Shenzhen Development Bank - Assignment Example

A Case Study of Shenzhen Development Bank Student Name Instructor Name Course Code and Name University Date of Submission A Case Study of Shenzhen Development Bank Q1. Shenzhen as an Attractive Target for Investment and Potential Sources of Value The case study provides different aspects that make SDB a strategic target for investment. However, one of the major reasons that make SDB an attractive investment is the Chinese economy. In particular, the annual GDP growth for China of 8.1% over the past decade provides opportunities for growth of the banking sector in China (Jin, Xuan & Bai 2011, p. 1). The economic growth in China is one of the fastest growing globally, and it has been projected that the country is likely to maintain a relatively high growth for a considerably long period. This implies that SDB provides an opportunity for foreign investors to have a share of the growth being experienced in the banking sector. The banking industry in China is also the largest source of financing for corporate institutions due to an undeveloped corporate stock and bond markets, meaning SDB will always have a market for its products and will likely reap high returns on assets. The financial reforms in the banking industry also make SDB an attractive investment for banking institutions seeking to venture into the lucrative Chinese market. The nationwide commercial banking license was an expansive branch network in a more affluent region, presents a large franchise value for any foreign bank that plans to enter and expand in a highly regulated Chinese banking industry. The bank has 225 branches spread across 17 cities across China, implying they have a deep penetration into the Chinese market (Jin, Xuan & Bai 2011, p. 5). SDB provides financing to export-oriented companies in one of the largest manufacturing bases in China, Pearl River Delta region and Shenzhen. In addition, the bank has a strong presence in the corporate sector with corporate loans contributing more than 73% of the company’s earnings. SDB is listed on the Shenzhen Stock Exchange meaning they are able to access additional capital through rights issues from the stock market that are the cheapest source of capital. A purchase of the 18.2% non-tradable legal person shares in SDB will make Newbridge the largest shareholder in the bank. This would mean that Newbidge will have control over the management and operations of the bank and will have the power to implement radical changes in the management of SDB. The control is important in that it is below the foreign ownership threshold of 20% in any financial institution, in China. This would make SDB the first bank to be under control of a foreign financial institution in China. As part of the purchase, Newbridge will also constitute 8 members of the bank’s board of the 15 board seats (Jin, Xuan & Bai 2011, p. 6). Further, the company will be able to change the management team and appoint their own. The company will be able to recoup their purchase price as they are allowed a lock-up period of five years, after which they will be allowed to sell their stake either through tradable shares or as legal person shares. However, it is the controlling interest that is the major gain for Newbridge. Q2. Key Risks of Investing in SDB One of the major risks that an investor has to deal with in relation to SDB is political interference. The bank has very close ties with the local government at Shenzhen majorly due to the role it has in the selection of the bank's management. This provides a conflict of interest threat majorly because the major shareholders of the bank are also the banks’ customers as they also have been issued with commercial loans (Bekaert, & Hodrick 2009, p. 54). Further, the central government has a major role in the decision making of the banks in China. This is because they’re not given the discretion to set the interest rates of their deposits and loans, which makes it difficult to properly price the credit risk in the lending business. This meant at ADB had to charge lower than appropriate lending rates for high credit risk loans specifically those of government affiliated entities. Therefore, there is a possibility that the size of SDB’s non-performing loans is large which may have an impact on the profitability of the company. There is a general over reliance on net interest income in the case of SDB as the revenue is not diversified thus a decline in the number of loans will have a direct effect on the revenues of the bank. Finally the bank risk being rendered insolvent if their capital adequacy ratio falls short of the regulatory floor proposed by the CBRC thus would require additional capitalization to be injected into the business. This capital infusion may dilute the shareholding of an inventing institution like Newbridge. Where Newbridge goes through with the purchase, and it needs to take the following measures in order to prevent the above mentioned risks from taking place. For a start, the bank needs to develop a credit risk management policy for all its classes of loans. Such a policy will provide a well-defined authorization and approval mechanism that will efficiently monitor and control the number of credit facilities granted. In addition, the bank needs to diversify into fee income businesses such as credit cards, asset management and mutual funds that do not require additional capital, but generate significant higher returns on capital compared to the net interest income. As a precautionary measure, SDB may benchmark their banking policies with the best practice in the international market which will allow them to maintain a CAR ratio higher than the regulatory floor. Also, SDB need to match their business portfolio with the CAR ratio such that they only offer loans to a level that is acceptable to the regulator (Casu, Girardone & Molyneux 2006, p. 19). Newbridge needs to reduce the conflict of interest by changing the management and creating a credit management division with the responsibility of issuing and approving loans instead of senior managers who have close relations to the major shareholders. In particular, the bank needs to implement a corporate governance policy that will have the directors have a fiduciary duty to act professionally and will have a board of directors that is independent from the bank and its owners thus reducing the conflict of interest. Q3. Reasons why Newbridge Can Win the Deal Newbridge is able to win the deal majorly due to its track record, especially with corporate turnarounds in Asian companies. To start with the company has been associated with the privatization of state-owned companies from inceptions. Currently in its development stage, Newbridge has been able to venture into a series of investments in China, notably Xuzhou VV Food and Beverage, North Iron & Steel Group and Guan Sheng Yuan where it has a minority shareholding (Jin, Xuan & Bai 2011, p. 4). This shows the company’s level of involvement in the Chinese market, which makes them a good candidate to win the deal, especially in a country where the government is quite skeptical about selling off state corporations to foreign companies. In addition, Newbridge had the opportunity of showing their track record with an example of Korea First Bank (KFB) where they had a 51% stake (Jin, Xuan & Bai, 2011, p. 6). KFB was experiencing the same challenges as SDB was facing, especially with management and its loan portfolio. It is this strong experience with financial institutions that made Newbridge the best bet for SDB with regards to the sale of the stake to a private firm. More so, Newbridge has the ability to raise the necessary capital injection that SDB is in need of to meet the regulatory requirements. Being a private equity company, Newbridge can provide the funds to improve the bank’s capital adequacy ratio in order to meet the ever changing regulatory requirements. Another that would enable Newbridge win the deal is that they will also inject foreign exchange as it is a foreign company that is able to raise finance in strong currency markets and at relatively lower interest rates a situation referred to as arbitrage. Newbridge’s acquisition of a stake in SDB will add value in that they bring international experience, for example, the experience of turnarounds that Weijian Shan brings in at the bank will likely transform it into a world-class bank. More so, being a private equity investor, Newbridge brings in managerial expertise that is in much needed at SDB that is meant to solve the conflict of interest problem with its management. Furthermore, Newbridge is in a better position to propose innovative products to offer the increasing number of bankable individuals in China. Since SDB relies heavily on the corporate segment they have to tap into the growing retail banking sector, thus require the experience at Newbridge in developing products that would attract new customers and diversify their incomes to ensure sustainability of their earnings. Also, because the majority of the bank's customers are exporting manufacturers, their need for foreign exchange to facilitate their international trade can only be provided by Newbridge. Aside from this, Newbridge may provide advisory services or facilitation to these manufacturers due to their experience in international trade. The Chinese banking industry is still conservative, and its mortgage market is still unexploited given the few numbers recorded thus SDB is able to benefit from the marketing know-how with regards to mortgages and can use this experience to develop their mortgage business. Q4. Reasons why the Newbridge-SDB Deal Failed The Newbridge-SDB deal failed to materialize majorly due to the role the bank played. In particular, SDB had established its branch networks in the Pearl River Delta region and Shenzhen, which are part of the largest and most important manufacturing bases in China having the largest number of local export-oriented manufacturers that heavily relies on SDB’s financing. Therefore, the SDB being a state-owned bank is considered as a special financial institution that provides some form of subsidized credit to their national exporters. This could explain the reason why it was difficult for the deal to sail through as the central government may not have control over the financing decisions of SDB if Newbridge has control in terms of company stock. The fact is that the terms of the loans as they are better compared to when Newbridge, which is a strategic investor seeking to reap high returns. Another reason why the deal was left off at the transition stage is the fear among SDB’s current management team with regards to their job security. They fear that their jobs may be on the line when Newbridge gains control of the bank and the Shenzhen government transfers management to them meaning they would lose their political connections. Finally, the other reason may be the modalities that were used to arrive at the final price for the 18% stake as it was argued that the deal was underpriced thus resulted in the deal failing prematurely. There are lessons that may be learned from the Newbridge-SDB deal that other investors may use when looking for a way to venture into the Chinese banking industry. For a start, there is a need to know that the regulatory environment plays a critical role in foreign investments. In particular, the CBRC required foreign companies to own up to 20% of the stake in Chinese banks. Even though Newbridge was negotiating for an 18% stake, the main aim of the regulation is to retain ownership in China rather than a foreign company. Newbridge saw the share structure as a way in which they would gain control and still adhere to the regulations, but this would still have brought problems to the private equity company. In particular, if the deal would progress Newbridge would be the first foreign company to have control of a bank in China where the majority or all the banks were state-owned and foreign investors only held a minority interest. There was a need for Newbridge to institute change over a period of time rather than immediately as they had intended to have a complete overhaul of the management at SDB. More so, Newbridge intended to replace the local manager with foreign managers thus lead to the fear among the current managers and the political class. From the Newbridge-SDB deal, one can learn that, for such high stake transactions, the national politics play a critical role as changes in the political structure and leadership is likely to change everything as the case was at SDB. Finally, SDB played the critical role of an export financing institution in China and thus was part of the government programs for economic development; thus, it would have been impossible for Newbridge to effectively manage risks associated with NPLs that are advanced to exporters (Howells & Bain 2008, p. 47). Q5. The banking industry is successful when the level of trust is high among its stakeholder and due to the fall-out in the deal there is a need for Newbridge to abandon the deal as it has lacked goodwill from the side of the Shenzhen government. However, if Newbridge decides not to give up the deal there are a number of things they have to take into consideration so as to save the deal. First, the company needs to guarantee that they will hold the untradeable stake for a longer period than the five years so as to have the trust of the Shenzhen government. In addition, Newbridge should guarantee that they will continue to offer incentives to the local exporters who are the major customers for SDB. In addition, the company should negotiate for the conversion of the licensed non-tradable stake to be tradable so as to allow for them to sell part of it at the Shenzhen stock exchange to raise the required capital to raise their capital adequacy ratio. This will dilute their ownership at SDB and allow domestic ownership while raising capital from a cheap source of capital. Newbridge should demonstrate their ability to bring in foreign exchange that is much needed by the exporting manufacturers in the Pearl River Delta region. As part of the post-investment turnaround plan, Newbridge needs to increase the fee income to reduce reliance on loan interest income. This will only be possible if the bank acts as an intermediary between the importers and exporters from China. Newbridge needs to propose and market the use of letters of credit as it would ensure exporters receive funds from importers promptly, and the risk of non-completion is reduced as pay will be based on documents rather than merchandise (Hughes & Macdonald, 2002, p. 98). This is one of the risk management measures that would reduce the NPLs and increase fees income which has a higher return on capital compared to loan interest income. Another area that needs urgent attention relates to corporate governance where Newbridge need to ensure that a new board of directors is in place with some of its members being independent from the bank (Heffernan 2004, p. 24). This would reduce the conflict of interest problem that has plagued the bank. There needs to be a credit department that will independently appraise customer loan applications and have responsible employees to make the decision to give or not to give the loans. This will prevent the haphazard manner in which loans were granted at SDB without a clear criterion. Finally, the bank should implement a policy that would ensure that their capital adequacy ratio is higher than the floor set by the regulator so as to protect bank deposits (Hughes & Macdonald 2002, p. 98). List of References Bekaert, G & Hodrick, R 2009, International Financial Management, Pearson, Washington, D.C.  Casu, B, Girardone, C & Molyneux, P 2006, Introduction to Banking, FT Prentice Hall, Upper Saddle River, New Jersey. Heffernan, S 2004, Modern Banking, John Wiley & Sons, Hoboken, NJ. Howells, P & Bain, K 2008, The Economics of Money, Banking and Finance: A European Text, FT Prentice Hall, Upper Saddle River, New Jersey. Hughes, J & Macdonald, S 2002, International Banking: Text and Cases, Addison Wesley, Bosto. Jin, L, Xuan, Y & Bai, XB 2011, Shenzhen Development Bank. Harvard Business School. Read More