Smoother Sailing for Taiwan’s Banks Offshore

The sector netted record profits in 2014 on the back of burgeoning offshore business, especially in China.

The crowded Taiwan banking sector is finding room to breathe at last. Rapid expansion of offshore business amid deregulation and improving asset quality helped banks post a record NT$332.8 billion (US$10.7 billion) in profits in 2014, according to the Financial Supervisory Commission (FSC). Banks’ annual return on equity (ROE) surged from 9.4% in 2013 to 12.6% in the third quarter of 2014, according to Taipei-based Primasia Securities. In 2010, by comparison, ROE came to only 7.5%. Fitch Ratings ascribes the healthy profitability mainly to Taiwan banks’ growing exposure in China, including yuan deposit placements and foreign-currency loans. Net profits from the China operations of Taiwanese banks rose 88% last year to reach NT$5.2 billion (US$164 million), the FSC said. In addition, analysts say, the credit-card crisis of 2005 taught Taiwanese banks important lessons in risk management; the banks now pay greater attention to asset quality and engage in more prudent lending practices. At the same time, Taiwanese banks have taken aggressive measures to write off non-performing loans (NPLs) and recover bad debts. The NPL ratio for domestic banks stood at 0.28% as of the end of February, down from 0.35% a year earlier, while all 39 of Taiwan’s banks had an NPL ratio of 2% or lower, according to the FSC. “Taiwan’s banking sector has become much more productive,” says Tony Phoo, senior economist at Standard Chartered Bank in Taipei, noting that net profit per employee rose from NT$1 million to NT$1.77 million between 2010 and 2014. “But the sector remains hyper-competitive and has difficulty finding revenue drivers,” he adds. Consolidation at home, meanwhile, once thought essential for reinvigorating the saturated sector, still seems unlikely for the foreseeable future. “There remains a great need for consolidation in Taiwan because overbanking still exists in the market,” says an analyst with a local securities house who spoke on condition of anonymity. “But the process has decelerated and it will continue to do so. The authorities are instead encouraging banks to look offshore, where return on equity (ROE) is much higher than in Taiwan.”  

The China factor

Because of oversupply in Taiwan’s domestic lending market, the loan-to-deposit spread – the difference between the lending rate charged to borrowers and the deposit rate paid to savers – is low, making offshore expansion a critical vehicle for growth. As the recipient of more than 60% of outward Taiwanese investment, China has been an obvious choice for that expansion. As of the end of January, a total of 13 Taiwanese banks had 18 branches, eight sub-branches, and two subsidiaries in China, according to the FSC. The FSC’s decision in 2011 to deregulate Taiwan’s offshore banking units (OBUs), making it possible for Taiwanese firms registered in China to borrow from the island’s banks, was a key catalyst for the current surge in growth, experts say. Taiwanese companies doing business in China previously borrowed from banks in Hong Kong or China, but switched over to Taiwanese banks because they offered lower-interest US$-denominated loans, says the local securities analyst. “As a net exporter, Taiwan has a surplus of US dollars to fund the loans in China,” he explains. Offshore lending has since become a major growth driver for several large Taiwanese banks, including Cathay United and Fubon, and has significantly outpaced the growth of local lending, says Cherry Huang, director of Fitch Ratings in Taiwan. “Taiwanese banks have been targeting China in particular to boost growth,” she notes. “Credit demand is much stronger there than in Taiwan.” In 2014, the branches and sub-branches of Taiwanese banks in China earned profits of NT$2.9 billion (US$93 million), up 113% year-on-year, while subsidiaries on the mainland posted earnings of NT$2.3 billion (US$73.8 million), an increase of 63% over 2013, according to the FSC. Fitch forecasts that loans by Taiwanese banks’ offshore units will represent 19% of total loans by the end of 2016, up from 15% in mid-2014, with loans in China alone accounting for 14% of the total. Overall China exposure – including loans, interbank exposures, and securities investments – is predicted to reach 15% of total assets over the same timeframe. Huang cautions that increased offshore lending will heighten the risk of overconcentration on China in the banks’ portfolios, particularly if Chinese assets grow excessively without generating sustainable profit growth or if Taiwanese banks fail to maintain sufficient capital to withstand possible shocks linked to China’s economic slowdown. At the end of December 2014, the total risk exposure of Taiwanese banks in China came to NT$1.75 trillion (US$56.3 billion), or about 68% of the NT$2.58 trillion (US$83 billion) net worth of domestic banks, according to the FSC. For purposes of risk management, Taiwan requires that its banks’ aggregate China exposure not exceed their book value. Fubon Bank has already hit that limit; its China exposure was US$4.9 billion as of mid-January, Global Finance Magazine reported in April. (Fubon did not respond to Taiwan Business TOPICS’ request for comment.) Another challenge facing Taiwanese banks’ China business is the holdup in the Legislative Yuan in considering the Cross-Strait Service Trade Agreement (CSSTA), part of the Economic Cooperation Framework Agreement (ECFA). The proposed free-trade arrangement in services was concluded between Taiwan and China in June 2013, but remains stalled in the Taiwan legislature. The government has so far been unable to assuage the fears of the deal’s opponents, who believe it will harm Taiwan’s economy and make the island more susceptible to political pressure from Beijing. The financial sector would be one of the top beneficiaries of the pact, market observers say. Under the agreement, China would give “special treatment” to Taiwanese banks in China, says Cheng Cheng-Mount, president of the Taiwan Academy of Banking and Finance (TABF). Perks would include a single license to operate anywhere in Fujian Province and the ability to undertake full RMB business after showing two years of profitability. “We need to ratify the Cross-Strait Service Trade Agreement,” he says. “If we can do that, it will be very good for our banking sector’s prospects in China.”

Expansion in ASEAN

Despite the importance of the China market, the FSC is also encouraging Taiwanese banks to expand to fast-growing Southeast Asia. “China is a huge basket,” says FSC Vice Chairperson Thomas Tien-mu Huang. “We should put some of our eggs in it, but not all.” To encourage broader expansion, Taiwan this January raised the limit on its banks’ overseas investments to 40% of net worth. The previous limit had been 40% of paid-in capital. The change is expected to free up NT$400 billion-$500 billion (US$13.3 billion- $16.7 billion) in capital throughout the banking sector for offshore acquisitions. “The regulator wants to moderate the concentration of risk in China, but the ambition goes beyond that,” says Phoo of Standard Chartered. “They hope Taiwanese banks can become regional Asian banks.” Cathay Financial Holding Co., Taiwan’s largest financial-services provider by assets, has been expanding rapidly in Southeast Asia. Since 2013, its subsidiary Cathay United Bank has set up branches in Singapore, Malaysia, and Vietnam, as well as representative offices in the Philippines, Thailand, and Myanmar. In 2013, Cathay acquired Singapore Banking Corporation Cambodia, becoming the first Taiwanese bank with a fully owned Cambodian operation. Cathay also applied in July 2014 to set up a branch in Laos. “Cathay is coming from behind,” says Cheng of TABF. “They have fewer foreign branches than Chinatrust [a major competitor] and are trying to catch up.” Cathay is also “asset-rich,” Cheng notes. “Their main business is life insurance. They need somewhere for all that liquidity to go.” For growth-starved Taiwanese banks, Indonesia is looking increasingly attractive, analysts say. The Organization for Economic Cooperation and Development (OECD) forecasts the Indonesian economy to grow at an average rate of 6% annually from 2014 to 2018, outperforming the regional average of 5.4%. In January, Cathay FHC entered the Indonesian market by acquiring a 40% stake in Bank Mayapada Internasional for US$280 million. Cathay was motivated by Bank Mayapada’s stable returns and its potential to benefit from Indonesia’s rapid economic growth, market observers say. CTBC Financial Holding Co., Taiwan’s third largest publicly traded financial firm by market value, is also active in Southeast Asia. Its subsidiary CTBC Bank (formerly Chinatrust) has 11 branches in Indonesia, 24 in the Philippines, and offices in Singapore and Vietnam. Overall, CTBC is considered the market leader in Southeast Asia among Taiwanese financial institutions. “The FSC chose them to be a pioneer in the region,” says Cheng. “Chinatrust’s former leadership had very strong unofficial relations with the leaders of many ASEAN countries. Now they just need to stay on top.” Taiwan’s state banks are eying Southeast Asia as well. In February, state-run Mega International Commercial Bank, the main subsidiary of Mega Financial Holdings Co., opened its second branch in Cambodia. Taiwan Financial Holding Co., the parent company of the Bank of Taiwan, is also mulling investment opportunities in Southeast Asia and may open a Myanmar office, chairwoman Lee Jih-chu said in February. Taiwanese Banks' Claims on China

Prudent risk management

As their offshore expansion accelerates, Taiwanese banks need to ensure prudent risk management, experts say. “Risk management is always our first priority,” stresses Thomas Huang of the FSC. “We need to strengthen the risk management mechanism.” Taiwanese banks also need to pay careful attention to the risks posed by expansion in Southeast Asia, Cherry Huang of Fitch Ratings says. “There are a lot of low sovereign rating countries in the region,” she says. “Indonesia, which is dependent on commodities, is vulnerable to a global liquidity shock. Governance deficiency is a problem in the Philippines.” At the same time, Taiwan banks are generally less capitalized – or more leveraged – than other international banks in the region. That limits their relative capability to withstand potential economic or other credit-quality shocks, she says. In addition, Southeast Asia poses operational challenges, Cherry Huang says, noting that management at Taiwanese banks has limited experience with cross-border acquisitions or earning sustainable profits offshore. The banks’ largest Southeast Asian subsidiaries, primarily in the Philippines and Vietnam, have posted either losses or only modest profitability for the past five years, according to Fitch Ratings. Thus far, those subsidiaries have accounted for only a small proportion of the parents’ total assets. At the same time, says Cheng of TABF, Taiwanese banks need to strengthen their due diligence in China. He cites the sudden insolvency of the Fujian-based Chinese footwear maker UltraSonic as an example, noting that Cathay United Bank led a US$60 million syndicated loan to the company. UltraSonic’s chief executive Wi Qingyong and his son, chief operating officer Wu Minghong, were reported to have absconded with millions of dollars of company cash in September 2014. Although they resurfaced several days later and denied taking the money, UltraSonic, which is listed on the Frankfurt Stock Exchange, still defaulted on the loan. “We will definitely be more careful when reviewing related cases in the future… We have learned a lesson from the incident,” Cathay Financial president Lee Chang-ken said after a November investors’ conference. “It’s a costly lesson, but it’s not surprising,” Cheng says. “Fraudulent accounting is common in China. Taiwanese banks need to be especially careful when choosing their Chinese customers.”