TAIWAN BANK M&A MAY PICK UP STEAM

UNCLAS SECTION 01 OF 04 TAIPEI 002875

SIPDIS

STATE PASS AIT/W AND USTR
STATE FOR EAP/RSP/TC, EAP/EP, EB/IFD/OMA
USTR FOR FREEMAN, WINTER AND WINELAND
USDOC FOR 4420/USFCS/OCEA/EAP/LDROKER
USDOC FOR 3132/USFCS/OIO/EAP/ADAVENPORT
TREASURY FOR OASIA/LMOGHTADER
TREASURY PASS TO OCC/AMCMAHON
TREASURY ALSO PASS TO FEDERAL RESERVE BOARD OF GOVERNORS,
AND SAN FRANCISCO FRB/TCURRAN

E.O. 12958: N/A
TAGS: ECON EFIN PINR TW
SUBJECT: TAIWAN BANK M&A MAY PICK UP STEAM

REF: A. TAIPEI 2131

B. TAIPEI 1878


1. Summary: Following the failure to privatize Changhwa
bank, Taiwan authorities are making measured moves to
encourage bank consolidation and proceed with the
second-stage of financial reform. While it appears unlikely
that the reform plan will achieve its stated benchmarks
established in October 2004, progress is being made and there
is increasing pressure for banks to actively seek merger and
acquisition partners. End Summary.

Second Stage of Financial Reform
--------------

2. Ref A reports on the failure to consummate the
privatization of Changhwa bank. The planned privatization
was to be the trigger point to start bank consolidation for
the financial reform plan announced by President Chen
Shui-bian on October 20, 2004. The plan, referred to as the
second-stage of financial reform in banking circles, was
developed by the Presidential Economic Advisory Team. Its
goal is to increase efficiency in the banking sector and the
utilization of banking assets. Currently, the banking
industry's rate of return on assets is less than one percent,
and the return on equity, according to figures from the first
quarter of 2005, has risen to a modest 3.7 percent. The
strategy calls for introducing international banking
standards into the market and decreasing the number of banks
and financial holding companies. The plan established some
quite specific benchmarks:

a. Having a state-owned bank sold to and operated by a
foreign one by the end of 2005;
b. Reducing state-owned banks from 12 to 6 by the end of
this year; and
c. Cutting financial holding companies from 14 to 7 by the
end of 2006.

Environment for Banking M&A
--------------

3. The American Chamber of Commerce held a seminar on May 18
featuring international (Goldman Sachs, Jones & Day and HSBC)
and local firms (ChinaTrust Bank) discussing the prospects
for banking mergers and acquisitions in Taiwan. The
participants noted that there is no shortage of political
will at senior levels of the Taiwan government for bank
consolidation and that the government wants to see
consolidation take place quickly. One banker also suggested
that the government's desire for rapid consolidation runs
counter to industry preference. He said that merging a weak
bank with a sound one would take at least a year and that
merging two sound banks would take considerably longer,
perhaps three years. While the industry as a whole agrees
that consolidation is good for the banking sector and for
Taiwan's economy, few, if any, senior bank executives want to
be the first one to sell or merge their bank.


4. Seminar participants said that it is not hard for the
government to realize its goal of bank consolidation because
it can quickly merge a number of existing state-owned banks.
This process may have already begun with banking circles and
press speculation on the expected merger of the International
Commercial Bank of China (ICBC) with Chiao Tung Bank. Both
of which are operated by state-owned Financial Holding
Company Mega Holdings. Other indications of M&A activity
include a June 30 resolution by the Taipei Commercial Bank to
merge with SinoPac Financial Holding Company; Yuan Da
Business Group acquiring Fuhua Financial Holding Company; and
Cathay Financial Holding Company announcing June 30 its
acquisition of Lucky Bank. (Note: Reftel B reports on
another ongoing merger in April of Macoto Bank with Shin
Kong. End Note.) The M&A experts, however, called on the
government to respect market forces and realize that foreign
banks will place a lower value on local M&A targets than will
domestic banks. Foreign banks will be unwilling to pay the
same price that local banks will, largely because local banks
have an unmet need for additional branch offices. One
seminar participant called on the government to make a
&good8 bank available for sale to all bidders, suggesting
that this would serve as a catalyst for increased M&A in the
banking sector. This comment reflected the market's view
that the Changhwa sale was flawed because it limited the
potential buyers to foreign banks and that Changhwa was not a
particularly sound bank.


5. Market participants and news reports indicate that
Changhwa bank is moving forward to try and recover from the
bungled sale to a foreign bank. Current plans call for
several sound local banks, as well as private placement
funds, to join together and propose a takeover mechanism.
Cathay, Fubon and ChinaTrust are reportedly in discussions on
how to solve the Changhwa problem.

Background on the Banking Reform Measures
--------------

6. Motivated by a sharp rise in the rate of nonperforming
loans in 2000, Taiwan launched a major effort to improve the
quality of its banks in 2001. The NPL rate in 2001 was
double the rate in 1997 when the Asian Financial crises
erupted. Taiwan Authorities established the Financial
Reconstruction Fund (FRF) with a capital base of NT$140
billion to address insolvent financial institutions. The
FRF, similar to the Resolution Trust Corporation in the US,
has taken over 47 insolvent financial institutions and,
eventually, sold them to sound banks. The 47 institutions
included the credit departments of 36 farmers associations,
nine credit cooperative associations and two banks. In
addition, Taiwan authorities offered incentives for financial
institutions that lowered NPL ratios below 7% by December
2002 and below 5% by December 2003. Institutions failing to
meet the targets would be subject to penalties. Similar
carrot and stick measures have been adopted for credit
departments of farmers associations and credit cooperative
associations. Officials hope that the combination of
incentives and penalties will encourage financial
institutions to consolidate.


7. Taiwan banks, responding to the government's measures,
cut their NPL rates by writing off bad debt and selling
problem assets to asset management companies. By December
2004, the quantity of non-performing loans fell 64.5% to
NT$590.7 billion (US$19 billion) from a peak of NT$1,661.9
billion (US$53.6 billion in March 2002. Average NPL ratios
dropped from 11.7% to 3.8%. The rapid write-offs eroded bank
profitability, causing banks to post a combined pre-tax loss
of NT$104.6 billion (US$3.8 billion) in 2002. By 2004,
though, banks returned to profitability and reported combined
profits of NT$153.3 billion (US$5 billion).


8. Reducing NPLs also eroded capital adequacy rates. Banks
compensated for the capital losses by issuing debt
(convertible into equity),resulting in total bank debt
reaching NT$676.4 billion (US$21.8 billion) in December 2004,
four times the level in 2001. The average capital adequacy
ratio reached 9.5%, higher than the existing requirement of
8%.

Current Banking Environment
--------------

9. The current banking environment consists of 48 banks, all
with less than a ten percent market share. This number is
down from the 53 banks operating in Taiwan at this time last
year. Senior officials routinely decry the &overbanking8
situation and call for bank consolidation. Financial
Supervisory Commission Chairman Kong Jaw-sheng told AIT/T
that his goal is to change Taiwan's banking environment from
one of lots of little banks into one of several large banks
capable of effectively operating in the regional market.

More Reform Needed & Delivered in 2005
--------------

10. Even while citing figures indicating that nonperforming
loan ratios continue to decline significantly, the FSC's
Bureau of Monetary Affairs has been enacting a variety of new
rules in 2005 to encourage banks to improve their operations.
BOMA has set targets for all banks to meet on rate of NPLs,
coverage of bad debts and capital adequacy. As of February
2005 all banks are required to lower NPL rates below 5%, to
increase the level of reserves to cover bad loans above 40%
and to achieve capital adequacy rates above 10%. Even while
the average rates achieved by banks in these three categories
are quite good, it is a different story when one looks at
individual banks. According to AIT/T analysis of data on
bank operations, some 60 percent of banks do not now meet all
three of BOMA's basic guidelines listed above. While most
banks probably meet one or two of the targets, fewer than
half meet all three of the targets.

Carrots...
--------------

11. Along with announcing the new requirements, BOMA offered
some incentives for banks to hit the targets. Among the
incentives for banks that bring NPL ratios below 5% and
increase bad debt coverage above 40% are: the ability to
introduce new financial products and services; relocate
branch offices (except for moving to Taipei and Kaohsiung);
install automatic service facilities outside banking offices,
and travel to China without applying for a permit.
Additional incentives for banks that bring their NPL below
2.5% include establishing offices overseas (including China);
replacing a full-service branch office with four
limited-service branches; and the ability to offer the
following services without going through and application and
approval process: investment below statutory ceiling limits,
introduction of collective management services for trust
funds and introducing mutual funds.


12. FSC offers extra incentives in the case of banks that
meet the bad debt coverage and capital requirements and bring
their NPL rates below 2.5%. Such banks do not need prior
permission from BOMA to introduce specified new banking
services. This benefit will help sound banks to quickly
offer new services in the marketplace. Foreign banks enjoy
this benefit as well as local ones.


13. The FRF has helped eight credit coops transform
themselves into banks. BOMA allows these eight new banks and
community-level financial institutions to relocate branch
offices provided their NPL rate is below 5%.

Credit Coop Incentives
--------------

14. BOMA is also trying to encourage community-level Credit
Cooperative Associations (CCA) to improve their quality.
CCAs may only operate in a county or city where no other CCAs
exist. An existing CCA may expand to two neighboring
counties or cities if its capital adequacy exceeds 12%, its
NPL rate is below 1%, and its bad debt coverage is 100%. A
CCA may expand to a single neighboring county or city if is
capital adequacy is 10%, its NPL is 2% and its bad debt
coverage exceeds 40%.

And Sticks
--------------

15. BOMA also has some penalties in hand for banks which
fail to meet the new targets. If a bank's NPL ratio exceeds
5%, it will be subject to the following:

-- Restrictions on establishing branches;
-- Limits on compensation paid to Board Members;
-- Limits on dividend payouts to shareholders;
-- Restrictions on investments in non-financial firms; and
-- Limits on loans or loan guaranties to related persons.

If the NPL ratio exceeds 15%, a bank faces the following
penalties:

-- Restrictions on providing banking services to high-risk
clients;
-- Restrictions on offering high interest rates for deposits;
-- BOMA may reduce the number of branches; and
-- BOMA may require removal of Board members and/or bank
managers. (Note: On June 26, the FSC announced that it has
ordered the Hualien Business Bank to dismiss the majority of
its Board Members for making improper loans to business and
personal associates. End Note.)

Comment
--------------

16. In the wake of the failure to sell off Changhwa bank as
originally planned, the government continues to make measured
moves to encourage bank consolidation. The market is
evaluating a wealth of M&A opportunities. It seems highly
unlikely that the first benchmark of the financial reform
plan -- a foreign bank operating a state-owned bank this year
-- will be met. Foreign banks are unwilling to pay domestic
prices for a financial institution. The second benchmark --
cutting back to 6 state-owned banks this year -- is clearly
within reach. Changhwa Bank will probably be taken over by a
consortium of domestic banks in the near future and, as
suggested by the AmCham seminar participants, the government
is moving to merge ICBC and Chiao Tung Bank. Over the next
several months Taiwan's smaller and weaker banks will come
under increasing pressure to consolidate with other
institutions. It may not happen as quickly as some in the
government would like, but some bank consolidation appears to
be a real possibility in 2005. The third benchmark --
halving the number of Financial Holding Companies -- is not
due until next year and is unlikely to be addressed until
then.
KEEGAN