– 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.