Competition for bank bonanza hinges on risk control
By Mo Fan and Yang Zhijie (China Business Weekly)
Updated: 2004-07-13 14:33

Domestic and foreign firms are accelerating the launch of derivatives businesses in China in a bid to cash in on a new bonanza in the nation's fledgling financial market.

Four foreign banks -- Citigroup, Standard Chartered Bank PLC, Nanyang Commercial Bank Ltd and the Bank of Tokyo-Mitsubishi Ltd -- announced late last month that the China Banking Regulatory Commission (CBRC) had approved the expansion of their derivatives businesses in China.

China's "Big Four" State-owned banks -- the Industrial and Commercial Bank of China (ICBC), Bank of China (BOC), China Construction Bank (CCB) and the Agricultural Bank of China -- and the privately owned China Minsheng Bank Corp had already obtained licences. China Minsheng was the nation's only shareholding bank to get the green light.

According to experts, the development of the financial derivative market industry is crucial to China's efforts to build a sound capital market and to overhaul the financial system, a major engine fuelling the country's economic growth. The licences broaden the scope for these banks to conduct derivatives business for their corporate and institutional clients in China.

Derivatives generally refer to contracts that derive from another -- whose value depends on original contract or asset. Derivatives are essentially devised as a hedging device to insulate a business from risks over which the business has no or little control.

The major function of the financial derivative is minimizing market risk, as well as maximizing the investors' returns.

Taking the insurance industry as an example. Interest rate risk accounts for about 70 per cent of the whole liability risk within the insurance companies. If the central bank lifts the interest rate, some policyholders will cancel their old insurance policies and choose some high return financial products. Now under the credit-tightening situation, the insurance companies need to take pre-emptive measures to manage the liability position and protect the asset value.

Banks also face the risk of interest rate fluctuations. If a bank has liabilities carrying floating costs and assets having fixed rates, it faces the risk of an adverse movement, that is, a decline in interest rates. Writing an interest rate swap can shelter this risk -- that is, swapping the floating rate for fixed rates.

Chen Xiaoping, CCB international department manager, pointed out that foreign banks are gradually bringing mature derivative products of forex interest rate to meet the needs of high-income clients.

The core of financial derivative business is risk control, which requires banks to establish a complete internal control mechanism and risk management system.

An official at a domestic bank, who declined to be named, noted that China's commercial banks have been dealing with traditional deposit and loan business. They are entering the emerging derivative business, but lack the expertise necessary to prevent potential risks.

As a result, risk prevention and control should be on the top of the agenda before the business is started.

Therefore, the banking regulator will speed up the opening of the business, accelerating the innovation and promotion of domestic commercial banks in the derivative market.

"We will be able to leverage our global leadership in derivatives to bring more sophisticated risk management products and technology to the local market to the benefit of our clients," said Robert Morse, chief executive officer of Citigroup's Global Corporate and Investment Banking Group in Asia-Pacific.

Another serious problem domestic banks face is the shortage of specialized staff who have a good idea of the products' profit earning structure and a good command of all kinds of interest and exchange rates' trends in the international finance market.

An unnamed official at the China Merchants Bank thinks a bank-to-bank battle in the derivative business is akin to a risk control and skills competition.

In the future, experts may come mainly from the group of brokers and traders in futures companies. It is said some banks including China Minsheng Banking Corp and China Merchants Bank have set out to train their own traders.

The domestic derivatives business started in 1997 when BOC launched its long-term forex settlement business. The nation's three other major State-owned banks soon joined in.

The People's Bank of China, the nation's central bank, loosened control on the interests rate of corporate deposits over US$3 million in September 2000, which triggered a derivatives boom as commercial banks recommended structured deposits and offered asset management services to corporate clients. Many of these financial products and their derivative products became the key businesses of commercial banks.

But except structured deposits, those unqualified banks, which could not set foot in other financial derivative business, complained that the four giants had an unfair advantage and had carved up the market.

Before the enforcement of the guideline, the minimal rules concerning derivative business in various types of forex management regulations proved unhelpful in financial institutions' efforts to effectively control risks, or for the regulator to conduct supervision, or the business to realize sound development.

Recently, the CBRC also has issued Interim Measures for the Management of the Dealings of Derivative Products of Financial Institutions.

Under the new guideline, all domestic banks will participate in a fair competition for financial derivative products, which will probably improve the growth of this business.

Domestic banks are eager to elbow their way into the derivative market because of the high returns. The large forex deposit provides a broad space for the sound development of China's derivatives market. By the end of December 2003, forex outstanding deposits amounted to US$148.7 billion, including US$51.9 billion belonging to enterprises and public service units, and US$85.5 billion in individual deposits.

In April 2003, the ICBC launched forex financial derivative business including forward, swaps, futures and options. In April alone, its forex settlement business towards enterprises totalled over US$50 million. Faced with such an inviting market, the unqualified banks are keen to make their entry.

This May, France's BNP Paribas (China) set up a trading room, regarded as a strategic move, after the new derivative guideline was issued.

In addition to corporate clients, competition is also intense with regard to private clients. After the introduction of the "interest rate option" into the personal financing arena by the Bank of China, other banks followed suit, striving to offer well-designed financial products targeting wealthy private clients.

These are mainly "structured deposit products," allowing the clients undertake part of risks and share the high returns accordingly.

China Minsheng Banking Corp has launched an innovative product named "Minsheng Wealth Financial Plan," which can guarantee the basic revenue for the private client. While other banks' products are partly linked to market index or interest and exchange rate, the revenue also fluctuates with market performance.

China is also eager to co-operate with the international exchange market to enhance derivatives development.

Chicago Mercantile Exchange Inc(CME), the largest US futures exchange for foreign exchange trading, and the China Foreign Exchange Trading System & National Interbank Funding Centre (CFETS) announced on June 8 that they had signed a memorandum of understanding (MOU).

Under the MOU, CME and CFETS agreed to create a forum for a continuous flow of information between the parties and for CME to provide advice, counselling, and expertise in the development of foreign exchange derivatives instruments for China.

"The continued expansion of China's economy may be achieved by more aggressively advancing the growth of China's financial futures and options markets." said Craig S. Donohue, CEO of CME.

"Access to global interest rate, stock index and foreign currency futures and options contracts will provide Chinese banks, corporations and financial institutions with valuable hedging and risk management tools necessary to preserve the economic benefits of China's increasingly free and growing market economy."

The authors Mo Fan and Yang Zhijie are industry observers.



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