Criteria for an Ideal Future Management Model for Chinese Securities Firms: Factors Within Firms

Advantages of Financial Holding Companies: Help Build up Competitiveness in Investment Banks Financial holding companies are an advanced micro-organizational form and a product of sustainable development of the financial industry. They are an organizational innovation by financial institutions helping to adapt to, survive in, and grow with the development and transformation of the financial system. Compared to an independent financial institution, a financial holding company has the following core strengths:

- Capital intensification: A financial holding company can raise capital by issuance of stocks, bonds, debentures, notes, and other securities and invest money in subsidiaries under its control. It can also manage and employ the assets of subsidiaries in a centralized manner. Through equity operations at different levels (a subsidiary can use the same holding strategy), the financial holding company can control a large business family and double the capital utilization ratio and assets in its actual control. Capital-intensified management is the fundamental operational advantage of a financial holding company.

- Diversification-induced coupling effect: The advantage of business diversification is one of the goals of financial capital operations. A financial holding company serves a purpose to break through restrictions on business activities and pursue a variety of financial services in hopes of building up operational advantages such as economies of scale and scope, synergies, and spread of risk. This model can bring to investment banks synergies, economies of scale and scope, cross-selling, information sharing, financial innovation, and so forth. Once having been incorporated into a financial holding company, an investment bank has a boost to grow, thanks to the homogeneity of financial services. Enlarged business network coverage, diversified services, and one-stop financial services help an investment bank attract more customers, increase market share, or further explore the needs of the established customer base.

- Effective spread of business risk: A financial holding company has a broad range of business. It can arrange different activities into a variety of business mixes at different risk levels. Therefore, it is less exposed to the risk of bankruptcy. A financial institution that chooses or is limited to a certain line of business, on the other hand, has a narrow range of options of asset combinations and business mixes. Therefore, it is highly exposed to the risk of bankruptcy. Learning from how the American investment banks responded to this financial crisis, the financial holding company model seems to be the optimal organizational model that provides shelter for investment banks. In Europe, the fact that many investment banks have chosen the financial holding company model sufficiently indicates the vitality of this organizational model that helps multibusiness investment banks survive and grow. In the United States, after the outbreak of the financial crisis, some large independent investment banks went bankrupt or were sold to commercial banks and became part of bank holding companies. Goldman Sachs and Morgan Stanley were converted into financial holding companies. In Japan and South Korea, investment banks controlled by financial holding companies dominate the securities market. From historical facts and current trends, we can conclude that although the financial holding company model might not be the only option for investment banks, it is at least an important organizational model that combines efficiency and risk control. Its vitality proves its importance in the development of investment banking. The high stability of German full-service banks over a long period of time and the bankruptcy of more than 1,000 single-line American banks since the 1980s seem to confirm both positive and negative conclusions.

- Market power: Thanks to the economies of scale, a financial holding company expands quickly. It takes a huge chunk of market share and gains a monopoly. By taking advantage of such influence in the market, the company earns excess profits. Such a natural monopoly that empowers a financial holding company for further growth is the main enticement for investment banks to choose this organizational model.

Financial Holding Company-Backed Investment Banks Are Stronger in Respect to Overall Competitiveness: Chinese Practice An analysis of the 2009 performance of Chinese securities firms leads to the encouraging discovery that investment banks controlled by financial holding companies have strong competitive advantages (see Table 3.4).

TABLE 3.4 Market Competition Performance of Financial Holding Company-Backed Securities Firms

Considering the status quo of Chinese securities firms, the regulatory authorities will generally select a small number of securities firms on the basis of their risk management capability and industrial influence for pilot programs of innovative activities. On the principle of "pilot arrangement before extended practice," the regulatory authorities will consider a series of indicators (such as net capital requirement, regulatory compliance, and net capital risk control) and pilot program implementation plans and select high-performing and prudent securities firms for the first pilot program. If the first one goes well and the market response is satisfactory, the authorities will extend the pilot program. Based on the lists of qualified securities firms for pilot programs of direct investment, QDII, margin trading and short selling, and stock-index futures, financial holding company-backed securities firms can better meet the CRSC requirements and have a better chance to first participate in new activities. This is thanks to significant advantages brought about by economies of scale. Therefore, financial holding company-backed securities firms have a natural competitive advantage in qualifying for new business.

Once qualified, a securities firm has a starter's advantage to get access to the new business market in advance and leave other securities firms far behind in the competition for new customers. Such an advantage is path-dependent. In the long run, this advantage will help enhance overall competitiveness and the strong will get stronger. Innovative products and services, which will be crucial for the upgrade of profit model and future competitiveness, will be a game for the strong, and will significantly widen the gap between competitors.

Net capital is at the core of investment banking oversight around the world. In China, regulators are working on the improvement of the risk control system in securities firms, with net capital as the core indicator. The CSRC released in July 2006 the Risk Control Indicators-Based Regulatory Measures for Securities Firms and the Net Capital Calculation Standards for Securities Firms. It imposed more stringent requirements in the revisions of June 2008, which provide that with the net capital requirement at the core, the regulatory system must directly keep a rein on securities firms as to the scale and structure of each business. Capital strength determines the future. A securities firm can use a financial holding company as a platform to reinforce capital strength for the securities firm to build on the advantages of the holding company and to have easier access to finance by means of IPOs, issuance of debentures, or others. According to the 2009 Chinese securities firm ranking by net capital, all the top six firms are backed by financial holding companies.

Financial holding company-backed securities firms have strong competitive advantages in the aspects of business capacity, profitability, risk control, and innovation capability, among others. And such dominant or potential competitive advantages will turn into overall competitiveness along with future business growth. This will be determined by the overall competitiveness and platform resources of the financial holding companies.

The Choice of a Future Growth Model for Investment Banks Should Comply with the Financial Services Framework That Leans toward Commercial Banking After the post-crisis reorganization, mainstream Wall Street investment banks did not disappear; they were integrated into a new business and regulatory system. In fact, among more than 880 mergers and acquisitions in investment banking in the past five years, more than 260, or 30 percent, involve commercial banks acquiring investment banks. This indicates that in the United States, commercial banks have been the main buyer in the purchase of investment banks. We cannot deny that the financial crisis has provided a business growth opportunity for the American bank-backed financial holding companies. In the financial crisis, as asset value rapidly shrank and bank runs escalated, investment banks suffered massive losses and could barely survive without external help. This paved the way for a series of mergers, acquisitions, and reorganization in the American financial industry. Major commercial banks were active in M&As and reorganization. In particular, several large commercial banks seized a rare opportunity and quickly divided up most of the assets in the American securities industry.

The financial crisis showed that the single-line business model does not perform as well as the crossover model does in respect to resilience to a financial crisis. The crossover model proves to be more risk-resistant.

^[1] Generally, in commercial banking, business management is more transparent. Risk management and control systems are also better. Together with strict regulatory oversight, diversified business activities, and other factors, they help stabilize sharp fluctuations in operating income.

Along with increasing competition and deregulation, commercial bank-controlled financial holding companies in China over the long run will have more vitality in the future competitive landscape. The reasons for this are discussed next.

The Chinese banking sector has access to most financial assets and customers. In the Chinese financial industry, the majority of capital, financial assets under management, and financial services customers are concentrated in the banking system. According to a study of Qian Xiao'an (2006), 93 percent of all the Chinese financial assets are controlled by the banking sector. Less than 7 percent are in the insurance and securities sectors. Because commercial banks have most of the assets and customers and can easily offer one-stop services, they have both a subjective impulse and objective facilities to convert into financial holding companies. The asset and customer structure in the Chinese financial industry determines that commercial banks will be at the core of financial holding companies. All subsidiaries in a financial holding company can share information and customers. Therefore, an investment banking subsidiary can expand its business and improve the quality of service.

Investment banks need liquidity. In the existing Chinese system, all financial institutions except commercial banks are unable to create liquidity on their own. However, they all have a strong need for liquidity,^[2] investment banks in particular. A review of the Chinese securities industry and the U.S. financial crisis shows that both Wall Street banks and Chinese securities firms are highly dependent on liquidity. The difference is that due to institutional dissimilarity, Wall Street investment banks can create liquidity and increase financial leverage by the so-called financial innovation. Before the financial crisis, the financial leverage ratio was up to 30 to 1 in the majority of Wall Street investment banks. This means that even if the total return on assets (ROA) dropped by only 3 percent, it could devastate these financial institutions.

Before the overall improvement initiative across the industry in China, securities firms had no legitimate financing channels. Some turned to illegal means for liquidity, such as misappropriation of clients' money in their securities trading settlement accounts, issuance of over-the-counter bonds, and wealth management contracts. Such means led to bankruptcy and shutdowns. After the overall improvement initiative, the regulatory authorities have enabled some high-performing and prudent securities firms to have access to some legitimate financing channels, such as IPOs and issuance of corporate debentures. For most securities firms, however, along with increasing innovative products and services and expanding asset services, the problem of liquidity shortage still remains. If an investment bank becomes a subsidiary of a financial holding company, the commercial bank in the same financial holding framework could provide liquidity support by means of business coupling, banking-securities cooperation, and others.

Investment banks also need public credit. Credit is the foundation of the financial industry and is usually divided into commercial credit and public credit (also referred to as government credit). Unlike general industrial companies, financial companies do not rely solely on their own commercial credit; they also need public credit. In China there is no investor protection law, deposit insurance system, or financial consumer protection system. This makes the need for public credit even more important for financial companies. Due to the public ownership and other historical reasons, the public credit of Chinese commercial banks is better than that of insurance companies and securities firms. Except for commercial banks, the public credit of Chinese financial institutions cannot serve its purpose. This is particularly true in the securities sector, where problems exposed during the overall improvement initiative dragged the public credibility of securities firms down to the bottom in the whole financial industry (even though the investor protection mechanism has been established). Definitely, an investment bank being a part of a financial holding company would greatly improve its public credit.

• [1] Compared with independent American investment banking, conventional European banking (especially German banking) took a relatively smaller hit in the crisis. The German universal banking model may not necessarily be superior to the independent American investment banking model, lacking theoretical proof and practical evidence. However, full-service banks are clearly exposed to less risk and are more robust.
• [2] Lloyd Blankfein, Goldman Sachs chairman and CEO, once said: "When Goldman Sachs was a private partnership, we made the decision to become a public company, recognizing the need for permanent capital to meet the demands of scale. While accelerated by market sentiment, our decision to be regulated by the Federal Reserve is based on the recognition that such regulation provides its members with full prudential supervision and access to permanent liquidity and funding" (Goldman Sachs, 2008).