Global Banks’ Potential Faustian Pact for Chinese Market Access

The office of the locally incorporated JPMorgan Chase Bank on Oct. 11, 2007, in Beijing. STR/AFP via Getty Images

Commentary

With the phase one trade deal with the United States signed and filed, China’s banking regulators have begun to ease restrictions on foreign banks to enter the Chinese market. Starting this year, foreign investment banks can take full ownership stakes in Chinese securities firms.

And that’s music to the ears of banking executives who have long salivated for a slice of China’s financial markets.

But how good of a deal is it? If global banks aren’t careful, they can undo a decade of investor goodwill and prudent risk management following the last financial crisis.

Foreign Ownership Allowance

Starting on April 1, foreign ownership caps for Chinese securities firms will be lifted as part of the phase one trade deal. That date has been accelerated from the December 2020 target date previously floated by Chinese securities regulators.

Foreign banks can now compete to be lead underwriters of debt and equity offerings, own asset management firms, and broker deals.

It’s been a slow build-up to this point. In 2014, Beijing set up the Shanghai–Hong Kong Stock Connect, allowing investors in each market to trade shares on the other using their local brokers. Two years later, a similar arrangement between Hong Kong and Shenzhen was established. Last year, a connection between London and Shanghai was launched.

Who’s jumping in so far? Swiss bank UBS in December 2018 became the first foreign bank to gain a 51 percent majority ownership stake in its local securities venture. In 2018, Japanese investment bank Nomura Holdings received approval for a 51-percent-owned Chinese venture. JPMorgan Chase also launched a majority-owned business in December 2019. Others, including Morgan Stanley and Goldman Sachs, are in the process of establishing similar footholds. The new rules clear the way for 100 percent ownership going forward.

What’s the benefit? A slice of China’s $45 trillion financial services sector, and the fees associated with arranging debt and equity raises, investment management, and mergers and acquisitions advisory.

Today, domestic banks dominate local Chinese investment banking league tables. The top of most lists for IPOs, debt, and equity capital markets are all state-owned entities, such as CITIC, China Investment Corp., China Securities Co., and Guotai Junan Securities Co.

At the minimum, a majority or full ownership would allow global banks to consolidate their Chinese revenues and profits into group earnings to appease investors.

A Fraught Path Forward

For global banks, the first challenge is a lack of competent staff inside China. Top bankers in New York and London, or even Singapore, aren’t going to suddenly pack up and move to China—and the ongoing outbreak of the novel coronavirus isn’t increasing China’s appeal.

Banks can poach talent from Chinese competitors. But there are a ton of landmines there. Wall Street tends to have a very short memory, so let’s take a walk down memory lane.

In 2018, UBS received a fast introduction to how Beijing conducts business. A UBS banker on a business trip to China was barred by authorities from leaving the country. The staffer was confined and interrogated for about 24 hours.

In 2016, JPMorgan Chase paid almost $300 million to settle a U.S. Securities and Exchange Commission probe into its hiring of children of well-connected Chinese officials and executives. The “princelings” scandal, as it was referred to, was a black eye for JPMorgan and other global banks that ran similar schemes in hopes of currying favor with local officials.

As international banks prepare to expand their presence in China, they must also be prepared to potentially compromise existing business policies. Let’s examine a few examples.

Chinese Communist Party (CCP) leader Xi Jinping has increasingly promoted the so-called “civil-military fusion” strategy. Essentially, it’s a strategy to accelerate China into a global superpower by merging civilian industrial innovation with China’s military. In practice, it means that any Chinese-domiciled company could be called upon to hand over information or otherwise assist the People’s Liberation Army.

“China has explicitly strengthened the corporate boards’ linkages to the Chinese Communist Party,” said Nazak Nikakhtar, assistant secretary for industry and analysis, U.S. Department of Commerce, International Trade Administration, during testimony on Jan. 23 in front of the U.S.–China Economic and Security Review Commission in Washington. Nikakhtar was referring to the CCP increasingly calling on companies—including foreign-owned companies—to support the creation of CCP party committees or cells within their offices.

China’s Company Law, which applies to both state-owned and foreign-owned Chinese companies, refers to party organizations but doesn’t define their roles. But such cells can influence corporate decision-making and could indirectly grant the CCP de facto “oversight” of the company.

For example, Beijing bureaucrats, through the party cells, can compel banks to lend to China’s state-owned or private enterprises regardless of their economic merit.

Such activities would surely be antithetical to U.S. (and European) national security or political interests, and let’s not get into the myriad corporate governance violations. How can investors of international banks square that?

Lastly, let’s circle back to Goldman Sachs, the investment banking giant whose most notable recent exploit in Asia was the 1Malaysia Development Berhad (1MDB) debacle in Malaysia, where the bank was accused of misleading potential investors in bond issuances designed to raise cash for 1MDB, the state development company.

On Jan. 23, Goldman CEO David Solomon told CNBC that the bank would no longer take companies public (through an IPO) unless the company’s board of directors has at least one “diverse” member.

Promoting a diversity of opinions within corporate governance is a noble goal, and it should be about more than just one’s skin color or gender. And Goldman could force some changes among U.S. companies looking to go public.

But will the bank promote the same diversity policy when it comes to its Chinese clients? What about boards entirely made up of CCP members whose only role is to rubber-stamp Party-sanctioned decisions? And what if those decisions hurt the bank’s U.S. shareholders or clients?

For global investment banks looking to make a quick buck in China, they should be careful what they wish for.