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Financial services for China’s newly affluent 77

Chinese banking faces a dramatic transformation over the next ten years. While we expect the overall profits of the sector to grow at an annual rate of about 10 percent, the source of its earnings will change signifi-cantly: by 2013, we estimate, corporate banking’s now overwhelming share of the sector’s profits will decline to little more than half as profits from retail banking increase more quickly (Exhibit 1, on the next page).

Three main forces will propel these developments. The first is strong and increasingly consumption-driven GDP growth, ranging from 7 to 9 percent in recent years. Prosperity will boost demand for retail-lending products such as car loans, credit cards, and mortgages. Second, demand for traditional corporate-banking products, particularly deposits and loans, will fall. As Chinese companies centralize their cash management, the “stocks” of deposits held by each of their provincial operations will be greatly reduced. Moreover, Chinese companies now rely almost entirely on bank debt for financing, but over the next ten years we expect the development of capital markets to reduce demand for loans. Third, over the next five to seven years, we believe that the Chinese government will gradually deregulate interest rates. That will significantly reduce margins on both deposits and corporate lending.

The shift in the profit mix from corporate to retail gives foreign banks a golden opportunity to tap into the Chinese banking market by targeting affluent customers, much the most attractive segment. Their financial needs are diverse, and they account for the vast majority of auto, mortgage, and personal-lending balances. Although they make up a mere 2 percent of the retail customers of Chinese banks, they account for as much as 55 to 65 percent of retail-banking profits. The “mass-affluent” segment accounts

Retail banking in China

The race is on to make money from individual consumers. Foreign banks had better get into the game.

David A. von Emloh and Yi Wang

The McKinsey Quarterly 2004 special edition: China today78

for 18 percent of all customers and for 40 to 50 percent of retail-banking profits, while the 80 percent of customers in the mass-market segment are largely unprofitable.

Affluent customers are highly concentrated geographically: three-quarters of them live in Beijing and in major coastal cities such as Shanghai and Guangzhou. Domestic banks can’t serve this segment effectively, because they lack risk-assessment skills in retail lending and a sales-and-service culture in their operations, which focus primarily on processing deposit account transactions. Some of the large institutions don’t even know who their affluent customers are, since they have little integrated informa-tion about the people who bank with them. McKinsey’s surveys of Asian banking consumers show that affluent Chinese are less satisfied with the level of service they receive than are their counterparts elsewhere in the region and that they would switch to banks providing better service even at the cost of higher fees or interest rates. Foreign banks, with their greater experience of serving the affluent market, are thus well positioned to capture this opportunity, for they will have to provide only a relatively small number of branches in a few big cities.

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The creation of wholly owned branch networks is likely to be a critical component of a winning strategy because they provide a platform for customer access and brand building. Leading foreign banking groups such as Citibank and HSBC are building their own branch networks in central locations (for instance, the Bund and Pudong financial districts in Shanghai) and luring top customers. For now, these branches are limited by regula-tion to foreign-currency deposits and loans, mainly to expatriates and affluent locals. But come deregulation, in 2007, they will be free to take local-currency deposits and to offer renminbi-denominated credit cards, mortgages, and other personal-lending products—a market whose profits are likely to grow by 30 percent a year. They will also have the right to market other products, such as life insurance and mutual funds (Exhibit 2).

Partnerships with Chinese institutions will probably be necessary for foreign banks that wish to compete for the affluent market. Since most product markets are now closed to them, such an alliance is the only way to get in early, become acclimated, and master the skills needed for success. What’s more, if market conditions change and the government alters its regulatory agenda with a view to limiting the expansion of foreign banks, partnerships are less likely to be affected. With them in place, the foreigners can pounce if opportunities arise early and stay ahead of the curve if the markets develop according to script.

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It’s in the cardsCredit cards are a prime example of the mutual benefits of partnership. Of the retail-lending products in China’s banking market, few will grow faster: according to our estimates, revenues from interest income and merchant

fees will rise by more than 50 percent annually, to reach $5 billion by 2013. Partnerships help foreign financial-services players to enter this attractive market quickly. Although the terms of China’s agreement with the World Trade

Organization prevent foreign players from issuing local-currency cards on their own until 2007, if they wait until then attractive customers will probably already have one or more cards from domestic banks.

Even if foreign banks could offer credit cards on their own today, they have no existing base of local-currency depositors. About 80 percent of the Chinese consumers who apply for a credit card obtain it from their primary bank because paying the balance is much easier if they have autopayment facilities on a savings account. Working with a Chinese bank thus not only helps a foreign one circumvent regulatory hurdles but also gives it instant access to an established body of customers.

Branding is another area in which partnerships can be of particular value. Our research shows that current and prospective card customers place virtually no value on cards issued or co-issued by foreign banks. While this attitude may change over time as they establish their brands in China, even foreign banks that think they can act alone shouldn’t ignore it.

Tying up with a Chinese bank has additional important long-term benefits, such as access to the mass-affluent segment, which is much larger than the affluent one. Because a foreign bank can establish a presence in only one province a year, partnering with a Chinese institution could provide access to a larger network of branches in a much broader range of geographic markets.

The advantages of partnering seem evident for foreign banks. But why would Chinese ones want to partner with them to issue credit cards? After all, Chinese banks, with their enormous pools of retail customers, extensive branch networks, and established brand names, seem well- placed to seize the opportunity in credit cards on their own. But they are held back by the traditional Chinese reluctance to lend money without

Credit cards are a prime example of the benefits of partnership: of the retail-lending products in China’s banking market, few will grow faster


collateral, by a lack of the skills needed to market credit cards to the more attractive customers, and by the difficulty of managing risk in a market where credit bureau data are largely absent outside Shanghai.

As an illustration of these problems, consider card issuance and risk control. About four million to five million cards now circulate in the Chinese market, but the number of active cardholders is probably only one-third that. This reality reflects the marketing approach of Chinese banks. Instead of targeting individuals, these institutions push cards to employees of their corporate-banking customers, without assessing the likelihood that the cards will be used.

The untargeted approach is unavoidable for many domestic banks because they have little centralized customer data and lack the modeling skills to mine what data they do have. Moreover, in many banks, risk control is decentralized and thus heavily dependent on the limited skills of the

frontline staff in the branches. A bank could take an enormous hit if its portfolio of millions of credit cards turned sour because of an economic downturn or poor risk-assessment practices. In 2003 many of South Korea’s biggest credit card issuers had to write off enormous losses resulting from unfo- cused marketing tactics and lax risk controls.

Domestic banks could hire skilled people from Chinese-speaking markets such as Hong Kong and Taiwan. Some, including China Merchants Bank, have actually done so, but more will rely on alliances with foreign banks to acquire the skills needed to build and manage a credit card business. Foreign banks and credit card

monolines (financial-services companies that focus solely on credit cards) have the risk-taking mind-set and the product-development, marketing, and risk-management skills that Chinese banks lack.

How to get inIn credit cards as in other product markets, a foreign bank setting up a partnership must find a formula to assume operational control of the business while maintaining some flexibility for other partnerships. The formula must also be acceptable to China’s powerful financial regulator, the China Banking Regulatory Commission (CBRC).


It helps if the partnership is structured so that the foreign bank is viewed as helping the Chinese one to improve its performance through new skills or new technology. If the foreign company seems to be depriving the Chinese bank of something it has—such as market share or ownership—support from the regulator could be less forthcoming. The key to making a card partnership work is making it function seamlessly within the Chinese banking system, so that the operating license belongs to the Chinese bank, the cards bear its brand, and card balances appear on its balance sheet. In reality, though, the foreign player will probably run much of the card operation.

Foreign credit card issuers are likely to encounter many challenges when setting up partnerships. A would-be Chinese partner, for instance, may need a year or more to reach internal consensus on the deal. The foreign issuer must then structure the agreement to ensure that it is exclusive and for the long term; otherwise there is a risk that the Chinese bank will either take the operation in-house or find another partner after a few years, when the venture starts reaping substantial profits.

Given the uncertainties surrounding regulation and partnerships, a foreign bank might create a portfolio of options covering a range of entry methods and products. HSBC has negotiated a partnership with Bank of Shanghai, teamed up with Ping An Insurance to acquire a small bank in Fujian province (in southeast China), and entered into final partner-ship talks with the Shanghai-based Bank of Communications. Although it remains to be seen which of these will ultimately succeed, HSBC’s portfolio of partnerships covers the attractive segments of retail banking and insurance and focuses on players with a strong presence in the more attractive coastal cities.

While it may be several years before the credit card market takes off in China, foreign banks that wait until the market opens up in 2007 may find that they are too late. Partnerships with local banks will be critical for foreign ones that want a toehold now, especially since several of the most desirable Chinese players are already tying the knot with foreign partners.

David von Emloh is a principal and Yi Wang is an associate principal in McKinsey’s Shanghai office. Copyright © 2004 McKinsey & Company.

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