From Debt to Respect: A Tale of Three Banks

Robert Hsu, March 27, 2008

Several years ago, China's three largest banks -- Industrial Commercial Bank of China, Bank of China and China Construction Bank -- were de-facto lending arms of the government. Basically, these banks existed only to provide government workers with jobs and finance bloated state-owned enterprises.

As you would expect, these not-for-profit "banks" racked up a huge number of bad debts in their loan portfolios. Perhaps as much as 30% of their loans were non-performing. This ratio is much worse than the percentage of non-paying mortgages in the United States. By Western accounting standards, these Chinese banks were technically insolvent.

In 2005, the Chinese government decided to transform its three giant lending outfits into real banks and take them public. The first step was to wipe out the bad debt so the banks could begin new lives with clean slates. China used a chunk of its enormous foreign reserves -- close to $80 billion -- to clean up the banks' bad debt.

After cleaning up the debt, the Chinese government invited international financial institutions to become strategic investors in their banks. In 2006 and 2007, Bank of America, Goldman Sachs, Royal Bank of Scotland and other global financial firms accepted the invitation to become major investors. Each of these international financial giants put up money for stakes of about 10% in China's restructuring banks.

These strategic investors also sent experts to China in order to teach their Chinese partners how to do things properly. Bank of America sent a team of 50 experienced managers to Beijing to train the management team at China Construction Bank.

Investment and training from leading global financial firms accomplished three things for China's major banks:

It raised fresh capital.
It changed the way business was conducted.
And perhaps most importantly, it created investor confidence in China's banks. The fact that leading international banks paid billions of dollars for small stakes gave investors faith that these formerly insolvent banks were serious about turning themselves around.

As Chinese financial assets appreciated rapidly in 2006 and 2007, the banks' balance sheets improved dramatically. All three Chinese banks took advantage of China's bull market and went public at high valuations. The banks' foreign investors made fortunes from these public offerings. For example, Goldman Sachs made more than $10 billion on paper from its initial investment of $3 billion in less than a year. (Unfortunately these banks don't trade on the U.S. exchanges, so we can't invest in them.) Today, these three Chinese banks are among the 10 most valuable banks in the world in terms of market capitalization.

The biggest winner, though, is the Chinese government. As a result of the banks' restructuring, the government gained credibility and clout with leading Western financial institutions. In addition, the Chinese government still owns roughly 70% of these banks -- a stake worth $440 billion today. That's a huge return on the $80 billion that the government spent in order to clean up the bad debt!

As you can see, it took a lot of time and effort to reform China's troubled banks. First, the government stepped in to solve the problem at hand by wiping out the bad debt. Next, the banks improved their business models and changed their lending practices. Third, credible investors stepped in, injected capital and restored confidence in the institutions. The last step was waiting for market conditions to improve and raising more capital. Perhaps Ben Bernanke and my old boss at Goldman Sachs, Treasury Secretary Hank Paulson, can apply a few lessons from China towards the current U.S. credit crisis.

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