Japan's Banks

Megamergers are a start, but the cleanup job remains enormous

A mad mating dance is sweeping Tokyo's once-placid Ohtemachi banking quarter. Ever since the scary collapses of Yamaichi Securities, Long-Term Credit Bank of Japan Ltd., and Toho Mutual Life Insurance over the past year, every financial exec in town has been in crisis-management mode. Now, hardly a week passes without news of a major deal, alliance, or merger in Japan's once-cosseted financial industry.

The latest deal is by far the biggest to date. On Aug. 19, three money-center banks, Industrial Bank of Japan, Dai-Ichi Kangyo Bank, and Fuji Bank, unveiled plans to form the world's biggest financial holding company, with $1.2 trillion in assets. The monetary Godzilla will dominate Japanese retail, wholesale, and investment banking, and make about 30% of all corporate lending in the country. It will pit itself against the world's best. "We aim to rank among the top five [global] lenders in terms of capital, profitability, and services," says Masao Nishimura, president of Industrial Bank of Japan Ltd., who will co-chair the operation with Fuji Bank President Yoshiro Yamamoto. DKB President Katsuyuki Sugita will be president.

Such ambitions would have alarmed rivals from Wall St. to Frankfurt a decade ago. No longer. Now Japan's banks, lumbered with $600 billion of bad debts, inspire more pity than awe abroad. About a year ago, Japan's top banks were seen briefly as such poor credit risks that they had to pay a huge 1 percentage point more than Western banks to borrow dollars on global markets. Ladles full of government cash--$500 billion of capital and deposit insurance for ailing banks plus $200 billion in aid to bolster their customers--saved the banking system from collapse.

RICKETY INSTITUTIONS. Japanese banks are not home free, however. The government may have to rein in some of its life support to banks because overall government borrowing now equals 100% of gross domestic product. Bad debts continue to grow apace: Those left behind by bankrupt companies jumped 50% year-on-year in July. Impending accounting rule changes will flush out billions more of bad corporate debts now hidden in the books of subsidiaries. They also will lift the veil on $660 billion of unfunded pension obligations that will cast a pall over the creditworthiness of some of the banks' customers.

Meanwhile, some of Japan's 100-plus regional banks, particularly those in Osaka and Tokyo, Are rickety. And there are big worries about the financial health of the nation's massive life insurance industry, which is squeezed between large-scale policy cancellations and a growing inability to cover claims from premium and investment income.

All the same, Tokyo Stock Exchange investors embraced the Aug. 19 bank deal. Japanese bank stocks soared 20% in the week following the merger's announcement and have now doubled in value since their October low (chart, page 32). That euphoria may be rewarded if the merger proves to be the first step in a massive consolidation of Japan's financial industry. Hakuo Yanagisawa, head of Japan's Financial Reconstruction Committee, certainly wants to see just that. If he gets his way, Japan's 18 money-center banks will be knocked into four or five $1 trillion behemoths capable of clawing their way back to the top rungs of global banking.

At first blush, the partners in the new grouping seem an odd bunch to achieve that goal. Each has flaws. Dai-Ichi Kangyo Bank Ltd. is tainted by recent scandals over payoffs to racketeers. Fuji Bank Ltd. lost $3.5 billion in the year through Mar. 31 after writing off $5.3 billion of dud loans, many owed by bankrupt affiliates of the Fuyo keiretsu to which it belongs. Even IBJ, the soundest of the three, has lost government guarantees on the 5-year bonds it issues to finance itself.

To be sure, the new combine towers over the likes of New York-based Citigroup or Germany's Deutsche Bank in assets. But it will be years before the trio will match the smarts, reach, or profits of global rivals. Japan's money-center banks are the least profitable in the industrialized world, racking up measly 2% to 5% returns on equity, vs. a typical 15% to 20% in the U.S. Lousy lending practices are partly to blame--but so is the woeful tardiness of Japanese lenders in grasping how to use mergers to spread huge information-technology costs over a bigger base, cross-market products from mutual funds to insurance on a global scale, and ruthlessly cut costs.

True, the trio's leaders promise to ax operating expenses by $1 billion. They plan to meld all their computer operations, for instance. Added to that, about 6,000 jobs on the combined 35,000 payroll will disappear, as will some 150 of their 700 branches. But they will sure take their time about it. The cuts are to be spread over five years--hardly the pace of a new breed of Japanese financiers who Yanagisawa wants to see "make decisions quickly with a real sense of crisis."

HORNET'S NEST. The deal isn't even a full-blooded merger. Once the holding company is set up next year, the three banks will take two years to gradually inject their operations into it. Such activities as securities operations might be merged. But most work will be carefully carved up between the banks. Foreign employees will get the chop first as the new outfit eliminates duplicate branches around Europe.

But the biggest potential for cost savings--and the bulk of the staff--are to be found in Japan. DKB's and Fuji's branch networks overlap extensively, for example. The new bank's leaders are leery of stepping into this hornet's nest. And with good reason: Japanese bank mergers often result in turf battles and failure to deliver promised cost savings. But unless managers act boldly to hack out domestic fat, the Financial Reconstruction Committee's reform plans will fall flat. Pessimistic analysts warn that the deal could turn into a reincarnation of the notorious "convoy system," long promoted by the Ministry of Finance, by which dud banks were coupled with healthier ones rather than closed.

Since being tapped by Prime Minister Keizo Obuchi last December, Yanagisawa and his 50-strong team of bank examiners and lawyers have attempted to make a break with the past. They have nationalized two giants, Long-Term Credit Bank and Nippon Credit Bank Ltd., and have shut down four regional players. If they succeed, Japan's sprawling banking industry will be slimmed down to a handful of sleek global contenders and a larger group of smaller banks that focus on domestic business or specialize in asset management, mutual funds, or investment banking. Up to a third of Japan's 100-plus regional and local lenders will be merged or driven out of business.

New forms of finance, such as online banking and brokering, will be part of the mix. So will the emergence of venture-capital finance--sorely needed if Japan's economic future is to be driven by startups in fast-growing sectors such as telecom, design, and the Internet.

Yanagisawa is being helped by Japan's 1996 Big Bang financial reforms, which only now are succeeding in tearing down barriers between banks, brokers, and insurers. Strong foreign players such as Fidelity Investments, GE Capital Services, and Goldman Sachs are adding to the pressure by making serious inroads into mutual funds, insurance, and asset management. New York investment group Ripplewood Holdings has even set up a $13 billion fund for its bid to buy LTCB from the government.

Still, progress will be painful and slow. Urgent work in identifying viable regional lenders has barely begun. In April, 2001, the government will stop fully guaranteeing all bank deposits. Instead, it will set an $86,000 limit per account. The change could prompt runs on the weak lenders that lack adequate capital reserves. In other respects, the government still plays an overlarge role in banking. Public-controlled lending outfits such as the Japan Development Bank now guarantee a generous 12% of all loans in Japan, figures Merrill Lynch & Co. economist Jesper Koll. He also notes that the Bank of Japan is now the main intermediary in the nation's commercial paper and interbank markets.

Despite the hurdles facing reformers such as Yanagisawa, though, the bad old days of state-directed allocation of financial resources and collusive lending practices between banks and big companies may be numbered. Budget constraints could increasingly sideline the government. The emergence of shareholder capitalism and internationally accepted lending and accounting practices could turn the postwar Japanese economic model on its head. "Japan really is changing now," insists Yoshifumi Nishikawa, president of Sumitomo Bank Ltd. "The old rules won't come back."

Old rules? Consider this: At the start of the decade, the Ministry of Finance had undisputed control over every bank, broker, and life insurer. Major lenders even maintained bureaus that wined and dined MOF bureaucrats to trawl for inside dope on competitors or to lobby to keep foreign players out. As recently as a year ago, such cozy ties allowed the nationalized LTCB and Nippon Credit to set up dummy affiliates.

"SAD JOKE." Bank lending used to be all about relationships, not risk assessment. Even after the bubble economy collapsed and shattered the prices of stocks and land that Japanese banks count as capital, the easy lending continued until late 1996. Lax accounting practices made it devilishly tough to figure out whether a borrower was really solvent or not. Credible information on pension liabilities, audited cash flow statements, and debt loads of subsidiaries were a "sad joke," notes Warburg Dillon Read analyst Timothy Marrable.

Once accounting reforms start to click in this year, giving bankers better numbers to work with, institutions may finally get their risk assessment skills up to snuff. Then they could become less reliant on low-margin lending to big corporate customers. At Sanwa Bank Ltd., new President Kaneo Muromachi sees no future in merely accepting deposits and then making plain-vanilla, low-margin loans to traditional corporate clients, presently about 80% of the bank's loan book. Instead, he is forming a comprehensive tie-up with three insurance companies, as well as Toyo Trust & Banking Co. and broker Universal Securities Co., to offer such asset-management products as 401(k) savings plans to corporate customers. On Aug. 24, Sanwa announced plans to sell mutual funds and other products managed by Morgan Stanley Dean Witter.

Muromachi is also trying to get middle managers to think creatively instead of passively following orders from the top. "We can no longer cruise along. I need ideas from a variety of people," says Muromachi. So he now reads a dozen E-mail messages a day from his staff. And during a roadshow in New York last month, he asked global investors for advice on refining his strategy.

If a new breed of managers like Muromachi can revive Japan's banking system, the potential payoff will be substantial. Japan needs to triple the return on its massive savings pool, to 7.5%, figures Deutsche Bank Asia economist Ken Courtis, to pay the cost of caring for its graying population. Some 70% of household savings still languish in bank accounts yielding just 1% to 2%.

And instead of throwing good money after bad into old and inefficient companies, more resources could be freed up for Japan's emerging entrepreneurial class. That's why Internet kingpin and Softbank Corp. founder Masayoshi Son is working with Nasdaq to set up a new over-the-counter market in Japan next year. "It takes about 20 years for a young company to have an initial public offering in this country," says Son. "It's nonsense." He knows: Two decades ago, he had to beg bankers for startup financing for his then fledgling software-distribution company.

Japan's backward financial system has cost the economy dearly. The hope now is that out of the ruins of the old Japan, something new and more dynamic can emerge. The creation of the first trillion-dollar bank might just signal that Japan's long financial nightmare is finally drawing to a close.

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