The Age of Financial Reform

In mid-September, as Typhoon Nari dumped rain on Taiwan for 50 hours straight, it incidentally extinguished a potentially explosive conflict. Wang Yao-shing, director-general of the Bureau of Monetary Affairs, satisfied that the bad guys in this little drama had only gotten their due, could not help declaring: "Heaven was watching!"

Cutting the ties that bind

The fuse for this abortive struggle was an order on August 10th by the Ministry of Finance (MOF) for the Central Trust of China to take over, in a blitzkrieg strike, 36 community financial institutions (like farmers' association credit unions) whose net value was in the red. The MOF designated ten banks in which the government holds stock to absorb these community institutions. Because local farmers' and fisher-men's associations are intimately involved in the distribution of local political patronage and assets, and also because employees of these institutions fear for their jobs, interested parties angrily intended to come north to Taipei to protest, only to have "Heaven" disrupt their plans.

As Wang Yao-shing says, not without some pride, "This is the first time in the financial history of the Republic of China that anyone has dared to act in such a decisive manner, fearless of the political pressures!"

The prerequisite to this decisive action, in which the years of mismanagement and bad debts at these 36 local institutions were wiped out in a single stroke, was the passage this June of new financial laws by the Legislative Yuan, effectively pulling the sword from the stone for government financial authorities.

One of the new pieces of legislation is the law governing the establishment and management of the Executive Yuan's "Financial Restructuring Fund." This statute states that over the next three years (with the possibility of extending to a fourth year) the government may, using funding from business taxes on the financial industry, commission the Central Trust of China to take over poorly managed financial institutions. The restructuring fund would then take responsibility for 100% of the debts of these institutions. Taking full responsibility for all debts means, on the one hand, that depositors need not fear for their savings, so they will not panic and make a run on these institutions. Secondly, it means that the banks that take over these failed institutions will not be dragged down by them.

"In the past, the government only guaranteed up to NT$1 million per account. Now it will insure every dime. Banking business won't be interrupted for even a single day," says Wang Yao-shing. Equipped with the "tranquilizer" of the restructuring fund, government agencies have a period in which they can put financial institutions on a more sound footing without looking over their shoulders all the time. The law was passed at the end of June, and by mid-August the authorities were already at work, seeking to make the most of their time and to get the huge task of financial reform underway as quickly as possible.

Bad debts sky high

However, when you look more closely, the picture is not so rosy. The restructuring fund is supposed to get its money mainly from business taxes paid by financial institutions between the beginning of 2002 and the end of 2005. The government is authorized to borrow money from banks in the short term against these long-term revenues. Unfortunately, given these revenue sources alone, the total size of the fund over this five year period would not exceed NT$140 billion, a figure dwarfed by the estimated total of NT$1 trillion in bad loans in Taiwan. Clearly the reconstruction fund will not have enough cash on hand to absorb all the poorly run financial institutions.

Looked at another way, the 36 local financial institutions that the government recently took over account for less than 1% of the total amount of banking business nationally. Yet, even this tiny tip of the iceberg will cost NT$70 billion to clean up, which is a full half of the revenues that are expected to come into the restructuring fund over the next five years. Thus, while the first shots fired for financial reform may look good, those on the inside cannot help but worry that the government will quickly run out of ammunition. Yet there would still remain more than 300 other community financial institutions which have been running at a loss for a considerable time, not to mention the state-run and private banks of a much larger scale whose bad debts are shockingly high. The govern-ment's ability to reform the financial system is going to face some pretty ruthless tests.

The question is, just how bad is the financial situation in Taiwan now? Even as financial reform is getting under way, there are all kinds of rumors floating around the marketplace. Could there really be a financial meltdown?

From banks to collection agencies

Statistics indicate that the ratio of non-performing loans for all financial institutions in the country has been steadily increasing over the last five years, so that by the second quarter of this year it had reached a new high of 7.44%, double the level of five years ago. The rate for community financial institutions is 18.5%, while that for banks is 6.63%. Clearly, these figures are a very long way from the 2.5% target set for the middle of next year for banks.

It should be noted that, according to international standards, a loan is considered "non-performing" if interest has not been paid in three months. But Taiwan uses a more lax standard of six months. And if you figure in special cases of the government stepping in to negotiate debt rescheduling for selected enterprises, or the postponement of debt repayment for victims of the September 21 earthquake, the real non-performance ratio for banks in Taiwan is over 10%, with total bad loans approaching NT$1.5 trillion. With such heavy debts, businesses face a bleak future as many banks have virtually halted normal loans, with operations focusing almost exclusively on loan collection.

To deal with the problem of all the bad assets generated by these non-performing loans, last year the Legislative Yuan passed a law to facilitate mergers among financial institutions which allows the establishment of asset management corporations, using commercial methods to handle the increasingly sensitive bad loans problem, so that it is not necessary to wait for public auctions instituted through lengthy court proceedings.

Since the middle of this year, Citibank (acting through Debenham Tie Leung, a property management firm based in Hong Kong) has held a series of auctions in Taipei and Kao-hsiung to sell properties from defaulted mortgages at steep discounts. Prices at these auctions have been about 60% of the open market price, sending shock waves through the real estate and financial industries. Some people are happy that there seems finally to be some way to clear away the hundreds of thousands of defaulted mortgages. But others are concerned that there will be a "price-busting effect" which will cause even more mortgage-holders to give up on their overpriced mortgages, preferring to default and let the house go back to the bank. This could end up actually increasing the number of defaults held by banks.

A Thai-style financial meltdown?

In this pessimistic atmosphere, the risk for domestic banks has certainly risen. According to a July report by Standard and Poor's, a well known American credit rating company, potential problem assets in Taiwan's financial sector account for between 15 and 30% of GDP. This is a sharp rise from the estimate of 10-20% made only six months ago, putting Taiwan in the same boat as Japan. It is only somewhat heartening to see that Taiwan is at least not in as dangerous a position as Korea, Thailand, or mainland China.

But given the government's apparent determination to reform the financial system, many scholars and experts believe there is a good chance to turn the situation around. If the government persists with reform, there is not likely to be any "Thai-style financial crisis" with a massive devaluation of the currency and widespread bank failures.

Peter Kurz, CEO of the investment consulting firm Insight Pacific, observes that although Taiwan's non-performing loan ratio is increasing, the amount for dishonored checks and bills has not correspondingly risen. "This indicates," he explains "that the rise in the non-performance ratio is a result of the government's increasingly strict oversight of the financial sector, and the increasing transparency of bank operations, which in fact are positive things from the point of view of foreign investors."

Size does matter

The government has had initial successes in financial reform in terms of clearing out corruption and strengthening oversight. However, the potentially fatal structural defect of "too many banks of too small size with too much functional redundancy" continues to worry the government and private sector.

As of the end of July of this year, the little island of Taiwan had 53 domestic banks and 39 foreign banks, as well as 362 community financial institutions (such as credit cooperatives and farmers' association credit unions), with a total of more than 4000 branches. And that doesn't even count the more than 1000 branches of the Post Office, which also offers banking services. When you crunch the numbers, it turns out that there is a depository institution for about every 4000 citizens.

Currently, the twelve largest banks hold 65% of the market, leaving only 35% or so to be fought over by the other 40. Even looking only at banks listed on the stock market, nearly 10 have less than a 1% market share. With so many small players, competition is intense and profit margins are paper thin. In particular, the more than 20 private banks that have opened since the liberalization of the banking sector in 1991 have been skating on thin ice since day one.

"People in Taiwan may find it hard to imagine," notes Wang Yao-shing, "but in some other countries one bank could have a market share of 50%, while the remaining institutions all have a very narrow focus, as in the case of trust banks, investment banks, and the like."

Internationally, the trend is certainly for the big to get bigger. For example, at the end of 1997, Union Bank of Switzerland merged with Swiss Bank Corporation, and the following year Deutsche Bank purchased Bankers Trust, while Citibank merged with Travelers Group. This last merger, between two companies that were already giants, gave the resulting firm a solid grip on its ranking as the financial institution with the highest net worth in the world.

It may at first come as a shock to hear banking expert Thomas Tunghao Lee (chairman of the Department of Money and Banking at National Chengchi University) say: "In the long run, no more than five big banks can survive in Taiwan." But this is really not that strange in a comparative context. In both Singapore and Hong Kong, three main banks account for over 80% of the market. The only way Taiwan's banks are going to be able to survive in the face of global competition is to link up and beef up.

Bank matchmaking

To encourage bank mergers, last November the Legislative Yuan passed the "Financial Institution Merger Law." One thing it does is to provide various incentives to encourage private sector companies to merge on their own. In addition, it also hangs out the welcome sign to foreign financial institutions aiming to buy local banks. With the legal foundation in place, financial businesses have been gearing up and rumors of various mergers and acquisitions are being bruited about.

The first strike came immediately following the passage of the new law. With the Executive Yuan calling the tune, it was announced that the United World Chinese Commercial Bank, the Chiao Tung Bank, and the International Commercial Bank of China would merge. Then it was announced that Taiwan Cooperative Bank would buy Chin Fong Bank, enabling TCB to leapfrog to the number two spot in Taiwan in terms of total deposits, behind only the Bank of Taiwan.

The Bank of Taiwan, though still ahead of the pack, could not in turn avoid being designated by the Ministry of Finance for a merger. In March, the MOF announced that three state-run banks (the Bank of Taiwan, the Land Bank, and Central Trust of China) would merge. The total size of the resulting firm will be NT$4 trillion, putting the institution into the ranks of the top hundred worldwide (it would currently stand at number 74).

With the MOF showing enthusiasm for playing matchmaker, the slogan "Year One of financial mergers" raised high expectations. However, warns Schive Chi, formerly vice chairman of the Council for Economic Planning and Development and currently president of the Taiwan Academy of Banking and Finance, "Mergers are no panacea, and there are more examples of failure than success, so it is necessary to be very cautious." He observes that while a number of banks in which the government holds stock have announced merger plans, so far no action has been taken. It looks like the road to merger is, as he suggests, not an easy one.

Thomas Lee points to numerous potential pitfalls. For one thing, "Most banks are already having financial difficulties of their own, and may have to close some of their branches as it is. Where are they going to get the money to acquire someone else?" Also, mergers and acquisitions are especially difficult given that domestic banks are highly redundant in function, and even tend to set up their branches in the same place. For example, in the commercial districts you can often find branches of the Bank of Taiwan and the Land Bank right next to each other. They will get nothing out of the merger but hard-to-sell floor space. Besides that, all three banks are 100% state-owned, and this kind of intra-governmental merging is no help in terms of putting private sector businesses on a more sound footing. As for private-sector banks listed on the stock market, because control of stocks is scattered, a proposed merger is sure to spark endless disputes over stock swaps and over which bank's stocks should be retained, and which discontinued.

However, none of these points can alter the fact that some banks will have to pull out of the market eventually, and merging is a somewhat more practical way to do this than to continue operations until losses reach such a level that the banks are ordered to close by the government or are taken over compulsorily. Although Schive Chi warns that bank mergers need to be done very cautiously, he also estimates that once a successful merger is completed, other banks will feel the pressure of their isolation, and the trend toward mergers will accelerate.

A new financial era

Mergers may not be easy, but a number of cooperation programs are quietly getting under way. In the middle of last year, the Taiwan branch of Citibank announced that it was buying a 15% interest in Taiwan's Fubon Bank, to build an even closer strategic alliance between these two consumer banking powerhouses.

"We have learned a great deal from Citibank," says Victor Kung, a managing director in the Fubon Group. Foreign banks are better at market forecasting, building client data banks, and creatively coming up with new financial products, so local banks can learn through cooperation. Even more importantly, both parties have very similar ideas about the future direction of Taiwan's market.

Kung explains: "Ideas about money are changing in Taiwan, and personal financial management will become increasingly prominent in the future." Currently, Taiwanese keep about half their liquid assets in bank savings accounts. In the US the proportion is only 20%.

Kung predicts, "As the law becomes increasingly relaxed, there will be more and more financial products available, and in the future people in Taiwan will move more in the direction of pro-active handling of their money." He expects that within a decade people in Taiwan will behave much like they do in other developed countries, putting their liquid assets into things like stocks, bonds, insurance, hedge funds and many other diversified financial products. Following on the relaxation of insurance items by the Ministry of Finance last year, Fubon is planning to put out "investment-tied life insurance" (in which insurance premiums can be used to purchase securities or be put into other financial uses) and other new products to encourage customers to dig into their savings.

As Kung analyzes the situation, traditionally banks made their income from the differential between the interest paid on deposits and interest earned on loans (this is called the "interest rate margin"). However, with competition as intense as it is today, banks have had to offer higher interest on deposits and lower-interest loans, so that over the last three years the differential has been, on average, only about two percent. It is virtually impossible for a bank to cover its operating costs with such a narrow margin.

Particularly now with the economy in the doldrums, when companies are not expanding, people are not buying houses, and even stock speculators are more careful, it is harder than ever to make money off of interest rate margins. Not to mention of course the possibility of being buried under an avalanche of bad debt at any moment. Banks are going to have to develop new sources of income by developing new financial products and providing a variety of value-added services.

Financial department stores

In order to create the legal foundation for diversification of financial products and greater flexibility in bank operations, the Legislative Yuan passed a new "Financial Holding Company Law" in June. This vital and very complex law (it runs to 69 articles) will go into effect November 1st.

Victor Kung notes: "In the past, in order to prevent financial risk from being overly concentrated in a single business group, the government ruled that banking, securities, and insurance functions had to be separated, with operations run by different companies." For example, in the Fubon Group building, banking is on the first floor and the securities department is in the basement. Each department must have its own separate entrance and exit, as well as different operational items and places of business, with everything clearly separated.

With the coming of the era of personal financial management, on the other hand, people will want to mix their own financial cocktails, using insurance, securities, and banking services, to make the best use of their assets. The barriers between financial areas will have to be broken down. The Financial Holding Company Law stipulates that in cases where financial institutions participate in two or more of the three main financial areas (banking, insurance, and securities) their once-separate subsidiary companies can now swap stocks and reorganize, and then apply to the governing authorities to establish a financial holding company. In daily business they can support each other, and the previous separation between operational areas will disappear.

As Wang Yao-shing puts it, "The Financial Holding Company Law should greatly increase the competitiveness of Taiwan's financial sector so that it can hold its own head-to-head against foreign competitors."

Now that multiple-area operations are permitted, many banks have re-designated some tellers as "financial planning experts." On the one hand, they continue to handle deposits and loans as in the past. But at the same time they are promoting sales of insurance, mutual funds, and other financial products. Customer information that used to be kept separated among the various companies within a single group can now be shared, which will help in identifying target markets. Different departments can now share computer systems and office space, and companies should be able to make do with many fewer individual insurance agents (since, in place of agents, who were needed to maintain personalized contact with clients, companies can network with their customers through their ordinary financial service people). Companies should be able to expand their operations, become more efficient, and lower costs all at the same time.

Although the Financial Holding Company Law has not yet formally gone into effect, Wang Yao-shing estimates that about ten large financial groups will probably apply to form holding companies right away. These include First Commercial Bank, Hua Nan Bank, the Fubon Group, and the Lin Yuan Group. Some ambitious financial groups are also scouring the market for acquisition targets, in order to strengthen and round out the capabilities of their future holding companies.

No fear of global competition

The government's goals for its financial policy are clear. It hopes, through mergers, holding companies, increased size, and diversification, to improve the structure of, and business environment for, the domestic financial sector. But in the end, the actions of management will be even more important to competitiveness, and this is a real weak link for Taiwan's banks.

"If you divide the financial sector up into state-run banks, private local banks, and foreign banks, the most at-risk group is that made up of the large state-run banks, which currently have the largest market share," says Schive Chi, who knows what he's talking about after years of experience in banking. The style of foreign banks is to make quick decisions based on comprehensive data, wielding a flexible array of products that keep up with the market. Domestic banks definitely are not up to this level.

A manager named Lee who works in the Bank of Taiwan admits that state-run banks are limited by the various regulations that govern civil service institutions. They can't even do things like hire students to work part-time running errands for clients, or set up counters in department stores to offer credit cards. Given their ossified management techniques, it is no surprise that they are ridiculed as being "run like pawn shops." Meanwhile, at most of the new banks, because of operational problems it is not easy to recruit the best people, and they don't have the resources to put out new financial products or develop new markets.

One figure in the business privately complains, "The government has always coddled Taiwan's banks under the rubric of 'maintaining financial stability,' and the banks have gotten used to it. You can't ask them to get lean and mean overnight." The financial sector serves as the circulatory system feeding economic development. Taiwan has a powerful manufacturing sector, but a weak financial sector, which has always been a drag on overall national development. With the economy at a low ebb and global competition increasingly intense, it is now urgent that we put the financial services system on a sound footing.

2001 is the year in which financial reform finally got started. The legal structure is now in place, and attitudes are beginning to change. The pressure of forthcoming entry into the World Trade Organization is leaving the government and private sector no room to procrastinate. The success or failure of financial reform will be directly felt in terms of overall national competitiveness and the thickness of individual wallets. Citizens would do well to keep a sharp eye on what's happening.

p.080

In this "Year One of financial reform," the task of modernizing the financial system is creating waves on the surface, while underneath treacherous currents circulate. Taiwan's future competitiveness hinges on the success of this project. The photo shows the lobby of the headquarters of the venerable Bank of Taiwan.

p.082

In mid August, the Ministry of Finance, acting with speed and decisiveness, took over 36 mismanaged community financial institutions. The photo shows the former Puyen Rural Township Farmers' Association, now under the management of Changhwa Bank. (courtesy of China Times data center)

p.083

Over the last couple of years the Ministry of Finance has produced a flurry of new laws and regulations. Wang Yao-shing, director of the Bureau of Monetary Affairs, has played a major role behind the scenes.

p.084

The property market is stagnant, the stock market is tanking, companies are relocating elsewhere. . . The manufacturing and financial sectors will have to both pull their weight to get everyone through this crisis period. The sign advertises services for emergency dumping of real estate.

p.085

Ratio of non-performing loans for various financial institutions in Taiwan as of June 30, 2001

Total 7.44%

For domestic financial institutions 6.63%

For foreign banks in Taiwan 2.97%

For community financial institutions 18.50%

Source: Financial Statistical Indicators, Ministry of Finance

p.085

Ratio of non-performing loans for all financial institutions in Taiwan

Source: Financial Statistical Indicators, Ministry of Finance

p.085

Ratio of non-performing loans

for community financial institutions in Taiwan

Source: Financial Statistical Indicators, Ministry of Finance

p.086

When the government permitted the opening of new private banks in 1991, big financial groups raced for their piece of the pie. Now there are too many banks, with profit margins cut to the bone by intense competition. It will take some time to clean up the mess that has been created.

p.087

Major finance-related laws and regulations passed in recent years

Law

Promulgation date

Focus

Trust Enterprise Law

July 15, 1998

To diversify the banking and trust industry.

Amendments to the Banking Law　November 1, 2000　To promote financial liberalization;

strengthen rules for credit to connected persons.

Financial Institution Merger Law　December 13, 2000　To promote bank mergers and increase competitiveness.

Formal establishment of asset management companies　January 11, 2001

To speed up dealing with bad loans and bad assets.

Regulations for Establishment of Restructuring Fund

July 9, 2001

To halt operations at mismanaged financial institutions

and protect the interests of depositors.

Financial Holding Company Law July 9, 2001

To remove restrictions on multiple-area financial

operations; increase size and competitiveness of firms.

Source: Bureau of Monetary Affairs, Ministry of Finance

Table by Laura Li

p.088

Foreign banks are flexible, fast on their feet, and creative. Though they do not account for a large share of the market in Taiwan, they have a disproportionate influence.