Wednesday, January 11, 2006

Inside Scoop on Overseas Banks

Morningstar, Ganesh Rathnam, 11 January 2006

Most individual investors treat stocks of foreign banks, trading as American Depository Receipts (ADRs), like litter on Wall Street. After all, there are more than 5,000 listed stocks in the U.S. to choose from. Moreover, timely information and financial disclosures on foreign banks is hard to come by. However, a well informed investor willing to focus on the right parameters and do the due diligence could profit handsomely by investing in foreign banks.

At Morningstar, our approach to researching foreign banks mirrors our approach to local banks. We use SEC filings such as the 20-F (the foreign-firm equivalent of a 10-K) to glean information about the business. In addition, we focus on several other critical aspects when looking at a foreign bank to better understand the landscape in which these firms operate. Our investment theses on these banks include all the subjective information that individuals should study before investing. We've highlighted some of the more interesting and important factors in this article. We will follow up with an article highlighting our favorite foreign banks, the firms that investors should pounce on should they ever trade in 5-star territory.


Famed investor Peter Lynch once said "If you spend 13 minutes per year trying to predict the economy, you've wasted 10 minutes." At Morningstar, we generally refrain from making macroeconomic and other top-down forecasts. However, when dealing with foreign banks, it is impossible to overlook the state of the economies in which they operate. Economic health is deeply intertwined with the health of resident banks and vice versa. Our list of international banks operate in different economies across the globe, and the economic cycles and characteristics vary widely. Rather than trying to determine what the economy or currency will do in the coming quarter or year, we look to see if sound policies are adopted to promote economic growth, the extent to which market forces are allowed to determine investment and capital allocation decisions, and whether growth is sustainable in the long run. We prefer to invest in banks that are not hobbled by a restrictive or structurally unsound economy.

Take the case of Ireland. Policies adopted in 1987 erased many socialist policies, established low corporate tax rates, and lengthened the work week. These initiatives turned Ireland from the poorest country in the European Union to one of the richest. Real GDP growth has averaged 6% over that time, attracting copious amounts of foreign capital and even reversing 200 years of emigration from the Emerald Isle. Needless to say, these factors provided a favorable tailwind for the success of Allied Irish Banks, one of our favorite foreign banks.

On the other hand, Japan has dragged its feet in implementing policies to reverse 16 years of economic decline. Two separate but related problems need to be addressed: writing off bad loans and letting insolvent companies die. These measures would have reduced overcapacity and diverted funds from the "living-dead" companies to stronger, more competitive firms in need of financing, speeding an end to the deflationary spiral. Japanese politicians, however, seem to lack the chutzpah to act. Millions of people would suddenly lose their jobs and many banks would fail to meet capital ratios. Instead, Japan watered down proposed reforms and prolonged the pain. Consumer confidence and thereby consumption continues to plummet as the population saves furiously, anticipating a huge hike in taxes to pay off the public debt, currently 165% of the GDP.

Regulations and Banking Laws

Different countries have vastly different banking regulations, determining how their banks are governed. The rationale is that each country's central bank knows what's best for its country. As such, the central bank has much leeway in making rules. For example, some countries require banks to have higher capital ratios than ones stipulated in the Basel Accord, a global agreement on a set of guidelines for bank supervision. In an effort to force weak banks out of the market, the Bank of Japan mulled disallowing certain types of assets ("deferred-tax assets" for you accounting types) from being used to compute the Tier I capital ratio, a primary indicator for a bank's health. This move would have forced weak banks to merge with healthier rivals.

Because of banks' power to allocate capital, governments also implement laws to subsidize sectors deemed economically vital. In Brazil, banks are required to extend heavily subsidized loans--equaling at least 25% of checking deposits--to the agriculture sector, regardless of merit or the creditworthiness of the recipient. The Reserve Bank of India requires 40% of all bank credit to be used for loans to so-called "priority sectors." Lending terms are generous and banks rarely profit from these loans. Often, lobbyists and special interest groups abuse loopholes in these regulations to secure below-market loans for clients. Consequently, banks and their shareholders are forced to shoulder the cost of development.

Another, more insidious form of regulation is driven by politics and xenophobia. Governments can--and often do--meddle opportunistically with the financial sector by changing laws or employing fierce protectionism. These moves are often sudden and unexpected, catching investors by surprise and dissuading foreign investment for fear of repeat events in the future. The damage done by government meddling can often haunt the country for decades in the form of a lack of confidence. This risk is more prevalent in politically volatile developing countries, but some developed nations are not immune to it.

The nationalization of Indian banks and insurance companies in 1969 was a wildly populist move that was championed as a victory for the poor. It hindered economic growth, stifled innovation, increased bureaucracy, and subsidized politicians' pet initiatives. Liberalization in 1991, after an economic crisis, slowly reversed the damage and led to the high growth that the Indian economy enjoys. However, the lingering effects still plague banks under government control, at which computers were a novelty even in 1999.

In Italy, erstwhile Central Bank chief Antonio Fazio blatantly thwarted ABN Amro's bid to acquire Italian bank Banca Antonveneta, instead favoring a bid by another poorly capitalized Italian bank, Banca Popolare Italiana. His motivation for this was partly personal; Banca Popolare is run by a close friend of Fazio. In the process, he destroyed all the credibility, much of which Fazio himself was responsible for, that the Italian central bank built with the public as well as the European Union.

Generally, we prefer countries with independent central banks and an independent policymaking body, free from partisan politics. Over time, this characteristic is a good predictor of stability and profitability of a country's banks.

Corporate Governance

Last but not the least, we look for evidence of solid corporate governance, more so because ADR shareholders have limited rights and need someone to protect their interests. Governance standards vary widely across countries. In some nations, the CEO holds the whip, whereas in others, it's the chairman of the board. Compensation and ownership structures are different. In our research, we highlight both the good and bad management practices of a bank to bolster our investment thesis. All told, we would steer clear of banks with questionable management.

For example, we view the management practices at HSBC Bank very favorably. Management is compensated for generating economic profits. Management is paid a pittance, especially when compared to U.S. peers. Cost control is an obsession that begins at the top with chairman Sir John Bond. He is known to estimate the cost of meeting, i.e. compute compensation being earned while managers sit in the meeting room, to keep meetings short. He travels economy class and personally turns off his office lights at the end of each day, a lesson he was taught when he first joined the bank in 1960.

On the other hand, we have management teams that show no compunction in giving shareholders a raw deal. Banco Santander Central Hispano's management team is a prime example. The Botin family--owners of the bank for more than 100 years before it was a public entity--control the bank and its board, even though they collectively own just 3% of its shares. Emilio Botin, the chairman, inherited the position from his father, and Ana Botin, Emilio's daughter, seems to be the heir-apparent to his throne. Empire building seems to be the main goal, with numerous acquisitions consummated around the world, especially in Latin America. The bank grossly overpays for these acquisitions, destroying shareholder wealth. Return on equity was just 8% in 2004, whereas return on tangible equity was over 20%. The bank exports its style of corporate governance wherever it goes, with the latest saga involving its attempt to re-enter the U.S. market via a 20% stake in Sovereign Bancorp. The move triggered a vicious ongoing shareholder battle between Sovereign and its largest institutional shareholder, partly over the obscene terms intended to protect Sovereign's CEO and board from being replaced.

There are, of course, numerous other anecdotes--both good and bad--we've come across. Next week, we'll profile our favorite foreign banks.