Morgan Stanley's Great Leap Forward

On Monday, Morgan Stanley (NYSE:MS) joined what will surely be a long and tumultuous race for the spoils of China's banking industry, outflanking its traditional investment-banking peers. It announced that it had acquired Nan Tung Bank in the port city of Zhuhai, obtaining a coveted commercial banking license in the process. It's a bold move that appears to take Morgan Stanley outside its traditional grazing grounds of securities trading and investment banking. In light of this, as well as the general level of interest in China's promise, I thought it might be worth looking at the white-shoe bank's latest chess move in more depth.

Enormous opportunity in a shifting environment
The allure of China for foreign banks that operate predominantly in mature markets is obvious, since growth opportunities are significant. In its report, "Banking on China," management consulting firm The Boston Consulting Group (BCG) estimates that between 2004 and 2010, annual banking revenues in China will grow by $130 billion, or 28% of the increase in annual global banking revenues.

The second factor that makes the market attractive is deregulation. In 2001, China made a number of commitments to deregulate its financial services industry in order to join the WTO. In December, foreign banks will be able to compete for local currency business with individuals across the entire territory. (Opening branches will nonetheless remain expensive, due to high operating capital requirements and a lengthy approval process.) However, the pace of continued deregulation is uncertain, and it's likely to be highly dependent on the rate at which domestic financial institutions become competitive with foreign entrants.

Despite the country's scale, value in the Chinese banking market is highly concentrated, both geographically and in terms of product type. This plays to the profile of Nan Tung Bank, which is located in the Pearl River Delta, the area of highest wealth concentration in Guangdong province. Guangdong, in turn, is the economic leader among China's 31 regions, contributing 12% of national economic output (three of the five Special Economic Zones are in Guangdong: Shenzhen, Shantou, and Zhuhai). Furthermore, BCG estimates that by 2008, renminbi-denominated corporate loans and deposits from retail and business customers will account for 80% of banking revenues.

The acquisition of Nan Tung Bank melds some of the advantages of the two approaches that foreign banks have typically adopted to enter the Chinese banking market: alliances through minority stakes in domestic institutions, and organic growth. Consistent with the former strategy, Morgan Stanley benefits from local knowledge of the market, an established brand name, and local banking personnel. However, this shouldn't be overstated -- with a single branch and just 30 employees, Nan Tung Bank is a minnow in the Pearl River Delta. In addition, its focus has been on foreign-funded companies and residents of Hong Kong, Macau, and Taiwan. Its penetration with domestic corporate and retail accounts is probably near zero.

The real benefit of the acquisition is the powerful combination of full operational control over the acquired entity (an organic growth strategy) with a regulatory arbitrage that allows Morgan Stanley to leapfrog competitors seeking a renminbi business license. Foreign banks that go it alone are normally required by regulatory authorities to show three years of business operations and two consecutive profitable years before they can apply for said license. Morgan Stanley will still need to apply separately for approval from the China Banking Regulatory Commission for each new financial product it intends to offer its clients, such as derivatives. This process can be time-consuming.

Although China generally restricts a foreign bank from owning more than 20% of a mainland bank (with total foreign ownership not to exceed 25%), Nan Tung is considered a "foreign-funded" bank because it was established by a Macau-incorporated subsidiary of Bank of China. According to the Financial Times, "there are only 10 other such foreign-funded banks, which rarely come up for sale."

Where do we go from here?
The BCG report identifies seven types of "target aspirations" for foreign participants in the Chinese banking market (from "leading national bank" to "wealth management specialist") and describes the competitive advantages that are necessary to achieve each of them. Assuming that Morgan Stanley is most interested in building a corporate bank through its purchase of Nan Tung Bank, let's evaluate the firm along these criteria:

• Proximity to China: Good. Although Morgan Stanley's home market isn't close to China, the organization should be able to count on management's understanding of this market. In August, CEO John Mack made his third trip to China in a year. In addition, the bank has three offices in China and is a 34% shareholder in a joint venture investment bank, China International Capital Corporation.
  
  
• Customer Segment Expertise: Weak. Morgan Stanley is a premier investment bank with virtually no corporate or retail banking capabilities. However, the firm has significant expertise in certain high-value products, such as structured derivatives, that it could market to corporate treasuries and high-net-worth individuals.
  
  
• Existing Customer Base: Good. Morgan Stanley has a wide network of high-level corporate contacts at multinational companies that have interests in China. The firm is building a similar network with Chinese companies through its securities business and its investment banking joint venture. These contacts should be helpful in the early stages of building a corporate banking franchise.

While it doesn't score full marks, Morgan Stanley's report card indicates that it can probably make a go of developing a banking franchise in China. Furthermore, BCG asserts that one of the megatrends that will shape Chinese banking is the shift from bank-credit financing to capital markets financing. If BCG is correct, Morgan Stanley's securities business could benefit down the road from ties with lending clients.

If we take John Mack at face value when he says he wants "to build the leading fully integrated financial services firm in China," then Morgan Stanley's strategy may be more expansive than that of traditional U.S. investment banking rivals Goldman Sachs (NYSE:GS), Merrill Lynch (NYSE:MER), or Lehman Brothers (NYSE:LEH). These firms appear more focused on making inroads in the Chinese securities industry (see table below). Actions speak louder than words, and this latest move is consistent with Mack's vision, putting his firm squarely up against universal banks such as Citigroup (NYSE:C), Societe Generale, and Credit Suisse (NYSE:CS) that already have commercial bank licenses and offer renminbi-denominated products.

Whether such an ambitious strategy will ultimately be successful will remain an open question for some time, but there's no doubt that this acquisition is a brilliant tactical move in support of the approach. Given the small size of the purchase in dollar terms, Nan Tung Bank looks like a low-priced entry ticket to participate in the rising Chinese banking sector.

Joint ventures between U.S. investment banks and Chinese securities firms

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Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.