Bank of China Hong Kong 's

Bank of China Hong Kong 's

Initial Public Offering

by

Hugh Thomas

Associate Professor of Finance

The Chinese University of Hong Kong

Draft of April 28, 2003

Accepted for publication in Journal of Financial Education. I am grateful to participants at the North American Case Research Institute 2002 conference in Banff, Canada, for their helpful comments and for research assistance from Wang Zhiqiang and Xu Zhi in preparing some tables. Please contact me at hugh-thomas@cuhk.edu.hk should you find any errors in the case.

Bank of China Hong Kong's Initial Public Offering

Abstract

China's entry into WTO has set a deadline on opening its financial services sector to foreign competition. Privatization is one strategy to help modernize the sector. The first bank in line for privatization is the Hong Kong commercial banking subsidiary of Bank of China (BOC), Bank of China Hong Kong (BOCHK), a subsidiary recently formed from the merged Hong Kong interests of BOC. Foreign investment and commercial bankers are meeting in January 2002 with BOC and BOCHK to negotiate the initial public offering (IPO) of BOCHK. But as the negotiations to IPO commence, a scandal erupts that adversely impacts the timing or pricing of the transaction.

Students must decide the timing, number of shares, pricing, place of issue, use of proceeds and strategic investors and negotiate in alliance and competition with others. They analyze financial statements, strategy, industry position and equity valuation in the context of an international banking IPO.

Introduction

It was January 2002. Top management of the Bank of China (BOC) was keen to proceed with the initial public offering (IPO) of shares of its newly reorganized subsidiary, Bank of China Hong Kong (BOCHK). BOC invited several foreign bankers to Beijing to discuss confidentially the IPO. These bankers included senior management from the equity underwriting departments of two investment banks Wall Street Associates and EuroUniversal Group and Asia Pacific executive committee members of two global financial groups, BankAssurance NV and FinServe Limited.

The bankers would form and propose, either individually or jointly, various strategies for underwriting and strategic partnering on the IPO. It was up to BOC and BOCHK to assess the proposals and determine a plan for approaching the equity markets. As the rumor mill was operating with its usual efficiency, by the time the five teams of visiting bankers had spent one night in the Peking Hotel, they all knew what each other was doing in town. Bankers being bankers, they discussed the transaction and potential for mutual cooperation and competition among themselves.

BOC and the Chinese Banking Industry

BOCHK was a wholly owned subsidiary of BOC, the second largest of the Big Four state wholly-owed commercial banks in China - in order of size, Industrial & Commercial Bank of China, BOC, China Construction Bank and Agricultural Bank of China. The masthead of BOC's web-page "About Us" trumpeted "Welcome to The Best Bank in China." It was a boast that rang true - at least among the Big Four.

More than any other sector of the Chinese economy, banking in the late 1990s and early 2000s was burdened with the failures of China's old planned economy. Under that system, banks had been effectively treasuries, providing funds for capital expansion as designated by the plan. If capital expansions were profitable, loans were repaid. If not, loans remained on the books for many years before they were finally written off. Because profitability was not often the main criterion for selecting planned projects, unprofitable projects were frequent. Although the reforms of the Chinese economy from state-planned to market-driven started in 1978, it was not until the 1990s that the reforms fundamentally addressed banking. Three particularly important aspects of this delay were (1) there was no effective bankruptcy legislation until 1991; (2) policy lending was not formally separated from commercial lending until 1994 and (3) not until 1998 did the Peoples Bank of China (China's central bank and commercial bank regulator) direct commercial banks to base lending on borrower credit-worthiness (See Exhibit 1). By then, however, the Big Four were all technically insolvent.

Recognizing the problem, in 1999 the Ministry of Finance set up four Asset Management Corporations (AMCs), one for each of the Big Four, to purchase non-performing assets . Each AMC used mixtures of AMC bonds and cash to buy assets from its parent bank. AMCs either auctioned off the assets or (more frequently) entered into debt for equity swaps. By the end of 2000, some RMB 1.49 trillion (US$180 billion) of non-performing assets had been purchased. But even after nominally implementing commercial lending practices and setting up of the AMCs, many branches of the Big Four continued to lend for political reasons. Within this dismal industry, BOC shone relatively brightly. For example, its asset management company, China Orient Asset Management accounted for a disproportionately low RMB 226 billion (US$32 billion) of total non-performing assets purchased from the Big Four by the end of 2000.

The predecessor of BOC was founded to serve as a modern bank for the Ministry of Revenue of the Qing Dynasty in 1904. The bank's name was changed to "The Great Qing Bank" in the final years of the Chinese Empire and within a year of the 1911 Nationalist Revolution that overthrew the Qing, the new nationalist government issued the bank a charter, giving it the name "Bank of China." Far more so than other Chinese banks in the early years of the twentieth century, BOC followed western banking precepts. Following the founding of the People's Republic of China in 1949, BOC assumed its role as the foreign exchange bank of the new regime. Whereas the other three of the Big Four were absorbed into the People's Bank of China, China's central bank, in the 1960s, only to be spun off again as separate banks in the 1980s, BOC continuously existed