But this doesn’t this mean that a rational Chinese bank will never engage in a foreign acquisition.On the contrary, it makes sense for state-controlled Chinese banks to make foreign acquisitions because the main shareholder, the government of China, has a much more complex incentive structure than do other shareholders.
As a shareholder, of course, the government would like to see rising share prices, and to that extent it should not encourage foreign acquisitions.However the government’s position is not so simple.In addition to its role as shareholder, the government has at least two other important roles.First, it guarantees the bank’s depositors, so it effectively absorbs any improvement or deterioration in the bank’s creditworthiness.Second, it regulates the banks as part of its overall responsibility for the health of the banking system.
It turns out that both roles also involve optionality.Creditors and regulators are effectively short put options on the asset value of the company because their exposure to increases in asset value is limited, while their exposure to declines is unlimited.Because they have differing incentive structures, their objectives differ.This is just a variation on what is known as the agency problem in corporate finance, in which managers (whose incentives, incidentally, are very similar to those of creditors) have goals that often conflict with those of shareholders.
Because the government in its role as guarantor and regulator is effectively short a put option on the asset value of the bank, this creates a strong incentive to minimize volatility.Lower volatility increases asset value, and so reduces the intrinsic value of the put option (the value of a put option always decreases as asset value rises), while lower volatility always reduces time value.
Along with being long a call option as a shareholder, the government is short a put option as guarantor and regulator, and as such it unambiguously benefits from any reduction in volatility.In this case the option framework simply makes explicit what we intuitively know: unlike shareholders, creditors and regulators worry far more about downside risk than about upside profits.
What the framework adds to the analysis is that for nearly insolvent banks, the interests of creditors and regulators are diametrically opposed to those of shareholders.Since its interests as guarantor and regulator almost certainly exceed its interest as shareholder, the government has a strong incentive to encourage behavior which may hurt shareholders in general but will benefit the government and all other creditors.China’s state-controlled banks are likely, in other words, to behave in ways which benefit managers, regulators and creditors at the expense of shareholders because its largest shareholder has a very complex incentive structure.
China’s government is not the only government whose interest may conflict with that of bank shareholders – this always happens in the case of banks with questionable loan portfolios whose deposits are implicitly or explicitly guaranteed, as the S&L crisis in the US during the 1970s and 1980s demonstrates.But because of the government’s mixed role as guarantor, regulator, and principle shareholder, it is important that investors understand that although their long-term interests may be similar to that of the government – a rapidly growing economy which translates into an increasingly valuable banking franchise – in the short term incentives are aligned in very different ways.
The option framework makes two clear, and easily verifiable, predictions.First, Chinese banks will almost certainly acquire assets and operations abroad because it is in the best interest of their regulator and primary shareholder that they do so.Second, any Chinese bank that makes a relatively large acquisition abroad will see its share price fall significantly.This may not happen immediately on the announcement of the acquisition – a surge of nationalist pride often causes the share prices to rise – but within days or weeks large institutional investors will dump shares until its price falls to reflect the reduction in time value.
Over the past few months I have fielded many questions from foreign investors about the overseas acquisition plans of Chinese banks.I have no inside information, but I think there are very good reasons to assume that Chinese banks will make acquisitions abroad. The option framework, however, makes two powerful, and perhaps surprising, predictions about foreign acquisitions: first, that the acquisition of a foreign financial institution is likely to have a significantly negative impact on the banks’ share prices; and second, that the largest shareholder, because of its multiple roles, will have a strong incentive nonetheless to encourage foreign acquisitions.
There are many good reasons why a Chinese bank may want to acquire a foreign bank.It may want to diversify its loan portfolio, to serve its Chinese customers abroad, to gain experience and technology, or simply to make a long-term bet in another market.At the time of the acquisition, however, the main effect on the value of the bank’s share price will be the impact of diversification – a Chinese bank with operations in the US, for example, will have a more diversified loan portfolio and earnings stream than if it had nothing but Chinese operations.
Diversification reduces volatility, and so usually increases a company’s asset value (for finance geeks, this occurs largely because of the accompanying reduction in financial distress costs).Since the intrinsic value in share prices consists of the difference between asset value and total liabilities, if asset value rises, the intrinsic value component of the share price must also rise – in other words, the excess of asset value over liabilities will rise.Normally we would expect that this would cause the combined market value of the merged companies also to rise.
But this is not always the case.A reduction in volatility may increase intrinsic value, but it always reduces time value (share prices always consist of more that just intrinsic value, and this excess is called time value).
What actually happens to share prices depends on which effect is greater.When the share price of the acquirer has high intrinsic value – i.e. the company is highly solvent and the value of its assets comfortably exceeds the value of its liabilities – it will typically have low time value, and the positive impact on intrinsic value will exceed the negative impact on time value.This will cause the combined share price to rise.
However when the share price of the acquirer has low intrinsic value and high time value – i.e. it is in a highly volatile business and has few real assets, like an internet company, or its liabilities approach or exceed its assets, like an insolvent bank – the impact of an increase in intrinsic value can be much less than the reduction in time value.In that case an acquisition will cause the combined share price to drop.
This is true not just for insolvent banks but for any company whose share price consists mostly or wholly of time value.For example when AOL and Time Warner announced in January 2000 that they would merge to create a media super-company, the first excited response of the stock market was to run up the combined value of the two firms by over 10%.Within days, however, as investors began to understand the implications of the merger, market sentiment changed and the combined value of the two firms dropped to 5% below the pre-announcement levels – during a period in which the relevant market index rose nearly 10%.Mergers involving start-up internet companies have almost always resulted in declining market prices for exactly this reason.
This also happens with bad banks.When one of Mexico’s two largest banks acquired a largish California-based bank (I think it was in 1992 or 1993), the first reaction in the market was a surge in the bank’s stock price as proud Mexicans celebrated the success of Mexican banks, but within a week institutional investors began dumping shares as the implications sank in, and soon the value of the Mexican bank was well below its initial price, even as the Mexican stock market raced upwards.
For Chinese banks, like for internet startups or Mexican banks, any large acquisition will almost certainly result in a lower combined share price once the implications to investors are digested.The negative impact on the Chinese bank’s time value will exceed the positive impact on its intrinsic value, or to put it another way, substantially more than 100% of the increase in asset value will go to the bank’s creditors, who benefit from more stable and diversified earnings.Equity investors, unlike creditors, place a high value on Chinese banks precisely because China’s economic future is so uncertain.
Any reduction in the volatility around future expectations will reduce their value to equity investors.Chinese banks currently have much higher price-to-book ratios than highly solvent global banks, and this high ratio reflects the high component of optionality (time value) in their share price.By sharply reducing time value a large foreign acquisition will effectively drive the price-to-book ratio lower, and so reduce the combined market value of the two banks.
In an article for the January/February 2007 issue of the Far Eastern Economic Review (“Buying into China’s Volatility”) I used an option framework to explain and predict the behavior of investors in China’s bank IPOs.Chinese banks are, or are close to being, technically insolvent. Share prices of insolvent or nearly insolvent banks consist almost entirely of what option traders call “time value”, with little to no “intrinsic value” (which is the excess of asset value over liabilities).
Not all of my readers will agree that large Chinese banks are basically insolvent, but I am very skeptical that the published figures correctly state the extent of bad loans.They almost certainly understate the extent of expected bad loans associated with the surge in new lending over the past three years.
The option framework predicts that in such a case investor perceptions of the quality of management or of levels of non-performing loans will have little to no impact on the share price performance of Chinese banks.Instead share prices will primarily reflect investor perceptions of changes in China’s underlying economic volatility.China’s banks are expensive, in other words, not because they are in good shape, but rather because there is so much future uncertainty about the Chinese economy, and it is increases in that uncertainty, not improvements in the quality of the banks, that are most likely to drive prices up.
This has happened in many countries undergoing reform besides China.For example when Mexico’s 18 banks were privatized in 1991-92 as part of the massive economic and political reforms the country was undergoing (I was part of the team at credit Suisse First Boston that advised the government on the privatization), their purchase prices far exceeded even the most optimistic estimates provided by the advisors, the government, and the banking industry, which were largely based on discounting expected earnings.
In fact, what investors were buying in Mexico was not the average expected outcome, but the fact that there was so much potential variation about the final outcome (which is another way to define time value).After the privatization, prices continued soaring and I often heard wry comments from senior Mexican bankers about their valuations relative to the Citibanks of the world.Of course those valuations didn’t last, and within the decade Mexican bank prices had collapsed to the point where they were nearly all acquired by foreign banks.This is a fairly typical story during the 1990s.
Basically the thrust of my Far Eastern Economic Review article was to argue that China is like many other developing countries with weak banking sectors who are undergoing major economic reform.Its banks will necessarily have very high valuations – indeed much higher than those of much more profitable banks in the developing world.This is because countries undergoing significant economic reforms are likely to have highly uncertain outcomes.
If it were possible to buy a call option on the underlying economy of a country experiencing massive reform, this option would be very valuable in the same way that any call option on a very volatile asset would be valuable.Most of the value would consist of time value, which is mostly a reflection of uncertainty about the range of outcomes.
It turns out that a bankrupt or near-bankrupt bank is actually very similar to such an option.Because the profitability of the banking sector is highly correlated with underlying growth, buying shares in a bank with very low intrinsic value (i.e. whose asset value is less than or barely exceeds its liabilities) allows investors to “buy” the country’s underlying volatility.In my previous life as a Latin American bond trader, I can say that most of the region’s banks were in very poor shape during most of the 1990s, but nonetheless they had much higher valuations than their rich-country counterparts once it was clear that these countries were going to undergo major reform – and it is worth noting that while some cases of reform were very successful, others were not, which is the definition of a volatile range of outcomes.
I still can’t respond directly to comments because Sampasite is blocked in China, and the proxy I use doesn’t allow me to see and post the required access codes, so I have to post responses in the form of new entries.
JKH, you ask if the way a purchase were funded might change my conclusion that a Chinese purchase of a foreign bank would, if large enough, actually destroy market value.You agree that this is the case for an equity-funded purchase but wonder what would happen if the purchase were funded by issuing debt.
The way I see it is that it would still cause a reduction in market value, probably even greater.Let us assume that Bank A (a Chinese bank) buys Bank B (a foreign bank) and pays for it by issuing $100 of stocks.We both agree that in this case there would be a reduction in total market value.
Now let us assume that the new (larger) Bank A issues $100 of debt and uses the proceeds to repurchase stock.I think you would agree that the resulting capital structure would be the same as if Bank A had funded the purchase of Bank B by issuing debt.The question is will this second transaction create or destroy value.
As I see it, since the new Bank A is almost certainly going to have more debt than is optimal, the “old fashioned” M&M framework makes it clear that the marginal cost (financial distress costs) of new debt will be much greater than the marginal benefit, so enterprise value will fall.That should reduce the total value of the combined venture even further.I realize that I am not answering your question directly but rather am backing into an answer, but my first reaction tells me that financing the purchase with debt would be even worse for total market value than financing it with equity because we are presumably on the wrong side of the marginal-value-of-new-debt curve.Would you agree?
As for your second point, I think you are saying that the more ownership the government sells, the more it is willing to force the bank to enter into transactions that protect the creditors (which encompasses the interests of regulators) and harm shareholders.I hadn’t really thought of that but if I am interpreting you correctly, then I agree fully.
Twofish, the idea that a share price is some sort of barometer of the health of a company is very widespread but, as you point out, wrong.To be technical, this is only the case if the share price has a great deal of intrinsic value and little time value (the case for a very solvent, healthy company).If it is all time value, then it reflects changes in volatility more than changes in “health”.This, in a way, is the main point of my Far Eastern Economic Review article – Chinese bankers and their regulators should not misinterpret what the market is saying about Chinese banks.
I think the option framework does support your conclusion that banks need to be heavily regulated because the temptation (especially with deposit insurance) to speculate wildly is too great.In a nutshell I believe that this is the story of the US S&L crisis of the 1970s-80s.Once the banks were made insolvent by DIDMCA, they asked for significant relaxation in their lending restrictions.Congress, unwilling to foot the bill for cleaning up the S&Ls, bought the argument that with more freedom the S&Ls could “earn” their way out of bankruptcy, but of course they were wrong.The incentive for the insolvent S&Ls was to borrow more (deposit-insured) money and speculate wildly in the hopes of success.Heads, I win; tails, the government loses.Who wouldn’t speculate under such conditions?
Not at all surprisingly, the S&Ls were the chief piggy banks for the then-exploding junk bond market and when heads turned up on the flipped coin, their investors made fortunes.When tails turned up, however, which it did more often than not, the government took it on the nose.As we all know, in the end the S&L clean-up turned out to be far more expensive for the US government than it originally would have been.This becomes breathtakingly obvious when you use the option framework to analyze the incentive structure and predict the banks’ behavior.In fact the option framework does an extremely good job of predicting a lot of otherwise inexplicable behavior.
Twofish, this is probably why I am so much more pessimistic than you are about the Chinese banking system.The way I see it, the incentive structure for excessive risk-taking is too great.
By the way, if you don’t have an FEER subscription (get one – it has become a very interesting read again) you can read the original FEER article here: http://www.iea.usp.br/iea/english/articles/pettischinasvolatility.pdf
From talking to friends much more knowledgeable that I am it seems that the 17th CPC Plenum, which will be opened next week, is turning out to be much more fractious than expected, and it is not clear that it will lead to a resolution of factional infighting.There will be no clear victory, apparently, for either of the major factions.
I can't comment on other aspects of what a divided leadership will mean, but I do worry that without clear lines of responsibility and control it may take longer than ever to resolve the large and growing imbalances in China's monetary condition. There seems to be a fight between those on the one hand who worry most about the consequences of excess financial expansion and those, on the other hand, who don't want anything done that might slow down employment growth in the near term.
As I see it, to take the bull by the horns and start applying the brakes is a no-win solution. If you are unsuccessful and overdo it, thereby precipitating a crisis, you will be blamed for it. If you are successful and save the country from a financial disaster, but do so at the cost of a short-term rise in unemployment, you are still vulnerable to criticism. You can't prove that you averted a crisis but you certainly can be blamed for the misery you caused.
In that case, there is less reason to take the risk of addressing the problems directly. Instead of simply convincing your boss that something must be down, and that there will be a cost to doing it, but that the cost is much less than the consequence of not doing it, you have to avoid getting blamed for any downturn. Even if what you do is right, if it allows your factional enemies to undermine you it is better not to do it.This cannot be a good thing if you believe, as I do, that some very difficult decisions need to be made as quickly as possible and then implemented without hesitation.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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December, 2007
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