When Frank Newman paid a visit to Shenzhen Mayor Xu Zongheng in early June, it wasn't just to exchange pleasantries. Newman will soon be chairman of Shenzhen Development Bank (SDB), the first foreigner ever to hold such a post, and he needed Mayor Xu's help. The private bank, which is 18% owned by Newman's other employer, Fort Worth-based private-equity firm Newbridge Capital Group, is loaded with bad debt. Newman was there to explain his restructuring plan to the mayor and seek his help in collecting from some local deadbeats. Having seen an ornamental sword in the office of Shenzhen Vice-Mayor Chen Yingchun a week earlier, Newman said to Xu only half-jokingly, "Maybe you can use that sword on these guys." Xu smiled and assured Newman that "we will use the sword of the law."
Can China repair its mismanaged financial system -- perhaps the most serious threat to sustained Chinese prosperity? Foreign investors, in hopes of finding the answer to that crucial question, are closely watching the unusual arrangement that gives Newman and his handpicked staff managerial control over SDB.
Newman, a bank turnaround artist who ran Bankers Trust Corp. in the mid-1990s, will officially become SDB's chairman later this year. But he has been scrutinizing the bank's operations for months, and he has observed plenty of the kind of trouble that is typical of Chinese banks -- a backward information-technology system, a bloated staff, primitive credit controls, and a complete lack of cost consciousness. Branch managers around the country have made huge, risky loans without ever getting approval from headquarters. And there are hundreds of borrowers who were unable or unwilling to pay the money back. In the weeks before Newman was to take charge, the bank finally called in the Shenzhen police to speed up collection from at least one delinquent debtor.
The world has rightly marveled at China's dazzling growth, but the colossal waste of money involved in pushing that expansion has been less well publicized. It takes $5 to $7 of investment to generate a dollar's worth of gross domestic product in China, vs. $1 to $2 in developed regions such as North America, Japan, and Western Europe. For now, China has both the enormous profits from its export trade and the captive savings of its citizens to invest recklessly. More than $3 trillion is stuffed inside Chinese banks, earning paltry interest, because the country's capital controls and undeveloped capital markets prevent savers from investing it elsewhere.
Unfortunately, much of that cash has been allocated so badly by China's four biggest banks and thousands of local lenders that most of them are limping financially -- along with many of the state-controlled enterprises that were recipients of the banks' loans. Beijing to date has spent some $100 billion bailing out the Big Four -- the Bank of China, China Construction Bank, the Industrial & Commercial Bank of China, and the Agricultural Bank of China. Standard & Poor's estimates the four will need an additional $190 billion later this decade to stay above water.
Why are China's banks in such terrible trouble? Because for most of their history they weren't banks in the Western sense at all; rather, they were financing arms of the Chinese government. "It used to be that local governments controlled the banks," says Fan Gang, president of the National Economic Research Institute.
BIG STEEL, LITTLE STEEL
Consider the steel industry. China now has more than 200 steel plants, in part because every regional government felt it needed one to feed the hot-rolled stuff to local industries. The steelmakers were all built with big bank loans. But the largest 85 of the plants produce 90% of China's steel. The rest are marginal operations that wouldn't exist without the generosity of the banking system. At the same time, China's rail network is starved for money, but its managers don't have the political connections to garner bank loans. The result is massive railyard bottlenecks. Last year 25% of those seeking to ship goods by rail were turned away, according to Andy Rothman, a strategist with investment bank CLSA Asia-Pacific Markets in Shanghai.
China's financial managers know the country's growth engine is at risk if it can't allocate capital more shrewdly. That's why they've developed a plan for each of the Big Four -- which together make 57% of all corporate loans -- to link up with one or more foreign banks between now and the end of 2006, when the banking system will be fully open to foreign investors. The idea is that the foreign stakeholders will lend their expertise and, among other reforms, help straighten out the big Chinese banks' loan books. Bank of America Corp. (BAC ) bought a 9% stake in China Construction Bank for $3 billion, and on June 23, Switzerland's UBS announced it was in negotiations to make up to a $500 million investment in Bank of China.
Analysts note, however, that the Big Four and their government overseers are unlikely to let foreign partners have much real control over management. That's why Newbridge Capital's effective takeover of SDB is so important. SDB is one of a half-dozen younger, privately owned banks created in the late 1980s. These smaller banks are much more malleable reform vehicles, although Newbridge's Hong Kong-based managing partner, Weijian Shan, notes that, even in those banks, "you really need an experienced management team" willing to shake things up. Several of these "shareholding" banks have important foreign partners. Shanghai Pudong Development Bank is 5% owned by Citigroup (C ), while Tianjin-based Bohai Bank is expected to get regulatory approval to sell a 20% stake to London-based Standard Chartered Bank later this year.
Newbridge's investment in SDB, a commercial bank with $25 billion in assets, took two years to negotiate. The talks were led by 51-year-old Shan, a Beijing native whose family was relocated to the Gobi desert during the Cultural Revolution and who later went on to earn a doctorate in business at the University of California at Berkeley. The key sticking points were share price and managerial control. In the end, Newbridge paid $145 million for its 18% stake in the bank, making it the biggest single shareholder. It bought the shares from Chinese companies with the consent of the government. As part of the deal, Newman was appointed chairman. He has recruited other outsiders for top bank posts.
`A BANKER'S BANKER'
Newman is no stranger to salvage jobs. As chief financial officer of Bank of America in the late 1980s, he plugged gaping holes that appeared in the bank's balance sheet after a wave of credit-card and consumer-loan defaults. In 1996 he took the top job at Bankers Trust after a scandal involving derivative contracts drove out a big chunk of senior management and sullied the bank's reputation. Newman "is a banker's banker," says friend Timothy C. Collins, CEO of Ripplewood Holdings LLC, the New York private-equity firm that acquired and turned around Shinsei Bank Ltd. in Japan.
Those turnaround skills will be sorely needed at SDB, where Newman has found that normal budget control mechanisms don't exist, and there is no system to measure which bank products are selling. When he arrived, Newman was shocked to find that loan officers didn't generate regular reports detailing which loans were being paid off and which were not. That matters greatly, since last year the bank doubled its provisions for bad loans, which pushed SDB's profits down 21%, to $39.4 million, on $1.08 billion in revenues. Bad loans now account for 11% of the bank's loan book. Also worrisome is SDB's capital adequacy ratio, which is 2.8%, well below the 4% mandated by Chinese regulators.
Newman, who doesn't speak Mandarin, is working with a team of experienced players who do. SDB President Jeffrey Williams is the former CEO of Standard Chartered Bank in Taiwan. Twenty years ago he opened Citibank's first mainland branch in Shenzhen. Other key players include Liu Baorui, head of retail banking, and NPL workout czar Wang Ji, both recruited from other Chinese banks. SDB's chief technology officer, mainlander Bruce Sun, is a former chairman of the Department of Information Systems at California State University. He worked for one of China's major banks before joining SDB.
Job No. 1 at SDB is to gain effective control over the bank's 230-odd branches in 18 major cities, including Shanghai, Beijing, and Chongqing. Newman says the branches have operated like "fiefdoms with their own emperors." And the little emperors have made bad loan decisions -- for instance, lending millions of dollars to build little-used toll roads connecting coastal cities. Now all major branch loan officers report to headquarters, and a central credit committee clears major lending decisions. "You try to turn off the spigot," Newman says.
A priority is doing triage on the bank's loan portfolio to decide which nonperforming loans it should attempt to collect. Newman says he has been surprised at the number of defaulted borrowers who suddenly come up with the money they owe when pressure is put on them. To go after the tougher cases, SDB has assembled a 130-person, specially trained loan collection department. "Collection has its own special set of techniques," says Newman. "You have to know how to work with lawyers, sometimes the local government, and sometimes you need to do a little detective work to see where people have assets hidden."
Another pressing issue is how SDB will raise the capital it needs to meet minimum capital requirements and upgrade its decrepit IT systems. Unless it can do that, senior executives won't be able to track costs and earnings in real time or invest in new businesses such as credit-card and mortgage lending -- a high priority for Newbridge. Newman says the bank likely will raise the cash it needs via a stock offering on the Shenzhen exchange, where it is already listed, perhaps in combination with a private placement of shares with another strategic foreign investor.
That's a tough strategy for the time being. China's markets are at an eight-year low, and stock prices will be held down for the foreseeable future by the government's promise to sell off a big portion of its shares in listed companies. SDB likely will try to raise $483 million this year, according to Hong Kong-based ABN-AMRO analyst Simon Ho, who is advising his clients to steer clear of the stock. Newman, however, is convinced he can put together a plan to raise the money he needs.
If he does, and if there isn't a huge increase in bad loans, SDB may have some interesting growth areas to exploit. First, Shenzhen (population: 10 million) is a major technology center, home to 100-plus major tech companies, including telecom networking equipment makers Huawei Technologies Co. and ZTE Corp. Newman wants to build up the bank's expertise in lending to them. He also intends to get into trade finance, raising and lending money in multiple currencies for the nation's exporters.
Then there's consumer lending. It represents only 11% of all loan assets in China, but it has doubled since 2000 as a middle class has emerged in the affluent coastal cities where the bank does most of its business. SDB has just a few hundred thousand credit-card accounts at a time when 98 million cards are in circulation in China. Lending rates on cards are capped at 18%, but the cost of funding is only 3.6% or so. The risk is that China doesn't really have a system of independent credit bureaus that can help banks assess risk.
Just how long will it take to get SDB back on its feet? Well, Newbridge has made a commitment to hold its stake in the bank through the end of 2009. After that, it will probably sell to the highest bidder -- and maybe make a bundle on the way out, as it did early this year when it sold its stake in Korea First Bank to Standard Chartered. But there's more to this saga. If Newman & Co. can refashion SDB into a bank with a real credit culture, its success could have a ripple effect throughout the Chinese money system. For an old banking hand from the States, that would be quite a legacy.
By Brian Bremner