Emerging Markets Banks #2. Riding the rise of a credit culture?

Emerging markets banks have doubled since 2005. They are relevant in the industry profit and revenue wise. The rise of a credit culture might explain this trend. Nevertheless, these banks are still not quite known by the rich-world investors. Is this an opportunity for further growth?

The bigger and bigger picture
May 13th 2010
From The Economist print edition

The developing world’s banks are flourishing

THERE is only one thing that is still small about banks in emerging economies: their bosses’ pay packets. The head of China’s ICBC, the world’s biggest bank by market value, received just under $134,000 in 2009, a couple of decimal places shy of his Western counterparts. On all other measures these firms are big enough to make a Wall Street banker reconsider his status in the universe. In terms of market value they now account for almost half the industry’s total worldwide, nearly twice as much as in 2005. That might reflect an excess of optimism, but emerging-market banks are big by other measures too. According to Tab Bowers, a consultant at McKinsey, they account for about a third of the industry’s global revenues, matching the emerging countries’ share of world GDP. By the most solid measures of all, profits, dividends and Tier-1 capital, listed banks domiciled in emerging markets now account for between 27% and 53% of the global industry (see chart 1). China is responsible for about half of this share. Big Western banks’ profits from developing countries add up to perhaps a quarter of the local firms’.

Despite their large size, most emerging-market banks are not household names in the West. Most rich-world investors are aware of China’s “big three” banks, at or near the top of the global rankings (see table 2), but know little about them. Aside from the Chinese banks, the global top 25 include a handful of big Russian and Brazilian firms, and lower down there is a long list of smaller banks that together add up to quite a lot. The average listed rich-country bank in the top 150 has a market value of about $36 billion, against $24 billion for emerging-market firms and just $15 billion if China is excluded. Many are state-controlled and most were handsomely profitable through the crisis and have good capital and funding profiles. Few have much business overseas.

The numbers game
League tables in banking are dangerous things. In 1990 all ten of the world’s largest banks by assets were either Japanese or French. Such things can change quickly. The big emerging-market banks should therefore view their rise with a mixture of pride and nervousness. China’s biggest banks are all still state-controlled. ICBC, spun out of the People’s Bank of China in 1984, is run by Jiang Jianqing, a career banker. It has been making a flurry of investments in Asia and Africa. China Construction Bank (CCB) has its roots in development banking. Its boss is Guo Shuqing, who ran China’s foreign-exchange fund before taking CCB public in 2005 in the first big bank flotation. Bank of China has a grand pedigree dating back to 1912. Traditionally China’s foreign-exchange and trade bank, it still has the largest presence abroad. Bank of Communications is the only Shanghai-based big firm, in which HSBC holds a 19% share.

Brazil’s two big private banks are widely admired. Itaú Unibanco was formed through a merger in 2008 which saw it overtake Bradesco by size. Both firms are battle-hardened survivors and have big insurance, credit-card and investment-banking operations. Listed but state-controlled, Banco do Brazil is the country’s biggest financial firm, with a fifth of total assets. It has increased its market share since 2007 and is looking abroad.

Russia’s banking system is fragmented, with only two giant firms, both state-controlled. Sberbank controls almost a third of the country’s deposits and has a mixed loan book. Its newish management is trying to cut costs and spruce up its business at home. VTB Bank started as a merchant bank but has gradually built up its branch presence. About a quarter of its profits now come from retail banking.

India’s banking system is small but growing fast. About three-quarters of the industry is in government hands, with the listed but state-controlled State Bank of India commanding about a quarter of the market. It has been revived under the watch of O.P. Bhatt, who became chairman in 2006. ICICI Bank, for a long time the pin-up of the private banks, paused for breath in 2009, rejigging its strategy to target industry as well as India’s burgeoning middle classes. Its veteran boss, K.V. Kamath, became chairman in 2009, with Chanda Kochhar taking over as chief executive. HDFC Bank is still a tiddler by assets but its market value has shot up, reflecting confidence in its domestic strategy and its combative chief executive, Aditya Puri.

Singapore, Turkey and South Korea also have banks with market values in the $20 billion range. But perhaps the most notable firm outside the BRIC group of countries is Standard Bank of South Africa, run by Jacko Maree since 1999. Almost a quarter of its profits come from outside its domestic market, mainly the rest of Africa. It got a big boost in 2007 when ICBC bought a 20% stake. A takeover, both parties say, is not on the cards, but Mr Maree’s business cards are now in both English and Chinese.

Just how big could such emerging-market banks get? Any self-respecting bank bull likes to whip out a chart comparing the ratio of bank loans with GDP in poor and rich countries. The poor countries generally have much lower ratios. The hope is that emerging-market banks will enjoy a double benefit. Not only will their economies grow fast but financial activity will become more intense, allowing banks to grow faster than GDP. Today quite a few banks in Asia, Africa and Latin America forecast that their loan books will rise by 20-30% annually over the next few years. Assuming that Western banks stagnate, that would mean China’s biggest bank would take about two years to reach the size of, say, JPMorgan Chase, measured by risk-adjusted assets. The biggest banks in Brazil, Russia and India will take seven to ten years.

The idea that banks are “GDP-plus” businesses has obvious pitfalls. In 2008 and 2009 the loan books of emerging-market banks outside China grew relatively slowly, at about 10%, although in China they expanded by about 30%, and the pace elsewhere will pick up this year. And if credit grows too quickly for too long the system tends to explode, as America and some other Western countries have found.

In central and eastern Europe too, where loans rose at twice the rate of nominal GDP between 2000 and 2007, they hit a brick wall in 2008 as overextended banks ran out of funding and bad debts mounted. In much poorer Nigeria, talked up in 2006 by Mayfair hedge-fund managers as the next great “frontier” banking market, credit as a share of GDP doubled in about three years to around 30%. With small branch networks and relatively few people in the formal economy, this was too much. About a third of the system by assets is now distressed. The lesson from the Asian crisis of the late 1990s is that systems generally shrink after a blow-up.

Credit relative to GDP, then, does not grow in a straight line, thanks to the economic cycle. But even in the longer term a rising trend is not inevitable. According to Credit Suisse, domestic credit to the private sector credit relative to the economy has been flat or falling between 2002 and 2008 in China, Mexico, Malaysia, Thailand and the Philippines. And even if borrowing levels are rising in the longer term, banks’ role in supplying that credit is not assured. In America much of the work of financing companies is done through capital markets. Emerging-market banks may face a similar trend. Except in Brazil, most of their business consists of loans to industry. Fast-growing local capital markets could take some of this away. If so, the biggest part of the banks’ balance-sheets would actually shrink relative to GDP.

Penetrating arguments
Yet for all the caveats, emerging-market banks can count on vast untapped demand. McKinsey estimates that most people in Latin America, Asia and Africa lack access to formal banking services. Slowly the supply is catching up. Bradesco in Brazil has recently opened the world’s first floating bank branch (which sails down the Solimões River in Amazonas) and the first branch in Heliópolis, a big favela (slum) in São Paulo. State Bank of India has more than doubled its number of ATMs since March 2008 without seeing a decline in transactions per machine per day, currently about 300. Most banks are trying to reach the “unbanked”. This is partly a question of technology—for example, providing biometric identity cards for illiterate people without papers. It is also a question of organisation. Mr Kamath, the chairman of ICICI, India’s biggest private bank, is thinking about appointing an agent in each village who would be given the kit to link up with the bank’s system. Indian government schemes to guarantee work for rural workers for 100 days a year and to introduce identification cards for all could be a catalyst for the spread of such schemes. Like most bank executives, Mr Kamath accepts that these will not make the industry money “for quite some time” but reckons that “no bank can afford not to be there.” Mr Puri, the boss of rival HDFC Bank, says that on a “five-year horizon it can absolutely move the needle”.

But the real boon for many emerging-market banks has been the rise of a credit culture among the middle classes. Well-off people behave in a way their parents would find unimaginable, buying homes and cars not by saving up but by borrowing. The ratio of household borrowing to GDP points to this in all big developing countries (see chart 3). If the world economy rebalances so that surplus countries save less and consume more, mortgages and consumer loans will become the banks’ biggest source of profits.

Although competition may put pressure on emerging-market banks’ high margins, there are offsetting factors. People will shift their savings from deposits to investment products with better yields that banks can charge fees for. Low-cost technology too could boost profits. India’s banks say they have leapfrogged the expensive mainframe computers of their Western peers and expect a rapid move towards mobile-phone banking among the young. In China people do not use cheques but can get text-message confirmations when they have used their credit cards, reducing the risk of fraud. Noel Gordon, a consultant at Accenture, jokes that when Western banks were fiddling with rocket-science finance, emerging-market banks were innovating more productively by opening up entire new markets that will make sustainable profits.

Emerging-market companies also promise to give the banks lots of new business. This year there will be a boom in loans as they shrug off the downturn. In the longer term banks will have to adapt as local capital markets develop and businesses expand abroad. Most lenders are building up investment-banking skills and a presence overseas that will generate income as more local businesses turn to issuing bonds and shares for finance.

And even though all these opportunities still lie ahead, emerging-market banks have already taken a giant leap in size and profits in the past decade. They have also maintained adequate capital ratios and ample deposit funding. The combination of growth and strength would appear to give them enormous advantages, heralding a rebalancing of power in global finance. Yet are those rock-solid balance-sheets quite what they seem?

Published by Janar Wasito

Janar Wasito is the manager of Magis Capital in San Diego, CA. He is a graduate of Harvard and Stanford Law School, and a former Marine Officer.

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