Why China's Banks Are Stronger than America's

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Bank of China, on the historic Bund in Shanghai

Last year China Construction Bank's net profit soared 10% to $11.9 billion. In the same period, Bank of America, which at the time owned some 19% of the Chinese lender, earned just $4 billion, down 73% from 2007. That's all you need to know to understand why Bank of America in May sold a 5.8% stake in China Construction Bank for $7.3 billion. Bank of America has been so badly hurt by the U.S. financial crisis that it needs to raise billions of dollars to recapitalize. Meanwhile, Chinese banks are making money hand over fist as China's economy continues to expand. (Read "Bank of America Needs to Play Its Merrill Card.")

What was up is now down and the other way around, and it's going to stay that way for some time. Former powerhouses such as Bank of America and Citicorp have turned into shadows of their former selves as they shed assets and withdraw from foreign markets. Meanwhile, lenders in China and India that are little known outside their home countries now have the wherewithal to expand internationally. They have the potential to become the Citicorps of tomorrow. (See pictures of the global financial crisis.)

Whether China Construction Bank and its developing-world brethren are actually willing and able to increase their international presence is an unanswered question. But the numbers indicate their relative financial strength certainly offers them the option.

Paul Schulte, a former Lehman Brothers star analyst who is now with Japan's Nomura (which took over bankrupt Lehman's Asian operations), recently compared bank balance sheets in various countries and discovered significant differences. One telling disparity is leverage. The higher the leverage, the greater the risk, and despite efforts to put them on sounder financial footing, U.S. and European banks remain overstretched by historical standards and relative to their peers. (See the top 10 bankruptcies.)

To determine leverage, Schulte divided U.S. banks' tangible assets (that is, assets, including loans, minus intangibles such as goodwill) by their tangible capital (the book value of capital minus intangibles). He got a ratio of 24.8. This is a worrying multiple: the leverage of U.S. banks in 1993, years before the start of the asset bubble whose excesses have now brought the world to its economic knees, was just 20. To bring leverage back to that pre-bubble level, Nomura estimates that U.S. banks need to either shed $2.8 trillion in tangible assets (by selling loan portfolios, subsidiaries and other holdings) or else raise $141 billion in new capital.

Europe's banks are in much worse shape, with a ratio of 40.5. They must either sell $9.7 trillion in assets or raise $485 billion in capital to bring leverage down to 20. The Royal Bank of Scotland (estimated leverage: 39.3) has already started slimming down. It recently put its retail and commercial businesses in Asia on the block. New CEO Stephen Hester has announced plans to create a subsidiary that will hold about $477 billion of the bank's assets that are earmarked for disposal.

Who has the money to buy them? Nomura found that Asia's banks are significantly underleveraged, meaning they have plenty of muscle for acquisitions. China's leverage ratio is 15.8, Hong Kong's is 14.3, India's is 11.6, South Korea's is 16.7. Having gone through rehab after the 1997 Asian financial crisis, the region's financial institutions went into the current Great Recession with robust balance sheets that they can now leverage up by acquiring the assets that Western banks are shedding. China's banks are in a particularly sweet spot. Grown fat on years of sizzling GDP growth, Bank of China (2008 profit: $9.7 billion) has a leverage ratio of only 14.

But just because you can afford to buy doesn't mean you will — or should. China's banks are still grappling with internal and external issues, including a shallow talent pool, a shortage of managerial expertise and a local currency that is not convertible, which makes it cumbersome to mobilize yuan assets to acquire and grow overseas businesses. Recent purchases by Chinese financial institutions have not turned out well. Insurer Ping An, which paid $3.5 billion for around 5% of Fortis, a European financial group, has decided to write off most of that investment after Fortis' share price fell 78% in the fourth quarter of 2008.

What Chinese banks are likely to do is to focus on Asia and other emerging markets, particularly in places where globalizing Chinese businesses are expanding. Industrial and Commercial Bank of China (ICBC) paid $5.6 billion in 2007 for 20% of Standard Bank, South Africa's largest lender, in part to serve Chinese-owned resources companies prospecting for oil, gold, copper and other metals in places like Angola, Congo, Liberia and Zambia. ICBC is now said to be interested in the Royal Bank of Scotland's Asian assets, along with Australia's ANZ Bank and Anglo-Asian lenders HSBC and Standard Chartered Bank.

Other buying opportunities will arise as Western banks, particularly those that have been bailed out by their governments, exit the world stage in order to refocus on their home markets. When these institutions regain their strength and start venturing out again, however, they may well find Chinese and other Asia-Pacific banks ensconced and thriving in many parts of the global marketplace — and ready to challenge them on their home turf.

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