Although Taiwan boasts Asia's fourth-largest financial-services market by revenues, many lenders lose money because of an endemic oversupply of banks. What's more, few banks have enough branches to operate efficiently. Our research found that for Taiwan's banking industry to become competitive, the overall number of banks and branches must fall and the surviving institutions encouraged to expand their networks of branches. This challenge will be daunting for Taiwan's banks and regulators alike.

To determine the number of banks that Taiwan needs, we studied Taipei's banking system, which is both fragmented and branch heavy (Exhibit 1). After calculating the available banking revenue by studying the behavior of local businesses and residents, we concluded that Taipei can profitably sustain no more than 500 of its 850 branches and just 15 of the 50 institutions currently in operation.¹ Such consolidation would substantially improve the industry's profitability while maintaining healthy levels of competition and customer service.

Banks aspiring to become leaders in the market should greatly expand their branch networks. By our estimate, a bank in Taipei needs around 100 branches to cover the affluent and mass-retail customer segments completely. Yet with the exception of Taipei Fubon Bank, few institutions have even one-third that number (Exhibit 2).

A bank's choice on where and how to expand is tricky, however, and will depend on its size and strategy. Our study showed that augmenting branch networks—whether through consolidation or the transfer of banking licenses to Taipei—is increasingly difficult because of the overabundance of branches, especially in attractive areas. Midsize players, which usually cover only a few attractive areas, are more likely to find complementary networks. In contrast, large banks have a more broadly comprehensive geographic reach and may identify fewer acquisition targets. For these institutions, much of the value of consolidation will come from cost reductions, branch closures, and layoffs.

The proper mix of branch formats will also be crucial. New branches in areas with a lower revenue potential, for example, should be small and offer only basic services in order to account for the lower incremental revenue each additional branch will generate (Exhibit 3). While this approach may sound intuitive, few banks currently have the proper data to enable them to adjust their branch formats according to the revenue potential of different areas in Taipei.

Clearly, Taiwan's banks have their work cut out. Achieving the necessary level of consolidation could entail a number of rounds of M&A, each requiring the integration of complex organizations with different brands, back-office systems, and company cultures. With this in mind, banks should begin by taking a fresh look at what role (for example, that of a large or a niche player) they want to play and which segments they want to serve (affluent or mass-retail customers, small or midsize businesses, or a combination of these groups). Then the banks should evaluate acquisition candidates to find a good fit.

The government, for its part, cannot remain passive if it hopes to realize its stated goals of reducing by half both the number of financial-holding companies and its stake in state-owned banks by the end of 2006. A comprehensive plan—detailing what needs to be done, how, and by whom—is required. Such a plan would include targets for the number and mix of financial institutions, clear performance indicators that can be used to evaluate banks, a timetable for government divestiture to avoid flooding the market and depressing share values, and the designation of a single government body to oversee the consolidation process.

If Taiwan succeeds in building large, highly skilled banks through consolidation, these institutions might go on to compete regionally with Singapore and South Korea, whose financial institutions have already expanded outside their home markets. The process could take five years or more, but it's worthwhile if it ensures a role for Taiwan in the future regional consolidation of the banking industry.