Rebuilding Japan's Banks

Prime Minister Koizumi's finance-sector overhaul is driving the nation's recovery. It has also kept him in power

Japanese Prime Minister Junichiro Koizumi led his party to a landslide victory in parliamentary elections on Sept. 11, humiliating opponents of his plan to accelerate economic reforms. Koizumi can now move ahead with new plans, including the privatization of the postal savings system -- the controversial proposal that was voted down by the upper house of the legislature, prompting Koizumi to call snap elections. That could eventually free up a big chunk of the $3 trillion that Japanese have mouldering away in postal savings accounts and insurance policies, enough to further energize Japan's underperforming economy.

But there is a story behind the story of Koizumi's electoral triumph. Analysts say Japan's voters might have thrown him out of office if he hadn't convinced them he knew how to make real reform happen through his thoroughgoing overhaul of Japan's financial system. Like postal reform, the financial overhaul was bitterly opposed. But Koizumi and his young Turks prevailed. The result is Japan's transformation from a quasi-socialist economy, in which credit allocation was directed to politically connected companies, to an economy in which capital and labor increasingly flow to companies that make the best products at the highest profits. Japan's banks today are far shrewder in their lending practices and no longer face a huge amount of government meddling. The result is a financial system healthier than it has been in 15 years. The Koizumi administration "took the view that the problems at the banks and the problems in the economy go hand in hand," says Thierry Porte, chief executive of Shinsei Bank. "That has helped get us to the position we are in now."

How bad was Japan's financial funk? Mizuho Financial Group President Terunobu Maeda said it well when speaking at an economic forum in May: "We have finally broken out of the pits of hell." Just days before, Japan's Big Four banks had announced that the burden of bad loans they were carrying had, as of March, dropped to 2.9% of all loans, down from a record 9% in 2001 and comfortably below the 4.1% target set by Heizo Takenaka, Koizumi's tough Economy & Financial Services Minister, who is also in charge of privatizing the postal system.

If the Koizumi government had not solved the bank crisis, it never would have had the courage or political capital to tackle the postal savings monopoly. For decades the banks had cultivated cozy relationships with Japan's big corporations through cheap loans and stock cross-shareholdings. The banks financed rapid, global corporate expansion in the 1980s, which struck fear in the hearts of U.S. businessmen and helped drive the Tokyo stock market to dizzying heights. Then it all collapsed. The Nikkei 225 index fell from a peak of almost 39,000 in December, 1989, to a nadir of 7,304 in April, 2003. Property values sank, and deflation set in, destroying profits while frightened consumers pulled back, prompting years of declining retail sales. When the big companies couldn't pay back their loans -- especially the notorious "zombie" companies that should have died but somehow staggered on -- their friendly bankers simply rolled them over, which shredded their own bottom lines. By 1997-98, the whole banking sector was choking on bad debt. The government had to step in and rescue several big institutions, including Long-Term Credit Bank, a potent force during Japan's post-World War II recovery.

It took a while for Koizumi to get a grip on this crisis. One problem was that Japan's regulators had a reputation for being too cozy with banks. So much so that in 1998 several Finance Ministry officials were arrested for supplying banks with details of upcoming audits in return for bribes and expensive nights on the town. But starting three years ago, the strike force led by Takenaka, a Keio University professor with no ties to the ruling Liberal Democratic Party, forced the big banks to write off their bad loans and cut off loose companies that couldn't pay their debts. His Financial Services Agency, which took over from the Finance Ministry as banking regulator in 2000, also began demanding far greater levels of openness from banks as part of a tough inspection regime.

The tough love approach has worked. Banks, by and large, are now back in the black. And what's good for Japan's banks is good for Japan Inc. With capital directed more to companies that can use it best, return on equity for Japan Inc. has jumped and corporate balance sheets have strengthened. In August, following a round of record corporate earnings reports, the International Monetary Fund revised its 2005 growth projection for Japan's gross domestic product from 0.9% to 1.8%. The same month, bank lending rose 0.2% -- the first increase since October, 1998. Tokyo land prices, which fell for 13 consecutive years and form the collateral for many bank loans, are rising again. The Tokyo stock market has reached its highest level since 2001. "Japan is back on the growth track,"'says Susumu Kato, senior economist for Lehman Brothers Inc. (LEH ) in Tokyo. "There are still risks, but the fundamentals are improving."

Profits, Profits

The government's refusal to play nanny to either the banks or the corporations had other beneficial effects. Foreign private equity firms have moved in to take over limping Japanese firms. In one of the early high-profile deals, New York-based Ripplewood Holdings took over LTCB from the government in 2000, rechristening it Shinsei Bank. Helped by the government's assumption of much of its debt, the consumer-oriented bank is now making solid profits and regularly appears at the top of customer satisfaction surveys. Shinsei's assets as of June, 2005, were $76.1 billion. Its consolidated net earnings for the year ended March, 2005, were $676 million.

The money center banks are healthier too. While their margins are still a fraction of their international peers', for the year ending Mar. 31, 2006, Japan's Big Four -- Mizuho, Sumitomo Mitsui Financial Group, Mitsubishi Tokyo Financial Group (MTF ), and UFJ Holdings Inc. -- are projected to post combined profits of $13.6 billion, an 800% increase over the previous year. Investment bank Macquarie Securities projects that MTFG alone will post profits of $11.4 billion in 2007 after it completes a $29 billion friendly merger with UFJ in January, 2006. Mizuho and SMFG won't be far behind. "Within a couple of years, Japan's banks will be generating enough earnings to be able to aggressively invest in new business areas," says Ned Akov, Macquarie's bank analyst in Tokyo. Through Sept. 12, the Topix index of bank stocks listed on the Tokyo Stock Exchange was up 18% for the year, compared with 12% for the Nikkei 225 as a whole.

All of which leaves Japan's big banks keener than ever to make up for lost time. They've been de-emphasizing low-margin corporate lending, for instance, in favor of retail businesses like mortgages, personal loans, and credit cards. "A lot of resources have been spent fixing our financial base," SMFG's new president, Teisuke Kitayama, told reporters in July. "Now we have to respond to changes in the market or be left behind." There's certainly room for growth in the retail sector, since retail customers have been the banks' poor relations for years. Even today, some banks' automated teller machines are open only during office hours, charges remain high, and Internet banking services lag behind those of overseas rivals. "Profitability is now the No. 1 priority, and simply concentrating on size and accumulating assets no longer makes sense," says Ryuji Yasuda, a professor of finance at Hitotsubashi University in Tokyo and director of Daiwa Securities. "Everyone is taking a new approach."

The banks are also taking advantage of the repeal of laws and regulations that kept them out of some businesses. To the consternation of Japan's big securities houses, bank branches are in charge of 60% of all mutual fund sales, while the home loan industry, until recently dominated by the government-backed Housing Loan Corp., has become a huge battleground with banks offering mortgages with interest rates fixed for several years at as little as 1%, helping to fuel home sales.

More opportunities lie ahead. Since December, banks have been allowed to sell stocks and bonds in branches through tie-ins with brokers. And in 2008, barriers between banking and insurance will fall. "Things are really starting to move," says Tetsuya Wada, director of retail banking at MTFG in Tokyo. "The U.S. financial-services market is a lot bigger, but the biggest opportunities from a pure growth perspective are in Japan." If the banks, under the expected Koizumi privatization, can get their hands on some of that $3 trillion in postal savings, that makes the retail future still brighter.

Japanese banks are also cranking up their overseas ambitions. According to Bain & Co., Japanese bank lending in Brazil, Russia, India, and China rose 40% in the year ended in March. Goldman, Sachs & Co. (GS ) notes the total of overseas loans made by Japanese banks increased 8.4% for that year, to $133 billion. That was the first rise in foreign loans since March, 1997. Mizuho unveiled plans in August to open 10 new overseas branches by 2009, for a total of 31.

All of this is not to say the banks have solved their problems -- or even that they're trying hard as needed. On the retail side, the big four banks still score very low in customer satisfaction polls. And despite the big push into retail, according to Macquarie Securities 56% of the big banks' profits are still from interest income, most of it derived from corporate loans, vs. 65% three years ago. Even as banks make new corporate loans, they are stumbling in the crucial area of risk assessment. "It's going to take at least five years -- there just aren't enough people in Japanese banking that understand how to do this," says Yukio Noguchi, a finance professor at Waseda University in Tokyo. Can banks price credit effectively yet? "I'd like that to be the case, but we don't really see it happening," says Shinsei's Porte.

What can't be disputed is that Japan's "lost decade" is fading into history, and bank reform has helped drive the process. For the first time in many years, Japan's banks are even daring to be ambitious. MTFG wants to be one of the top five global banks in terms of profit by 2008 -- a goal that would have provoked rivals' laughter not long ago. Today, the world's bankers need only glance at the Japanese banks' strengthening balance sheets to know that they are once again a force to be reckoned with.

By Ian Rowley

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