Foreign banks still flock to China despite rocky regulatory landscape

Many still keep their eyes on opportunities.

Foreign banks in mainland China continue to be optimistic about their future performance going forward, based on a report which polled 41 locally-incorporated foreign banks and branches’ CEOs and senior executives.

According to a release from EY, however, despite the optimism, many find the market challenging and complicated by issues surrounding financial reform and economic uncertainty.

“The regulatory landscape continues to challenge foreign players; alongside are also the opportunities generated from the evolving RMB internationalization and interest rate liberalization,” says Jack Chan, Managing Partner of Financial Services at EY Greater China.

The most difficult regulatory challenge in 2014 was access to the bond market, followed by the myriad of rules and regulations and capital and liquidity constraints. As China’s economy evolves, foreign banks believe it is critical that the capital markets open up and the foreign banks participate more fully in the bond market.

In addition, the respondent bank executives have ranked "remove foreign debt quotas", "remove foreign guarantee quotas”, and "better coordination among regulators" at the top of their wish list of regulatory reforms.

Here's more from EY:

Foreign banks in SFTZ - Regulators’ requirements for a standalone system for conducting businesses inside the SFTZ have created hesitation among foreign banks. Participants in this report say that the cost of such a system could range from US$2m to US$10m, but cost-benefit considerations preclude making a viable business case to their respective head offices.

On the other hand, opportunities associated with “cash pooling” received frequent mention, although the list of products that can be offered in the SFTZ remains unclear. Those surveyed also mentioned trade finance and cross-border loans as opportunities in the SFTZ.

As of 30 September 2014, 23 foreign banks have registered in the SFTZ. The survey indicated that the others are either sitting on the fence or have decided against setting up a presence inside the zone.

Impact of deposit insurance scheme and less market access restrictions - A broad outline for a deposit insurance scheme was announced on 30 November 2014, soon followed by the easing of restrictions on branch openings and rules governing RMB licenses for foreign banks on 21 December 2014.

Chan says: “The latter amendment seeks to lower the threshold for foreign banks to set up branches and do business in China. It is a largely symbolic move to make good on promises to open the country’s domestic financial sector to competition. In addition, it shows that China is preparing for RMB internationalization.”

Chan continues: “Deposit insurance is considered a precondition for liberalizing deposit interest rates and one of the final steps required in achieving interest rate liberalization. This change will have widespread impact for both domestic and foreign financial institutions; however, foreign financial institutions will likely be better positioned to respond swiftly to this change when formalized.”

In general, foreign banks surveyed do not believe a deposit insurance scheme will have a direct impact on their business. However, it is expected to suppress margins further, and will be most directly felt by retail banks.

Digital transformation - Mobile banking and the power of social media are already creating new opportunities as well as threats for foreign banks that have entered the retail banking arena. The difficulties of limited physical distribution channels have put foreign banks at a distinct disadvantage compared to the local banks.

While online and mobile banking offer a way of working around this and attracting the attention of the younger, upwardly-mobile financial consumer segment, the prevalence of internet finance services, such as Alibaba and Tencent, highlight another key challenge faced by foreign banks in the retail space. These groups, which typically operate outside of the regulatory net, offer arguably more attractive alternatives to consumers and contribute to the banks’ challenge of achieving a profitable retail banking operation.

In March 2014, the regulators approved the set-up for five new privately owned banks --- a move that will further increase competition. “Arguably, foreign players with a focus on retail banking will need to ask themselves if this will continue to be a primary focus in the future,” Chan says.

Challenges posed by the ceiling on equity investments - Partnerships with domestic players as a means to achieving market penetration and growth continues to evolve slowly. The investment ceiling restricting foreign banks to no more than 20% holdings in domestic operations no doubt contributes to the appetite of foreign banks to explore this as a means to expand their operations in China. Notably, respondents indicated the investment ceiling as the fifth most significant regulatory challenge they face.

Chan advises: “Given the relatively large influence a holding of that size provides, foreign banks should give due weighting to the strategic benefits, in addition to the financial payoff, of such an arrangement in their decision-making.”

Optimistic about future performance - In terms of total assets, based on the China Banking Regulatory Commission’s 2013 annual report, foreign banks’ market share in China was just 1.73% as of 31 December 2013. This was below their market share of 1.84% back in 31 December 2004.

Looking into the future, foreign banks expect a modest improvement in performance over the next three years. 50% of the participants predict a slight improvement while 45% of them hope to see a significant improvement.