july 2012 banking on china - oracle · 1.6 million wealthy households1 in china in 2010. this...

July 2012

Banking on China a Look at the key issues and Challenges for international Banks Entering the Mainland China Market

Contents

China’s Economy in 2012

Foreword 1

2

5Business Opportunities for Foreign Banks Coming to China

12

Key Success Factors for Moving a Core System to China 16

Core Systems in Mainland China

Conclusion / Recommendation 17

Although China still remains one of the largest financial markets in the world and offers significant market opportunities, the global financial crisis has made it challenging for international banks to operate and expand as quickly as before while still managing their balance sheet effectively. As they seek to continue to expand and develop in the face of more tempered economic growth andincreased competitive pressures, financialinstitutions (FIs) are increasingly focused on technology as not only a key potential source of cost savings, but a source of competitive advantage.

An institution’s core-banking system is obviously a large part of any organization’s technology footprint and is a unique consideration for any China strategy both because of the external market challenges and demands as well as China’s industry regulations themselves.

With this in mind, the Banking on China report, published by Kapronasia and Oracle, takes a detailed look at the challenges for FIs in more detail, identifying the key business opportunities for International banks in China as well as some of the unique core-banking considerations that these institutions should keep in mind when they come to China.

We hope you find this report as interesting to read as it was for us to research.

1. Foreword

Banking on China: A Look at the Key Issues and Challenges for International Banks Entering the Mainland China Market | 1

Zennon Kapron Managing Director KapronAsia

Parvez Ahmad Director, Marketing Oracle Financial Services

2. China’s Economy in 2012

China continues to be one of the strongest growing economies in the world and has grown to be the second largest economy in the world behind only the United States. Although China’s economic growth has been somewhat tempered in the past few years, GDP remains, much to the envy of the rest of the world, in the high single-digits.

Currently there are several trends in the market that are affecting the economy as a whole:

Eased overheating followed by robust and stable growthDuring the early part of the current Global Financial Crisis, China managed to sustain double-digit GDP growth through an aggressive stimulus program designed to mute the impact of the crisis. This inevitably led to the threat of overheating the economy as the worst of the crisis past. Consequently, the government has taken a series of macro-level measures to smooth the economic growth and so far has avoided a hard landing. The recent successive interest rate cuts and deposit reserve ratio reduction further reflect China’s focus on robust economic growth and long-term stability.

Inflation and Investmentconsistent with China’s growth outlookAs the stimulus program was very large, it was unsustainable both from a ‘sound economics’ perspective and a fiscal perspective as it relied heavily on infrastructure investment to prop up capital formation. Recent policies and pilot initiatives imply that regulators are working to move the economy onto a path of more sustainable long-term economic growth.

Political policy changesThe forthcoming leadership transition is, in some sense, a stress test for China’s economy. Although the leadership transition has been carefully planned and coordinated, transitions have always given China observers both domestically and abroad food for thought. Though the short-term will be somewhat uncertain in terms of future policy, it is likely that more reform-minded politicians will continue to push and drive reform both in the financial markets and in China as a whole.


Oracle July 2012 Kapronasia

China’s GDP Outlook

Source: IMF World Economic Outlook Database, Kapronasia

China’s GDP PPP-Based Share of World Total




China’s Total Investment vs Gross National Savings


China’s Inflation Outlook




3. Business Opportunities for Foreign Banks Coming to China

China’s economic and financial services landscape continue to be ever-changing: China still serves asone of the preeminent driversof global economic growth, in spite of the slight GDP drop from double digits to high single digits;the coming leadership transformation heightens the political uncertainty; banking and securities market are seeing a myriad of regulatory reforms to boost financial innovation and improve trading infrastructures.It is therefore of central importance to capture the most relevant and significant market dynamics for global banks establishing or expanding their business in the Chinese market.

In this section, we identify the key China market trends and elaborate on the business opportunities and challenges for international banks in China.

3.1. Overview of China market

Increased trade still a key driver of growthAs a prominent player in international trade, China has delivered an average trade growth rate of some 20%. Despite the slight drop at the start of the global financial crisis from 2008 to 2009, growth took off again in 2009, again reaching nearly 20% annually, signaling China’s continued importance in international trade markets.

Goods, Value of Imports & Exports

Source: China National Bureau of Statistics, Kapronasia



Importance of RMB increasing in global investment and paymentAs the RMB continues to grow as an accepted trade currency, Chinese authorities are further moving to promote RMB internationalization in the hope of raising its currency’s importance and profile in international trade and investment. More than a year ago, China and Russia announced bilateral agreements to use their national currencies for cross-border trade settlement and by the end of 2011 RMB-denominated trade between the two countries had climbed to almost 2 billion yuan ($317 million). Recently, China and Japan made similar announcements to encourage more extensive use of their currencies in bilateral trade between the two countries.

Offshore RMB trading has also developed rapidly. Besides Hong Kong, the biggest offshore RMB trading center, London has already grown to become a key offshore RMB hub as well. According to SWIFT, 30% of RMB payments and 46% of RMB foreign exchange conducted outside of mainland China and Hong Kong went through London in Q4 2011.

Although the RMB remainsa less important medium of exchange in global paymentsthan other global currencies such as the US dollar or British pound, it has emerged as the #3 currencyfor the global issuance of letter of credit, second only to US dollar and Euro.

China’s International Trade

Source: China National Bureau of Statistics, Kapronasia



Global Issuance of Letter of Credits, Transaction Value

Source: SWIFT RMB Tracker, May 2012, Kapronasia

On top of the aforementioned trends of internationalizing RMB, the deteriorating confidence in Euro due to the recent European Debt Crisis will likely further raise the relative importance of RMB in global markets.

Wealthier consumers fostering a boom for private bankingBeyond RMB internationalization, another result of China’s increased trade and relevance on the global market is an increasingly wealthy population.There were estimated to be 1.6 million wealthy households1 in China in 2010. This number is anticipated to surpass 4.4 million in 2015, next only to the USA, Japan, and Britain after adjustment of wealth by purchasing power. It is also expected that the number of wealthy households in China will grow at 16% per annum on average for the next five to seven years, which is actually faster than the expansion of the overall economy; an anomaly that is uncommon in more developed nations.2

Wealthy defined as US$3M or more of investible household assets. McKinsey: Understanding China’s Wealthy.

12



Recognizing the market trend, both Chinese and foreign banks have taken more aggressive steps to move into the wealth management market, notably since China Banking Regulatory Commission announced the “Notice of Issues for Enhancing the Standardization of Commercial Banks’ Personal Finance Services and Investment Management” in July 2009.

UBS and Citigroup were among the foreign banks to start building their private banking arm in China at a very early stage. In addition, according to China Private Banking Development Report 2012, eleven domestic banks have established private banking division by the end of 2011, including Bank of China, China Merchants Bank, CITIC, Bank of Communication, ICBC, China Construction Bank, Minsheng Bank, Bank of Agriculture, Industrial Bank, Pudong Development Bank, and Huaxia Bank.

3.2. Business Opportunities

The ever-changing China market, as summarized above, offers enormous opportunities for international banks. In this subsection, we highlight some of the specific business opportunities for international banks that have arisen as a consequence of the market trends above.

Bright outlook for trade financeChina’s robust long-term growth prospects in international trade present a promising outlook for international banks involved in trade finance and other intermediary businesses to facilitate global transaction risk management.International banks have an advantage with their prior expertise, state-of-the-art business solutions and global infrastructure.

High Net Worth Population

Source: China Private Banking Report 2012, Kapronasia



In spite of the rise of RMB as an international payment currency, payments denominated by US dollar and Euro remain dominant in global payment market. Therefore, the demand from corporations for hedging FX risk will remain strong in the near future.

Risk shift brings new business from foreign customersThe key implication of RMB internationalization lies in the shift of FX risks and costs from China to foreign countries. RMB-denominated securities and contracts are initiated and traded to hedge and manage the new risks. As a matter of fact, international banks can see this shift as an opportune moment to enrich their risk management services withforeign customers. Having the RMB as an international currency makes of RMB-denominated assets more attractive to foreign institutional and retail investors; international banks typically have a well-established client relationship with these foreign investors.

Potential services for RMB overseas direct investmentIn January 2011,the RMB Overseas Direct Investment (ODI)program started to allow Chinese enterprises to conduct overseas direct investment in RMB. This creates huge opportunities for international banks to develop their intermediary business by targeting promising investment projects for Chinese investors.

The wealthy in China in need of comprehensive private bankingThe demographic aspects of high net worth consumers in China point toward extraordinarily intriguing opportunities for international private bankers. Studies show that consumers with high net worth in China are concentrated in the age group of 30 to 49, younger than those in developed countries. They are informally defined as the first generation of wealthy people in China and may need insightful financing advice to expand their enterprises or to invest liquid assets abroad. In many cases, it is also likely that their children are planning to study abroad and thus may need international student banking services.

International banks have an advantage with strong wealth management reputations and long history of providing private banking services, their expert wealth management practice, their tailored products in global markets, and superior service quality.

Geographically broad potential business in Chinese private bankingCurrently, the majority of high net worth consumers are located in China’s more developed eastern provincesincluding Beijing, Guangdong, Shanghai, Zhejiang and Jiangsu where many foreign banks have already established branches. There are however an increasing number of wealthy individuals in many of the western markets, where private banking and wealth management services are not as common. Fast-growing west provinces include Sichuan, Hubei, Hunan, and Liaoning where the number of high new worth population has grown at 31%-40% in 2008-2010, compared to 16%-25% in Beijing, Guangdong, Shanghai, and Zhejiang.3

China Merchant Bank and Bain Co.: China Private Wealth Report 2011. 3



Geographic Distribution of High Net Worth Population in China

Source: China Private Banking Report 2012, Kapronasia

3.3. Challenges

Although there are some clear opportunities for international banks in China, there are also a number of challenges.

Fewer intermediaries leading to decreased fee revenueOne challenge that increased RMB settlement and clearing presents is a reduction in intermediary services as what was previously a three-country payment flow may reduce to a two-country flow with payments cleared in mainland China or Hong Kong. As a consequence, fewer intermediaries are involved in international trades and therefore bank revenues from intermediary services are likely to shrink. Further, the risk shift from China to foreign countries is likely to impose downward pressure on international trade volume.

Nevertheless, international banks can face up to this challenge by proactive RMB strategies and smart utilization of their RMB capabilities to pitch for new businesses.

Local banks becoming increasingly competitive internationally The increasing presence of Chinese banks in international RMB clearing should not be underestimated as they are actively expanding their business by opening offices throughout the world. In addition, Chinese banks with overseas branches see the internationalization of the RMB as an opportunity to build up their payments clearing business and bring funds from foreign corporations into China.



To remain competitive, foreign banks must work to maintain a strong relationship with their existing customers through strong customer service and tailored solutions.

Private banking in its infancy in China: At present, regulations surrounding private banking continue to be very stringent. Restricted by QDII quota, the ambition of a truly globally diversified wealth management service seems far from being fulfilled. In China, private banking and wealth management is still relatively new vocabulary in the financial dictionary of the wealthy. The majority are used to simple personal finance products of low risk profile.

Notwithstanding the inhibitive state of China private banking, we expect the market will see tremendous expansion as the regulation loosens and business environment improves.



4. Core Systems in Mainland China

4.1. Latest Developments and Regulations Affecting Foreign Banks

Loosening monetary policy is revitalizing the economyAs we discussed before, China has adopted a series of macro-level initiatives to temper growth and reduce the risk of the economy and asset prices overheating. The People’s Bank of China announced 3 successive 0.5% reductionsin the deposit reserve ratio, pushing down the ratio from 21.5% to 20.0%. Moreover, PBOC announced a half-percentage-point cut in the benchmark interest rates for deposits and loans. It is widely believed that these policy movements will reactivate the credit market and release tremendous liquidity into the housing market or other sectors in demand of funding and thus continue to support China’s economic growth.

Substantial progress in financial standardizationChina has dedicated considerable effort and resources to establishing a coherent financial-standard system and ensuring the widespread implementation of formalized financial standards in order to boost the capacity of financial standards in standardizing industrial portfolio management and enhancing system interconnection and consolidating China’s global financial competitiveness.

The PBOC continues to advance the financial standardization strategy in the course of the 12th Five-Year Plan by working intimately with China Financial Standardization Technical Committee (CFSTC), other financial supervisory and regulatory authorities and financial institutions.

Pilot Financial Reforms in ChinaThe recent Wenzhou pilot program aims to optimally allocate the massive funds in the private sector of Wenzhou and to formalize and enhance the regulation of private lending by establishing legal platforms with more transparency and efficiency than the current mostly informal lending network.

Shenzhen has been flagged to be the next to promote a series of similar financial reforms to enrich financing opportunities for small and micro firms. Shenzhen is also improving its infrastructure for cross-border RMB settlement and encouraging multi-national corporations to set up global RMB clearing houses in the Qianhai Bay economic zone which has been poised to be a new financial and commercial hub. More favorable QFII regulationConsistent with China’s positive policy on QFII which has been more pronounced in the recent two years, CSRC put forward revisions of the regulation on QFII last month in the hope of attracting more overseas capital and consolidating confidence in the domestic market. Some aspects of the revision are worth attention of foreign banks:



First, QFII qualification requirements have been lowered. For example, a commercial bank would qualify as a QFII if its securities asset holdings exceed $5 billion whereas the threshold was previously $50 billion. Second, QFII are allowed to open separate securities accounts for proprietary trading and wealth management. Third, the investment scope of QFII is significantly broadened to include the interbank bond market as well as the stock index futures market. Finally, a group company is permitted to apply for multiple QFII licenses for its subsidiaries within a group.

QFII License Issuance

Source: China Securities Regulatory Committee (CSRC), Kapronasia



Type of QFII Licensees

Source: China Securities Regulatory Committee (CSRC), Kapronasia

Mixed prospects of QDIIIn addition to China’s advancement of the QFII program, the country’s regulatorshavealso been intensively pushing forward the development of QDII both in terms of license and quota allocation.

Contrary to the official enthusiasm, investment via QDII has not attracted sufficient attention from domestic investors largely due to the poor performance since its introduction. What is more, for lack of experience in overseas investment, local QDII fund managers have been unable to sufficiently diversify their portfolio to reap global capital market profits across different asset classes including derivatives, thereby creating a gap between clients’ expectation and products actually offered.

4.2. Current Issues and Needs from Core Systems in China

Existing research has studied extensively and intensively on core banking systems and related issues, challenges, and prospects. In this report, we concentrate on current issues and needs from core system in China that are specifically linked with the latest market trends and business opportunities or challenges that we highlighted in the previous sections.Increasing trade driving need for synergy in customer services

With increasing tradeto and from China, it is essential for banks to have a unified and complete view of their customers across all entities and businesses. As trade volumes increase and more counterparties are involved in international trade and transactions



become more complicated, it becomes more and more important for core banking systems to streamline and simplify the process so that both bank employees and the actual customers themselves will have an accurate and comprehensive understanding of their financial status.

Rapid business and branch expansion drive need for flexible and extensible infrastructureAlthough foreign banks are largely limited in the number of domestic branches and branch locations, core systemsneed to be able to support rapid growth both as individual banks are allowed to expand and the market regulations loosen to allow greater overall market expansion.

Rising RMB posing challenges to customer risk managementRMB internationalization will shift currency risks from domestic companies to foreign companies, thereby raising the demand for hedging against the appreciation or depreciation of RMB. As a result, the next generation of core banking system should be designed or upgradednot only to facilitate RMB-denominated global trade payments, but to respond to changing risk exposure in a timely and cost-saving way as well.

Customer-centric core systems essential for wealth managementAs private banking and wealth management grows in China, customers will demand greater customization in terms of products and services. Given the increasing wealth, better financial literacy and increasingly complicated customer needs, it becomes critical for banks to adopt their core banking systems to be more customer-centric with built-in analytics to identify, analyzeand track customer behavioracross products.

Banks’ Integrated risk management module of core systemsA bank is typically exposed to a wide range of risks, namely capital market risk, credit risk, counterparty default risk, operational risk, etc. Soundness of a bank’s balance sheet is of paramount importance to its day-to-day business operation and bank-customer relationship. Consequently, it is critical for banks to have a core banking system that can measure risk across the entire organization both in terms of product and geography.

Regulation-adaptive core banking systemThe one consistency in China’s financial industry regulation is the consistency with which it changes. Unlike the United States which was largely a loosely regulated market that has transitioned to a much more tightly regulated one, China has come from a highly regulated market that is gradually loosening. The additional complication this year is the leadership transition which has already brought in new heads for each of the three main financial industry regulators and will later this year see China have a new President. Core banking systemsmust similarly also be able to consistently adapt to the changing market.



5. Key Success Factors for Moving a Core System to China

Attracted by the continuous opening-up of Chinese financial market and enormous market potential, many foreign banks are still very optimistic about their future development in the local market, which is reflected by the increasing number of foreign banks opting for local incorporations.

With foreign incorporated banks are mandated to maintain an independent core banking system in China, it is imperative for foreign banks to have a capable information technology team in place to help either relocate their core system to the local market, or install a new core system, to better cater to their local business needs. In this process, there are a couple of key factors which are expected to determine the success of these initiatives:

Plan for system relocationIt may seem simple, but having a well thought out system migration plan is important. Depending on system architecture, each foreign bank will require different solutions to realize system independence based on their unique circumstances. Instutitonswill also need to communicate and coordinate regularly with the regulatory authority in order to determine how to achieve the relocation and regulatory compliance requirements.

Develop the local information technology teamManagement should ensure that the local information technology team has the correct skill set to cope with the post-implementation management. Although some foreign banks in China choose to outsource the operation and maintenance of core banking system to a local third-party vendor, security and service quality remain big concerns. It will be sensible for management to develop a local information technology team to be able to handle day-to-day operation and maintenance.

Disaster recovery planningIf the bank chooses to set up a new core banking system at the local level, the local disaster recovery plan should also be taken into consideration at the same time. The disaster recovery resource investment, selection of recovery sites and scoping of the disaster recovery scale should be included in the overall planning of system independence projects. In addition, in China it is important to pay attention to the growing regulations surrounding disaster recovery which have seen several changes in the last two years.

Industry reputation and commitment of the core banking vendor is keyVendor selection should also include assessing previous experience in mainland China and commitment to the market. Previous experience is fairly straightforward – a vendor who has worked in mainland China will understand the intricacies and nuances of the market that make it unique. In addition, a long-term commitment and view of the market will ensure that the vendor will be able to continue to provide adequate services in the future.



6. Conclusions

Although there are some near-term risks to China’s continued economic growth mainly concerning trade with Europe and the United States, long-term, China still remains one of the largest and fastest growing economies in the world. Along with that growth comes the need for a robust and varied financial services industry which means big opportunities for international banks who can leverage their experience in other markets and sophisticated risk, product, and customer service expertise to gain a competitive advantage.

Entering the market however does not sure success. It is only through a well-thought out market strategy that banks will be successful. A key element of that is the technology strategy and determining how the core infrastructure of a institution, the core banking system, can not only meet the current demands of the market but be flexible and adaptable enough to meet the needs of the future.



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july 2012 banking on china - oracle · 1.6 million wealthy households1 in china in 2010. this...

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