But the financial results announced in March brought hope that the banks may at last be escaping from the quagmire and that reform is well under way. Nearly all the major banks posted profits for the fiscal year ending in March 2004, revealing a significant reduction of non-performing loans (NPLs) from their books and low quality deferred tax assets from their Tier 1 regulatory capital.
The proposed merger announced last month between Mitsubishi Tokyo Financial Group (MTFG) and UFJ, two of Japan’s four “megabanks”, is another clear message that banking reform in Japan is entering its final stages. With a few operational provisos, analysts see this as a positive deal for both banks. UFJ has a weak balance sheet and was forced by the Japanese regulator, the Financial Services Agency (FSA), in June to make a series of earnings downgrades ahead of its results, subsequently posting massive losses. But it has relatively strong operations in retail banking and loans to small to medium-sized enterprises. MTFG has a strong balance sheet but is struggling to make money from its traditional areas of business, such as corporate lending.
Search for new customer classes
Equally encouraging is the evidence that partnerships and product strategies that were previously unthinkable are now in the making. For too long reliant on income from interest alone, banks are now looking to new customer segments and developing new business models that will boost their bottom lines and help to spread risk across the financial system.
In April, MTFG acquired a 15% stake in consumer finance company Acom. It is a tacit admission that MTFG does not possess the necessary credit scoring skills or customer reach, and that it is willing to merge with a specialist firm in a bid to tap retail margins. According to reports, Sumitomo Mitsui Financial Group (SMFG), which this year posted profits of $3.8bn, is also pursuing a capital tie-up with the consumer finance firm Promise.
While such partnerships would probably be commonplace, if useful, anywhere else, they are seen as evidence of a sea-change in Japan. MTFG declined to take part in this feature, but industry analysts have been keeping a close eye on the sector’s progress. David Threadgold, senior vice-president and head of equity research at SwissRe in Tokyo, says: “Five years ago, MTFG would have been much more cautious of being seen to get too close to a consumer finance group for fear of reputational damage and creating the sense that it was unable to pursue such opportunities unaided. But this deal is a clear example that Japanese bank management teams have a new vision. They now feel able to seek strategic alliances that take them into new business areas.”
Down the credit curve
While lending portfolios have shrunk at most of the major banks, partly as a result of meeting the FSA target to reduce NPLs by March 2005, Japanese banks have been moving down the credit curve: targeting smaller businesses to improve profitability.
Sumitomo Mitsui Banking Corporation (SMBC), part of SMFG, introduced its uncollateralised Business Select Loan (BSL) in 2002. Aimed at small businesses with annual sales of up to Ą1bn ($9.25m), firms can borrow up to Ą50m (average borrowings are Ą20,000-Ą30,000); by the end of March 2004, the bank had lent Ą1100bn. SMBC is unwilling to reveal spreads but, according to Hironari Nozaki, managing director, equity research, at NikkoCitigroup, BSLs generate net margins of 2%-2.5%, compared with net corporate lending margins of 0.8%-1.1%.
“Improving profitability is one of our key commitments,” says Takashi Morita, of SMBC. “We see this as a major customer segment and will keep building this business. Between now and March 2005, we aim to lend another Ą1000bn. We have also been increasing our lending to medium-sized enterprises. In the last fiscal year, we lent Ą2600bn; we hope to lend a further Ą3600bn to such businesses in the coming year.”
BSLs move away from the traditional Japanese lending model, which relied on collateral (and which precipitated Japanese banks’ massive debt problem when the inflated property prices of the 1980s collapsed), and implement a new risk-weighted lending model.
The introduction of BSLs has necessitated the development of a new credit scoring system and SMBC’s Mr Morita admits that it is a lack of this model that helps to explain why Japanese banks have taken so long to move into more lucrative lending areas. “Japanese banks have typically relied too heavily on collateral. SMBC has developed new methods of measuring default and counterparty risk,” he says. “We analysed our own historic data to build a credit-scoring model and then added data from the Risk Data Bank [established in April 2000, it has 39 financial institutions as members, including all the major banks in Japan]. With a good credit-scoring model, we can properly assess the risk and accurately price the loans.”
SMBC is heralded as a particularly strong success story because 50% of the 17,000 borrowers taking loans under the BSL scheme are new customers to the bank, and SMFG has broken fresh ground in utilising marketing methods that are common elsewhere but unusual in Japan. “SMBC carried out a high-profile marketing campaign on television, radio and in newspapers,” says Mr Nozaki. “This was very unusual in Japan. Before then, you didn’t really see banks’ financial products advertised on television. It has brought significant results: in other banks, 80%-90% of borrowers in new products are existing clients.”
But this, too, demonstrates new skills. “Even if [the other megabanks] have yet to prove as good in attracting new customers, this does show that banks are getting better at cross-selling products to existing customers,” Mr Nozaki says. “This evidence of increased productivity is seen as a very healthy sign for the banking system.”
Universal model?
Jean-Francois Minier, managing director and head of capital markets for Japan and Asia Pacific at Dresdner Kleinwort Wasserstein, believes that recent changes represent the emergence of a new banking model: “It looks like the long-term model that is emerging is moving towards a universal one – or at least a broad-based model that includes a mix of retail and commercial banking, retail and institutional securities sales, and investment banking. This kind of structure offers the ability for Japanese banks to smooth their revenue streams and to reduce vulnerability to cyclical markets. The only question that remains is whether or not the model will include insurance.”
Some argue that change has been led by Shinsei Bank. Says one Japanese banker: “Whether or not you agree with Shinsei’s approach to its corporate borrowers, it has built a retail presence very quickly and has shown that a diverse business can be very profitable. Other Japanese banks are now following the same strategy; it remains to be seen whether Shinsei will be so successful when the likes of Mitsubishi Tokyo, Mizuho and Sumitomo Mitsui are targeting the same products and client groups.”
Shinsei, which successfully floated earlier this year, is the resurrected form of Long Term Credit Bank under a coalition of foreign investors led by US private equity house Ripplewood Holdings. It has drawn admiration and ire in equal measure for what has been seen in Japan as a ruthless approach to its existing borrowers and a strictly risk-based pricing model applied to new customers. It has aggressively pursued a broad business model, including a new retail bank. Free ATM use and free transfer of funds over the internet – both new concepts to Japanese banks – have attracted 700,000 new accounts since the retail bank was launched in June 2001. It is about to introduce home loans and sells variable life products and mutual funds as an intermediary.
Masamoto Yashiro, chairman and CEO of Shinsei Bank, says: “Customers were dissatisfied with existing bank services. By offering new and free services to retail customers, we bring in a lot of other business, such as structured FX deposits that earn good revenues. In its third year, our retail bank improved the bottom line by $50m, now we are making money every month.”
Shinsei has also built a diversified investment banking business that includes structured trading, speciality finance, corporate advisory, private equity, asset management and financial markets. A diversified business means diversified revenues. “We don’t rely on any of the business lines for more than 20% of investment banking revenues,” says Mr Yashiro.
Fee and commission business
Other banks deny they are emulating Shinsei, but they have certainly been trying to decrease their vulnerability to interest rates by increasing fee and commission-based business over the past year or so. Mizuho Corporate Bank, a part of Mizuho Financial Group, which in March posted profits of $8.4bn, for example, has created what it calls a Solution Bank. This offers a range of advisory services and aims to bring together clients that have business synergies. “This is a new kind of service in Japan,” says Kazumi Sugimoto, of Mizuho Financial Group. “In the last fiscal year, fee-based business accounted for 36% of our profits [it has not released figures for the previous year]. Our aim is to build that to more than 50%.”
The major banks are also placing greater emphasis on other advisory and investment banking business lines. SMBC says it has increased its fee-based profits from Ą264bn in the year ending March 2002 to Ą397bn this year by building its capability in syndicated lending, securitisation and M&A. The bank is reluctant to split out many of its figures, but its 2003 results show that it generated income of Ą25bn-Ą30bn through syndicated lending. Analyst house Dealogic’s syndicated lending figures for the year-to-date reveal that SMBC has executed 110 deals to the value of $13.4bn this year.
According to Mizuho, as of March 2004, the syndicated market stood at Ą19,100bn outstanding, of which Ą14,700bn was syndicated in 2003, while Ą5,800bn of it was arranged by Mizuho. The bank is focusing on other areas, too. “We are also promoting a finance arrangement business, including acquisition and real estate finance and securitisation, as well as strengthening our foreign exchange and domestic remittance business,” says Mr Sugimoto.
Mizuho Corporate Bank’s deals include acting as financial adviser to Ripplewood Holdings when it acquired Japan Telecom in Japan’s largest ever leveraged buy-out in November last year, and as arranger to the Tokyo Mid-town Project (Tentative Nama) with SMBC when it structured non-recourse finance of Ą90bn (out of an estimated total package of Ą150bn) in June 2004.
Securitisation has already become a popular tool. According to Hideyasu Ban, executive director and bank analyst at Morgan Stanley in Tokyo, the securitisation market is estimated to be more than Ą15,000bn outstanding. In terms of asset-backed securities, Mizuho commands 44% of the market so far this year. Daiwa SMBC is second (11%), Nikko Citigroup and Shinsei are fifth (6%) and UFJ lies seventh (5%). Alongside syndicated lending, it signifies a move towards market-oriented indirect financing. Mizuho particularly is pushing the sort of asset turnover-based business that will enable the bank to target profit growth derived from asset turnover rather than the balance sheet.
Cross-selling skill
Cross-selling new products will be a major part of growing commission business and the financial deregulation that has been pushed by the government has opened valuable new product channels. In December 1998, it became legal for banks to sell investment trusts and mutual funds, and almost two years ago, annuities were added to the pot. Nikko Citigroup’s Mr Nozaki says this is enabling banks to grow commission revenues in certain areas by about 20% year on year. He says that of the Ą38,400bn sales in investment trusts in 2003, 30% were sold over bank counters (and Ą2010bn by SMFG). And, according to Mr Ban, of total variable annuities sales of Ą1.433bn up to September 2003, a massive 70% were sold in bank branches.
SMFG owns 40% of Daiwa SMBC Securities and Sumitomo Mitsui Banking Corporation – wholly owned by SMFG – owns SMBC Friend Securities. The group is developing internal synergies to drive up its securities-related revenues. For example, five branches of SMBC have Friend Securities outlets up and running already. “Since we began implementing this strategy in December 2002, we have been quite successful in building sales from these points,” says Mr Morita.
Mizuho, too, is looking to continue leveraging its three securities businesses: Mizuho Securities, Mizuho Investors Securities (MIS) and Shinko Securities. It is implementing a “combined branch” strategy in which MIS (for retail clients) has outlets within Mizuho Bank branches. So far, the bank has 21 combined branches. “In the first half of this year, we plan to add another 10; ultimately we are aiming for 100 combined branches,” says Mr Sugimoto. The strategy is beginning to pay off. Combined, the three businesses have increased net income by Ą78bn in the last fiscal year.
Hironari Nozaki, Nikko Citigroup
New relationships, new markets
Since the end of the Second World War, Japan’s corporate and banking sectors have been characterised by shigarami – the so-called special relationship between banks and borrowers. This had been expressed by a complicated web of cross-ownership that blurred business and financial relationships. But, as a new generation of employees and companies gain ascendancy and as a response to the country’s woes of the past decade, the special relationship is being dismantled and cross-shareholdings are being unwound.
“Japan is beginning to take a far more ‘rational’ approach to business. Under shigarami, it was difficult to impose sensible lending spreads or to criticise customers. As new businesses emerge, there are no shigarami relationships; the younger generation are guided more by economic value than tradition,” says Mr Nozaki.
The loosening of relationships between lender and borrower has enabled the syndicated lending market and the secondary loan trading market to begin to develop. Multiple lender relationships are more acceptable and it is seen as less “inappropriate” to trade the loan of an important client. In January 2001, 32 financial institutions founded the Japan Syndication and Loan Trading Association (JSLA), which is chaired by Shusaku Minoda, managing director of loan trading at Mizuho Corporate Bank. Now with 80 members, the JSLA has done much to promote syndicated lending: it has achieved several landmarks in terms of formalising terms and conditions, lending agreements and the treatment of borrowers’ information.
While syndication is still a fledgling market, many believe it will have significant and long-term ramifications for the Japanese financial system and economy. Mr Ban argues that the key benefits are the transparency and standardisation that are a natural function of sharing information between syndicate members. He believes it will play a major role in spreading counterparty and default risk across the system, and “normalising” the cost of lending.
“Syndicated lending is, anyway, a more efficient way to allocate the balance sheet and it brings more banks into the field. It will help to increase transparency and therefore make it easier to introduce a more market-related spread; it will therefore help to normalise loan pricing as well as bring more liquidity to the market,” says Mr Ban.
According to Mr Sugimoto, developing the syndicated market has been a strategic step by Mizuho. He says the bank has expanded the market by bringing regional banks into syndicates and spreading the technology and structures to new participants. “Since 1999, we have been pushing the syndicated loan market. Mizuho gets an arrangement fee as well as any interest on the loan, we reduce our risk in selected areas and help our regional bank clients to enter a new market. It is very healthy for the Japanese economy.”
Develop the secondary market
Syndication will also help to develop the secondary market. Mr Nozaki says: “The syndication process updates and standardises loan terms and conditions. They are getting closer to those of the bond market. For example, loan covenants now have similar conditions to bond issues. It therefore becomes much easier to sell loans in the secondary market or to securitise them. This makes it much easier for banks to proactively manage their balance sheet.”
In October last year, Mizuho Corporate Bank established a loan-trading department and Mr Morita says that SMBC is also building this capability, although he acknowledges that it is “a market yet to be developed in Japan”. Mr Sugimoto says the market is still young and that only 30-40 loans are currently being traded. However, indications of interest suggest that there could be 200-300 as the price improves and liquidity deepens. “It’s still a new market; we have to develop this. So far, regional banks, for example, are unwilling to sell loans because they have less opportunity to develop their lending books. But in the future, this market will help them build healthy portfolios,” says Mr Sugimoto.
Masamoto Yashiro,Shinsei Bank A new risk management culture?
Increasing adoption of credit-related products and financial technologies indicates that Japanese banks are developing a more risk management-based banking culture. Since 2002, they have been using the discounted cash flow model to estimate loan losses, instead of basing calculations on past losses. They are building credit-scoring systems and appear to be stepping up their efforts to capture the market value of assets; similarly, they are focused on improving their pricing capability. According to one Japanese banker, many banks now do regular stress testing of their portfolios. “This would not have happened under the traditional Japanese banking model,” he says.
Hirofumi Gomi, commissioner at the FSA, says that Shinsei has been leading the way in credit risk management and other areas. Mr Gomi does not go as far as saying there is a new risk management culture, but he does believe that other Japanese banks are following Shinsei’s lead. “Shinsei has introduced very rigorous and dynamic credit management structures. It fully analyses clients’ creditworthiness and allocates appropriate costs. Another change it has implemented is the shift to a more fee-based structure. Other banks are also implementing [these changes].”
More luck than judgment?
Some commentators are more cautious, however. David Atkinson has been a Japanese bank analyst at Goldman Sachs since the mid-1980s and is a devout sceptic; he is not so sure that the picture of Japanese banks embracing a risk management-based culture is accurate. Progress, he feels, is more by luck than judgment.
“Their responses have been a series of knee-jerk reactions forced on them by economic forces as far as I can see,” he says. “If [the banks] argue that their strategies have constituted a plan, then their plan would have been for no growth for the last 15 years. Syndicated lending and securitisation techniques are welcome developments, and are long overdue, but I’m not sure they signify the emergence of a risk management culture.”
Even among those who are positive about Japanese banks’ more risk-aware behaviour, there is a fear that it is not a new management culture but a response to market conditions and to a more rigorous FSA. Many argue that luck – in the form of an improving economy and a rising stock market – has played a large part in this year’s favourable results. If the good times return with a vengeance, ask detractors, will Japan’s banks fall back on bad habits?
If the FSA is to be believed, they will not have the opportunity. The regulator has recently stepped up its governance of banks and this more stringent supervisory framework is not about to be dismantled. Increasingly, the FSA is behaving like a strict and independent regulator.
In addition to its power to invoke the Prompt Corrective Action Scheme (which has been used almost 100 times since its introduction in 1998), in October 2002, the FSA instituted an “early warning system” that enables it to monitor deterioration in bank management that does not manifest itself in the capital adequacy ratio. Under this system, a bank can be required to make a report based on Article 24 of the Banking Law if improvement is deemed necessary in terms of profitability or management of market risk, liquidity risk or credit risk. Mr Gomi says: “Now most banks accept that this forms part of a rational system of oversight.”
Mr Gomi adds that the FSA’s supervision will evolve alongside the banks. “We will make an effort not to disturb banks’ efforts to improve their profitability, but the nature of their risks may change, such as away from lending to fee-based or capital markets-based business. Therefore we will continue to monitor closely developments in the sector and adopt appropriate supervisory methods.”
There are still many challenges ahead. One is the lack of transparency. While reporting and openness has drastically improved, it remains difficult to extract information from a lot of Japanese banks, especially information on off-balance sheet deals. “There is little available data on the size of derivatives markets, for example, and it is often difficult to get detailed data from individual banks. Given limited data, our analysis tends to be conservative.” says Reiko Toritani, senior director, financial institutions at Fitch. “Capital markets are also immature in Japan and there is no real sense of accurate pricing for each borrower.”
According to Mr Atkinson, banks must also beware that as they cut costs – which they have been doing mercilessly – they do not cut opportunity. “Japanese banks have the lowest cost to revenue ratio in the world and they must make sure that this ‘disinvestment’ does not cut their lifelines to new business. They may have had bloated branch networks, which had people doing the wrong jobs, but branches and businesses needed restructuring, not shutting down.”
New opportunities
Whether or not you believe that Japanese banks have changed their spots, there are many avenues for them to continue building alternative revenue sources and increasing profitability. Mr Ban says structured finance, including securitisation, will continue to be a good opportunity for banks to increase their fee-based revenues.
“There is still a lot of asset inefficiency in Japan. Corporates have cut costs but have had difficulty growing absolute profits, so one way they can increase return on equity is to shrink their assets through securitisation. Currently, the market stands at about Ą15,000bn but that is only about 10% of their securitisable assets, so there is plenty of room for development. Higher asset turnover will be a major driver for increased earnings,” says Mr Ban.
Equally, there is plenty of opportunity for banks to intermediate in the development of the capital markets, where there is relatively little retail activity. Mr Ban says banks now have a prime opportunity to package investment banking products for retail investors. “Several trust banks are repacking trust products, for example; they create a pool for leasing receivables to sell the trust certificate in a small lot to retail investors,” he says. “Mizuho Trust has sold over Ą400bn of such products so far and Mitsubishi Trust also started offering similar products more aggressively a few months ago. The major banks have shown that they are willing to make big changes; there is a lot more they can do.”
