Financial Holding Companies Are the Best Choice for Large Chinese Investment Banks, Subject to the Constraints of the Current Financial System

The Financial Holding Company Model: Enabling Crossover under the Regulatory Framework That Is Based on Separation of Activities In the second half of 1992, there was a rush in real estate and securities investment. By way of the interbank lending market, a great amount of credit funds flooded into the stock market, causing chaos and disorder across the entire financial system. Consequently, the government worked to bring order to the financial sector, and the central leadership required strict legislation on operations and oversight based on separation of activities. Such a principle was put forward officially at the national financial work conference in early 1995. Subsequently, the enactment of the Commercial Banking Act, Securities Act, and Trust Act laid the legal foundation for operations and oversight based on separation of activities in the financial sector.

Clearly, such an arrangement is an effective institutional arrangement that has worked in the realities of Chinese economic development and financial operations. Integration in the financial industry brings positive effect only on the premise that the regulatory authorities have enough authority, experience, and skills to regulate and supervise such integration at a low cost. Financial institutions must also have effective internal risk control, sound rules and regulations, professional staff, and enough management skills to manage the business at a low cost. Otherwise, any hasty move to integration of financial services would likely lead to excessive speculation, uncontrollable risk, and an overheated market, among others. The financial history of other countries indicates that the decision to separate financial activities was mostly for the purpose of strengthening regulation and preventing risks.

Financial holding companies, as a new management model for crossover, are in fact the result of organizational innovation by banking and other financial institutions under the legal framework of separation of activities to bypass the legal obstacles and expand their business territories. The reason financial holding companies emerged in the United States is that American banking (commercial banking in particular) made an organizational innovation to bypass the regulation on separation of activities when competition got intense and business was tough. It is safe to say that in the institutional context at that time, financial holding companies built a bridge for American banking to complete a smooth transition from separation of activities to crossover.[1]

Although a financial holding company is allowed to engage in at least two of the activities of financial business, it does not cross over such activities directly by itself. Instead, it uses subsidiaries as business platforms, and separation of activities remains among subsidiaries. The financial holding company can benefit from the economies of scale by creating complementary activities, making money arrangements, and attracting and retaining employees with expertise in or between subsidiaries. It can also avoid the spreading of risk among subsidiaries by building a firewall between subsidiaries.

Therefore, financial holding companies smoothly combine the safety provided by separation of activities and the efficiency accompanied by integration of activities. Like a ferry or bridge to integration of activities in the Chinese financial sector, such a model can enable integration within the current Chinese legal framework based on separation of activities. In China, the emergence of financial holding companies is not the start of overall crossover, but merely an innovation, in a sense, under the separation-based financial system.

Chinese Financial Holding Companies: Emerging to the Surface Although in the Chinese legislative and regulatory landscape operations and oversight are based on separation of banking, securities, insurance, and trust business, such a model proved to be defective in practice. Under strict regulatory separation of activities, the banking and securities businesses are almost like water and oil. They make it impossible for financial institutions to carry out some activities that could benefit economic growth and the public. The People's Bank of China released the Provisional Regulations on Intermediate Business of Commercial Banks in July 2001, allowing commercial banks to engage in some nonbanking activities. PBC also issued the Circular on How to Implement the Provisional Regulations on Intermediate Business of Commercial Banks in April 2002, requiring commercial banks to categorize their intermediate business. (In fact, such classification helps commercial banks engage in securities-related activities.)

Financial holding companies are not expressly prohibited in existing laws and regulations. A financial holding company actually engages in "financial services-related management and activities" instead of directly in financial services itself. It does not cross over financial activities directly. Instead, it uses subsidiaries as business platforms and separation of activities remains among subsidiaries. This does not contradict the regulatory principle that is based on separation of activities. Therefore, there is no legal obstacle for the incorporation of a financial holding company. The Chinese Commercial Banking Act (revised in 2003) provides in Section 43 that "within the People's Republic of China, commercial banks shall not engage in trust investment and securities business. They shall not invest in non-owner-occupied real estate or non-banking financial institutions and business, except as otherwise provided by the Chinese law." The Securities Act (revised in 2005) provides in Section 6 that "securities, banking, trust and insurance are subject to operations and oversight based on separation of activities. Securities firms, banks, trust and insurance companies shall be incorporated separately, except as otherwise provided by the Chinese law." Legislatively, such provisions allow for integration. In fact, no Chinese law expressly bans an entity from holding shares in a commercial bank, an insurance company, and a securities firm at the same time.

In the suggestion on the 11th Five-Year Plan, which was adopted at the Fifth Plenary Session of the 16th CPC Central Committee in October 2005, the CPC Central Committee made a point to speed up the financial system reform and steadily push forward pilot programs and schemes for integration of activities in the financial sector. In recent years, a series of reformative measures have been taken, which are designed to push the financial market reform further and deregulate the financial industry. Some of them have relaxed the strict restrictions of separation of activities. These major breakthroughs in policy indicated a systematic market change in the Chinese financial system, and the change did happen (as shown earlier in Table 3.3).

Coexistence of Independent Business and Financial Holding Company Models: Competitive Landscape for the Ideal Investment Banking Model in the Future

The growing and all-embracing international financial market pushes investment banking to integration, leading to the emergence of "financial supermarkets or department stores" and a dazzling variety of innovative products and financial derivatives. However, quite a number of investment banks stick to specialization, which makes the best of their advantages and gives prominence to particular services they offer. Integration is the trend of the investment banking development, and it usually suits large investment banks only. In fact, there is always a place for small and medium-sized investment banks, regardless of how the investment banking market changes and how the industrial concentration improves. This is also an important criterion, to some extent, for a sound and reasonable capital market structure.

The Independent Business Model Suits Small and Medium-Sized Investment Banks Independent, specialized investment banks, a product of the separation of financial activities, can be found everywhere around the world. They are completely independent and are not controlling or being controlled by commercial banks or other financial institutions. This independent business model helps small and medium-sized investment banks in market segmentation and functional orientation.

Independent investment banks are most endogenously motivated. Such a bank can make a decision on its own for the purpose of maximizing long-term benefits and maintaining goodwill. Such a bank in partnership can especially avoid the behavior that benefits group interests at the cost of investors. This could be very good for the long-term development of investment banking. On a run for profit, investment banks also keep searching constantly for profit-making opportunities and developing new products and services, which significantly boosts their innovative power.

Small and medium-sized investment banks also work on segmentation and compete against large investment banks on the basis of staggered competition. The history of the U.S. stock market indicates that regardless of the swing between separation of activities and crossover, small and medium-sized investment banks that are unable to diversify their activities have been sticking to characteristic, specialized services as the only way to survive and grow in the margins of the market. It is these small and medium-sized investment banks that make the piece that completes the competitive landscape in the securities market. For example, the American commission rate liberalization reform after the 1970s was largely due to small and medium-sized investment banks in competition. Because small and medium-sized investment banks work on specialization and segmentation more than large investment banks do, small and medium-sized banks can offer products and services at a relatively lower cost and have their own customer base and market influence in the capital market.

Alternatively, the development of large investment banks may be limited by the independent business model for the following reasons:

- Small asset size: A relatively small amount of capital is the biggest flaw in an independent investment bank. Although some major investment banks around the world (such as Merrill Lynch, Goldman Sachs, Lehman Brothers, and Nomura Securities) have tens of billions of U.S. dollars in net assets and hundreds of billions in total assets, such amounts are still small compared with their competitors in the form of multibusiness financial conglomerates, such as Citigroup, J.P. Morgan, Deutsche Bank, ABN Amro, Credit Suisse, and HSBC.

- Lack of information superiority: Among all financial intermediaries, commercial banks are considered to have information superiority. Usually, a commercial bank has already established a capital settlement relationship with a company before its IPO, and therefore has a lot of information about the client. A financial holding company that integrates multiple activities can maximize the value of information, while an independent investment bank that cannot get client information from a commercial bank does not have the information superiority for its business. This could also prove from another angle the inevitable choice for large investment banks to convert to financial holding companies.

Private Investment Banks Can Adopt the Independent Business Model There will be an increasing number of private quasi-investment banking companies. In the future competitive landscape in Chinese investment banking, private investment banks or quasi-investment banks will constitute a special competitive group. There will be an increasing number of private companies taking up some investment banking activities (including financial consulting firms and consulting and management companies)—essentially quasi-investment banking companies.[2] These companies are mostly incorporated by returnees who have accumulated during overseas studies or employment quite a lot of advanced management experience and business skills and also have sharp eyes for market opportunities and a quick mind for creative means. They may also be professionals who, with working experience at securities or other companies and established connections, offer on their own some investment or M&A advisory services and even some project financing and wealth management services.

In recent years, many professionally capable private consulting companies have enthusiastically played a part in corporate restructuring and mergers and acquisitions in the capacity of financial advisors. And they have successfully helped clients complete some notable mergers and acquisitions. For example, Unisplendour Investment Consulting Co. helped TEDA take control of Meilun by way of backdoor listing, Beijing Xinmin Financial Advisors brought Xidan Shopping Mall and Beijing Friendship Store Group to a merger agreement. Shanghai Asian Business Investment Consulting Co. Ltd. helped COSCO Group take control of Zhongcheng, and Shangfang Group take control of Jiafeng in the capacity of financial advisor. Such cases have a great impact on state-owned-enterprises (SOE) restructuring. Such private quasi-investment banks have also brought along creative business reorganization models and demonstrated how listed companies can successfully complete mergers, acquisitions, and reorganization.

Partnership is probably the preferred form of such quasi-investment banks. For the purpose of business growth, most private investment banks choose to be independent entities. Some may choose to be companies, but most choose to be partnerships. After all, partnership is the independent business model admirably suitable for those quasi-investment banks. Partnership has existed since the very beginning of the investment banking history of more than 100 years and has the natural inherent rationality.

As a typical intelligence-intensive business, investment banks require high business skills, innovation capability, and professional ethics of their employees, and they regard human capital and intelligence resources as the most important capital and resource. In some professional services, such as law, accounting, auditing, tax accounting, and management consulting, partnership or independent practice has been a tradition. In a partnership, equality, cooperation, and personal responsibility have been deeply rooted in the moral values of each partner. The long popularity of partnership in investment banking is also proof that partnership once was the most effective organizational model for investment banks.

Along with the development of the capital market and the diversification and expansion of investment banking, large investment banks have converted into companies or corporations.[3] Such change seems to indicate that notwithstanding many merits, and due to some inherent characteristics, partnership may also hinder the development of large investment banks to some extent. For example, there is some internal instability with respect to capital size and structure. When a senior partner retires, the partner takes away a share of capital, causing a significant reduction in available corporate capital. Such impact on the business can be devastating in a year when the partnership is not doing well. The limitation of partnership on the business is not significant if an investment bank is small and mainly engages in activities that require a small amount of capital. However, as investment banking keeps pushing the bar higher and higher as to the size of capital and the speed of expansion, it is challenging for partnerships to meet the huge capital requirements for some businesses.

Along with the business expansion of large investment banks, business risks increase. For example, there is a possibility of massive loss within a short period of time. When a partnership is faced with such high risks, it is partners who have unlimited joint and several liability for debts. The mechanism seems to be deeply flawed. Unlike a public company, a partnership does not have to disclose its operating status and financial position. In a highly competitive capital market activity, the lack of sufficient transparency, market surveillance, and public oversight leaves risk management suspicious in a partnership. This would impose greater pressure on the internal control mechanism.

Currently, most American investment banks are companies or corporations. However, there are quite a few small and medium-sized investment banks in partnerships. In China, partnership never existed in investment banks. However, partnership is far too outmoded for investment banks, because investment banking cannot shake off individual character and skills. Business forms vary to fit different sizes and activities, and each form has a specific orientation. This means that regardless of partnerships or companies/corporations, independent, private quasi-investment banks that adopt the competitive strategies for differentiation and specialization will achieve success in the competitive landscape in the Chinese securities market, thanks to a particular competitive advantage in human capital.

  • [1] The current crossover in American banking is mostly within financial holding companies, where subsidiaries are engaged in different activities respectively, and each is relatively independent in legal capacity and management. The current crossover is not a simple recurrence of the pre-1930 crossover.
  • [2] Although these management or financial consulting firms cannot obtain from the regulatory authorities licenses for IPO underwriting, brokerage, and other business, they can still be regarded as investment banks because of the services they offer to their clients, such as M&A and IPO consulting services, project financing, financial advisory services, company research, and venture capital services.
  • [3] In August 1998, 188 Goldman Sachs partners voted for selling some shares to public investors. This indicated that the partnership model, which had been widely accepted in investment banking for centuries, seemed to be no longer popular or to have been abandoned by the mainstream investment banks.
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