Most observers believed that a crisis-driven boom in Asian bank mergers and acquisitions would start in 1998. They were wrong: in the nine key markets of emerging East Asia—China, Hong Kong, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and Thailand—private-sector bank M&A remained roughly flat in 1998, at around $5.6 billion. That is comparable to the levels of 1996, before the crisis.

Yet the forces driving this merger boom that never came didn’t go away; they intensified. The M&A boom is already starting, and over the next two years it will hit with a vengeance. By the time this wave has passed, a third to a half of Asia’s banks will either acquire other banks or be acquired by them. Every player in the region must consider the strategic implications of the changes that are about to occur. The boldest players will seize this brief window of opportunity to reshape Asia’s banking industry and become the new leaders of what will probably be the world’s fastest-growing financial services market over the next ten years.

Why bank M&A activity is about to surge

Local banks need capital, and they must turn to outside investors to find it. Nonperforming loans threaten to wipe out existing bank capital across most of Asia; in Indonesia, South Korea, and Thailand they are expected to peak at 300 to 500 percent of bank equity. At the same time, bank stocks have plummeted. Share prices (reckoned in US dollars) have declined by 80 percent or more in Indonesia, Malaysia, and Thailand and by 40 percent in Singapore and Taiwan. Local banks are now virtually shut out of capital markets: new debt and equity issues reached only $13.7 billion in 1998, less than 25 percent of the 1997 level. Despite repeated attempts, banks in some of the hardest-hit countries, including Indonesia and South Korea, have failed to raise substantial outside capital.

Meanwhile, governments across Asia are forcing the pace of recapitalization and restructuring by adopting wide-ranging and aggressive programs, including measures to nationalize or close troubled banks, to establish management companies for bad assets, and to relax limits on foreign ownership. Nationalizations have soared from nothing in 1996 to $12.4 billion last year (see Exhibit 1).

This activity is important in two ways. First, it shows that governments are serious about taking over banks that can’t work out their problems quickly enough. Second, nationalized bank assets—which in 1997-98 totaled $15 billion—represent a massive "inventory" that will be sold off to private investors. The sales of Korea First Bank (to Newbridge Capital, a US buyout fund) and of SeoulBank (to HSBC) are but a first glimpse of what will become a giant wave of privatization activity over the next several years (Table 1).

Governments are further encouraging the inflow of capital by raising foreign ownership limits more dramatically and rapidly than ever before. Indonesia, South Korea, and Thailand have now joined Hong Kong in allowing 100 percent foreign ownership of local banks. Limits have been raised to 60 percent in the Philippines and to 50 percent in Taiwan; other countries will probably follow suit.

So the table is set for truly industry-transforming transactions. The most respected local banks are negotiating more flexibly than they did in the past. Just three years ago, many deals had to be structured as minority investments, but this approach is now much less common, involving only 11 percent of all agreements in 1998, while mergers of equals and asset purchases have suddenly assumed great importance. Would-be acquirers enjoy new flexibility in structuring deals and have a wider range of attractive partners to pursue (Table 2).

As a result, a number of regional and global banks have become active acquirers. Among Asian players, the Development Bank of Singapore (DBS), Singapore’s largest bank, has so far been the most ambitious. In its home market, DBS merged with Singapore’s Post Office Savings Bank to consolidate its domestic leadership position and to achieve the scale it requires to become a leading regional player. DBS has also been the most active bank acquirer across the region, taking control of banks in Hong Kong, Indonesia, the Philippines, and Thailand. Thanks to all this, DBS has emerged as Southeast Asia’s biggest bank, with about $70 billion in assets and the stated goal of building a preeminent regional franchise.

Meanwhile, several US and European banks are seizing the opportunity to acquire growth platforms across the region (Table 3). ABN AMRO, a leading example, has acquired Bank of Asia, Thailand’s tenth-largest bank by assets before the acquisition (see text panel), and intends to build on this platform to penetrate the top tier of Thai banks. Early results are encouraging. In the six months after the deal’s announcement, Bank of Asia’s market share doubled from an already substantial base, and its share price rose by 70 percent during a period of market decline.

These regional and global players are sparking an explosion in cross-border M&A. In 1996, the only such transactions of any significance involved Chinese and Malaysian conglomerates diversifying into banking and multinationals restructuring their Asian portfolios. But since the crisis hit, there have been 36 cross-border transactions in Asia; overall, this kind of activity has more than quadrupled, from $529 million in 1996 to $2.3 billion in 1998. Purchases by US and European banks have increased more than tenfold, from just $80 million in 1996 to more than $1.1 billion in 1998, and the level of activity in 1999 is already far ahead of last year’s pace. And all this is merely the tip of the iceberg.

Lessons from Latin America

Asia today has all the ingredients required for a great expansion of bank M&A. What will be its magnitude and impact? Latin America’s experience after the financial turmoil of the mid-1990s offers clues about what will happen in Asia. In the wake of the 1994-95 Latin American banking crisis, it took more than two years for major foreign players to regain sufficient confidence in these local economies to start making deals to buy Latin banks and for mergers and acquisitions of banks by other banks to take off. July 1999 will mark the start of Asia’s third year of crisis. Recent market activity and press coverage suggest that confidence in Asia is returning, setting the stage for an M&A boom.

Latin America offers three other powerful lessons for Asia. First, ambitious players can use M&A to leapfrog the old leaders. In Latin America, three multinational banks—Banco Santander, Banco Bilbao Vizcaya, and HSBC—used aggressive M&A programs to transform themselves into the region’s leading bank franchises, with top positions in most key markets. They also adopted M&A models that fit their own distinctive strategies and gave them the ability to add value to their acquisitions (Table 4). These three banks became crucial drivers of the Latin American bank M&A boom, as well as its most obvious beneficiaries.

Second, Latin America’s local banking sectors consolidated rapidly. From 1994 to 1997, the number of financial institutions shrank by 32 percent, 14 percent, and 16 percent, respectively, in Argentina, Brazil, and Venezuela. The same pattern, apparent across Latin America, is beginning to emerge in Asia. Indonesia, for example, recently announced the nationalization of 7 banks and the closing of 38 others; the government’s stated long-term goal is to reduce the number of banks from 237 to 30 or fewer. Similarly, in South Korea, 5 insolvent banks have been forced to merge with healthier ones, and the largest banks are rapidly consolidating to form a small top tier.

Third, foreign players greatly increased their share of Latin American markets. In Argentina, the proportion of local assets controlled by foreign banks increased from 15 percent in 1994 to 55 percent in 1997; over the same period, it rose from 8 percent to 40 percent in Venezuela and from 6 percent to 22 percent in Mexico. In Asia, this trend is most advanced in Thailand, where ABN AMRO, GE Capital, and DBS have acquired significant local positions, and in South Korea, whose two leading banks have been sold to foreigners.

Overcoming the challenges

Banks hoping to succeed through aggressive M&A strategies must overcome a number of challenges. First among them is valuation: with asset prices extremely volatile and macroeconomic forecasting all but impossible, few buyers and sellers will agree easily on price. Most sellers, believing that current asset prices are unsustainably low, are going to seek prices that match what they paid or will allow them to cover their borrowings, which are often in US dollars. Many buyers, by contrast, believe that the current uncertain economic outlook justifies relatively low valuations, particularly in view of the paucity of good information and the inherent uncertainty about nonperforming loans and collateral recovery levels. Varying assumptions about these and other key factors within a range of realistic scenarios can produce 300 percent swings in a target bank’s valuation.

Often, sellers ask for a price that is two to three times higher than the buyer is willing to pay. In one recent case in Indonesia, the seller refused to consider any price less than 20 times the institution’s market value! Adding to the challenge is the fact that many potential sellers are third- or fourth-generation family owners, for whom businesses have more value than cash flows alone would suggest. Because of this "value perception gap" between buyer and seller, straightforward deal structures are not likely to succeed. More flexible and creative proposals are needed, perhaps including deferred-payment and price adjustment mechanisms, as well as evolutionary governance arrangements, in which the acquirer gains management control of the target gradually, giving the previous owners a highly visible continuing role in the business.

Would-be acquirers must also recognize that key government officials are central to any deal. In many Asian markets, banking regulations remain unclear or are evolving rapidly; legislation must often be amended to permit transactions. When these regulations have a material impact on a bank’s value, as they often do, this additional uncertainty must be factored in to the equation. Moreover, government support—typically in the form of loss-sharing agreements or the assumption of bad loans—will usually play a critical role in making the economics of deals work. Successful acquirers will therefore treat central bankers and regulators as "sponsors" of the transaction, involving them at every stage.

Successful acquirers must also meet the challenge of undertaking adequate due diligence in an environment where detailed and reliable data often cannot be had. Information on borrowers, for example, is sometimes mostly qualitative and may not include financial statements or credit agency reports. Although local players understand and accept this practice, it greatly complicates the difficulty facing cross-border acquirers new to the market. They will have to form teams of managers and advisers with deep local market knowledge to supplement the efforts of their head offices.

The required resources can be enormous: Citibank sent some 50 to 100 people, including many bankers from abroad, to Bangkok City Bank, where their due-diligence effort uncovered problems that ultimately killed the transaction. In a recent smaller deal, the acquirer had to deploy a due-diligence team of more than 20 people for two months. Given the nonperforming-loan problems of most targets, ensuring confidence in a due-diligence analysis will require the involvement of senior credit and risk executives from the acquirer’s head office.

A particular note of caution is warranted about deal pricing and the challenge of capturing synergies. Price-to-book ratios have fallen,¹ but prices—on a discounted cash flow basis—have not sunk to "bargain basement" levels, especially in competitive bidding situations. Most of the acquisitions soon to take place in Asia will therefore fail to create value unless the acquirers can achieve significant cost and revenue synergies.

Given the current uncompetitiveness and lack of sophistication of most Asian banks, significant synergies should be available. Yet they will prove difficult to capture. In such markets as South Korea, militant unions stand in the way of cost cutting, while government officials are reluctant to see large numbers of people added to already swollen unemployment rolls. In every market, it will be expensive and time-consuming to deploy best practices in such areas as credit management, information technology, and cross-selling. Often, the only easy profit opportunity will be the cost of funding, since the acquirer’s superior credit rating cuts the interbank funding costs of the target and helps it increase its deposit base.

Successful acquirers will therefore enter every negotiation with a clear understanding of the sources and scope of opportunities to create value. Both traditional bank buyers (such as ABN AMRO and DBS) and nonbank buyers (like Newbridge) will begin early on—even before they complete due diligence—to prepare for the immediate integration of the target and to pursue opportunities for improving its profits.

Every bank active in Asia must consider the strategic implications of the unprecedented M&A wave now gathering strength. Banks that move aggressively have a historic opportunity to reshape Asia’s banking industry and to secure a leading position in it. The Latin American case is instructive: there, as in Asia today, a financial crisis rapidly restructured the banking industry, producing both winners and losers. Before the crisis hit Latin America, Banco Santander, Banco Bilbao Vizcaya, and HSBC were relatively minor players in the region. Just four years later, they are its leading bank franchises.

Likewise, when the current Asian crisis has passed, a handful of banks will have emerged in each market as the leaders—and they may not be today’s top names. Two or three may succeed in building preeminent regional bank franchises with leadership positions in all or most of Asia’s major markets. Early frontrunners include ABN AMRO, DBS, and HSBC, but most industry-shaping transactions in Asia are still to come.

Which companies have the vision, commitment, and appetite for risk needed to show the way? In less than 24 months, we will know the answer.