Asia’s wholesale banking markets have performed exceptionally well in recent years. But even though this engine shows no sign of running out of steam, the underlying structure of the markets is already starting to change. Global banks once could operate out of financial centers in Hong Kong and Singapore and exploit cross-border flows, but they now face a future in which localization will be much more important. Consequently, they need new strategies and new tactics.

Participants in Asian markets (excluding Japan) have certainly enjoyed good times recently. Since 2003 wholesale-banking revenues have been led by investment banking and equities, which are estimated to have grown by 16 and 29 percent a year, respectively (Exhibit 1). The global banks have done particularly well, increasing their revenues by more than 50 percent over the same period (Exhibit 2).

The current wholesale-banking boom follows several previous cycles. Global-fund managers discovered the region, for the first time, in the early 1990s, prompting strong growth in Asian institutional equities. The middle of the decade saw investment flows into Southeast Asia and the emergence of Chinese red chips. In the late 1990s, Asia caught the dot-com fever that gripped the rest of the world. From 2001 to 2003, there was a shakeout as global players downsized and some midsize regional players and locals exited the market altogether.

But the current wave, beginning in 2003, is characterized by the strength of new businesses and the simultaneous surge of different markets. On the investment-banking side, the flow of Chinese IPOs culminated in the $21 billion listing of the Industrial and Commercial Bank of China (ICBC), in late 2006. Meanwhile, private equity activity and interest by multinational strategic investors have supported the related growth of M&A and leveraged finance.

An influx of hedge funds has dramatically improved the economics of equities. Hedge fund assets under management now exceed $100 billion, with broker-dealer commission levels in the range of 20 to 30 basis points, thanks to the heavy trading of hedge funds and demand for prime brokerage services. By contrast, trades with domestic institutional investors, which do not need full prime service, typically involved commissions of 8 to 12 basis points.

Sustainable but getting tougher

The broad trends suggest that the current wholesale-banking boom has stronger legs than previous ones. Economic growth in Asia is projected to remain robust, at 6 percent a year, until 2010 (according to the Economist Intelligence Unit), with North Asia and India especially prominent. Hedge fund and private equity activity will continue to be supportive. The top ten private equity firms alone have raised more than $10 billion in Asia-focused funds outside of Japan. Continued liberalization in the large but nascent markets of China and India also bodes well for the future. But the focus will shift to markets that are more domestic, making it tougher for global firms.

The clearest form of localization will affect investment banking. Although headlines across the region highlight the way huge IPOs by Chinese companies are targeting international investors, megadeals in the pipeline are coming to an end. Most large Chinese state-owned enterprises are beginning to take advantage of the reinvigorated domestic capital markets, and most of the top Chinese companies in their industries have already gone public (Exhibit 3).

From now on, the raising of capital in China will become more local. After a five-year slump, China’s capital markets have undergone a renaissance in 2006. The main stock index has risen by more than 60 percent since the lows of mid-2005, and more than $13.5 billion of domestic deals were conducted from early 2006—when the market became active again—to the end of October 2006. While 80 percent of equity issues went international in 2005, we estimate that this figure will be approaching 50 percent by 2010 if China follows the South Korean pattern. Thanks to the liberalization of commercial paper, in mid-2005, fixed income also has flourished in China, with more than $24 billion of paper issued as of the end of July 2006.

Localization is occurring across the region. The boom in South Korea has taken place in the domestic fixed-income market, particularly in over-the-counter and exchange-traded interest rate derivatives and structured credit. Taiwan’s corporate-bond trading has grown by 29 percent annually since 2003. Foreign-exchange trading in China and India will also grow rapidly, as a result of liberalization. Domestic Indian investors, for example, have been allowed to invest in foreign currencies since mid-2006. As for China, the end of its peg to the US dollar, in mid-2005, unleashed a series of reforms that introduced an interdealer trading system, a forwards and swaps market, and interest rate derivatives. India’s traditional high spreads and low volumes should reverse with the expected increase in trading and growth in liquidity.

China still restricts foreign access to its domestic market by requiring joint ventures with local partners. South Korea and Taiwan impose high capital requirements and have long waiting periods for local branch licenses. International players operating mainly from Hong Kong, Singapore, and other regional financial centers therefore risk missing the domestic wave.

Moreover, the nature of competition in domestic markets is different. In the current wave of Asian growth, foreign players have dominated key high-margin cross-border businesses, such as equity issuance, M&A, and prime brokerage (Exhibit 4). Winning in domestic investment banking and domestic sales and trading is more difficult. Local brokerage firms can rely on their large retail base to compete for equity capital market (ECM) mandates. The corporate relationships of local banks and securities firms help them capture mandates, and the large local-currency balance sheets and in-house treasury activities of domestic commercial banks make for formidable competition in foreign-exchange and fixed-income trading. Local competitors will not cede these markets easily to global players. Their clients—local corporations or institutional investors—prefer to deal with local counterparts rather than bankers in distant hubs.

Finally, executing new strategies in Asia is becoming more difficult as the war for talent heats up. Compensation for top professionals in Hong Kong has already risen close to the levels seen in New York and London. Some banks have had to constrain their growth because of personnel shortages.

Capturing the domestic opportunity

Given the constraints on the supply side, how should global players address the new wave of opportunity in Asia? Our experience suggests some measures to take. Admittedly, capturing the next wave presents numerous challenges, including ownership restrictions and the management of joint ventures. Even so, some of the areas to consider are more straight-forward. Opportunities range from domestic fixed income and equities to companies and domestic investors that are looking abroad.

Domestic fixed income

Many global players already operate banking businesses, either commercial or retail, in Asian markets. This is the perfect platform for building fixed-income and foreign-exchange sales and trading businesses by leveraging access to local-currency financing and an existing client base of multinational corporations active in local markets.

China liberalized access to the local-currency commercial business in late 2004, although geographic restrictions still limit the opportunities.¹ India imposes ownership restrictions on new bank entrants, but many commercial banks have operated there for a long time and could use these operations as a base. South Korea and Taiwan are open to entry, but high capital requirements force new entrants to generate sufficient revenues (likely from multi-product businesses) to justify the charges.

Domestic equities and investment banking

For nonbank securities firms and banks that want to participate in the institutional-brokerage and investment-banking markets, a securities platform is the only feasible entry strategy.

Global firms have successfully set up securities operations in South Korea, Taiwan, and most Southeast Asian markets; as a result, they have captured most of the international institutional-brokerage businesses. The next prize is India, where some players, including Morgan Stanley, have established joint ventures with local players. Others have opted to set up stand-alone operations: Goldman Sachs recently ended a joint venture with a local partner, and Merrill Lynch bought out its local partner. These firms are well positioned to capture growth in India’s institutional-brokerage and M&A markets (see sidebar, “China and India: Disparate giants”).

In China, the restrictions are far more severe. Local ownership must be at least 51 percent, so a joint venture partner is required—although Goldman Sachs and UBS have secured management control notwithstanding their minority-ownership stakes. Beyond brokerage, China’s big prize is the expected flood of domestic equity issues, which can be accessed only through joint ventures.

Sophisticated products for local markets

Foreign players, bringing their global capabilities to bear, are often the critical enablers for the development of the more sophisticated products in Asia. Structured products, credit derivatives, and structured credit were often initially developed in Asia by foreign players in more mature markets, such as Hong Kong, Japan, and Singapore. Few of these products exist in China, India, and other nascent markets, but there is certainly some potential for them: structured deposits linked to foreign underlying equity indexes have begun to appear in China, for example, as has warrants trading. While efforts to build these nascent markets today do involve some risk that they will not materialize in the future, foreign players are well positioned to exploit the possibilities.

Companies looking abroad

Domestic Asian companies looking to buy assets or companies abroad are often overlooked. Foreign direct investment from Asia has grown from $22 billion in 2001 to $42 billion in 2004. Asia’s world-class firms increasingly see M&A as a strategic tool to expand locally, regionally, or even globally. In fact, most mergers and acquisitions in South Korea and Taiwan—home to many leading global companies—are currently initiated by or between domestic companies. A similar trend will likely occur in markets such as China and India. Foreign players are much better positioned than locals to advise on regional and global deals.

Domestic investors looking abroad

While M&A advice to local companies has been a thriving business for many years, the emergence of Asian investors on the international stage is a relatively new phenomenon—and the trends are positive. Government investment companies, including Singapore’s Temasek Holdings and Malaysia’s Khazanah Nasional Berhad, have been particularly active direct investors. In early 2006 China announced a limited qualified-domestic-investor scheme allowing Chinese institutions to invest in Hong Kong-listed equities. Further liberalization is expected as China grapples with its large balance-of-payments surplus. Global players need only extend their already successful M&A and institutional-brokerage platforms to take advantage of these emerging opportunities.

Shifting mind-sets to go local

Considering the growing possibility of supporting investment in local platforms in Asia, international firms need to think carefully about how they enter local markets. While these firms have done well in the recent wholesale-banking boom, the domestic arena will require a different mind-set and a review of existing business models.

Up until now, foreign players have successfully operated from regional hubs and focused on lucrative higher-margin product and cross-border flows. But entering domestic markets selectively to focus on less-sophisticated local-currency products is likely to be the new imperative. Foreign players will have to closely evaluate their appetite for risk, particularly since the credit counterparties will be lesser-known names.

Universal banks with strong retail- and corporate-banking ambitions will have an advantage, in view of their existing banking platforms in local markets, such as mainland China, India, South Korea, and Taiwan. These platforms offer an entry point and a portfolio of potential clients. Wholesale-only players will need to choose carefully where to compete.

Global firms also must gain access to new talent pools, beyond the expensive centers of Hong Kong and Singapore. They will need to shift from a reliance on expats to an embrace of local professionals, though competition for experienced capital markets professionals who speak Mandarin or Korean will be hot. Foreign commercial banks in China and its top-tier domestic banks are potential new sources of recruits. Forward-looking firms will also see China and India as excellent sources of talent for their global businesses.

Asia’s capital markets continue to thrive, and the medium-term outlook remains bright. But global players need to acknowledge that their most lucrative opportunities are likely to be in the newly liberalized domestic markets—and then position themselves accordingly.