Damage Control In Japan

A scandal involving Citi's private bank has the giant scrambling to make repairs

Douglas Peterson was attending a business dinner at a Tokyo restaurant early last September when he received an urgent call on his mobile phone -- one he had been expecting since he was appointed head of Citigroup's (C ) Japan operations three months earlier. Unable to extract himself from the dinner, he met the caller, a Citi staff member, in the restaurant bar. The news was grim. Japan's Financial Services Agency, which had been investigating alleged improprieties at the bank for months, had come to a decision. It would terminate Citigroup's (C ) private banking operations in the country, a shocking setback for the biggest and oldest foreign-owned bank in Japan.

Two weeks later the formal decision was handed down to close the private bank, a bitter pill that Citigroup recently disclosed cost it $244 million in the fourth quarter alone. Peterson, who is CEO Chuck Prince's hand-picked troubleshooter in Japan, has been scrambling ever since to pick up the pieces. Job No. 1 has been bowing and scraping to FSA officials and other Japanese regulators, trying to convince them the bank is contrite and determined to make amends. At the same time, Peterson has been trying to protect and bolster Citi's other Japanese businesses -- like its consumer and corporate banking units -- which together constitute one of Citigroup's strongest franchises outside the U.S. "The Citibank brand in Japan is strong, and we want to recapture that," says Peterson, 45, who previously served as chief global auditor. "We know it has been damaged."


A key part of Peterson's mission is to make sure the damage goes no further. Citi officials blame unclear lines of authority for the problems in Japan, where the heads of key divisions reported to different bosses in New York. FSA investigators fault a culture where profits were chased at any cost. Bank officials allegedly misled some clients about their investments and gave loans to others that were used to manipulate stocks. Worse, regulators had warned Citigroup in 2001 about similar problems. "Quite frankly, we had some people doing bad things," Prince said in November.

The lesson Citi learned from the private bank scandal was the importance of appointing country CEOs like Peterson, to whom all the Japanese staff now report. Citigroup has just created a CEO job in China and plans to roll out the country CEO system in a half-dozen other nations in the near future. The Japan CEO is buttressed by another newly created position -- country chief financial officer -- and by a legal adviser and compliance officer who are now equal in stature to business division heads. What's more, a midlevel team of employees dubbed Project K, a play on the Japanese word for "respect," has drafted a tougher set of internal ethical guidelines. All of that has gone a long way toward placating regulators.

Then there's the issue of recharging the remaining business. The private bank, which will close next September, was one of Citi Japan's smallest units, with 5,000-plus clients and only $84 million in income. Citi's consumer, corporate, and brokerage arms are far larger. Japan operations earned $769 million in 2004, or 4.5% of Citigroup's total. Citi prides itself on being one of the first foreign banks in Japan, tracing its corporate history there back to 1902. In 1987, it established a retail bank arm that quickly introduced the country to 24-hour automatic teller machines and phone banking -- services that some domestic rivals still don't offer. Peterson wants to expand that lead by taking advantage of a rapidly changing market. In December, the government lifted a ban on sales at bank outlets of securities such as stocks and bonds. Citigroup has ties with Japan's third-largest broker, Nikko Cordial Corp., through a joint venture and is well-poised to offer brokerage services to its retail banking clients, although no decision has been made to do that. "We want to build off our strong legacy in Japan and begin to invest and grow when we emerge from our problems," says Peterson.

A bigger challenge is consumer finance -- the business of extending unsecured loans at double-digit interest rates. Citi has been a player in Japanese consumer finance since 2000, when it took over a trio of brands with 1,000 consumer loan outlets nationwide. Although low Japanese interest rates should mean high-margin spreads, profit growth at the consumer finance unit has stalled in the past couple of years because of an unexpected surge in defaults. From 2001 to 2003, delinquency ratios doubled and net credit losses in Japan grew to $1.3 billion. Last year, consumer finance revenue slipped 7%, to $2.5 billion.

Peterson wants to bolster the franchise by offering products that appeal to a more credit-worthy clientele. Two new programs were rolled out last month. The "Smart Lady" loan targets women by promising borrowers they will only deal with other women, a shrewd psychological touch. And a "Smart Loan" program aimed at 20- to 30-year-old clients guarantees 60-second approvals for a loan via a PC or Internet-linked mobile phone. While it's too soon to know if these will catch on, the overall consumer business in Japan appears to be in better shape. On Jan. 20, Citigroup reported earnings from Japanese retail banking and consumer finance surged 54% in the last quarter, to $163 million.

Sounds promising -- as long as that scandal goes away. FSA officials are awaiting an internal report being compiled by a 100-person team at Citigroup in Japan, which could reveal more embarrassing details about the private bank and its clients. Meanwhile, bank officials are working to close out the 5,000-plus private banking accounts, some of which invested in complex derivative transactions, by the time the bank shuts its doors for good. There's also a possibility that criminal charges could be filed by Japanese authorities for the alleged violations of Japanese securities laws, although FSA officials indicate they may not press the matter with public prosecutors.

Getting through this hellish period will be made easier for Peterson by the fact that he appears to have convinced Japanese financial authorities of his sincerity. "Peterson recognizes the gravity of the problems and has come up with an acceptable plan to deal with them," says Takafumi Sato, head of the FSA's supervisory bureau. Faint praise -- but the best Peterson and his bosses in New York can expect under the circumstances.

By Chester Dawson in Tokyo, with Mara Der Hovanesian in New York

— With assistance by Mara Der Hovanesian

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