Emerging Markets Hype Meets Reality

NEW YORK ( TheStreet) -- Bank executives have been hawking pitchbooks at shareholder meetings for months, trying to convince investors that the road to greater profits will be paved with BRICs - shorthand for emerging markets like Brazil, Russia, India and China.

In presentations littered with phrases like "leverage the global platform," bankers have touted breathtaking statistics related to emerging-market growth.

They've highlighted the "wealth expansion" and "urbanization" of the "global middle class." One particular PowerPoint, issued by Goldman Sachs ( GS) was chock full of encouraging charts and graphs , with arrows pointing upward to indicate growth, toward words like "OPPORTUNITY" and away from words like "REGULATION."

"This will be the century of the BRICs," CEO Lloyd Blankfein told a group of investors and industry insiders at a financial-services conference in November where he gave the presentation, adding that "we still, obviously, have a lot of room in which to grow."

Of course, Blankfein wasn't wrong about the potential growth of these economies, but becoming a dynamo in emerging-markets banking isn't quite as simple as those bullish statistics suggest.

"Banks will say, 'There are so many millions of people and so many unsold cars and so many unmade purchases and this is how big the market is and we'll get this much market share and our profit will go up this much,'" says Werner Bonadurer, a former CEO of UBS ( UBS) Hong Kong. "It doesn't work that way."

In fact, bankers and consultants who have built their careers around goals similar to Blankfein's say it's difficult, time-consuming, costly and incredibly risky to become an emerging-markets powerhouse. And, as recent turmoil in Egypt has made clear, some of those risks are significant, indefinable and hard to predict.

"European and American banks have been so big elsewhere that they just march in, put up a sign and say, 'Hey, I'm open for business,'" says Bonadurer, who now teaches finance at Arizona State University. "But there's a higher regulatory risk out there, there's a higher legal risk out there, there's a higher political risk out there - those risks are much, much higher in emerging markets and it's very hard to hedge for those risks."

Still, big U.S. banks seem to have little choice but to look beyond developed markets for growth. The outlook for the U.S. and Europe is sluggish at best. Meanwhile, new regulations prohibit the industry's most profitable activities, such as prop trading at investment banks like Goldman and card fees at big consumer franchises like Bank of America ( BAC). International capital requirements will also force banks to hold more capital against the businesses they're still allowed to engage in.

Essentially, the industry needs a surefire way to boost the top and bottom line - one that presents a compelling story for shareholders and a strategy that won't rile regulators and elected officials.

"Emerging markets" fits that description, but it will be hard for banks to replace lost profits overnight. That's especially true because banks are left with little choice but to build out their business from the ground up.

For instance, Bank of America had acquired equity stakes in China Construction Bank, Itaú Unibanco ( ITUB) and the Mexican unit of Spanish lender Banco Santander ( STD) years ago to gain exposure to fast-growth markets of China, Brazil and Mexico. It was easier and less costly than building brick-and-mortar franchises in unfamiliar territory. Similarly, Goldman acquired a big stake in Industrial & Commercial Bank of China in 2006.

Last year, BofA sold those assets in order to raise capital and repay TARP. Goldman is in the midst of a multi-year sale of its ICBC stake to comply with restrictions on proprietary investments.

Now, the two firms are spending millions of dollars each quarter to regain access to those markets through client relationships instead.

A key challenge to that goal is navigating the vast economic, regulatory and cultural differences that exist. Some burgeoning financial markets have restrictions that are not only unusual in developed markets but are an anathema to the business of banking.

For instance, some very wealthy countries in the Middle East ban the collection of interest for religious reasons. China has tight restrictions on foreign enterprises operating within its financial industry at all.

Ed McNally, a former banker and managing director at the consultancy Grammer & Co., has been working with banks on risk management in emerging markets for more than a decade. He offers Kenya as an example of how challenging it can be to build even a simple banking operation abroad.

The country prohibits a basic type of business lending known as factoring, which relies on accounts receivable as collateral. Many Kenyan businesses don't have any other kind of collateral, says McNally, leaving them unable to attain financing. In consumer banking, he says, it took the country 15 years to establish a credit bureau. But even now it's illegal to publish "positive" information on potential borrowers, acording to McNally, with the rationale that it would lead banks to "steal" one another's customers.

"I don't have any problem with the likes of JPMorgan, Citi, Bank of America, Goldman being in emerging markets," says McNally. "They are huge banks with a lot of ties overseas historically and it makes sense for them -- although not for reasons like the economy here and regulation, because the regulation is pretty tight in a lot of these other countries, too."

F. John Mathis, a former World Bank official, also notes the 30-year mortgage which dominates U.S. housing barely exists abroad, while down payments are often more than 50% of the home price. Such variances have led big U.S. banks to focus on capital markets activities, like investment banking and wealth management, instead of commercial banking. They're also targeting corporations and wealthy individuals in sophisticated cities like Hong Kong, where big deals can get done more easily and investments are more likely to pay off.

"You're doing large dollar volumes," says Mathis, who now oversees a global finance center at the Thunderbird School of Global Management. "Therefore, you're getting a relatively small percent of that large dollar volume but you're making a huge amount of money. Whereas with retail clients, it's a high cost to try to get a client in the door, much less maintain that client after dealing with government regulations and simply getting access to that emerging market."

Big banks are now struggling to one-up one other as they hunt big game in key markets. It's not hard to see why, when the biggest deals can bring in hundreds of millions of dollars' worth of fees and building relationships with smaller companies or wealthy families can pad the bottom line further.

Last year alone, Brazil's Petrobras acquired $43 billion worth of oil and gas assets, Carlos Slim's America Movil paid $24 billion for a Mexican telecom company and Agricultural Bank of China issued $22.1 billion worth of stock in the biggest IPO in history. Meanwhile, in thousands of smaller deals, emerging market issuers raised a record $1.16 trillion worth of debt and equity financing last year, according to Dealogic. Investment banks took in a record $15 billion worth of revenue from emerging markets, with the biggest growth in North Asia and India.

JPMorgan Chase ( JPM) ranked No. 1 in the emerging-market league tables, with 5% market share, followed by Credit Suisse ( CS) and Morgan Stanley ( MS). Jes Staley, the new head of JPMorgan's investment bank, also achieved his goal of doubling revenue from Asia.

But success doesn't come easy - nor does it come cheap. Bank of America, for instance, spent millions last year hiring about 1,000 employees to expand its nascent emerging-markets franchise. Its personnel costs were up $400 million last quarter alone, about half of which was attributable to its international build-out. JPMorgan's expenses were up $79 million last quarter, which CFO Doug Braunstein said is "primarily related to the international expansion."

Beyond personnel and infrastructure, Mathis points out that new capital requirements have put the overall cost of doing business in emerging markets on the rise.

"The risks are very large, which makes the cost very high," says Mathis. "If you're doing business in a risky country, you burn up a lot of your capital very quickly because you've got to put aside more capital for every dollar of exposure you have."

At the same time, increased competition has made it more difficult to nab top deals. Bonadurer, who left banking in the late-90s, says banks have a tendency to undercut one another on pricing simply to gain market share. They also have a tendency to exaggerate the profitability of emerging markets while downplaying the cost.

"It has become such a strategic mandate that you can't go back and tell the board, 'We're not doing so well in China,'" he says. "You have to be part of it or else you're toast. But, by and large, the increased competition is a bit of an ego trip. The costs are way higher, the deals are much smaller - you can add it up and profits will just not be there."

When emerging markets experts are asked which U.S. bank is best positioned to succeed over the long run in extracting more profit from emerging markets, Citigroup ( C) comes up time and time again. Its brand is recognized at both the consumer level and capital markets level in far-flung cities across the globe that competitors are only starting to target aggressively.

For instance, while JPMorgan and Morgan Stanley are just now gaining licenses to do commercial-banking business in China, Citi entered the country in 1902 and became a locally incorporated bank in 2007. Its Banamex subsidiary in Mexico -- where Citi has the biggest emerging-market franchise -- has been operating since 1882.

Those credentials are a key component of Citi's post-bailout turnaround story. But results at Citigroup last year showed signs of increased competition, as well as the complexity of targeting emerging markets - a large, diverse group of countries that are lumped in together simply because they're expected to grow fast.

Within its core Citicorp division, Citi derived 59% of net revenue from operations abroad in 2010, down from 68% the previous year. Net revenue from Latin America remained flat, while revenue from Asia grew a mere 3% -- even though Citi had its "most successful year ever" in China and led a record number of IPOs there, according to a spokesman. Citi ranked No. 7 in the league tables for emerging markets investment banking, behind JPMorgan, Credit Suisse, Morgan Stanley, Goldman, Deutsche Bank ( DB) and UBS, according to Dealogic.

On a conference call, CEO Vikram Pandit explained that inflation in some high-growth markets had caused currency fluctuations, hurting results in dollar terms. Meanwhile, Europe's debt crisis limited business in fast-growing Eastern European markets. Despite those headwinds, Pandit said, the firm is well-established and well-positioned to take advantage of the growth it expects to see over the long-term.

"The underlying dynamics of the consumers in these markets and the growth models - actually finding a real, solid development model - has not really changed," CEO Vikram Pandit said recently. "And so we expect to see continued increase in loan demand; we expect to see continued increase in capital markets activities; we expect to see continued growth not only in the Asian markets, but also in the Latin American and some of the African markets."

It's easy to see why Citi's competitors are now targeting these areas for growth as well - even if they're a century behind. It's less easy to believe that they will be able to make up for tens of billions in lost revenue and profits in a highly competitive atmosphere.

"The U.S. is often so ethnocentric and egocentric that we fail to consider, let alone appreciate and understand, the world around us," says Jim Wheeler, an attorney with Morris Manning & Martin who has worked on cross-border banking deals. "The US is in its infancy compared to many of the 'emerging markets,' markets, which are many times both envious and suspicious of the U.S. Any number of banks consider themselves, or at least tout themselves, as global, but few really are."

-- Written by Lauren Tara LaCapra in New York.

>To contact the writer of this article, click here: Lauren Tara LaCapra.

>To follow the writer on Twitter, go to http://twitter.com/laurenlacapra.

>To submit a news tip, send an email to: tips@thestreet.com.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

More from Stocks

10 Stocks Goldman Sachs Thinks Will Crush the S&P 500's Performance in 2019

10 Stocks Goldman Sachs Thinks Will Crush the S&P 500's Performance in 2019

Dropbox Is the New Defensive Stock to Own With the Market Falling Apart

Dropbox Is the New Defensive Stock to Own With the Market Falling Apart

3 Warning Signs the Stock Market Could Collapse

3 Warning Signs the Stock Market Could Collapse

Dow Tumbles as Trump Ratchets Up China Trade Fight

Dow Tumbles as Trump Ratchets Up China Trade Fight

This Should Be Your Retirement Savings Plan When the Stock Market Crashes

This Should Be Your Retirement Savings Plan When the Stock Market Crashes