Grow, but don't try to rule the world

Banks in emerging markets can hope to attain world scale on the back of strong domestic growth and restricted foreign competition. International exposure, not domination, is what they should aspire for.

Emerging markets have come out of the sub-prime crisis better than the advanced economies. Banks are a play on the economy, so this is reflected in the condition of banks in advanced and emerging economies. In 2009, banks in the US, UK and elsewhere reported their lowest return on assets in years, if not decades.
   
Profitability of banks in India and China, two leading emerging markets, was not only high but higher than in pre-crisis years! The average return on assets in both India and China in 2007-09 was 1%.

In the period 2004-06, the figures for India and China had been 0.8% and 0.7% respectively (Source: IMF's Global Financial Stability Report, April 2010). Banks in other emerging markets, such as Brazil and Russia, have also remained profitable although profitability declined during the crisis years.
   
At the turn of the century, most people thought it was only a matter of time before puny domestic banks in emerging markets were overrun by foreign giants as the markets opened up to competition. As a comprehensive survey of banks in emerging markets in the Economist (May 15-21) points out, this does not seem likely anymore.
   
On the contrary, emerging market banks could soon reach a size (measured by market capitalisation) comparable to that of their counterparts in advanced markets. Some are already there.

China has three banks in the top 10 in the world. Brazil and Russia have one each. India's SBI is in the top 50. The question for emerging market banks is not whether they can grow. It is how fast they should grow; and whether a large overseas presence should be part of the growth strategy.
   
In the advanced markets, banks are still going through a process of de-leveraging consequent to the financial crisis. This is causing balance sheets to shrink. Credit growth, even when it resumes, will be slow. Emerging markets, in contrast, face the prospect of credit growth of 20-30%.

Many emerging markets, notably India, experienced this sort of growth during the boom years. It now looks set to continue given that the bank loan to GDP ratio is way below that in advanced markets.
   
Banks first need to judge whether it is prudent at all to grow the loan book at such a pace for years together. Rapid loan growth in a system is known to be one of the surer signs of an impending crisis. All too often, such growth is based on lax lending standards and it tends to fuel asset bubbles that collapse one day.
   
Credit quality is not the only issue. Operational risks mount when banks expand at a heady pace. Loan growth of 20-30% requires expansion in branches, hiring of large numbers of people. There are bankers who will say that it is wise to forgo some opportunities and to ensure that growth is well managed.
   
On this point, one cannot generalise across emerging markets. In India, there are mitigating factors to the risks of rapid growth. High loan growth in recent years is partly on account of an undertapped retail market. Nearly 50% of retail loans are home loans and these are among the safest loans to make.
   
Besides, rapid expansion in branches has mainly taken place amongst private banks. Public sector banks, whose share of the market is 75%, already have in place the branch network they need. Unlike in China, loan growth in India is not driven by lending to government institutions.

Commercial loans are made mostly to a vibrant private sector. Finally, there are strong regulatory checks on exposure to risky sectors — real estate, the stock market, commodities.
   
The second strategic issue for the stronger emerging market banks is whether they should seize the opportunity to venture into advanced economies now that banks in those economies are in disarray. Should emerging markets banks be making big acquisitions abroad?
   
The arguments against going global are compelling. One is the experience of advanced market banks. A telling example is HSBC whose acquisition in 2002 of the US consumer finance company, Household, proved a disaster. ABN Amro also came a cropper trying to become a global bank.
   
The only banks with a global presence that are making money are ones that have been long entrenched in foreign markets, such as HBSC, Standard Chartered and Citibank. Emerging market banks thinking of making foreign acquisitions need to worry about their lack of knowledge of overseas markets and the difficulties in managing foreign staff.
   
Then, there is the experience of emerging market banks themselves. Some Indian banks have had overseas branches for decades. Very few make profit. The contribution to total profit is negligible. Simply catering to the diaspora is not a viable proposition.
   
Some Indian banks talk of catering to Indian corporates that have ventured abroad. As Aditya Puri of HDFC Bank points out, the number is not large enough to justify a presence in foreign markets. Nor do Indian banks have the strengths to address the local market overseas.
   
A third reason against venturing abroad is that the regulatory climate has undergone a sea-change after the recent crisis. India is not alone in being wary about letting in foreign banks in a big way. Other emerging markets feel the same way. The old argument that emerging market banks need to venture abroad so that they can better deal with foreign competition at home has lost its edge.
   
There is also greater appreciation in emerging market of the role of stateowned banks. The Indian model of having a mix of state, domestic private and foreign banks, with state-owned banks having a significant share, is widely seen as one that works.

Even private bankers concede that state-owned banks have played in a role in anti-cyclical policies in the crisis. Emerging markets are unlikely to open up to foreign banks in a big way in the near future.
   
Emerging market banks will thus have the home market pretty much to themselves. They can hope to quickly attain world scale on the back of strong domestic market growth and restricted foreign competition. But world scale is not world class.

Emerging market banks will still lack the repertoire of skills necessary to make an impact overseas. Global exposure, not global domination, is what they should aspire for. Grow, but don't try to rule the world.