After The Coverup, The Mop Up

Daiwa Bank Ltd. is in play--Japanese-style. In a market where the Ministry of Finance pulls the strings, the scandal-plagued bank may soon be gobbled up by Osaka-based Sumitomo Bank Ltd., Daiwa's prestigious hometown competitor. Not that Daiwa has much choice in the wake of its coverup of $1.1 billion in bond-trading losses on Wall Street. U.S. and Japanese regulators have hit the bank with sanctions so tough--including expulsion from America and the shutdown of much of its international operation--that Daiwa probably couldn't survive on its own.

With combined assets of $706 billion, a Sumitomo-Daiwa tie-up would produce a megabank rivaling last spring's $712 billion marriage of Bank of Tokyo Ltd. to Mitsubishi Bank Ltd. A Sumitomo-Daiwa merger could also clear the way for MOF to put other big lenders in play as it tries to refashion Japan's glutted banking business into a handful of full-service monoliths. Indeed, with 21 major and 129 regional lenders chasing the same corporate customers even as they struggle under the burden of an estimated $800 billion in problem loans, it's easy to understand why the MOF might want to shrink banking's ranks.

But the MOF needs to hustle. Daiwa's comedown has put the Japanese banking system under the sharpest global scrutiny since the country's bubble economy burst six years ago. Risk-averse investors are now forcing Japanese banks to pay 0.6 percentage points more than other banks when raising cash overseas. The penalty could grow if the MOF can't get a financial overhaul in gear.

Turning the MOF's dream of a shakeup into reality will be another matter. The Ministry may be reluctant to sanction a huge consolidation wave right away if it means saddling profitable banks with the losses of the industry's basket cases. "I don't believe bigger is really better," warns Makoto Utsumi, a former MOF tax and international finance chief and now a Keio University business professor. The only other option the MOF has is to issue bonds to bail out the insolvent housing loan industry, which owes commercial banks billions, as well as tap more public funds to refinance Japan's depleted deposit insurance plan.

But even without public cash, some mergers will occur. Indeed, prices of many banks' stocks have jumped lately on takeover rumors (table). But if Sumitomo snares Daiwa--one of the big gainers this fall--it will probably be at a bargain price. Deutsche Morgan Grenfell banking analyst Paul Heaton estimates that, given the bank's $3.8 billion in problem loans and the $1.3 billion fine it faces in the U.S. if convicted on fraud charges stemming from the coverup, Sumitomo may snag Daiwa for $8.2 billion. That would be 25% below its current market value. Daiwa declines to comment.

Also complicating matters are objections from Nomura Securities Co., which owns 3.7% of Daiwa and is eyeing the bank's lucrative trust business. On top of that comes a power struggle within the MOF, which already has been deeply humbled by its slow disclosure of Daiwa's bond scandal to U.S. regulators. The Ministry's Banking Bureau took six weeks to disclose the Daiwa mess. That prompted rival officials in the MOF's International Finance Bureau to push through sanctions to fend off U.S. criticism that the Ministry was dragging its feet.

BAD DEBTS. None of these hurdles is likely to block a Sumitomo-Daiwa deal, however. And a bunch of other possible takeovers are waiting in the wings. Sanwa Bank, Fuji Bank, Sakura Bank, or Dai-ichi Kangyo Bank might like to buy a weakened trust bank to get into the securities business. And three lenders that the MOF would love to marry off--Nippon Credit Bank, Chuo Trust, and Hokkaido Takushoku Bank--are burdened by bad debts and are in need of serious restructuring.

How rapidly the MOF launches a workout of the industry's bad debts and stage-manages the marriages of tottering rivals will determine whether Japan's banking system can remain globally competitive. With the $800 billion in bad loans, one of its biggest members humbled by a billion-dollar scandal, and funding sources beginning to dry up overseas, time is running out to start a fix-up campaign that's long overdue.

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