Cleaning Up Japan's Banks--Finally

Tough audits may turn the tide in the bad-loans mess

Few Japanese have ever heard of Hirofumi Gomi and Takeshi Go Kimura. Yet in Tokyo banking circles, they are loathed and feared. Gomi is the head of the Financial Services Agency's inspection division. Kimura is a brash former Bank of Japan official who is president of KPMG Financial K.K. Co., the Japanese branch of the international accounting firm. No ordinary bean-counter, Kimura has the ear of Prime Minister Junichiro Koizumi. Kimura and Gomi are triggering panic attacks among Tokyo's pinstriped set.

Why? Gomi's FSA, which oversees Japan's banks, has its 360-member inspection division conducting brutal, in-your-face examinations of the loan books of Japan's major banking groups, including giants such as Mizuho, Mitsubishi Tokyo, and Sumitomo Financial. In the past, such audits had the intensity of croquet matches, featuring vague discussions about risk-management systems and lending practices. Nobody asked the obvious question: Are any of your biggest borrowers about to fall on their faces?

Thus, banks spent years glossing over the true extent of their problems. Many suspect Japan's bad loans approach $1 trillion. The official estimate is $135 billion. Few believed regulators had the guts to force the real numbers into the open.

OWNING UP. But something important is happening: The banks are starting to come clean. In announcing results for the half year that ends in September, Japan's top 13 banks tripled their earlier projections of the bad debt they are holding. Top lender Mizuho, for example, says it will write off $16 billion in dud loans, a surprising number few thought the bank would ever own up to. All told, the top banks will probably set aside an additional $50 billion as reserves against nonperforming loans for the fiscal year ending next March.

This suggests Team Gomi's arm-twisting is having an impact. That the auditors have the freedom to ask hard questions owes a lot to lobbying by Kimura. In private meetings with Koizumi and top Liberal Democratic Party brass, he has argued the banks need to take off the kid gloves when dealing with their biggest corporate borrowers. Says Hironari Nozaki, analyst at HSBC Securities and a former bank exec, "As a banker, I was very scared of Gomi, while Kimura reflects the [skeptical] market view" of the bad debt crisis. Kimura himself says that until the banks reveal the true value of their loans to the 30 or so biggest borrowers, "they are avoiding reality."

The FSA auditors, now that they have been given free rein, are providing that reality check. Since early November they have spent hundreds of hours poring over the banks' evaluations of borrowers' underlying earnings power, debt loads, and credit ratings, looking for the next likely corporate collapse. The goal of the audits, to extend into next year, is to flush out the bad loans, get them properly classified and provisioned, then start to crack down on chronic deadbeats. Gomi is cutting little slack for bankers reluctant to reclassify loans. "He is a very tough negotiator," says a Bank of Japan official. Already, the FSA figures 15% of the loans at the top 10 banks need to be reclassified, which means declaring many "problem loans" as nonperforming. That number may well rise before they are finished.

With the FSA bloodhounds at work, the question is what Koizumi will do with the results. Opposition to the auditors' demands is already building. Akira Kanno, vice-chairman of the Japanese Bankers Assn., argues that it would be suicidal for banks to damage vital corporate relationships by cutting companies off at the knees. International Monetary Fund Asia-Pacific Director Kunio Saito calls such statements "an excuse for not taking action."

Koizumi, whose reform drive has foundered of late, may yet be able to use the audits as political cover for a unpopular bailout of the banks. It's becoming clear that the record write-offs will bankrupt many banks as well as their borrowers. In that case, the government can inject capital into the banks and start the grisly business of working out the bad loans.

The agency likely to play the central role is the government's Resolution & Collection Corp. The RCC may issue bonds for as much as $100 billion that will be purchased by the Bank of Japan. The RCC would use the proceeds to buy bank loans from lenders at their true market worth. Then it could come down hard on delinquent borrowers--either shutting them down or refinancing them on much more stringent terms. The political question is whether lobbyists for hard-hit industries like construction can head off any such action. Koizumi's strategy, no doubt with advice from Gomi and Kimura, is clear: He knows that before the bankruptcies and mass layoffs can begin, the auditors have to reveal the true extent of the banking fiasco.

By Brian Bremner in Tokyo

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