Asia’s local financial institutions can no longer afford merely to tinker at the edges; more open markets, more demanding customers and foreign institutional investors, and more intense competition from abroad are all putting extraordinary pressure on private and state-owned banks to raise their game to unprecedented levels. To survive, such banks will have to improve their performance hugely over the next few years. In fact, they will have to remake themselves from the ground up.

The transformation of Asian financial institutions will unfold in three stages. In the first, they will have to secure their lifelines by recapitalizing and restoring public confidence in their basic solvency. In 1998, foreign banks like Citibank, HSBC, and Standard Chartered were flooded with deposits from Hong Kong, Malaysia, and Singapore as frightened depositors moved money from local institutions to these seemingly more secure multinational ones. To win back such deposits and reassure long-term corporate borrowers, local banks will certainly have to show that they are financially sound by writing off bad loans, receiving new capital, and implementing more transparent policies.

Local financial institutions will have to change their strategies and their management cultures

Refocusing, stage two, will have to proceed nearly in parallel with the first or follow it immediately. During this second stage, which is likely to last two or three years, institutions will have to refocus on areas where they can build the greatest competitive advantage. Accustomed until now to being all things to all people, they will have to redirect their efforts to customers and products that attract the least intense foreign competition. Of course, the banks must also recruit staffs capable of developing and implementing these more focused strategies, and they will have to learn how to analyze their opportunities in a more sophisticated way. That in turn will mean relying on ideas from staff members who are close to customers, not on commands from senior management. In short, refocusing presents local financial institutions with a twofold challenge: they must alter not only their strategies but also their basic management culture.

Finally, in the third stage they will have to raise their skills to world-class levels in management leadership, human resources, marketing, distribution, processing, and risk management,¹ steadily narrowing the gap between themselves and foreign organizations like ABN AMRO and Citibank, which are expanding in Asian markets. To meet this challenge, surviving local banks will almost certainly be forced to import managers and techniques from abroad.

Asia’s strongest local financial institutions could complete all three stages of the transformation by 2005. Banks that do so will benefit from, and perhaps drive, the coming boom in mergers and acquisitions. Those that do not will be swallowed up. But since the challenges facing private and state-owned banks differ so markedly, it is best to consider the problems of each separately.

State-owned banks

During much of the 1990s, the major state-owned banks dominated many Asian banking markets; as late as 1997, they held significant shares of the action in China, India, Indonesia, Malaysia, Singapore, and Taiwan (Exhibit 1). In some cases, governments saw their participation in banking as a critical element of a centrally controlled supply-driven economic strategy of funneling money to specifically targeted priority industrial sectors. Indeed, governments hoped to manage the flow of funds to key corporate sectors not only by exercising firm control over state banks but also by guiding all banks through ministries of finance and central banks. Moreover, state ownership of banks sometimes benefited powerful government officials financially.

State banks were not managed to maximize their economic performance. Although this history of serving political rather than economic ends did not prepare them well for the future, some of their assets will prove very valuable. In many cases, state banks have extensive branch networks and relationships with all kinds of customers: large corporations, middle-market companies, and consumers. They are also well known in their local markets. Properly harnessed, these franchises could be very valuable. (See boxed insert, "State Bank of India: A giant awakens to its consumers.")

Reforming many state-owned banks is a matter of turning bureaucratic organizations into market-oriented, profit-making businesses. This is hard to do at the best of times—and potentially overwhelming during a financial crisis, when state banks may be crucial sources of liquidity for whole economies.

Yet Singapore’s state-controlled bank, the Development Bank of Singapore (DBS), managed to face the challenge. In August 1998, the country’s government turned to a Westerner, John Olds, from J. P. Morgan, to run the bank and set it on a new path—among other things, by merging it with another state-controlled institution, the Post Office Savings Bank, to create a strong platform for regional expansion.

DBS basically operates in one city-state and has a staff of just 4,000 people, all fluent English speakers. Few other governments will face such a simple situation, be so bold, or have an equal ability to attract strong reform-oriented managers. How would China’s government, for example, attract them to reform its four big state-controlled banks? In 1997, the largest of them employed more than 600,000 people, operated in every province of the country, and functioned only in Mandarin and other Chinese dialects. Similar challenges face anyone trying to reform state banks in Indonesia or Korea.

State banks can, however, move down more than one path to change. In 1998, Taiwan started to reform its government-controlled banks: Chang Hwa Commercial Bank, First Commercial Bank, and Hua Nan Commercial Bank. First Commercial branches quickly put up splashy banners to herald a new name, "First Bank." But real change would be long in coming: the nonautomated, bureaucratically run branches behind the banners remained pretty much the same.

Given the extent of the change that state banks must undergo to become full-fledged commercial players, many of them might be wise not to attempt a full transformation. Instead, they could break themselves up into institutions specializing in particular activities and ally with other entities to extract the value of their customer relationships and networks, without attempting the enormous cultural challenge of a total revamping.

Many state banks are deeply involved in lending for infrastructure, so turning this part of these institutions into independent project-financing enterprises could make a lot of sense. Similarly, large corporate lending businesses could be hived off from state banks and become parts of specialized investment or wholesale banks, though governments may have to scrub these units’ loan books clean before any private institution would accept them. Relatively focused entities of this kind might raise money from the capital markets, with all the discipline that entails.

If these large wholesale units were spun off, state banks would be left only with retail and small-business activities, carried on mostly in large branch networks. Such networks are profoundly inefficient, and in some countries branches in outlying provinces or regions are subject to local political influence. Yet the networks, for all their deficiencies, could be valuable to local or foreign entities aspiring to push into the markets they serve. Through alliances, mergers, or even outright sales, governments could energize local economies and release the power of these franchises by putting them under more market-oriented managements.

Private local banks

Like state banks, their private local counterparts face stark choices—and similar ones at that: building the capital, products, organizations, and skills they will need in a more competitive environment. While less hidebound than state banks, they will not find it easy to change. They must also deal with the expectations of their customers and with the growing capabilities of their competitors. (See boxed insert, "Thai Farmers’ battle.")

As local product regulations and demarcations fall by the wayside, private local banks will have to resist the immediate temptation to become true universal banks. Instead of trying to be all things to all people, they must define market niches, invest in their chosen businesses, and build strong risk management capabilities. Which customers can such institutions serve with what range of products to generate attractive risk-adjusted returns? How can they attract quality staff as global banks expand into their markets? Such questions will have to be answered.

Besides these strategic challenges, organizational issues confront private local banks. At the end of the 1990s, for example, families still controlled many of them (Exhibit 2). As they face up to more intense competition, the ability of family members to serve in senior roles will have to be judged objectively, for they will need the best managers they can find. Moreover, as these banks expand, their capital requirements will rise. Families will have to be prepared to meet their share or reduce their ownership stakes. In fact, as in the West, the need for management skills and capital will slowly squeeze many families out of dominant roles in "their" banks. This pressure will raise issues of pride, or "face," for throughout the 1990s in many Asian countries, families had to own banks to be regarded as leaders of the business community.

Nevertheless, markets have changed so much that Asian banks have no choice but to change their corporate strategies fundamentally. Exhibit 3, a strategic-control map for Asia, highlights the average value of the top three private banks in all Asian markets relative to the average value of the leading banks in the United States and Europe as of September 30, 1998. Apart from banks in Japan, Asian institutions were relatively small by international standards, and they were also relatively undiversified within Asia: because of past regulatory constraints, the top three banks in each Asian market hold the vast majority of their assets in their home countries.

The small size of the leading Asian private banks and their lack of international diversification make them vulnerable, and banks below the top level are even more so. All of these banks will have to struggle to finance improvements in the products, technology, and skills needed to compete with the global giants, and in a world of declining margins they will continue to be subject to geographic concentration of credit risks without any adequate reward. The corporate strategy for such banks must help them resolve these problems.

Financial turmoil in Asia will force many banks to sell out or to ally themselves with foreign institutions to increase their capital base and to acquire the skills they need to compete. In 1998, for instance, Bank of Asia, in Thailand, sold 75 percent of its equity to ABN AMRO, and Kwong On Bank of Hong Kong sold out to Singapore’s DBS. Other banks could pursue intraregional mergers to create regional banks with greater geographic diversification. After all, why should the only broadly based regional competitors be HBSC, Standard Chartered, Citibank, and ABN AMRO? For most banks, attempts to act alone will lead only to narrow niche roles or to an eventual sale forced by weakness.

In the 1980s and 1990s, vast wealth was created and then destroyed in Asia, enriching its banks and later impoverishing them. That cycle will probably be repeated during the first decade of the 21st century, but by then the winners in the coming struggle will strive to earn profits differently. In an environment of more transparent information, more sophisticated customers, more open competition, and more demanding international investors, banks will have to manage all elements of every financial business with far more discipline than they showed in the 1990s. And to secure positions of leadership, many will have to expand through acquisitions.