FINS5530 - Financial Institution Management

Case study: Shenzhen Development Bank

Eric Adrien Mermod

Student ID: 5088452
University of New South Wales
September 14th, 2015

Initial Situation
Weijian Shan, Managing Partner of Newbridge Capital, needs to decide whether or not to renegotiate the deal he had with Shenzhen Development Bank (SDB) regarding acquiring a
stake close to 18% in the bank. This opportunity is unique regarding the competitive position
and effective control of the bank at stake, however, SDBs precarious looking financial
situation and the huge political risk associated also are major concerns.
As Newbridge is looking to replace it, the existing management is making it difficult for the
deal to take place. As well, SDB is now getting other propositions after the recent media
exposure the deal got. Newbridge was supposed to pay this investment 1.6 times the priceto-book value, but it now seems like Shan will have to offer even more in order to acquire the
stake.

SDBs Asset Quality

In order to assess whether or not Newbridge should pursue its will to invest in SDB, an
objective review of the Chinese banks financial situation should be conducted first. Looking
at Case Exhibit 10, we get an overview of SDBs asset quality. Even though it was at 22.7%
in 2000 and 15.3% in 2001 (As shown in Table 1), their non-performing loans (NPL)
proportion ratio of 11.6% in 2002 is still well above the average of 7.3% of its joint-stock
banks industry peers. Only BoComs is higher, however, BoCom is a non-quoted larger jointstock bank, with higher amounts of gross loans and deposits, which can explain the higher
NPL/loans ratio, and it still looks healthier regarding their more adequate level of loan loss
reserves (LLR) in proportion.
The fact that, generally, official disclosed levels of NPL in China seem to be underestimated is
also a concern. In 2002 S&P estimated the proportion of NPL to gross loan of Chinas banking
system at 50%, more than double the estimation of the Chinese government standing at 24%.
Although our considered sample sits well below 24%, all of those low ratios belong to listed
banks, it seems therefore likely that they do not completely reflect the reality, as there are
even more incentives for those banks to report better results to shareholders and potential
investors. Moreover, the general tendency for poor corporate governance and risk
management in the Chinese banking sector, as well as personal rewards seeking behaviour
among executive management might be another indicator of lack of transparency and
reliability in banks financial statements. Supporting those concerns, Newbridge also
estimated in due diligence that SDBs actual NPL size is much higher than the official
published numbers.
SDB implemented better monitoring of its loans quality, classifying them into one of 5
categories based on the measured credit risk. However, as displayed in Table 1,
computations based on Case Exhibit 8 reveal that SDBs LLR should amount to about 603.5
US$ MM had the bank followed its own reserves guidelines. Instead, the aggregate of LLR for
2002 was 391 US$ MM. Those results show that SDB would have to increase its reserves by
over 50%. The banks LLR/Loans ratio would go from 3.9% to a more appropriate 5.9% and

the new LLR/NPL would go from 33.2% to over 51.1%, which would be closer to the peers
average, although still under. Looking at the actual amount of reserves, SDB seems to be
overly exposed to doubtful customers, which could threaten the solvency of the bank.
Building up the reserves would improve SDBs capital adequacy, as its Tier 2 capital and
therefore Total Capital Adequacy Ratio would get bigger. The actual provision management
contributes to worsen SDBs general capital adequacy.

SDBs Earnings Capability

Case Exhibit 9 shows that the net interest margin went from 3.5% to 2.4% between 2000
and 2002. As SDBs net interest income almost doubled by the same time, it means that its
average interest earnings assets increased even more in proportion. Case Exhibit 6 displays
numbers supporting this statement. This means that SDBs loans quality and return
depreciated over the last years and earned lower interest income.
Non-Interest Income/Operating Income augmented, which is mostly due to the larger
increase of other interest income, as the net fee income didnt grow much in comparison. A
positive point is the decreased proportion of Operating Expense/Operating Income, which
can indicate an improvement in operating efficiency.
Taking a closer look at SDBs Income Statement, we can better reveal the full picture about
SDBs earnings performance. As summarized in Table 2, Shenzhen banks Pre-Provision
Profit (PPP) grew considerably in two years. After associated computations, we can see that
its PPP/Total Operating Income, PPP/Total Assets and PPP/Equity were either maintained
or considerably improved. SDB was therefore apparently able to generate more revenue
relatively to its size. However, after the sudden increase in taxes from 2001 combined with
the unavoidable need to build bigger provision as years went by and SDBs earning-assets
quality deteriorated, the ROAA saw a large decrease from 0.9% to a below industry average
0.3%. Because of this, the banks net profit figure considerably decreased from 2000, whereas
Total Assets and Equity respectively increased by 164.6% and 12.3% in the meantime.
Looking at its industry peers in Case Exhibit 10, SDB still has average looking interest
margins and operating expenses proportions, however, its high percentage of NPL/Loans
and bad overall loan credit quality drive its ROAA and ROEE well below the other considered
banks average.

SDBs Capital Adequacy

Shenzhen Banks Total Capital Adequacy Ratio (CAR) decreased from 10.6% to 9.5% between
2001 and 2002, as seen in Case Exhibits 9 & 10. This difference is easily explained by the
fact that SDBs risk-weighted assets are growing much faster than its capital. Although it still
sits over or very close to the average in every capital adequacy category, the situation could
become alarming very soon. When reported, every CAR of SDB has been consistently
decreasing since 2000. Even if the Chinese regulatory floor is still below at 8%, it is not
unlikely that it will be raised in the following years in order to force the Chinese banking

sector to get healthier. As Newbridge promised to lock up its stake in SDB for at least five
years, it should be a major concern when contemplating whether or not to pursue this deal,
and drive its price down consequently. SDBs under capitalization will be further assessed in
the next section of this report.

Evaluation of Newbridges Investment

We shall now try to find an appropriate valuation range for SDBs stake that Newbridge is
looking to acquire. Looking at Case Exhibit 13, we can see that the 2002 price-to-book (P/B)
ratio of SDB stands at 5.5, which is considerably higher than its peers average of 3.1. As well,
whereas the average is expected to drop to 2.2 by 2003, SDBs ratio is estimated to increase
to 5.9 by the same time. The reason for this is that SDBs shares are likely to be grossly
overpriced. This would be partly due to the fact that after Newbridges deal with SDB was
announced, the banks share price went up considerably. The deal got a large media coverage
and SDB is now even supposedly getting a better offer from Chinatrust Commercial Bank
(CCB). The Chinese stock market is known to be highly speculative and volatile, and the
limited supply of listed companies in comparison to the huge demand for stock investments
allows for a global overvaluation in Chinas stock market. Those events and facts are
therefore likely to have inflated SDBs price and future estimated success, and the valuation
should be scaled down in consequence.
Now should Newbridge fight CCB for SDBs stake? The acquisition of this 17.89% stake in
SDB, although illiquid non-tradable legal person shares, would allow Newbridge to become
the single largest shareholder of the bank. As well, the government has planned to permit the
conversion of those shares into tradable ones, which could happen by the five years lock up
Newbridge agreed to. If the deal is sealed, since the next largest single ownership part in SDB
would amount to only 3.2%, as well as looking as the well-dispersed ownership of over 70%
of SDBs shares (Case Exhibit 7), Newbridge is looking at obtaining effective control of the
bank. Furthermore, the company would also effectively gain the right to appoint the CEO and
obtain 8 out of a total of 15 board seats.
The maximum single foreign ownership in a Chinese bank being regulated at 20%, and as no
other banks of any scale is believed to offer the potential for effective control to foreign
investors in the foreseeable future, Newbridge clearly understands the additional value this
brings. As for the time being, this is a unique opportunity for a foreign bank to enter and
expand in the heavily regulated Chinese banking industry, using SDBs nationwide
commercial banking license and extensive network in Chinas affluent regions.
As established earlier, although SDBs financial performance is clearly not impressive at first
glance, it really is its bad interest-earning assets quality that penalizes an otherwise good
looking Pre-Provision Profit. If Weijian Shan is confident about his ability to devise an
effective turnaround strategy for SDB - and he would have good reasons to be, looking at his
previous successful experiences and transactions in South Korea and China - this acquisition
could turn out to be extremely profitable for Newbridge. Shan is also able to use his network
and connections in order to find and recruit an experienced and skilled specific new
management for SDB.
4

However, as under-capitalized as SDB currently is, there is a non-negligible probability that

SDB will have to raise additional equity capital for solvency or regulatory reasons. The bank
would have to do so via rights offerings, public share issuances, or private placements. This
would then raise another concern, the potential dilution effect on Newbridges stake. As well,
its ability to raise this capital might be impaired by poor market conditions as well as by the
need for government approval, which might result in SDB having to discontinue its
operations. Also, if Newbridge is looking at restructuring the company over the next years,
they will face associated costs which are very likely to penalize profitability at first.
Since 1999, a few foreign banks and investors have already completed some minority-stake
investments in Chinas banking sector, which also give some reference points, although each
deal had its own features. Price-to-book ratios for those deal ranged between 1.2 and 1.5. The
largest ownership transfer was a 1.2 P/B ratio, 15% stake in Nanjing City Commercial Bank,
allowing the International Finance Corporation to become its third largest shareholder. For
all the reasons stated before, the initial deal of a P/B ratio of 1.6 for Newbridges acquisition
of SDBs stake does not seem disproportionate.

Conclusion
Despite SDBs declining looking performance, Newbridges investment of 18% into SDB for the
price of 1.6 times the book value is appropriate. That is, given that Newbridge will get a
significant influence on SDBs decisions, while being able to enter the Chinese market
completely. As well, Newbridge will have to make the correct decisions regarding investments
allowing for higher quality assets, less non-performing loans, and the need to raise more capital
in order to improve SDBs capital adequacy while minimizing the dilution effect it would have.
Shan should probably look to re-negotiate the deal and try to find a solution to make it happen
at a price not significantly higher than previously agreed. If a bidding war against CCB or any
other competitor in unavoidable, Newbridge probably should give up pursuing the deal in order
not to overpay for the stake.

Appendix
Please refer to the attached Excel spreadsheet for more details about the computations
Table 1
2002A
Gross Loans (US$ MM)

10 159

Normal

8 611

Special Mention

369

Substandard

400

Doubtful

740

Loss

40

Reserve Ratio Guideline

Normal

1%

Special Mention

2%

Substandard

25%

Doubtful

50%

Loss

100%

Actual LLRs (US$ MM)

391

LLR/Gross Loans

3,8%
11,6%
33,1%

NPL/Gross Loans
LLR/NPL

Guideline Reserve Levels Needed

Normal

86,11

Special Mention

7,38

Substandard

100

Doubtful

370

Loss

40

Total LLRs needed (US$ MM)

603,5

LLR/Gross Loans

5,9%
11,6%
51,1%

NPL/Gross Loans
LLR/NPL
2001 NPL/Gross Loans
2000 NPL/Gross Loans

15,3%
22,7%

Table 2
Shenzhen Development Bank
Total Operating Income (TOI)
Operating Expense
Pre-Provision Profit (PPP)

2000A

2001A

2002A

217

313

442

-142

-206

-258

74

108

184

PPP/TOI

34,1%

34,5%

41,6%

PPP/Total assets

0,98%

0,74%

0,92%

PPP/Equity

15,9%

21,2%

35,3%

61

67

68

-5

-22

-21

56

46

47

4 331

6 457

10 159

-305

-306

-391

Net Loans

4 025

6 151

9 768

Other Interest-earning Assets

3 497

7 870

9 636

Total Interest-earning Assets

7 522

14 021

19 403

Total Assets

7 522

14 509

19 900

Total Liabilities

7 058

13 999

19 378

464

510

521

PBT
Tax
Net Profit

Gross Loans
Reserves

Equity