Business Economics 501

– Assigment 3, Hong Kong Banking Sector Essay, Research Paper

ECO 501 BUSINESS ECONOMICS

AMA, HK, Intake 4

Lecturer: Dr. Mahendhiran Nair

Word Limit: 4,000

Executive Summary3

Consolidation a Requirement?4

Strong Consolidation Case Remains4

Consolidation activity in Hong Kong In the Past4

Oversees experience5

Traditional banks5

Internet Banks and Telecom providers of financial services5

Historical Profit Driver No Longer Present6

Consolidation Eases/Removes Disadvantages6

Efficiency Improvements6

Mergers Could Deliver Even More6

Mergers?The downside7

Mergers?The upside7

Longer Term Revenue Enhancements7

Technology7

Costs, Information And Distribution7

Customer Information Databases8

Product Delivery With Minimum Overhead Resources8

Internet Transaction Costs Tiny Relative To Branches8

E-Banking a Necessity8

Future Competitive Landscape8

Today?s Playing Field8

Larger Players to Remain Unchanged9

Corporate-Owned Banks Obvious Targets9

Mainland Majorities Likely to Remain9

The Players (Mergers or Acquisition targets)10

Potential Acquirers10

Potential Targets10

Conclusions and Recommendations11

Executive Summary

Only a few major banking groups dominate the local Hong Kong banking industry. The oligopolistic market structure and the Interest Rate Rules ensure a fat interest rate spread across the board for all banks. Even an average local bank without a good long-term business strategy achieved solid earnings growth in 1990s and throughout the financial crisis of 1996-97.

As with an oligopoly environment characteristics include:

? Consortiums and cartels;

? Such is the case with the Hong Kong banking sector groups such as Jetco (ATM banking service carried by most banks outside the HSBS-Hong Kong and Shanghai Banking Corporation Group).

? Bank Consortium Trust (for MPF, syndication loans and others).

? Net Alliance (for Internet Banking)

? Card Alliance (for credit card)

? All of which aim to achieve economies of scale and share capital investments, while maintaining independent management at the member bank.

NB: OPEC and De Beers, a good example outside the banking sector.

? Price leadership

? Following HSBC?s lead most companies bank charges are similar, if not the same as, Hong Kong?s leading bank.

? Cost-plus pricing

? A method for determining the price of goods by adding a percentage markup to average variable cost (also used in a monopolistic environment). Where profit margins in Hong Kong in the banking service industry are the same.

? Game theory

? A model used to analyse oligopolistic behaviour as strategic moves and countermoves, very much like a game of chess

? Kinked demand curve

? A demand curve that illustrates price stickiness

? If one company cuts prices so does the competition. If one firm raises prices so does the competition (See Figure)

? An example here can be illustrated by interest rate hikes. Although the Hong Kong Monetary Authority (HKMA) may increase or decreases prices, banks do not necessarily have to follow suit but they usually do.

? Inter-bank rates are another example (the money that banks lend each other).

The Asian currency crisis exposed banks? weaknesses such as the fragile credit policy, heavy loan concentration, and the lack of a diversified revenue base. While the strong family tie has remained a barrier for takeovers and mergers, I believe the rapid technology development and the growing demand for one-stop financial shopping will speed up industry consolidation in Hong Kong. Therefore, the long-term competitiveness of Hong Kong?s banking sector will be determined by the strategies that are employed in the region.

Banks offering a convenient and comprehensive range of banking services and further customized investment products are at a better competitive advantage to recruit quality customers. Large banking groups, such as the Bank of China group, HSBC group, Standard Chartered Bank together with the newly acquired Chase?s Hong Kong operations are threatening the survival of the mid-range banks (banks with capital in the medium range). Those smaller banks failing to address customers? needs, will result in a shrinking customer base and eventually will be driven out of the market.

Hong Kong?s banking sector comprises of banks in the following groups:

? Small – Banks such as the previously run Kwong On Bank and the likes of as Liu Chong Hing Bank (LCHB), International Bank of Asia (IBA) and FPB Bank.

? Niche ? Merchant banks, specialised and offshore service banks. Citigroup for high net worth individuals or ABN AMRO in the mortgage arena.

? Mid-range – medium-sized local banks with broad franchises such as Hang Seng Bank (HSB), Bank of East Asia (BEA) and Dao Heng Banking Group (DHBG)

? Large (global) ? Hong Kong Banking Corporation (HSBC), Standard Chartered Bank (SCB), Bank of China Group and Citibank.

Niche market players are not widely present in Hong Kong, however, new market segments are likely to be exploited by other banks, once they are identified and proven profitable.

It is believed that alliances such as Jetco, Net Alliance etc., will pave way for mergers in Hong Kong. Smaller banks, including International Bank of Asia (IBA), Hong Kong Commercial Bank (HKCB), LCHB, are more likely to become the merger and acquisition targets.

Consolidation a Requirement?

The urgency which the past several year?s financial pressures has forced small and medium-sized banking institutions, to consider and discuss more openly potential consolidation activity has dissipated as the operating environment has improved with little real progress (DBS Bank?s acquisition of Kwong On Bank was the only corporate activity). However, I believe the case for consolidation within Hong Kong?s banking sector was strong before the financial crisis and remains strong today. Smaller players need to find ways of overcoming their scale, penetration and technology disadvantages to large, medium and even global banking groups in order to stay competitive.

There has long been a case for consolidation within Hong Kong?s banking sector given the sheer number of banks and bank branches operating in the SAR. The pressures of the operating environment during 1998 and 1999 accelerated speculation about merger activity and banks themselves became more willing to consider and discuss the idea. The Financial crisis had major effects on Hong Kong?s banking sector due to bad debt and loans in Asia that were given during 1997.

Strong Consolidation Case Remains

The case for consolidation is as strong now, if not stronger, than in 1998. Whilst it may no longer be the case that smaller players face immediate liquidity or capital concerns that could force them into other arms, the changing face of banking sector in Hong Kong should inevitably drive consolidation. Slower rates of loan growth (historically the key profit driver for small banks), the need to increase penetration in the consumer segment, achieve cost efficiencies and the rapid pace of technological development, all make the future competitive landscape for smaller banks much tougher, not to mention the possible entry of non-traditional players such as telecoms providers and retailers into the business of providing financial services.

Consolidation activity in Hong Kong In the Past

Consolidation has not been entirely absent from Hong Kong?s banking sector ? DSF purchased Wing On Bank from HSB in the early 1990?s as part of its drive to become a full service retail bank. DHBG acquired OTB (Overseas Trading Bank) from the government in 1993 including the now very successful credit card business, and BEA bought Union Credit Bank (UCB) in 1995. The possibility of foreign purchasers should also not be ignored (DBS?s acquisition of Kwong On Bank has already been mentioned and there was some speculation that both ABN AMRO and GE Capital have long been rumoured to be interested in acquiring a local retail presence).

Chase by putting up its retail business for sale on Hong Kong aligned its business model with its global strategy of focusing on wholesale and investment banking. Chase’s Hong Kong operations sold its four branches and credit card business in Hong Kong to Standard Chartered Bank for US$1.3 billion. According to Chase, the book value of these assets amounted to US$640m at the end of 1999.

Oversees experience

The experience of the US and UK markets shows that stand-alone e-banks suffered losses due to the sizable promotion expenses and the skinny interest rate spread for gaining market share of loans and deposits quickly. Major local banks are still hesitating in setting up an e-bank as the revenue model will be quickly duplicated by competitors. There will be stronger competition among the virtual banks because of the lower entry barrier and the more sophisticated customers that are likely to be more price-sensitive and demanding.

Dah Sing Financial (DSF) had incorporated plans to launch the first stand-alone e-bank in Hong Kong by the end of 2000 and would have had a first mover advantage, however, other banks such as Hang Seng Banking Group built up a distinctive e-banking strategy earlier.

Hong Kong would do well to adhere to overseas concerns.

Traditional banks

Globalisation of business activity is intensifying competition, forcing firms to focus on their strengths and eliminate their weaknesses the 1990?s saw an unprecedented number of mergers and acquisitions in a whole range of industries from retail to financial, from media to technology. As two organisations merge the potential property rationalisation increases.

Lloyds TSB merger (in late 1995) has resulted in 1,800 overlapping branches – it is estimated that a the merger allowed for between 700 and 800 outlets to be eliminated. The cost saving and efficiency improvements for the merger where estimated to be huge.

The disposal of waste = improvement in efficiencies.

Again due to global pressures and economies of scale Banque Nationale de Paris and Paribas formed a merger in 1999 to create BNP-Paribas, now among one of Europe?s 10 leading banks.

Efficiency gains and reduced overheads were the prime reason for the merger as was the case with Deutche-Bankers Trust, Chase-Chemical, Citibank-Travellers and even the IBJ-Daichi Kangyo-Fuji mergers.

Internet Banks and Telecom providers of financial services

Direct forms of customer contact such as telephone service and Internet banking are replacing traditional high street banking and what is termed ?bricks and mortar outlets?. The bank, First Direct, services all one million customers from just four sites displaying the profitability that can be gained from on-line banking if no land and overheads are kept to a minimum.

Net.B@nk – operates through NetBank, a federally insured bank operating exclusively on the Internet. The online bank provides a broad range of banking and financial services. The Company offers a broad array of products and services that customers would typically expect from a traditional bank. Products and services include checking and money market accounts, certificates of deposit, Individual Retirement Accounts (IRAs), electronic bill payment, debit cards, credit cards, mortgage loans, business equipment leases, securities brokerage services, home equity lines and electronic document and image storage in a virtual safe deposit box.

VirtualBank is another example of a non-traditional bank and financial services organisation that with low overheads in land and overheads such as labour can offer direct banking services.

Historical Profit Driver No Longer Present

Between 1995 and 1997, small banks in Hong Kong grew their loan portfolios at an average of over 30% per annum. Loans for use in Hong Kong, already standing at over 150% of GDP at the end of 1998 as well as a significantly slower rate of nominal GDP growth than Hong Kong has typically been used to, the opportunity for loan growth of this scale (without serious asset quality implications) simply will not exist in the local market

Consolidation Eases/Removes Disadvantages

Consequently, smaller banks could find themselves increasingly squeezed out of the potentially more profitable segments of the market. However, by joining forces with a partner, domestic or foreign, some of these disadvantages could be overcome. At the very least domestic consolidation could create efficiency opportunities and larger customer bases over which to spread development costs, while co-operation with a foreign partner could give access to skills and technology which would be too expensive for a small institution to develop alone.

Efficiency Improvements

Cost/income ratios in Hong Kong are not high by international standards, varying from HSB?s 27% to a little over 50% at the likes of Dah Sing Financial (DSF) and Wing Hang Bank (WHB). However, it is clear that greater efficiencies can be achieved in the banking system. Even without consolidation, several banks in Hong Kong reduced costs dramatically in response to the operating pressures of 1998. DSF, having closed 5 branches and shed almost 17% of its staff last year is currently seeing costs running 10% below the level of the same period last year whilst IBA reduced headcount by 26% in 1998 and expects to see a double-digit reduction in costs in 1999.

Mergers Could Deliver Even More

Consolidation could achieve more. Many US bank mergers are predicated on 30%-35% cost savings for the combined entity. Taking an oft-talked about example combination (DSF-WHB) and assuming cost savings could be implemented for 2000, a 10% reduction in the combined cost base could enhance attributable profit by 8% and, assuming a prospective PER in line with DSF (currently the more lowly valued of the two banks), lift the combined value by 5%. A 35% cost saving would lift combined profits by 29% and potential valuation by 25%. In fact, a combined DSF-WHB would have total assets of HK$88bn and be much closer in scale to the likes of BEA and DHBG, both of which enjoy significantly higher valuations.

Mergers?The downside

Mergers do, however, have significant downsides and these need to be considered by the Hong Kong Monetary Authority as the impact of globalisation and consolidation in Hong Kong increases. The biggest losers are the consumers and in this case can be considered as Small-Medium Size (SME) companies, consumers (everyone with a bank account) and even the larger enterprises whose choice of banks and therefore, possible providers of required loans needed to operate, are reduced. In addition, those employee?s that are likely to lose their jobs may need retraining and assistance with recruitment functions.

Mergers?The upside

There are two key areas of merger efficiency ? removal of branch duplication and reduction of central overheads. There is approximately one bank branch for every 3,000 people in Hong Kong, twice the ratio of the US or UK in a geographically much smaller area. Most of the small-medium sized banks have similar branch networks in terms of geographic spread and the elimination of duplication would be a key area of efficiency in any merged entity.

Head office and back office functions such as human resources, transaction processing and property management could be combined and reduced ? a merged entity would not require two administration departments. Unlike the case of DHBG?s acquisition of OTB from the government, it is not expected that non-rationalisation clauses (imposed regulations on the bank and what it is able to do with OTB by the government) to feature in any future merger activity. There could also be efficiency in the form of lower funding costs generated by a large deposit gathering franchise.

Longer Term Revenue Enhancements

In focussing on efficiencies one should not ignore possible revenue enhancements. Whilst some combinations may in fact have considerable customer overlap, some banks would benefit from a larger customer base into which to sell their existing products ? DHBG with its credit card business or DSF with its life insurance arm for example.

Technology

Costs, Information And Distribution

Technology has three key roles to play in the future of banking ? lowering transaction costs, information warehousing and enhanced distribution. A domestic merger would probably focus on the first of these but would also enable the development cost of information and delivery systems to be spread over a larger income base whilst acquisition by a foreign party might immediately bring technology enhancement benefits in all three areas.

Customer Information Databases

As cross-selling becomes more and more important to revenue, customer information databases ? made available to all sales staff ? which contain information regarding the existing products a customer and, based on the banks knowledge of the customer?s personal circumstances, suggest suitable additional products will be vital in the scramble to grab wallet-share (revenue market share)..

Product Delivery With Minimum Overhead Resources

The potential cost benefits of improved technology, both in processing and delivery channels, are substantial. Not only can telephone, ATM and internet banking deliver a bank?s product to consumer with minimal human resource and no real estate cost (a significant saving in Hong Kong?s high property price environment), but the penetration of the population can be increased. There is an average of more than one residential telephone line per household in Hong Kong and enough PCs to cover 78% of homes.

Internet Transaction Costs Tiny Relative To Branches

Recent estimates suggest that the cost of a telephone banking transaction for the provider is half that of the same branch-based transaction, ATM transaction costs are as little as 20% of branch-based costs and internet banking transactions can be processed for just 2% of the cost of branch transaction. The players who have the resources to develop these systems will ultimately enjoy much lower cost/income ratios than they do today. But the development cost of such systems is enormous and smaller banks are unlikely to be able to go it alone.

E-Banking a Necessity

e-banking service has become a necessity for the success of a bank, not only because of cost savings, but also for recruiting the desirable customers. Overseas market studies found that those banks with a strong brand image and the first to launch Internet banking will be able to recruit the young affluent customers (also long term potential customers). These customers can bring in profitability, as they usually have greater demand for financial services and carry lower credit risks. Those banks failing to cope with the technology revolution will result in retaining only the less profitable customers.

Smaller banks, such as Liu Chong Hing Bank (LCHB), International Bank of Asia (IBA) and FPB Bank, may have to invest more on the IT and upgrade their operating platform and procedures before considering e-banking on a large scale. They are also the potential to become merger and acquisition targets as discussed below. Automated banking service has been well received in Hong Kong. Hang Seng Bank (the second largest local bank) has over two millions of customers from all walks of life in Hong Kong, yet 82% of the transactions are performed through automated channels. Off-counter transactions will increase further when their customers become more familiar with the Internet banking and mobile banking services.

Future Competitive Landscape

Today?s Playing Field

The local banking scene in Hong Kong today essentially has four key segments:

? Large universal financial services providers such as HSBC, Standard Chartered and the Bank of China Group

? medium-sized local banks with broad franchises such as HSB, BEA and DHBG

? Smaller banks focussed on small and medium-sized companies and sometimes specific ethnic segments such as Hindu Banks and Muslim orientated organisations

? Foreign and Niche players specialising in key market segments (Citigroup for high net worth individuals or ABN AMRO in the mortgage arena).

Larger Players to Remain Unchanged

The large players are likely to remain in their current form. The medium-sized players have relatively little to gain from an acquisition of a smaller bank (some cost synergies) unless the target bank enjoys a specific franchise segment in which the acquirer has little presence. However, these medium-sized players could be attractive to foreign banks looking to expand their international franchise (ABN AMRO, OCBC).

Corporate-Owned Banks Obvious Targets

Corporate-owned smaller players (listed or unlisted) could find themselves available for sale as their conglomerate or foreign parents seek to focus on core businesses. In particular banks with significant Japanese shareholders would be obvious acquisition candidates for larger or overseas banks who can bring additional expertise, specifically in the area of technology. The level of family ownership amongst small banks in Hong Kong remains high and it likely to continue to be difficult to gain control of such banks except in the case of family financial distress ? instead we could see greater focus on niche strengths.

Mainland Majorities Likely to Remain

Finally, there are the so-called ?red chip? banks where the major shareholder is a mainland entity. Even if the operating environment deteriorates and profitability is eroded for these banks they could find themselves ultimately wholly-owned by mainland parties with profitability a secondary concern to prestige value.

The Players (Mergers or Acquisition targets)

Potential Acquirers

The very largest operators in Hong Kong?s banking sector are unlikely to be interested in further expanding the franchise through acquisition. However, mid-sized players such as BEA and DHBG could have an interest in acquisitions that would add new products, services or customer segments (it is known, for example that DHBG did cast an eye over Kwong On Bank). Amongst smaller players, IBA probably has most financial clout through its parent whilst DSF may well entertain the prospect of a merger of equals. A number of foreign players are also believed to be interested in entering or expanding their presence in Hong Kong, most notably ABN AMRO and GE Capital and OCBC (DBS having already acquired Kwong On Bank).

Potential Targets

Potential targets in our coverage universe are DSF and WHB (relatively high asset quality and some income diversification coupled with major shareholders with less than 50% interests). DHBG with its successful credit card and direct mortgage business would be an excellent entry for a foreign player were majority shareholder Guoco to decide to sell. FPB was recently taken off the market by its parent but WLB could be regarded in play if DBS decides to unload its stake now that it has another vehicle. HKCB, after recent well-publicised problems, might even be actively seeking a suitor. LCHB, whilst controlled by a combination of the Liu family and Cosco Pacific, appears attractive at least in valuation terms (although the franchise it would bring is unclear).

Smaller banks, such as Liu Chong Hing Bank (LCHB), International Bank of Asia (IBA) and FPB Bank are also key targets of mergers and acquisitions.

Conclusions and Recommendations

In order to survive in Hong Kong?s banking sector some recommended strategies that could be adopted but are not limited to include the following:

? Consolidate through merger or acquisition.

? Because of the standardized features of most of the banking products, keen price competition is driving down the average loan yield and therefore profits. Net profit growth will mainly stem from the banks? aggressive promotion of the fee and commission income services and lower provision charges as credit quality continues to improve.

? Past investment in technology is paying off. While it will be unlikely to achieve a spin-off of the e-banking operations to boost valuation in the near term, banks with comprehensive e-banking service will be on higher grounds to compete for young and higher-value customers. However, clear strategic direction as to future technology adoption will be needed if any bank is going to be able to compete effectively in the future.

? The growing popularity of e-banking will further strengthen large banks? market position. Equipped with more advanced information technology and leveraging on a broad customer base and strong consumer confidence, large banks are set to gain market share from their smaller peers. Again, the industry?s consolidation will increase.

? Customers demand breadth and depth of banking services; Educated young people, middle-income earners and the high net-worth individuals are the more profitable market segments to the banks. While the high net-worth individuals are unlikely to be loyal customers for the local banks, the growing affluence of the educated young people and middle-income customers will provide greater growth opportunities for the banks. These customers are more concerned about their life quality and have better financial planning for protecting themselves and their families. They will demand a broader range and more customized financial services as well as the convenient account services. In addition, the increasing price transparency will drive down the profit margin of the transaction-oriented banking services. Demand for wealth management and bank assurance will accelerate and become a major revenue source to the banks in the coming few years.

? Market segmentation and marketing strategy; Local banks are offering similar financial services. The management quality and marketing strategy make the difference. Cost-effectiveness and the ability to address customer needs have become more critical. To leverage on the existing customer base, banks have placed more emphasis on data mining to segment customers into micro-niches and apply more effective marketing strategies to cross-sell services. Through various distribution channels including branches, call centers and direct mailing, banks have to actively promote their services. Banks in Hong Kong need aggressive and pro-active management together with global and Chinese market exposure.

? Customer confidence is the essential; Trust and awareness are the two key elements for the success of a bank. Besides an effective marketing strategy and a good product mix, banks must have a strong capital and reasonably large operating scale to cultivate customers? confidence. Local banks have survived the Asian currency crisis and they are in good shape, thus demonstrating their financial strength and management ability to handle tough situations. However, mid-cap banks still have to compete at price levels for both customer loans and deposits. Brand building.

? Achieve some of the benefits of merger without actually merging. Notable is the recent example of the Bank Consortium Trust, which has been formed to develop the infrastructure for common Mandatory Provident Fund and its products, which will be marketed through the branch networks of the participating banks. Ten banks are now involved one way or another in this project, which will enable development and IT costs to be shared and the economies of scale which are normally available only to larger institutions to be achieved. This is an imaginative response to the competitive environment and one, which the HKMA strongly supports. It is expected that this co-operation can be extended into other business areas, and hopefully, as the banks work increasingly closer and closer together, relationships can be forged which will lead in the direction of eventual shared ownership. This will help when competing on a global basis not just in Hong Kong.

? Look to other alternatives of mergers such as alliances in potential regional powerhouses such as China, where, WTO entry is likely to increase competition on the mainland and offer local Hong Kong banks in particular, greater opportunities.

Conclusions of the oligopolistic environment of the banking sector in Hong Kong will lead to:

? Interdependence in decision making, no one bank will make a move without the other banks following suit.

? Oligopolies (therefore the Hong Kong banking sector) avoids price competition

? In the long run consumers will pay high prices and consume less than in a pure competitive market

? Consumers may pay economic profits in the long-run

? Employees of possible mergers and acquisitions may require training and assistance.

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