Japan's Cracked Banking Colossus

Can Mizuho Financial pull through?

If only global finance were like sumo wrestling, where sheer heft equals power. For no bank carries more weight than the Mizuho Financial Group. Although few people outside Japan have heard of it, Mizuho is the world's biggest banking group, with $1.28 trillion in assets, far outstripping No. 2 Citigroup's (C ) $1.05 trillion. In Japan, Mizuho covers the waterfront of financial services, from no-frills corporate loans to exotic derivatives, from credit cards to home mortgages. It even runs Japan's Takarakuji public lottery.

The problem is that Mizuho is more like Goliath than Godzilla. Created two years ago when three of Japan's better-run banks--Dai-Ichi Kangyo Bank, Fuji Bank, and the Industrial Bank of Japan--joined forces to form a holding company, Mizuho promised investors a clean break from the failed strategies and tattered balance sheets that have long exposed Japan's banks to ridicule. Even its name, which means a fresh harvest of rice, suggested a new start. But the bank got anything but a new start when the merger took full effect Apr. 1. The automated teller network went haywire after a series of computer-programming errors, causing duplicate withdrawals and delaying cash transfers. It took two weeks to sort out the mess. And that's been the least of Mizuho's problems, as its bad loans pile up and the task of combining three huge banks proves daunting. Today, Mizuho is in crisis.

With rumors swirling that the government was about to take over Mizuho, President and CEO Terunobu Maeda hit the reset button on Dec. 4, unveiling a restructuring plan for the group. There will be accelerated layoffs, wage cuts, and branch closures. Maeda also signaled that the bank may seek to raise cash, probably via a share offering, if its capital base is eroded, as expected, by tough new rules on bad-loan write-offs. "At present, we have capital," said the 57-year-old Fuji Bank veteran, but he added that there were "uncertainties" about what the government might demand next year.

The rumors of an imminent takeover proved unfounded. But what still scares Maeda--and other execs at Japan's big banks--is that Tokyo's new chief bank regulator and economic czar, Heizo Takenaka, will follow through on his call for a new round of bank inspections, plus tougher rules on loan classification and capital ratios. For instance, Japanese banks have bolstered their capital with billions of dollars worth of credits against future tax payments. Proposed new rules would limit such write-offs to 10% of capital. That alone would cut Mizuho's capital ratio from a healthy 10.1% to a depleted 4.8%, according to HSBC Securities (Japan) Ltd. The bank would have to come up with an estimated $17 billion in new capital to fill the gap, says HSBC--not easy in a year when Mizuho expects to lose $1.77 billion. That's one reason Mizuho watcher James P. Fiorillo, a Commerz Securities analyst, figures the bank will try to bring in $6.5 billion in a preferred or common stock offering next year. "They have a tough sell," he says.

What bankers want to avoid is having Takenaka and his team step in to supply the needed capital, which would mean the economy minister would be calling the shots. Execs such as Maeda could lose their jobs, and his bank could be broken up and auctioned off. Japan's other megabanks--among them UFJ Holdings Inc., the world's 14th-largest banking group, and Sumitomo Mitsui Financial Group Inc., No. 17--also are trying to avoid this fate. The prospect of a government takeover has "instilled a sense of crisis in bank management," says HSBC analyst Hironari Nozaki.

A cynic might say Mizuho's new plan amounts to reshuffling the deck chairs on the Titanic. That's unduly harsh. Mizuho will take a machete to its bloated cost structure by cutting the pay of top executives and board members by 30%, eliminating 6,300 jobs, or 21% of the workforce, and closing dozens of branches at home and abroad. Maeda's plan also will create a holding company that will impose tighter control over Mizuho's commercial and investment banking units. And he wants to eliminate duplication by merging the group's two trust banks. He hopes to reduce costs by 20%, or $1.3 billion, when all this is done by March, 2005.

Dicier, though, is Maeda's plan to transfer Mizuho's $44 billion in nonperforming loans into a newly created company devoted to complicated workouts and corporate restructuring. Right now, loan officers from the old Fuji Bank or Industrial Bank of Japan have little time or incentive to crack down on delinquent borrowers. They are more focused on finding new customers than shedding old ones. By pooling these bad loans in another company, Mizuho hopes "to focus people only on working out the loans," notes Standard & Poor's analyst Naoko Nemoto. In practice, she says, Mizuho will still be up against the old-boy network that makes cutting off borrowers in Japan very difficult.

Meanwhile, a series of visits to the U.S. and Europe by Maeda and his investor-relations team has failed to shore up Mizuho's anemic share price, down 47% since January. That's a lot worse than the Nikkei's 15% drop. "There is now a deep cynicism toward Japanese banks," says Ian Burden, chief investment officer with Invesco Japan, which manages $2 billion in assets. On top of that, bank shares are now only 7% of Japanese stock-market capitalization, vs. 20% in the late 1980s. Consequently, mutual-fund managers feel less of a need to put money into this sector.

The worry is that if they can't get enough money in the capital markets, Mizuho and other megabanks will simply do what they've always done: turn to friendly, affiliated life insurers and big blue-chip companies with which they have longstanding business ties. That's the classic Japanese way--but critics say it's no way to run a modern financial institution. In the short term, Mizuho and the other banks might get away with this tactic, if their vows to restructure provide the political cover they need to blunt Takenaka's campaign.

On investor roadshows, Maeda talks the talk when it comes to taking the painful steps needed to turn Mizuho into a take-me-seriously bank. And Maeda can draw on a talented workforce and build on pockets of strength in investment banking and asset securitization. But now is the time for Mizuho to get costs under control and clean up its loan book. This leviathan's very survival depends on it.

By Brian Bremner in Tokyo

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