Industry Focus: In A Fix
In the first of a series, we examine Taiwan's financial sector. What we find is not too pleasing: the system is struggling under the weight of bad debt. Though new legislation should pave the way for NPLs to be cleaned up, it remains to be seen what will happen.
By Matthew Smith More Than A Paint Job
Taiwan's financial sector is at a critical point: bad debts must be cleaned up, starting now
"At least we're not in as bad shape as Japan." That is about the only positive sentiment players in Taiwan's financial industry have in common these days. It could hardly be considered an optimistic opinion; more like the race's fiftieth finisher laughing at the hundredth. It's also easy to see why there is little space for optimism in the sector: if financial systems could be likened to houses, Taiwan's would have a leaky roof, peeling paint, and an increasingly shaky foundation.
But to take the metaphor a bit further, there's no need for the house's residents to panic and run - at least not right now. No earthquake has yet toppled it, and although the landlord has been negligent with maintenance for the past few years, he is at least creating tools to repair it. Whether the repairs can be carried out in time, or whether current tools are enough to avert a structural crisis, is another question. But that crisis is not yet upon Taiwan.
More's the pity, many commentators might say, because at the heart of Taiwan's problem - the cobra living in the basement - is a worryingly high ratio of loans in the banking sector that are deemed "non-performing," and which don't seem to be getting the kind of attention a crisis would guarantee. The government puts this ratio at 7.8% of all loans outstanding, but analysts estimate it to be anywhere from 12-20%. For this survey, we will throw our dart in the middle - 15 percent - as our assumed ratio. This would mean that Taiwanese banks are holding no less than NT$2.16 trillion in non-performing debt.
How did this come to pass? There are plenty of reasons, but two stand out: overcrowding of the industry as a result of the banking sector's liberalization a decade ago and the kind of real estate speculation that spawns folklore. The effects of those years of extreme excess have been passed down to the present - in magnified form.
The problems, like elsewhere in East Asia, were ignored for most of the latter half of the 1990s as they continued to grow. Taiwan earned bragging rights for its economic performance during the Asian financial crisis of 1997-98, but the old boasts have since turned hollow. NPLs have become well and truly alarming in the past two years as manufacturers have accelerated their movement offshore, in many cases abandoning their lenders and leaving employees with no income to pay off their own personal loans. Taiwan now finds itself caught in a kind of NPL vortex, in which past efforts to patch the system's cracks have only helped to postpone the implementation of real solutions and made resolving the sector's weaknesses even more difficult.
The terrible condition of the banking sector throws up problems that must be addressed in the wider context of the economy. It makes rational lenders unwilling or unable to make new loans, so businesses are unable to expand and generate GDP growth. It also damages Taiwan's attractiveness as an investment destination - and not only for foreigners.
Taiwan's authorities do recognize the need for some DIY financial repair work. Under President Chen Shui-bian, the government has been piecing together a new package to augment the existing rusty set of financial tools, including an impressive laundry list of new and revised laws. "I've seen more financial services reform in the past 24 months than I'd seen in the previous 20 years," says Thomas McGowan, legal consultant with Russin & Vecchi.
How quickly and how deeply these changes will be felt, however, is another story. The issue is pressing, all the more so because there appears to be no "plan B" in place to deal with a possible crisis. Because of its unique political status, Taiwan cannot count on help from international lenders such as the International Monetary Fund. And although it has enormous resources, the government clearly wishes to avoid using taxpayer money to bail out the entire banking system. The problems can be solved by other means, but doing so will require even more reform and fundamental changes in the business and regulatory environment. And without question, these changes will take years of hard work.
This Way to the Egress
Closing down the grassroots co-ops was a good start, but banks present a bigger challenge
When the operators of the credit department at the Taiwan Provincial Farmers' Association left their homes on the morning of August 10, 2001, they were probably expecting a normal, relaxing Friday at work. But along with colleagues in 35 other grassroots credit cooperatives across Taiwan, they were destined to host a most unexpected party. Their uninvited and unwelcome guests - a task force of officials from the Ministry of Finance, the Central Bank of China, the Central Deposit Insurance Corp., and the nation's largest banks - entered quickly and made themselves at home.
The callers did not let good manners get in the way of their fun, but rather began poking through the institutions' lending records. And although they couldn't get an immediate handle on the extent of bad debt the institutions were carrying, they certainly didn't like what they saw. It may have been a breach of etiquette, but it was also a crucial first step in the difficult and pressing task of tackling the nation's growing non-performing loan (NPL) problem.
Without question, Taiwan's regulators deserve the widespread praise they have since received for those actions. It would take auditors several months to dig through the credit cooperatives' dodgy books and determine exactly how bad their condition was, but one thing was abundantly clear right away: they were bankrupt, and had to be taken over.
Fortunately, the raids on arguably the worst of Taiwan's notorious farmers' and fishermen's credit associations were not marred by violence. But they did raise the heckles of opposition politicians. This is hardly surprising, considering the DPP-led administration had a clear political incentive: the grassroots credit institutions had long been used by purveyors of "black gold" politics to fund the vote-buying campaigns of the KMT. But this is beside the point. The cooperatives were deeply in the red, and removing them from the market was the proper thing to do from an economic standpoint.
It was also a good place to start on the difficult task of cleaning up mounting piles of bad debt in the financial sector as a whole. In total, Taiwan's credit cooperatives are thought to be carrying average NPLs of 30 to 40 percent of their total loans; they are definitely the worst of the worst credit institutions in Taiwan.
But by the same token, that's all those 36 were: a start. Fixing the problems of mainstream banks, which have lower NPL ratios but much higher NPL values, will be a far more complex task. "Taking over the credit cooperatives was easy," says Norman Yin, a banking professor at National Cheng Chi University. "The real problem lies within the banks."
And there's the rub.
The Mess We're In
NPLs: What are they and exactly how are they measured?
Just how bad are NPLs at Taiwan's banks? Nobody really knows. Partly, this is due to the narrow definition regulators apply here. In theory, loans in Taiwan are classified as non-performing when the principal (the amount borrowed) is three months past due, when medium or long-term installment loans are six months past due, or when interest payments are six months past due. Ministry of Finance (MOF) officials correctly point out that there is no single international definition for NPLs, so they are not violating any international accounting standards. But they do recognize that their definitions are not as strict as those in Europe and the United States.
Therefore - and again in theory - term loans overdue for more than three but less than six months, loans with principal payments up to date but interest payments overdue by three to six months, and NPLs that are "exempted from calculation with (MOF) approval" are all classified as "under surveillance." If official NPLs and loans under surveillance are combined, then the overall ratio of non-performing loans (as a percentage of total outstanding loans) among Taiwan's banks reached 11.53 percent as of September 30, 2001.
Exactly what "surveillance" means is anyone's guess. For sure, minor shareholders are not granted access to the results of all this observing. But it does work out nicely for both regulators and bankers. Because loans in this category are not officially classified as NPLs, banks are not required to set aside provisions for them, which means they can book higher capital. Thus, when government officials direct a bank to restructure loans to well-connected companies, the bank does not have to report the asset as an NPL, which results in higher reported profitability. Nobody loses, except the bank's minor shareholders, depositors, and eventually every taxpayer in Taiwan.
Ironically, while this method of hiding bad debt boosts the balance sheet, real profits take a beating, because restructuring debt often means giving away reductions or granting moratoria on interest payments. Interest spreads on performing loans (the difference between what a bank charges borrowers and gives to depositors) are already less than 3 percentage points (see chart on next page), so the nation's banks are in no position to be handing out these discounts. Yet the handouts continue.
Although the details of most of these shenanigans are off-limits to the general public, one need only look at the shares of listed banks - many of which are trading far below book value - to see just how little wool has been pulled over the eyes of investors. "The only reason many of these banks are still given investment-grade ratings is because the government does not have a history of allowing them to fail," says Chen Chung-hsing, president of Taiwan Ratings.
Fortunately, analysts do not have to rely on the banks' methods of creative financial reporting to gauge the NPL problem. They can engage in residual measuring, which entails looking at the structure of a bank's outstanding loans. By accounting for factors such as the value of short-term and long-term debt and calculating the value of collateral loans, an analyst can intuit reasonable interest earnings and revenues for a bank. These figures are then compared with the bank's report, and any differences likely mean that the bank is carrying hidden bad loans. "But even so, there are still other ways for banks to cover up their bad debts," says Chi Schive, president of the Taiwan Banking Association and former vice chairman of the Council for Economic Planning and Development.
Thus, the best anyone can come up with for the real NPL ratio of Taiwan's banking system is an educated guess. Estimates range from 12% to 20% of outstanding loans, with 15% roughly the mean. It's a precarious position, because at that level, the net equity of the entire banking system is roughly equivalent to total NPLs. In other words, the system is at the break-even point: it cannot afford further shocks. But that is exactly what's in the cards: amid the uncertainty about the problem's extent, NPL growth is accelerating like never before. This means that addressing the issue is incumbent upon the current administration, even though its main causes predate Chen Shui-bian's election as president.
A Complex Past
Too many banks have been piling up too many poor quality loans for more than a decade
The current banking problems are rooted in Taiwan's legendary asset bubble of the late 1980s, best described by Steven Champion in The Great Taiwan Bubble (Pacific View Press, 1998). "It was as if [Taiwanese] had discovered how to exceed the speed of light, freed themselves from all previously binding physical constraints, and arrived in a strange new dimension where clocks stopped and parallel lines intersected," he wrote.
These were exciting times, and deregulation was the watchword. It was decided that Taiwan needed competition in the banking sector, but the government didn't want just anybody opening a bank. So regulators set the minimum capital requirement for the establishment of new financial institutions at a hefty NT$10 billion. They also didn't want these institutions controlled by powerful individuals, so they set the requirement that no single shareholder could own more than 5% and no group could have more than 15%. What they had not reckoned on, however, was Taiwan's conglomerates, which had enough cash and enough cross-holdings in different companies under their control to meet the requirements. With the stock and property markets booming, it was a no-brainer for Taiwan's captains of industry to jump into the fray, as no one wanted to be left without a seat at the banking table. So in the blink of an eye, more than a dozen new banks were licensed.
As long as the tycoons maintained liquidity and a controlling stake in their banks, they had access to funds far greater than the value of their invested equity. So the asset bubble continued to inflate, and real estate conglomerates with names like Hung Kuo, Hong Yuan, and Tuntex gorged themselves at the banking system's trough. Scornful of market demand, these and other groups engaged in an orgy of overbuilding that would leave perhaps one million vacant housing units islandwide by 2001.
When the stock market began its famous collapse in 1990, real estate prices did not immediately follow. The ultra-competitive environment created by the large number of new banks provided generous liquidity for new properties, and conglomerates that controlled banks were still able to lend themselves depositors' money, often using their own stocks - or those of their major shareholders - as collateral. But when Beijing lobbed missiles into the Taiwan Strait in 1995-96, the luster of Taiwanese real estate began to fade, and it took government action - preferential rates for first-time homebuyers - to spur a recovery. This and similar policies have been utilized many times to boost the housing market since, but as Norman Yin says, pulling future demand into the present creates an inevitable vacuum somewhere down the road. "They reduce the effectiveness of these tools every time they use them, because there is less demand to pull from the future," he says.
An Uncertain Future
It's not easy being a bank, given the property binge hangover and the China drain
Yin's future vacuum draws nearer, and it is not the only source of an ominous sucking sound: The movement of manufacturers to China has worsened the problems of Taiwan's financial system.
Knowingly or otherwise, banks here have been the financiers of Taiwan's westward expansion. How so? To avoid the government's "go slow, be patient" restrictions on cross-strait investment, companies and their major shareholders took out short-term loans based on their property holdings in Taiwan, but then used the funds for long-term expansion plans in China.
The weakness of this loan structure became apparent in 1998, when a stock market dip in the wake of the Asian financial crisis devalued the collateral on these loans, prompting the banks to panic. Once they started dumping shares, a downward spiral was set in motion as the banks' selling pressure forced the index lower, which in turn prompted the banks to accelerate their selling. Eventually, this brought the heavily indebted conglomerates to their knees. But it was a losing situation for the banks also, as the old adage once again rang true: when you owe the bank a million, it's your problem; when you owe the bank 100 million, it's the bank's problem. Thus, loan refinancing and government-directed bailouts were the tragic climax to the drama. Even though the banks quickly developed a reluctance to lend, some large conglomerates found that the threat of insolvency was enough to obtain more loans. According to Chen Chung-hsing of Taiwan Ratings, the Tuntex Group managed the singular feat of borrowing the legal maximum from every bank in Taiwan.
Finally, the exodus of Taiwan's traditional manufacturing industries to China has also undermined the financial sector in an indirect way: by aggravating the unemployment rate. The nation's increasing number of jobless workers are having difficulty meeting their housing mortgages, credit card payments, and other consumer loans. The result: high NPLs getting higher.
The biggest question is where this ascent is going to lead. Prior to last year's raid on the grassroots institutions, the bad debt problem had been festering in Taiwan's financial system for more than a decade. Little was done to fix it because of its complexity and the pressing concerns of domestic politics - even though it is still nearly impossible to get any government official to admit as much. "Taiwan has carried out healthy financial supervision for a long time," says Minister of Finance Yen Ching-chang. "We don't allow our banks to engage in too much risky behavior." Maybe not, but the risks that began to be taken more than a decade ago have come back to haunt the financial sector. And exorcising this poltergeist will take much more than the closure of 36 small credit cooperatives.
Prescription Incomplete
What has the government been doing to clean up NPLs, and what more remains to be done?
Most of us could be forgiven for having missed the remarkable wave of financial sector liberalization enacted by Taiwan's government over the past two years. After all, this stuff is hardly as intriguing as what really matters to local media: martial artistry in the legislature, spring-autumn romances, and the images produced by strategically placed pinhole cameras. Yet although it might not appeal to our prurient instincts, the speed and extent of reform has been remarkable, and demonstrates that the current government understands the need for a streamlined, healthier, and more sophisticated financial system.
A comprehensive review of these reforms would range far beyond the scope of this article. They include promoting mergers and acquisitions among financial institutions, establishing a NT$142 billion Financial Restructuring Fund, reducing restrictions on foreign ownership of listed companies, and allowing the establishment of financial holding companies (FHCs) and asset management companies (AMCs). There are other reforms on the table for 2002, including passage of crucial legislation related to bankruptcy procedure, securitization of financial assets, and mergers and acquisitions of non-financial companies. These and other changes make up an impressive cocktail prescription for streamlining and reforming the financial sector.
Sadly, as much as this is, it is simply not enough. There are still too many powerful disincentives for banks to realize their NPL losses, and there is still no established mechanism by which to force insolvent banks out of the market. "The framework that has been established is great, but I don't really see much being done," says one industry observer. Indeed, it can be argued that some of the laws work against each other in practice. For example, setting the minimum capitalization for a holding company at just NT$20 billion makes it too easy for smaller players to avoid the hard but necessary step of merging, thus discouraging much-needed sector consolidation.
Perhaps, but the real reason why everyone is still waiting for the sky to light up over the financial sector is the same reason why reforms became so necessary in the first place: those pesky NPLs, something like NT$2.16 trillion worth. Hiding them behind opaque accounting standards and burying them in the finance ministry's "surveillance" category doesn't seem to be fooling anyone. Foreign banks have shown little interest in snapping up problematic local institutions, and neither have the handful of domestic standouts. Why should they? None of these well-managed banks are looking to buy their way into a mess. "If they want to consolidate the banking industry, they've got to clean up the NPL issue first," says William Bryson, senior consultant with Jones, Day, Reavis & Pogue. "Otherwise, very few banks are going to attract merger partners." Moreover, forcing big state-owned banks to take over smaller, illiquid institutions will only warehouse the problem, rather than resolving it.
So it's first things first: Get NPLs off the books (and don't forget there are plenty of NPLs that aren't on the books), then consolidate. But bankers in Taiwan are reluctant to tackle their NPLs, and for good reason. Admitting their mistakes would be a loss of face for senior managers, many of whom themselves authorized loans years ago that have since turned bad. With an eye on retirement, they are fearful of the consequences, which might include them being seen as responsible for any possible job losses and perhaps even the closure of their banks. Furthermore, after losing their highly paid positions, they would likely be unemployable in their field - a daunting prospect for aging executives. And it can be safely assumed that such fears are not assuaged by the prosecution of managers from some of the credit cooperatives that were taken over in August.
The threat of criminal liability is a particularly thorny issue. Mainstream bankers who made questionable loans that would later become NPLs often did so at the direction of government officials. It's hard to see why these bankers should be targeted for prosecution, and it is not certain that they would be. But that lack of clarity is itself an impediment to fixing the NPL problem: bankers don't know whether or not they will be hauled into court, but they are - understandably - reluctant to test the waters by realizing their losses. One observer who requested anonymity believes that the government should make clear that it will not prosecute mainstream bankers for losses realized at their banks. "I suppose you risk a certain amount of moral hazard when you say that, but at the same time you have to make a choice," he notes.
So where do we start?
It will probably take a combination of government stick-waving and carrot-dangling to get the process of writing off the loans under way. The revised Banking Law contains provisions allowing regulators to issue a Prompt Corrective Action (PCA), which would force banks to set aside a higher minimum amount of capital against their reported NPLs. As of press time, the details of implementing this regulatory tool had yet to be released, but one analyst suggests the minimum provision be set at 50% of the value of NPLs, and that the standard be applied to all banks that are carrying reported NPLs of 3% or higher. "If you provision for half of your NPLs, then I think everybody in the world will respect your balance sheet," says the analyst.
This provisioning would impact a bank's earnings and could reduce its capital adequacy ratio to below the 8% minimum required by the Bank for International Settlements (BIS). If this were the case, the institution would be given a grace period of no more than two years to bring its BIS ratio back to 8%, either by injecting capital or decreasing risk-weighted assets. Crucially, banks that failed to reach the 8% level by the deadline could then be pressured to exit the market via a merger or sale or else face the prospect of losing deposit insurance protection.
Deposit insurance is an immensely powerful tool that the government could use to better effect, however, by applying its standards more strictly. Regulators certainly sent the wrong message to the public in August when, in order to prevent a run on deposits at the 36 credit cooperatives taken over, they used the Financial Restructuring Fund to guarantee all deposits - even those greater than the regulatory maximum of NT$1 million. Analysts say that the extension of coverage interrupted a "flight to quality" among depositors that had been spurred by the collapse of Chung Shing Bank in April 2000. The result could be that more depositors choose to put their money in higher-yielding accounts at risky credit cooperatives, because they believe that the government will bail them out - regardless of their deposit amounts - if the institution goes belly-up. Textbook moral hazard.
Setting these standards and then implementing them across the sector is vital. It will protect the administration from charges of politically motivated regulatory action whenever KMT-controlled banks are targeted. It would also restore health to the financial system, which would then be better able to fuel economic growth. And then everyone can get back to more important matters, like how the koalas are getting along at the Taipei Zoo.
The ABCs of AMCs
Foreign investors will play a major role in cleaning up Taiwan's NPLs, but not from a sense of charity
There's nothing quite like passing your problems over to someone else. Too bad it's not always easy to find that person.
In recognition of the need to set up a platform for liquidating NPLs, Taiwan's finance ministry granted a license to Taiwan Asset Management Corp. (TAMCO), the nation's first asset management company (AMC), in April 2000. An AMC is an entity that buys distressed loan assets from a financial institution at a discount to their face value, then attempts to turn a profit on that investment. It can do this by restructuring the loan and continuing to accept repayment in the hope that more money will eventually be collected than the purchase price of the original debt. A more immediate way is to foreclose on the loan and sell the collateral. The loans can also be repackaged and sold off to someone else at a higher price.
As far as Taiwan's banking system is concerned, an AMC is simply a vehicle for cleaning up NPLs - or it would be, if only it worked in the current environment.
Initially, the government promoted "warehouse AMCs," says William Bryson, senior consultant with Jones, Day, Reavis & Pogue. In this model, an AMC would be formed as a joint venture between a foreign investment bank and a large, solvent domestic bank. The AMC would then buy NPL portfolios from other domestic banks. Despite some initial promise, the warehouse idea failed because prospective joint venture participants did not want to be bound to a single partner. "It's the typical problem with an immature market," says Bryson. "Nobody knows where the opportunities are, and therefore you want to keep your options as wide open as possible - even if you may in fact be losing opportunities by doing so."
So a new model has emerged as the front runner: the portfolio-specific AMC. This will be a joint venture between a foreign investment bank and a local bank with NPL assets that it needs to sell off. The AMC will only focus on buying NPLs from that specific local bank; if the foreign investors are interested in another bank's assets, they will have to establish a separate joint venture AMC with the second bank. This model will allow greater flexibility, and seems likely to be the one that will make deals happen. Which brings up one little detail: Not a single NT dollar's worth of assets has yet been liquidated through an AMC in Taiwan. TAMCO, which was set up by the Bankers Association of the ROC and is the only AMC yet established, has not been a rousing success, and the portfolio-specific joint ventures have yet to get off the ground.
What's holding up the AMCs? The biggest impediment is the vast difference in expectations about the price that these assets should fetch. "I've heard of pricing differences where the foreign bank thinks the assets are worth 5 cents on the dollar and the originator thinks they're worth 85 cents on the dollar," says Bryson. "I've been practicing law for 17 years and I consider myself a reasonably good negotiator, but I can't bridge that gap."
It's not simply a case of greedy foreign carpetbaggers vs. money-grubbing local swindlers. For one thing, the portfolio-specific model will allow the asset originators - the local banks - to realize a return from the sale of their NPLs because they will own a 50% stake in the AMC to which they sell their assets. In fact, the reluctance to sell at the substantial discounts demanded by foreign investors can in part be blamed on the regulatory environment. After all, local bankers can be prosecuted if they allow their institutions to take too strong a hit - even for loans made under government pressure. At the same time, the foreign investment banks are not coming here for reasons of charity. The process has reached a stalemate.
Even so, Bryson believes that AMCs will start to function and deals will get done in the first half of 2002. Part of his optimism springs from his observation of the pricing issues being solved, and part comes from the very exigency of the NPL problem. "If we don't start seeing deals in the first half of the year, the banking industry is going to be in a true mess in the second half of the year. And Taiwan can't afford for these deals not to be done."
Insufficient Securities?
Taiwan is trying to adopt financial instruments that have worked elsewhere in the world, but the outlook for their success is uncertain
For any investor out there who has always wanted to own a piece of an abandoned machine parts assembly plant in Chiayi, the Legislative Yuan is about to make your dreams come true.
Actually, the Financial Asset Securitization Law, pending its third reading in the LY as of press time, holds much greater promise. If the details of the final version come out properly written, it will be another major step in Taiwan's march toward greater capital markets sophistication. Securitization will create a valuable new option for investors while at the same time providing liquidity and greater asset transparency for the financial sector.
Essentially, the law will allow lenders to sell the value of their loans (principal plus interest) to investors via a special purpose vehicle (SPV), which, according to the most recently revealed draft, must be a trust. Through this mechanism, lenders will be able to obtain immediate access to their future interest income - thereby giving them more cash with which to make further loans - while investors enjoy a better rate of return than they would on an ordinary savings deposit. "It's a good opportunity even for regular retail investors who may not be very sophisticated," says Charles Hwang, attorney-at-law with Qi Lin International Law Offices.
However, it will only work if the package that is being offered to investors can be made attractive enough, and there are a number of possible stumbling blocks in the way. Unfortunately, foreign intermediaries report distressing news from their initial discussions with Taiwanese bankers on the subject. Rather than seeking to securitize good quality loan categories such as housing and automotive mortgages, credit card receivables, and other personal loans, bankers are instead talking about their NPLs. Not only is securitizing these assets difficult from a legal standpoint, but it will be difficult to attract investors. "Basically, the government now is really encouraging the securitization of financial assets that are of good quality, that are less likely to become non-performing loans," says Hwang. "Securitization does not work without cash flow, and few investors are going to be interested in purchasing securitized NPLs."
Adequate cash flow will require the participation of foreign players - investors, investment bankers, and credit ratings agencies. But it is unclear whether the final draft of the law will establish the necessary legal structure for securitization to succeed. Perhaps the most pressing issue: the SPV must be "bankruptcy remote" from the original lender. In non-legalese, this means that when the assets are transferred to the SPV, it should constitute a real sale so that in the event of the lender going bankrupt, there is no chance of creditors popping up to lay claim to the SPV's assets. But under current law in Taiwan, the court can unwind a trust formed up to six months prior to the originator's bankruptcy. "No-one is going to invest if they think the SPV might not exist in 6 months," says William Bryson of Jones, Day, Reavis & Pogue. "Nobody is going to touch a securitization structure that has a significant bankruptcy risk to it."
Securitization has another potential deal killer: the taxman. While taxation at the investor level is reasonable, levying taxes on the SPV only serves to reduce the value of the securitized assets and detracts from the attractiveness of the securities from the standpoint of investors and ratings agencies. Moreover, allowing SPVs to be formed as companies (and not only trusts) would provide greater flexibility. The revised Company Law would support it, so there is no reason to maintain the proscription against SPVs being set up as companies. Finally, the law only applies to financial assets (loans), which are assets owned by a financial institution. What about other assets? "At the end of the day, if the market is going to mature, you have to allow MiTAC, Acer, TSMC, and other industrial companies to securitize their future receivables," says Bryson, pointing out that such assets are commonly securitized in the United States.
If these changes are implemented, securitization will prove to be a boon for the financial industry. The extra liquidity will provide fuel for further economic growth, and the participation of foreign credit ratings agencies will ensure higher asset quality among Taiwan banks. But with SPVs subject to bankruptcy risk, there will be no investors. And without investors, securitization will fail. It can only be hoped that the LY is listening.
Horizontal Challenge
Financial holding companies are finally a reality. Let the games begin
Walk into any of Taiwan's large state-run banks. Grab a number from the machine and join the seated crowd of elderly customers, each patiently awaiting their turn and recounting their huge wads of blue notes. Take a look behind the counter. You can't help but notice the dreamy, contented smiles on the faces of the managers seated behind their desks, hands folded placidly in their laps and eyes vaguely focused on their younger colleagues in front. Perhaps you are here to change some foreign currency, or to transfer money overseas. Sit back and relax. Ask yourself (you will have at least 45 minutes to ponder the question): is this bank ready for international competition?
Of course, Taiwanese banks have traditionally focused on lending operations, leaving non-interest income business such as underwriting and derivatives to foreign banks. But with the passage last year of the Financial Holding Company Act, the financial sector has a powerful new vehicle with the potential to give even multinational financial institutions a run for their money in the Taiwan market. If you don't believe it, just ask them: "Foreign banks are going to get squeezed, especially in areas such as priority banking and truly viable credit card operations," says Eric Chen, country corporate officer for Citibank, N.A.
In Taiwan, a financial holding company (FHC) acts as an investment platform with ownership of its subsidiaries, which in the formative stage can include a bank, a securities company, a property and casualty insurer, and a life insurance company. Entities within a holding company will have the opportunity to streamline their businesses and create more efficient sales and back office operations. "We will integrate any operations from which we can derive common characteristics that we think are important for the company's future," says Paul Lo, chairman of Bank SinoPac, which will form an FHC along with National Securities Corp.
Company managers say that the biggest advantage of forming an FHC lies in the ability to share information about customers and to cross-sell financial products. When a customer buys automotive insurance from an institution that is part of a financial holding company, the insurer can pass information about the customer - for instance, the make of his car - to the other entities under the FHC. These companies can target their marketing to him at an appropriate level of financial product sophistication. Also, under the "financial services supermarket" concept, consumers will theoretically be able to purchase any product offered by an FHC at any of its subsidiaries' outlets. Want life insurance? Try your neighborhood bank branch.
Proper product design and pricing should result in increased sales: Victor Kung, chairman of the newly formed Fubon Financial Holdings Company, says Fubon currently sells 2.5 products per customer, but expects to raise that to 6 once the group's operations are fully integrated. In truth, related firms in Taiwan have long engaged in quiet cross selling, but establishing FHCs will make it more efficient, transparent, and - as an additional attraction - legal. "FHCs should be thought of in functional terms," says Sophia Cheng, vice president with Merrill Lynch Taiwan, Ltd. "What matters is the cross-sector integration beneath the FHC."
For Taiwan's consumers, FHCs might prove to be a double-edged sword. For cross-selling to work, product designs have to be simple, so that all FHC employees can explain them with a minimum of training. Consumers unsatisfied with generic financial services will still be able to obtain tailored products from specialist salespeople, but they will have to pay more for them. On the other hand, FHCs will introduce a new level of financial sophistication to Taiwan, where more than half of total savings is still sitting in bank deposits, by giving customers more efficient options. And investors will benefit, because FHCs eliminate the ambiguity created by opaque cross-shareholding arrangements of financial companies: all entities under the FHC structure are 100% owned by the FHC.
The FHC Law has its critics, including Chen Chung-hsing, president of Taiwan Ratings, who argues that European-style "universal banking" is more appropriate for Taiwan - and more efficient. Also, supervising the cross-industry partners will require an unheard-of level of cooperation among the regulators of the various industries. Others argue that the opportunity to establish FHCs has encouraged financial institutions to avoid merging and thus delayed industry consolidation. As of press time, up to 20 groups had either applied or were in the process of applying, and at least six had been approved. The ministry exacerbated this early rush by setting the minimum capital requirement for establishing FHCs at just NT$20 billion, an amount easily reached by too many unsuitable financial institutions. Most experts agree that the market can reasonably support just five to eight FHCs, which means that the newly formed companies could encounter the same hyper-competition that has plagued Taiwan's financial industries for more than a decade.
But there is reason for hope that overcrowding will not be permanent. Eventual market leaders are likely to be those FHCs with the flexibility to integrate quickly and efficiently across industries with very different cultures. "The depth of thought that is put into overall strategy will be what's going to differentiate these companies," says James Hexter, associate principal with McKinsey and Co., Inc. "The ones that really collaborate will win." And the ones that lack the commitment to streamlining and integrating their CRM systems and human resources will lose.
As one insider notes, the leading FHCs will pose a huge challenge to the nation's state-run banks - a challenge he thinks the behemoths will be unable to meet. Even government companies that become FHC subsidiaries are likely to dominate the FHC with their rigid bureaucratic culture. So which companies are likely to emerge as leaders in upcoming years? According to our unofficial survey, look for names like Fubon, SinoPac, Chinatrust, CDIB, and Taishin to stand out from the growing throng. But the process will take time, not just for the companies to learn how to integrate horizontally, but also for financial regulators to do the same.
No Easy Outs
It will be difficult, but fixing the problems of Taiwan's financial sector is necessary. And it can be done
It's time to recognize a few unpleasant facts about the health of the financial system in Taiwan. Burying the NPL problem under opaque accounting methods won't cure it. Warehousing the problem and waiting for the glacial growth rate of domestic banks to take care of it won't work either. Foreign investors might be willing to purchase some of Taiwan's low quality loan assets, but only if they see the potential for fat profits. It's a big world, and they can take their money elsewhere. And no large solvent bank - foreign or domestic - should be expected to merge with or buy a Taiwanese bank saddled with a high level of bad loans. In this story, there are no heroes, and there are no magic wands.
But the fable of Taiwan banks' bad debt doesn't have to end in tragedy for the nation either. By recognizing the problem's true extent, getting NPLs off the books, and taking the painful step of realizing those losses, the financial system can have its vibrancy restored. Everyone knows that there are too many banks, so forcing institutions that are carrying negative equity to exit the market would also serve the purpose of making it possible for the healthy, well-managed institutions to thrive. Admittedly, it would also aggravate the unemployment rate, which would not win much voter sympathy. But the cost in political capital would be far less than the alternative: waiting until the problem is so bad that the entire banking system has to be re-capitalized with taxpayer dollars. It would be preferable to take this bitter medicine now; society will have to pay the price either way.
A leaner, healthier financial system will have enormous influence over the rest of the economy, as it will help to power growth in consumer spending and domestic investment once external demand picks up again. Yet this point brings up another fact that needs to be recognized: for Taiwanese banks to grow, they must have access to the same growth opportunities enjoyed by the rest of the corporate sector. Domestically, there is still room for growth in areas such as consumer lending, but Taiwan's property market is almost completely mortgaged and companies are moving their operations overseas more quickly than ever before, mostly to China. Taiwanese banks remain the natural financiers of Taiwanese manufacturers with operations on the mainland. They know the industries and the individual companies much better than Chinese or even Hong Kong banks. Moreover, they have actually financed much of this very expansion, albeit in an inappropriate backdoor manner that has aggravated the NPL problem. This has to change. "The pull of the Chinese economy is so strong that [Taiwanese authorities] can't resist it entirely," says Peter Kurz, chairman of Insight Pacific. "They can drag their feet, they can jawbone, and they can stall - but they can't stop it." As part of its WTO agreements, China has pledged to open its market to foreign banks over the next five years, but whether Taiwan will join the party is a decision that must be made by the government here. Hopefully, officials will make the right choice.
Repairing Taiwan's crumbling financial house is an extremely daunting task, but there is no viable alternative other than to get on with it. Unfortunately, the clock is ticking, and delaying the implementation of solutions will only allow the situation to worsen. Under President Chen Shui-bian, the government has come a long way with reforms, and industry experts praise officials for having demonstrated the wisdom and flexibility to accept their input - and the courage to act on it. These are positive signs, but at the end of the day realism must still hold sway: It will take even more reforms - and years of diligent and disciplined implementation of the new rules - to get Taiwan's financial system out of its current fix.
