidies and the operation of state-owned enterprises, in light of the state's large role in China's economy. 3 Undertake important changes to its legal framework, designed to add transparency and predictability to business dealings and improve the process of foreign market entry. 3 Agreement to assume the obligations of more than 20 existing multilateral WTO agreements, covering all areas of trade. 3 Under the acquired rights commitment, agreed that the conditions of ownership, operation, and scope of activities for a foreign company under any existing agreement would not be made more restrictive than they were on the date of China's accession to the WTO. • Licensing procedures that were streamlined, transparent, and more predictable. Commitments Specific to the Financial Services Industry 2 Allow foreign banks to conduct foreign currency business without any market access or national treatment limitations. 2 Allow foreign banks to conduct local currency business with foreign-invested enterprises and foreign individuals (subject to geographic restrictions). 3 Banking services (with a five-year transitional plan) by foreign banks: Within two years after accession, foreign banks would be able to conduct domestic currency business with Chinese enterprises (subject to geographic restrictions). Within five years after accession, foreign banks would be able to conduct domestic currency business with Chinese individuals, and all geographic restrictions will be lifted. Foreign banks also would be permitted to provide financial leasing services at the same time that Chinese banks are permitted to do so. 518 In-Depth Integrative Case 1 HSBC inChina 519 HSBC, known for its international scope and careful, judicious strategy, made a series of key investments between 2001 and 2005 that arguably gave it the most extensive position in China of any foreign financial group. These investments included two separate transactions that resulted in a 19.9 percent stake in Ping An insurance, and, in June 2004, a $1.8 billion successful tender for a 19.9 percent stake in Bank of Communications, the fifth largest bank in China. HSBC had a long history in Asia, and was uniquely positioned to take advantage of China’s vast population and mushrooming middle class, high savings rates (in the range of 40 percent), and huge capital investments (US$50 billion FDI in 2005). HSBC recognized that the current banking system was not capitalizing on this vast opportunity, and sought to get in on the ground floor in this new environment. Perhaps, with further liberalization, however, China would allow future investors to establish even greater claims to Chinese banks. Citigroup’s successful effort to gain a controlling stake in Guandgong Development Bank appeared to undermine earlier investors who had been limited by China’s rule that allowed foreigners to own no more than 19.9 percent of domestic financial institutions. Did the huge potential rewards of being an early mover in China mitigate the promise of uncertainty and risks of doing business in an emerging market? After being burned in Argentina, could HSBC relax its conservative philosophy in its China strategy? If the economy took a turn for the worse, HSBC could face heavy losses. On the other hand, could HSBC afford not to be an early mover in a region where it had a longstanding presence? Background on_HSBC______________________ History Thomas Sutherland founded the Hongkong and Shanghai Banking Corporation (Hongkong Bank) in 1865 to finance the growing trade between Europe, India, and China.2 Sutherland, a Scot, was working for the Peninsular and Oriental Steam Navigation Company when he recognized a considerable demand for local banking facilities in Hong Kong and on the China coast. Hongkong Bank opened in Hong Kong in March 1865 and in Shanghai a month later. The bank rapidly expanded by opening agencies and branches across the globe, reaching as far as Europe and North America, but maintained a distinct focus on China and the Asia-Pacific region. Hongkong Bank helped pioneer modern banking during this time in a number of countries, such as Japan, where it opened a branch in 1866 and advised the government on banking and currency, and Thailand, where it opened the country’s first bank in 1888 and printed the country’s first banknotes. By the 1880s, the bank issued banknotes and held government funds in Hong Kong, and also helped manage British government accounts in China, Japan, Penang, and Singapore. In 1876, the bank handled China’s first public loan, and thereafter issued most of China’s public loans. Hongkong Bank had become the foremost financial institution in Asia by the close of the 19th century.3 After the First World War, the Hongkong Bank anticipated an expansion in its Asian markets, and took a leading role in stabilizing the Chinese national currency. The tumultuous Second World War, for its part, saw most of the bank’s European staff become prisoners of war to the advancing Japanese. The Postwar Years In the postwar years, Hongkong Bank turned to dramatic expansion through acquisitions and alliances in order to diversify. The acquisitions began with the British Bank of the Middle East (Persia and the Gulf states) and the Mercantile Bank (India and Malaya) in 1959, and were followed by acquiring a majority interest in Hong Kong’s Hang Seng Bank in 1965. The 51 percent controlling interest in Hang Seng Bank was acquired during a local banking crisis for $12.4 million. As of 2002, HSBC’s interest in the bank was 62 percent and was over $13 billion. Hang Seng, which retained its name and management, has been a consistently strong performer. The bank made further acquisitions in the United Kingdom and Europe (from 1973), North America (from 1980), Latin America (from 1997), as well as other Asian markets. Under Chairman Michael Sandberg, Hongkong Bank entered the North American market with a $314 million, 51 percent acquisition of Marine Midland, a regional bank in upstate New York. In 1987, the bank purchased the remaining 49 percent, doubling Hongkong Bank’s investment and providing the bank a significant U.S. presence. As a condition of the acquisition, however, Marine Midland retained its senior management. Move to London and Acquisitions In 1991, Hongkong Bank reorganized as HSBC Holdings and moved its headquarters in 1993 to London from Hong Kong. Sandberg’s successor, William Purves, led HSBC’s purchase of the U.K.’s Midland Bank in 1992. This acquisition fortified HSBC’s European presence and doubled its assets. The move also enhanced HSBC’s global presence and advanced the bank’s reputation as a global financial services company. Other major acquisitions of the 1990s included Republic Bank and Safra Holdings in the United States, which doubled HSBC’s private banking business investments moves in Brazil and Argentina in 1997, and acquisition of Mexico’s Bital in 2002. In 2000, HSBC acquired CCF in France. By 2006, HSBC had assets exceeding $1,860 billion, customers numbering close to 100 million, and operations in six continents. In recent years, HSBC has made 520 Part 4 Organizational Behavior and Human Resource Management a major commitment to emerging markets, especially China and Mexico, but also Brazil, India, and smaller developing economies. Expansion, Acquisition, and Succession----------------------------------------------- The World's Local Bank HSBC, holding company set up a group policy in 1991 that established 11 quasi-independent banks, each a separate subsidiary with its own balance sheet.4 The head office provided essential functions, such as strategic planning, human resource management, and legal, administrative, and financial planning and control. This setup promoted prompter decision making at a local level and greater accountability.5 HSBC portrays itself as “the world’s local bank,” recognizing the importance of globalization, flexibility, and local responsiveness. As of 1998, HSBC established distinct customer groups or lines of business that would overlay existing geographic designations. This encouraged maximizing the benefits of its universal scope, such as sharing best practices of product development, management, and marketing. The geographic perspective was melded closely with a customer group perspective, demanding both global and local thinking. Traditionally, HSBC’s culture has embraced caution, thrift, discipline, and risk avoidance. The bank looked at long-term survival and considered markets in 50-year views. Thrift manifested through the company, and even the chairman flew economy class on flights less than three hours.6 In 2005, incoming Chairman Stephen Green recognized the company’s rule “to follow the letter and spirit of regulations” and signaled his intention to protect the bank’s reputation as it extends into consumer finance.7 Bond's Rein and Move to "HSBC" Sir John Bond joined Hongkong Bank in 1961, spent most of his early career in Asia and the United States, and is credited with turning around Marine Midland Bank in the late 1980s. Bond became CEO of HSBC in 1993, and chairman in 1998, bringing with him a hands-on entrepreneurial style and exceptionally ambitious goals.8 He pursued acquisitions beyond HSBC’s traditional core, in pursuit of such attractive financial segments as wealth management, investment banking, online retail financing, and consumer finance. Bond considered shareholder value and economic profit in deciding when acquisition premiums were in order, which was in contrast to his predecessor’s “three times book value” rule.9 By 2001, Bond had authorized investments of over $21 billion on acquisitions and new ventures.10 In 1998, Bond adopted the HSBC brand, and preserved “The Hongkong & Shanghai Banking Corp.” name only for its bank based in Hong Kong. HSBC branded its subsidiary banks across the world with the parent bank’s acronym and greatly expanded marketing efforts in 2000. In March 2002, HSBC’s marketing message became “the world’s local bank,” which would help the brand become one of the world’s top 50 most recognizable brands by 2003.11 Household Acquisition In 2003, HSBC’s acquisition of Household International became the basis of HSBC’s Consumer Finance customer group. Household utilized a unique system to forecast the likelihood that customers would repay debt, which used a 13-year database of consumer behavior. Household was controversial and yet presented great opportunity. HSBC desired to leverage this new skill in developing countries, yet was unable to find all demographic and credit data that Household normally relies on in the United States. HSBC particularly looked to extend the Household model into China and Mexico. Transitions In May 2006, Sir John Bond presided over his final board meeting, with CEO Stephen Green poised to replace the retiring chairman. Green had been with HSBC for nearly a quarter century, after also spending several years as a consultant at McKinsey. Green’s style is known to be more cerebral and low key than his predecessor.12 Stephen Green was succeeded as group chief executive by Michael Geoghegan, 52, who joined HSBC in 1973 and was formerly chief executive of HSBC Bank plc, the group’s principal subsidiary in the U.K. Geoghegan has a reputation as an aggressive banker who is not afraid to make tough strategic decisions. Shortly after his appointment, Geoghegan traveled around the world visiting more than a dozen countries and meeting with thousands of HSBC employees. Overall, the appointments were met with guarded optimism in the investment community, though not without detractors. One shareholder said: “The question is whether HSBC should have an independent nonexecutive who might make a future chairman and therefore widen the choice in the future.”13 Managing for Growth_______________________ HSBC’s strategic plan, “Managing for Growth,” was launched in the fall of 2003. This strategy builds on HSBC’s global, international scope and seeks to grow by focusing on the key customer groups of personal financial services; consumer finance; commercial banking; corporate, investment banking, and markets; and private banking.14 “Managing for Growth” is intended to be “evolutionary, not revolutionary,” and aims to vault HSBC to the world’s leading financial services company. HSBC seeks to grow earnings over the long term, using its peers as a benchmark. It also plans to invest in delivery platforms, In-Depth Integrative Case 1 HSBC in China 521 technology, its people, and brand name to prop up the future value of HSBC’s stock market rating and total shareholder return. HSBC retains its core values of communication, long-term focus, ethical relationships, teamwork, prudence, creativity, high standards, ambition, customer-focused marketing, and corporate social responsibility, all with an international outlook.15 Strategic Pillars As part of the growth strategy, HSBC identified eight strategic pillars: Brand: continue to establish HSBC and its hexagon symbol as one of the top global brands for customer experience and corporate social responsibility. Personal Financial Services: drive growth in key markets and through appropriate channels; emerging markets are essential markets with a burgeoning demand. Consumer Finance: offer both a wider product range and penetrate new markets, such as the emerging country markets. Commercial Banking: leverage HSBC’s international reach through effective relationship management and improved product offerings. Corporate, Investment Banking, and Markets: accelerate growth by enhancing capital markets and advisory capabilities. Private Banking: a focus on serving the highest value personal clients. People: draw in, develop and motivate HSBC’s people. TSR: fulfill HSBC’s TSR target by achieving strong competitive performances in earnings per share growth and efficiency.16 Challenges in Investment Banking Within the CIBM group, HSBC had always excelled at the “C” (global corporate banking) and “M” (markets—sales and trading of bonds, foreign exchange, derivatives, and other instruments) but had lagged in its execution of the “IB”(investment banking). Therefore, as part of the managing for growth initiative, HSBC launched an ambitious plan to strengthen IB. Executing the plan proved to be challenging within the HSBC culture. According to a Wall Street Journal report, the budget for the first two years—mostly for hiring new talent and improving technology—was around $800 million. The then chairman, Sir John Bond, needed top IB talent to lead the change. He hired John Studzinki, a very experienced banker who had worked for Morgan Stanley. Studzinski was paired with Stuart Gulliver, an experienced veteran of HSBC’s international manager program. Because Gulliver had worked for HSBC for 26 years, he was accustomed to HSBC’s very strict cost-control policies. Studzinki started building a team from scratch by hiring people from competitor’s banks, such as Credit Suisse, Lazard Frères, and Goldman Sachs.17 According to the Wall Street Journal account, spending was drastically increasing and Gulliver was disturbed by this change in HSBC’s traditional prudence. For example, although unusual for the banking industry, some bankers were promised fixed bonuses (they are usually paid based on the company’s financial performance).18 Although expenses were increasing, profits were down. In the first half of 2005, costs for the CIBM unit were up 24 percent to $3.32 billion, whereas pretax profit decreased by 18 percent.19 HSBC was outranked by other banks in terms of mergers and acquisitions for 2006. The bank ranked number 13 (see Exhibit 2). The IB strategy appeared to stall. In November 2005, Sir John announced his retirement for the next May, and in May 2006, Studzinki announced he would leave in September 2006. Focus on Emerging Markets_________________________ In 2000, HSBC had half of its assets in developing countries.20 Most earnings, however, stemmed from mature markets, such as Hong Kong and Britain. All but 5 percent of group profits came from five economies, while India and Latin America each only added 1 percent to group profit.21 Exhibit 2 HSBC Mergers and Acquisitions Ranking Adviser 2006 Rank (first nine months) Value of deals in USS Number of deals Goldman Sachs 1 731 b 237 Citigroup 2 659.7 225 J.P. Morgan 3 652.9 313 Morgan Stanley 4 574.2 263 Merrill Lynch 5 543.3 197 Credit Suisse 6 497.1 211 UBS 7 477.0 271 Lehman Brothers 8 430.5 138 Deutsche Bank 9 388.7 161 BNP Paribas 10 292.3 82 HSBC 13 211.2 58 Source: Carrick Mollenkamp, "HSBC Stumbles in Bid to Become Global Deal Maker," The Wall Street Journal, October 5, 2006, p. A1. 522 Part 4 Organizational Behavior and Human Resource Management The Draw of Emerging Markets Recognition of the impact of emerging markets is an essential thread running throughout the elements of the “Managing for Growth” strategy. Since 2000, many of HSBC’s emerging markets’ profits have increased dramatically (see Exhibit 3). Across the board, HSBC’s pretax profits in emerging markets have increased from $905 million in 2000 to $3,439 million in 2005. China, which lost $26 million in 2000, made $334 million in 2005, an increase of 944 percent from 2004 alone. Mexico has also had great success, increasing from $9 million profit in 2000 to $923 million in 2005. In 2006, this trend continued, as total profit before tax during the first half of 2006 increased by 18 percent over the first half of 2005 (see Exhibit 3). The biggest winners were India (99 percent increase), the Middle East (95 percent increase), and China (74 percent increase), while Indonesia (-51 percent) and Argentina (-50 percent) fell by the greatest percentage. Incoming Chairman Stephen Green underlined HSBC’s focus on the potential of emerging markets: “There is a general rule of thumb that says the emerging markets grow faster than mature markets as economies and the financial services sector grows faster than the real economy in emerging markets because you are starting from very low penetration of financial services in general.”22 Specifically in consumer finance, Green recognized the importance of importing HSBC’s model into markets starved for credit cards and loans, saying, “Any analysis of the demographics of emerging markets tells you that consumer finance is going to be an important part, and a rapidly growing part, of the financial-services spectrum for a long time to come.”23 Success in Mexico HSBC has had phenomenal success in Mexico, which led emerging markets with $515 million in pretax profits during the first half of 2006, an increase of 20 percent over the same period in 2005. Indeed, Mexico’s market is expanding at a very rapid clip. In 2002, HSBC purchased the undercapitalized Mexican bank Grupo Financiero Bital SA. Four years later, HSBC opened Bital’s new headquarters in an impressive tower in Mexico City’s Paseo de la Reforma. HSBC’s tagline in Mexico City proclaims: “13,500 tons of commitment to Mexico.”24 The slogan works well with the proudly nationalistic Mexican population. Today, foreign banks control more than 80 percent of Mexico’s banking assets. Turning over the assets was the easiest way for policy makers to escape the “Tequila Crisis” of 1994-95, which wiped out half of Mexico’s assets. HSBC and other foreign banks that bet on Mexico have won big, as profits in Mexico have skyrocketed. HSBC has taken a long-term view of Mexico, which has a relatively stable economy and a very young population (about 45 percent under age 19), in addition to great opportunities arising from NAFTA. HSBC’s plan includes offering credit cards to a customer base that uses primarily debit cards. “That’s part of a wide-ranging retail-banking strategy for Mexico, where we are also growing our deposit products [and] remittance products for the very considerable flow of retail remittances,” according to Chairman Stephen Green.25 Setback in Argentina Not all emerging markets have been as successful for HSBC as Mexico. A hefty investment in Argentina, for Pretax Profits 2005 vs. 2006 Exhibit 3 HSBC Emerging Markets Pretax Profits 2005 vs. 2004, 2002 Country 2000 (US$ mil) 2004 (US$ mil) 2005 (USS mil) % Change 2004- 2005 Country 2006 (USS mil) % Change (2006 over 2005) Argentina 112 154 244 58 Argentina 157 -36 Brazil 208 281 406 44 Brazil 526 .30 China -26 32 334 944 China 708 112 India 87 178 212 19 India 393 85 Indonesia 70 76 113 49 Indonesia 71 -37 Malaysia 116 214 236 10 Malaysia 274 16 Mexico 9 774 923 19 Mexico 1009 9 Saudi Arabia 30 122 236 93 Saudi Arabia 181 41 South Korea 65 89 94 6 South Korea 48 -13 Taiwan 45 107 68 -36 Taiwan (23) NA Turkey 59 142 265 87 Turkey 217- -18 UAE 130 192 308 60 Middle East 730 25 Total 905 2,361 3,439 +46 Other 166 -15 Total profit 18,943 20,966 + 10.7 Total 4,533 19 before tax Total profit 22,086 5 (all countries) before tax (all countries) In-Depth Integrative Case 1 HSBC in China 523 example, spiraled out of control. In 1997, HSBC completed its acquisition of Grupo Roberts, becoming one of the major players in the country and expanding its Latin American presence. Four years later, however, Argentina went from seemingly one of Latin America’s strongest economies to a stunning failure. Much of the damage stemmed from a governmentmandated conversion of U.S.-dollar-denominated assets into pesos. Argentina removed an 11-year-old mechanism pegging the peso one to one to the dollar, which led to the peso’s sharp devaluation, and resulted in massive losses for many banks. In the 2001 meltdown of Argentina’s economy, HSBC lost $1.152 billion, with bad debt charges on HSBC’s Argentina exposure of $737 million, even though the country only accounted for 0.5 percent of HSBC’s assets.26 Faced with huge losses, HSBC was forced to cut 2001 profit estimates 10 percent and considered exiting the country. Despite its long-term approach, the fluid, unstable economy was daunting, and demonstrates the volatile nature of emerging markets. More recently, HSBC’s position in Argentina has recovered somewhat (see Exhibit 3). Liberalization of China's Banking Sector____________________________________ China's Banking Sector Pre-WTO Before the WTO accession negotiations, China’s banking industry operated as a cog in China’s centrally planned economy. The state commercial banks performed a social function, during China’s post-Mao drive to industrialize, instead of operating for economic return. Consequently, the banks adhered to directed lending practices from the government and in turn created some of China’s most successful enterprises, but also supported thousands of other, inefficient, and unprofitable state-owned enterprises. This practice left state commercial banks with massive amounts of debt that were largely unrecoverable and hordes of nonperforming loans. In addition to widespread losses, instability ensued in the banking system overall. To make matters worse, corruption and mismanagement ran rampant throughout the sector, sapping away consumer and investor confidence. WTO Accession Following 15 years of negotiation and two decades of economic reform in China, December 11, 2001, marked China’s accession to the World Trade Organization. The main objective of the WTO agreement was to open China’s market up to foreign competition. The deadline for complete implementation was December 11, 2006. China made a number of implementations immediately. To begin with, foreign banks were allowed to conduct foreign currency business without any market access restrictions. Also, foreign banks were allowed to conduct local currency business with foreign-invested enterprises and foreign individuals (with geographic restrictions). Within two years of accession, China agreed to allow foreign banks to conduct domestic currency business with Chinese enterprises (geographic restrictions). Within five years, foreign banks could conduct domestic currency business with Chinese individuals (no geographic restrictions); and foreign banks were able to provide financial leasing services at the same time as Chinese banks. Under the WTO investment provisions, China agreed to allow foreign ownership of Chinese banks (up to 25 percent), with no single foreign investor permitted to own more than 20 percent. “Bank reform has become the most crucial task for the government in pushing forward economic reforms,” said Yi Xianrong, an economist at the Chinese Academy of Social Sciences in Beijing.27 Indeed, bank reform is critical to stabilizing and advancing the Chinese economy. Domestic Reform China has undertaken a number of domestic reforms in order to overhaul the banking industry. China has engaged in interest rate liberalization by removing certain interest rate and price controls. Instead of being pegged to the U.S. dollar, as it once was, China’s currency exchange rate is now pegged to within 0.3 percent of a basket of currencies, dominated by a group including the U.S. dollar, euro, Japanese yen, South Korean won, British pound, Thai baht, and Russian ruble. The yuan was revalued by 2.1 percent against the dollar in July 2005, but analysts estimate that it remains 10-30 percent undervalued. Regulation has long been a concern in the Chinese banking industry. China has made major progress by creating regulatory agencies. In 2003, China created a central regulator, the China Banking Regulatory Commission (CBRC), out of the central bank. The regulator’s 20,000 staff members endeavor to shift the banks’ focus from senseless loans and grow mind-sets to a goal of preserving capital and generating returns. Lenders not meeting a capital ratio of 8 percent of risk-weighted assets (as decreed by Basel I, a global standard) by 2007 may face sanctions, which could include the removal of senior management. Still, the CBRC faces an uphill battle. Han Mingzhi, as head of the CBRC’s international department, admitted in 2004 that “we lack people who understand commercial banking and microeconomics. It is a headache for the CBRC.”28 Concurrently, China is striving to make regulatory and reporting requirements more clear, because they have often proved confusing barriers to foreign investment. Since 1998, China has intensified accounting, prudential, and regulatory standards. Prior to 1998, the banks booked interest income for up to three years even if it was not being paid. Now, the banks can do so for only 90 days, which is the international norm. Still, it has been all too 524 Part 4 Organizational Behavior and Human Resource Management common for Chinese banks to ignore regulations and not monitor loans. As a result of poor accounting, the banks themselves are sometimes unsure of their bad loans. Lai Xiaomin, head of the CBRC’s Beijing office, admits that “when our banks disclose information, they don’t always do so in a totally honest manner.”29 Indeed, the lack of reliable accounting can hamper investment. As one Hong Kong investor put it, “When you take a state-owned enterprise that has had weak internal controls, it can be enormously laborintensive to come up with financials we can work with.”30 In 2006, regulators overhauled the system in which almost one-third of a company’s shares were “nontradable.” Fixing this problem has helped energize the market and welcome in individual investors.31 Recent Regulatory Moves New regulations also hope to address China’s history of dishonesty and embezzlement. With the tight connection of Chinese banks with local governments, corruption has choked the Chinese banking system. Some common practices have historically encouraged corruption, such as allowing the same person to make and approve a loan. Former bank Chairman Zhang Enzhao himself was arrested in June 2005 for allegedly taking bribes. At the China Construction Bank alone, there were more than 100 cases of theft and embezzlement between 2002 and 2004.32 These old habits have to be rooted out. China is working hard to transition its traditional banks into “universal” banks. Most of China’s 128 commercial banks have introduced better governance, shareholding, and incentive structures, while also adding independent directors to their boards.33 Foreign management and knowledge are intended to flush the Chinese banking system with managerial talent. To help encourage foreign banks, China is relaxing some foreign bank restrictions. The Chinese government has also taken steps to eliminate bad loans, by bailing out banks. IPO Explosion China has aggressively pursued IPOs of state-owned banks, a policy which has been met with a strong response from investors eager to tap into the populous country and seize first-mover advantages (see Exhibit 4). HSBC’s purchase of a 19.9 percent stake in Bank of Communications (BoCOM) in June 2004 was the pioneering, substantial foreign bank investment in China. HSBC previously made large investments in Fujian Asian Bank (50 percent) and Bank of Shanghai (8 percent). In 2005, foreign banks invested $18 billion in several of China’s largest banks. The October 2005 listing of China Construction Bank Exhibit 4 Foreign Bank Investments in China PRC Bank Foreign Partner % Stake Price Date Bank of Shanghai HSBC 8.00 $62.6 m 12/2001 IFC 7.00 $25.0 m Shanghai Commercial Bank (HK) 3.00 $15.7 m Shanghai Pudong Dev Bank Citigroup 4.62 $72.0 m 12/2003 Fujian Asian Bank HSBC 50 Less than $20 m1 12/2003 Bank of Communications HSBC 19.90 $1.75 b 6/2004 Xian CCB Scotia Bank 12.4 $3.2 m 10/2004 Jinan City CCB Commonwealth Bank of Australia 11.0 $17 m2 11/2004 Shenzhen Dev. Bank Newbridge Capital 17.9 $1.23 b 12/2004 Minsheng Bank Temasek 4.9 1/2005 Hangzhou CCB Commonwealth Bank of Australia 19.90 $78.0 m 4/2005 China Construction Bank Bank of America 9.00 $3.0 b 6/2005 Temasek 5.1 $1.5 m3 Bank of China Royal Bank of Scotland 5.00 $3.1 b 8/2005 UBS 1.6 $500 m4 9/2005 Temasek 10.00 $3.1 b5 9/2005 Industrial Commercial BOC Goldman, Allianz, AmEx 8/2005 Nanjing CCB BNP Paribas 19.20 $27.0 m 10/2005 Hua Xia Bank Deutsche Bank 9.9 $329 m6 10/2005 Sal. Oppenheim Jr. 4.1 10/2005 Bank of Beijing ING 19.90 $214 m 3/2005 ’HSBC Press Article, accessed October 3, 2006, www.hsbc.com.cn/cn/aboutus/press/content/03dec29a.htm. 2Guonan Ma, "Sharing China's Bank Restructuring," China and World Economy 14, no. 3 (2006), p. 8. 3David Lague and Donald Greenlees, "China's Troubled Banks Lure Investors," International Herald Tribune, www.iht.com/ articles/2005/09/21/business/bank.php, accessed on October 4, 2006. 4 "UBS to Invest $500 million in Bank of China," CBS News, www.cbsnews.com/stories/2005/09/27/ap/business/main D8CSHPLOO.shtml, assessed October 4, 2006. 5Luo Jun and Xiao Yu, "Temasek to Buy 10% of China Bank," International Herald Tribune, www.iht.com/articles/2005/09/01/ bloomberg/sxboc.php, accessed on October 4, 2006. 6 "Deutsche Bank Seals Chinese Deal," BBC News, news.bbc.co.uk/2/hi/business/4348560.stm, accessed October 4, 2006. In-Depth Integrative Case 1 HSBC in China 525 (CCB), China largest at the time, raised $8 billion from foreign investors for 12 percent of its shares. CCB further obtained an additional $4 billion ahead of its float by selling stakes of 9 percent to Bank of America and 5.1 percent to Temasek, Singapore’s investment agency. In the following months, the Royal Bank of Scotland put $3.1 billion into Bank of China, Temasek another $3.1 billion and Switzerland’s UBS $500 million. In May 2006, Bank of China, the country’s second-largest lender, raised $11.2 billion in a Hong Kong stock sale, which was the fifth-largest initial public offering in history. In July 2006, the Chinese government announced approval for an even larger IPO of the country’s largest bank, Industrial & Commercial Bank of China, to raise $18 billion or more in one of the largest stock offerings ever.34 The central bank expects foreigners to bring much needed improvements to the state banks’ risk-management and internal control systems, including credit-risk assessment and more transparent reporting. With capital allocated more efficiently, a more stable financial system will follow, and the economy will become more open to foreign competition. Two Steps Forward Pulling back from some of its commitments, China indirectly delayed the implementation of its WTO commitments. On February 1, 2002, the People’s Bank of China (PBOC) issued regulations and implementation rules governing foreign-funded banks. While these measures met the commitments of the WTO agreement, the PBOC was taking a very conservative approach in opening up the banking sector. For example, foreignfunded banks could open only one branch every 12 months. In the wake of these early obstacles, there have been positive changes. Capital requirements were reduced, additional cities were opened up to foreign banking, and the “one branch every 12 months” restriction was lifted. Central bank officials have indicated willingness to eventually elevate the foreign ownership limit above the current 25 percent, but experts doubt it will ever go beyond 50 percent.35 A 2006 study by McKinsey found that underperforming loans with merely negligible returns are also very damaging to the Chinese economy. McKinsey estimates that reforming China’s financial system could boost GDP by $321 billion annually.36 China’s banking sector plays an excessive role in the overall financial system. The share of bank deposits in the financial system ranges from less than 20 percent in developed economies to around half in emerging markets. China, however, has a share of bank deposits at a sky-high 75 percent of the capital in the economy, which practically doubles any other Asian nation (see Exhibit 5).37 Capital is still mostly allocated to state-owned enterprises, even though private companies have been China’s growth engine. Private companies produce 52 percent of GDP in China, but only account for 27 percent of outstanding loans.38 By sinking money into state-owned enterprises, China’s banks are dragging the economy. China’s banks had difficulty lending to private companies in the past, because of challenges related to gathering and processing the necessary information on them. As a response, Exhibit 5 Financial Depth in Major Market Financial Depth, 2004 Financial Assets as a Percent of GDP 450 — Source: McKinsey. 526 Part 4 Organizational Behavior and Human Resource Management China launched its first national credit bureau in early 2006. China’s banks have been satisfying a social role, but now must allocate capital efficiently in order to generate positive economic return. Investments in Ping An and BoCOIVI____________________________ With its longstanding presence in China, HSBC was among the most well-positioned financial institutions to take advantage of China’s market opening. Ping An Investments In October of 2002, HSBC announced that it had taken a 10 percent stake in Ping An Insurance, China’s second largest insurer for $600 million. U.S. investment banks Goldman Sachs and Morgan Stanley already had a combined 14 percent stake in Ping An. Chairman Sir John Bond indicated that HSBC was particularly attracted to the long-term prospects in the insurance and asset management sectors. In May 2005, HSBC indicated it was investing an additional HK$8.1 billion ($1.04 billion) for an additional 9.91 percent stake in Ping An, doubling its holding in the numbertwo life insurer. HSBC paid HK$ 13.20 a share for the stakes held by investment banks Goldman Sachs and Morgan Stanley, lifting HSBC’s holding to 19.9 percent, the maximum stake allowed by a single foreign investor. “This is good news for Ping An,” said Kenneth Lee, an analyst at Daiwa Institute of Research. “HSBC is buying at a premium and is replacing Goldman Sachs and Morgan Stanley, which are venture capital investors. HSBC is a long-term investor and will help Ping An to develop its insurance platform,” he said. The company’s market share of more than 15 percent of the Chinese market puts it behind domestic competitor China Life Insurance Co., which underwrites about half of all Chinese life insurance premiums. In 2005, HSBC Chairman John Bond commented, “We are optimistic about the long-term prospects of the insurance industry in mainland China and believe Ping An is well-positioned to benefit from the sector’s development.”39 In addition to holding a stake in Ping An Insurance, HSBC has applied for its own life insurance license in China. Foreign firms only account for 5 percent of the life insurance market in China, while three domestic firms (China Life Insurance, Ping An Insurance, and China Pacific Insurance) hold 76 percent of the market share. The bank hopes to start operations in 2008, and says it will maintain its relationship with Ping An.40 The BoCOM Deal____________ ______________________ HSBC invested $1.8 billion for a 19.9 percent stake in BoCOM in June 2004. HSBC’s chairman at the time, Sir John Bond, commented on the company’s long-term perspective, “[I]t is inevitable that China will become a superpower. And indeed, desirable. And we are positioning our business for the decades ahead accordingly.”41 HSBC wanted a piece of the alluring Chinese market, which Goldman Sachs predicts will overtake the United States as the number-one economy in the world by 2040, and wanted to deepen its international scope in line with the “Managing for Growth” strategy. Speaking one month after HSBC’s big move, thenCEO and future Chairman Stephen Green expounded upon China, “[T]he potential in China’s domestic market is the largest in history.” China is the “world’s manufacturer,” and as the population continues to urbanize and industrialize, it increasingly has more disposable income, the workers become greater consumers, and the middle class expands.42 China has one of the world’s highest savings rates, at around 4Q percent, and already has around one-third of the $1.2 trillion of central bank foreign exchange reserves sitting in Asia. Further, access to capital is not a problem, as FDI floods the country. The challenge facing China is to recycle and invest its pool of savings efficiently. HSBC recognized the huge potential in the market for banking services, as well as credit cards. As part of its emerging market strategy, HSBC wanted to feed the demand for credit cards in these markets. Green commented: “[O]ur joint venture with Bank of Communications for credit cards is one which we think has a lot of exciting prospects. Bank of Communications has over 30 million debit cards in issue. Over time, a proportion of those is going to convert to credit cards. And we are issuing co-branded credit cards with the Bank of Communications.”43 HSBC saw an opportunity to shepherd millions of new people into the banking system. HSBC’s Green acquiesced that emerging markets do carry risk. This risk was starkly evident during the HSBC debacle in Argentina during the country’s economic crisis. China’s epic turnaround could conceivably flop, and heavily invested banks could pay dearly. The banking system in China was and is very fragile. Would China’s banks be able to break away from state-directed lending and its lasting effects? The banks further rely on the continued acceleration of the economy, and many rely on volatile real estate loans.44 HSBC recognized other challenges for China, including the need to strengthen regulations, build social security, stem corruption, and fortify the financial system.45 Green contends that “emerging markets growth will continue at quite a rapid clip for the foreseeable future. I think that China will continue on a strong growth path.”46 HSBC, in investing in BoCOM, was wagering beyond continued growth and counting on the financial system finally being fixed. HSBC trusts that the banking cleanup would continue with cleaner, more competent corporate governance, decreased corruption, and more transparent practices.47 Margaret Leung, general manager and global co-head commercial banking for the HSBC Group commented, In-Depth Integrative Case 1 HSBC in China 527 “[W]e believe we have a unique advantage [in China]. A lot of analysts... have been saying that if any foreign bank is going to succeed in China, that would be HSBC.”48 BoCom’s net profit soared from Rmbl.604bn (US$200m) in 2004 to Rmb9.249bn in 2005, and a BoCOM-HSBC credit card has successfully been issued to over 650,000 people.49 However, with the passing of the WTO deadline, BoCOM now faces greater competition from foreign banks, which are now better able to compete under the new Regulation on Administration of Foreign-Funded Banks (adopted in late 2006). Under these new regulations, foreign banks are allowed to issue local currency loans and are no longer limited in the size and scope of their business. Recent Developments and Future Competitive Conditions_____________________________ Current Strategies in China Foreign banks that operate in China have different strategies. Some of them have purchased smaller stakes of Chinese financial institutions, while some prefer to buy a bigger stake of a small bank. Nevertheless, they all want to be in China. The best strategy, in theory, has turned out to be with a local partner. Bob Edgar, senior managing director at Australia and New Zealand Banking Group Ltd., said that “it would be very difficult to go into a market like that and undertake the cost of establishing a branch network, getting a customer base of hundreds of thousands if not millions of customers. That already exists, so why would we want to set it up again?”50 Many foreign banks however experience difficulties when working with a local partner. The credit standards are not as strict as they should be, and there is still high corruption at different levels. In addition, the partners gain influence in the foreign bank. This is the reason why HSBC has decided to invest “outside the Big Four” so it would have bigger control in operations. Peter Wong, executive director of HSBC’s Hong Kong and Mainland China operations, has commented: “[T]he state-owned banks would be too big.” So only the future will tell what is the best strategy.51 Recent Developments One significant development in the bank sector in China was the IPO of Industrial and Commercial Bank of China IPO. As expected, it was the world’s biggest IPO. ICBS raised $19.1 billion, exceeding investors’ predictions, valuing the bank at more than $108 billion. The previous IPO record was $18.4 billion and was held by NTT DoCoMo Inc., a Japanese mobile company.52 The bank has announced that the money will be used to fund its expansion. The competition in China’s banking industry is continuing to grow. Recently, Morgan Stanley announced its expansion into China, given the company’s desire to tap into the growing Chinese market and become competitive there. The company chief executive commented, “[T]his platform will allow us to provide a wider array of new product capabilities that are currently offered only by commercial banks with a presence within China.”53 Another important development was the deal in which a consortium led by Citigroup took control over the Guangdong Development Bank (GDB). The agreement was reached on November 16, 2006, after a year of negotiations. Citigroup and its investors’ partners have agreed to pay about $3.1 billon for 85.6 percent of Guangdong Development Bank.54 The deal is significant since this is the first time that a foreign investor has been able to gain control in a Chinese bank. It is expected that Citigroup alone would purchase only 20 percent of Guangdong Development Bank; however, its partners would split the remaining 65.6 percent. The China Life Insurance Co. and State Grid Corporation each own 20 percent, followed by Citic Trust & Investment Co. with 12.9 percent and Yangpu Puhua Investment and Development Co. with 8 percent. Interestingly, IBM also has a stake at GDB, owning 4.74 percent of Guangdong Development Bank. Another issue that makes the deal special is the fact that in January 2007, China opened its financial sector to foreign investors, which was one of its last WTO membership commitments. Under the new rules, foreign batiks in China finally have the opportunity to offer services in the local currency—yuan—which was previously prohibited.55 In a statement issued after the deal was announced, William R. Rhodes, the chairman and chief executive of Citibank, said, “The continued emergence of China’s economy represents a tremendous opportunity for Citigroup.”56 Although Citigroup has gained more market opportunities since the deal was approved, analysts say that there are certain risks involved. It is publicly known that the Guangdong Development Bank has been struggling financially, and there is speculation about the amount of bad loans that have not been put on the books. Bad loans have been an issue for the Chinese banks. However, it seems that the experience in banking and asset management that Citigroup possesses, in addition to the IT support offered by IBM, would make this investment beneficial to Guangdong Development Bank and could turn the bank around.57 In June 2007, the Guangdong Development Bank issued an outline of its five-year plan. The bank aims to reach the average levels of its Chinese bank peers for all major operational indicators in the next two to three years and become a leader among midsized Chinese banks within three to five 58 years. Other recent developments include the Ping An and China Life Insurance initial public offerings in China. Ping An raised 38.9 billion yuan ($5 billion) with its February 2007 IPO and plans to use those funds to finance 528 Part 4 Organizational Behavior and Human Resource Management operations. In January 2007, its main competitor, China Life Insurance Co., was also listed on the Shanghai Stock Exchange, making an IPO of $3.6 billion. In July 2006, it was announced that Bank of Communications President Zhang Jianguo had submitted his resignation, and would replace Chang Zhenming as president of the China Construction Bank. It was not clear whether HSBC was consulted in this move. On September 11, 2006, HSBC opened a new subbranch in Beijing. With the opening of its fourth branch in Beijing, HSBC became the foreign bank with the most branches in Beijing. Richard Yorke, chief executive officer China at the Hongkong and Shanghai Banking Corporation Limited, commented: “[We] are delighted to be able to further expand our service network in Beijing. It is part of our overall network expansion in China where HSBC has a long-term commitment. Beijing is a key retail market for HSBC in the Mainland and we shall provide diversified products to meet our customers’ growing needs for world-class banking services.”59 Yet another recent development for HSBC was its decision to reduce its exposure to the U.S. subprime lending market in early 2007. HSBC had entered the market when it purchased Household International Inc., a U.S. subprime lender, in 2003. However, since then the subprime lending market has begun to fail as a result of the huge U.S. construction boom and rising interest rates. Delinquencies on subprime mortgages in the United States rose to a four-year high in the fourth quarter of 2006, contributing to a 5.7 percent drop in HSBC’s total second-half profits (an 87 percent drop in its North American profits alone).60 This prompted HSBC’s early 2007 announcement that it would stop buying second-charge loans from other lenders. In addition, HSBC has decided to change the management of Household in order to bring the business “under the HSBC model,” as Michael Geoghegan, chief executive of the HSBC Group, put it.61 In addition to shrinking its U.S. mortage unit, HSBC continues to invest in fast-growing emerging markets, including Asia, Latin America, and the Middle East. Malaysia is one country where HSBC’s expansion is quite noticeable. As of March 2007, it operated 40 branches there and was awaiting approval to open eight more. HSBC also has plans to extend its insurance business to other countries.62 Future Competitive Conditions China has the highest foreign direct investment (FDI) in Asia; however, the high growth in FDI is beginning to slow. According to the Ministry of Commerce, for the first eight months of 2006, China drew $37.2 billion in FDI, or 2.1 percent, less than during the same period in 2005. In August 2006, FDI was down 8.5 percent compared to the same month of last year. David Li, an economist from Tsinghua University, argues that “an opposition to FDI is a sign of economic maturity.” China’s local companies are growing and becoming stronger.63 One of the challenges facing foreign firms in China is that foreign mergers and acquisitions are becoming less welcome. The Chinese economy’s annual growth is 10 percent, and therefore, the opportunities for local firms are growing. As such, there is a concern with the increasing number of mergers and acquisitions. However, Arthur Kroeber, managing editor of China Economic Quarterly, has said that despite this concern, “they are still happy to have you come and build a factory.”64 HSBC is an institution that actively seeks new opportunities; indeed, HSBC was the first foreign bank to invest in China in 2001. Peter Wong has commented, “[We] are reacting to the evolution of the China market. The government basically opened the door and said, ‘Why don’t you [foreign banks] start investing and see what happens.’ So we invested in the Bank of Shanghai. Then they opened the door in insurance, so we invested in Ping An insurance. Then it was joint-stock banks, and we invested in Bank of Communications.”65 Exhibit 6 summarizes HSBC’s strategic stakes in Chinese financial institutions. *lnvestment made by Hang Seng Bank of Hong Kong, which is majority controlled by HSBC. Source: K. C. Swanson, "Buying into China's Banks," Corporate Dealmaker, SeptemberOctober 2006, p. 18. Exhibit 6 HSBC’s Stakes in Chinese Financial Institutions Date Target Amount (millions of US$) Stake (%) May 2005 Ping An Insurance Group Co. (second stake) $1,040 9.9% August 2004 Bank of Communications 1,750 19.9 December 2003 Industrial Bank Co. Ltd. 205* 16.0 October 2002 Ping An Insurance Group Co. (first stake) 600 10.0 December 2001 Bank of Shanghai 63 8.0 In-Depth Integrative Case 1 HSBC in China 529 HSBC’s future development will depend heavily on two things. First, the competition will play a major role in HSBC’s strategy. HSBC competitors are aggressively seeking opportunities in China, and HSBC has to constantly work to maintain and expand its market position. Second, HSBC’s success will depend on the opportunities that the company sees in the other emerging markets of the world. Questions for Review 1. How has HSBC adapted its global strategy to operate in China, both before and after China’s WTO accession? 2. Discuss HSBC’s strategy for entering and operating in other emerging markets. Where has it found success, and where has it faced setbacks? Why? 3. What are the pros and cons of HSBC’s “Managing for Growth” strategy? 4. Discuss Stephen Green’s leadership style. How does he differ from his predecessor, Sir John Bond? How might Michael Geoghegan lead HSBC going forward? 5. Do you think HSBC should reevaluate its corporate strategy in China, now that the WTO deadline has passed and the new regulations for foreign banks are in place? Exercise HSBC is considering asking the government of China (China Banking Regulatory Commission—CBRC) to allow it to increase its state in BoCom above the limit currently in place (25% total foreign ownership; 20% for an individual foreign investor). Break into four groups: 1. HSBC 2. BoCom 3. Citibank 4. CBRC Groups 1-3 should prepare a 5 minute presentation on whether the government of China should grant the request and, if so, what the ownership limit should be (30%? 50%?) and whether it should be extended to other foreign financial institutions (e.g., Citibank). Then, Group 4 should discuss the question and report its decision. Source: This case was prepared by Jonathan Doh of Villauora University as the basis for class discussion. Research assistance was provided by Courtney Asher and Elizabeth Stewart. It is not intended to illustrate effective or ineffective managerial capability or administrative responsibility