Having been asked to work with a number of Chinese banks to explain the role of Western Investment Banks (IBs) and how they make money, it became interesting to compare and contrast against the Chinese system. This is particularly poignant as it was exactly a decade ago that the wheels came of the Western banking model. So, I thought I would reflect on two areas:
- Is the model of Western IBs the one China should follow?
- What role will Chinese IBs play in the next 5-10 years
Anyone seeking to understand the landscape of IBs should refer to dealogic and their wealth of current market data. Reviewing their latest analysis of income generation for the first half of 2017 shows that Mergers and Acquisitions continue to drive profits for the main banks and accounted for $14.5bn or 1/3rd of all revenue. This was closely followed by Debt Capital Markets at $14.3bn then Equity Capital Markets with $11.2bn and lastly Syndicated Lending at $8.6bn.
This income split is explained by companies sit on relatively high cash balances and locking in relatively low cost long term fixed income funding. IPOs and traditional bank financing has been reduced in importance.
Contrarian approach – the Chinese way
Whenever I advise UK firms on dealing with China I always tell them to start by assuming the Chinese will take the exact opposite approach to you. If you think white then they will think black. So does this stack up in terms of the Chinese banking system? From my view it pretty much does.
|
|
West |
China |
Comment |
|
M&A |
10/10 |
6/10 |
State Owned Enterprises still control major industries with M&A driven by central government rather than efficient allocation of resources. |
|
DCM |
10/10 |
3/10 |
Investment grade bond market is early stage and no high yield/mezzanine markets. Security and covenant packages still unclear while ability for international investors to exercise control rights do not exist. |
|
ECM |
10/10 |
3/10 |
Strict control of IPO listings despite/because of overwhelming demand restricts ability for firms to select best options to raise finance |
|
Syndicated loans |
10/10 |
6/10 |
‘Traditional’ loan market is fairly mature however failure to permit development of an efficient secondary market and recognise non-performing-loans means it falls short of Western approach |
If we review these 10/10 scores for the West and think back to 2007, would they have still stood up to scrutiny? Are we able to set the West up as the benchmark for China? For my part I would suggest the 4 areas above would stand up to the test of time however what was not referred to above were the regulatory/compliance issues which were woefully inadequate. Similarly, the imbalance of risk/reward for those driving the market meant that unrestrained manipulation of LIBOR/FX/Swap markets led to the largest fines ever being imposed on Western IBs. We see China trying to curb market practices 1:01 such as insider trading which seem innocent compared to some of the practices undertaken in the mid-late 2000’s but how does that work for wider market manipulation?
Regulation – has China got it right?
Away from discussion on China’s ever tightening capital controls, the iron grip that China has on its ‘liberated’ markets makes me wonder if China will ever replicate the IB infrastructure the West has in place? Many of those involved at China’s Executive and Supervisory level for financial control learn their craft through the late 1990’s and 2000’s from IB specialists like Henry Paulson of Goldman Sachs. The lingering memories of future wealth through globalisation were cut short in 2008 which now hampers wholescale adoption of systems and markets that have proven their worth in creating efficient capital structures for companies that generate wealth.
What Western governments failed to do in the mid 2000’s was to impose stricter controls on Investment Banks and the market they operated in. In the UK, Chancellor Alistair Darling found tax revenues and status of London as the leading financial centre in the World intoxicating and did not ask the question “How did we get here and is this sustainable?” No-one wants to kill the golden goose but if it turns out to be infected anyway then maybe euthanasia is the best way?
President Xi has taken a hard-line proactive approach to controlling his financial markets by locking down elements that are getting out of control, notably IPO front running and real estate development. However, governments have never been good at allocation of capital over the medium to long term and so there needs to be a move towards adoption of the best parts of Western capital markets while controlling excesses.
The future
PWC produced a report in 2011 that looked at the role of BRICS equity markets would place in 2025. Even back then, China was viewed by 55% of those surveyed as being a likely market for secondary IPO listings. However, those surveyed also cites political uncertainty and regulatory interference as being the biggest inhibitors to them making the decision to list in such markets. In terms of China it will be critical to Western markets to understand the outcome of the Q4 National Congress where the new leadership, if any, will deliver the regulatory environment for IBs over the next 5-10-20 years. We know that if you left markets to decide then the Western model could be adopted rapidly by Chinese banks however China’s leaders may have other ideas. We know the building blocks are in place such as the Renminbi having Special Drawing Rights, AIIB driving pan-Asian investment, Belt and Road Initiative supporting major infrastructure investment etc however without clear direction from President Xi we will not know for certain whether the next 5-10 years will see an integrated and efficient capital market system where Chinese IBs take their place on the world stage.