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Banking Industry Overview

11, 01. 2004

Current State

Japanese City Banks Will Be Reorganized into Three Megabanks

Ministry of Finance Japan
Ministry of Finance Japan

   The Japanese financial services industry is in the midst of a reorganization of unprecedented scale. The Japanese banking industry is currently centralized into four megabanks. They are The Bank of Tokyo-Mitsubishi, Ltd. (formed through a merger of The Mitsubishi Bank, Ltd. and The Bank of Tokyo, Ltd.), Sumitomo Mitsui Banking Corporation (SMBC; formed through a merger of The Sumitomo Bank, Ltd. and the former Mitsui Bank Ltd.), Mizuho Bank, Ltd. (formed through a merger of the Industrial Bank of Japan, Ltd., Dai-Ichi Kangyo Bank, Ltd., and Fuji Bank, Ltd.), and UFJ Bank Limited (formed through a merger of Sanwa Bank, Ltd. and Tokai Bank, Ltd.).

   However, disposal of nonperforming loans is not progressing at UFJ Bank, and the bank is facing difficulties securing an adequate equity ratio on its own. For this reason, UFJ Bank is trying to advance a merger with The Bank of Tokyo-Mitsubishi. Meanwhile, SMBC is also exploring the acquisition of UFJ Bank, and it has announced a policy to block a merger between UFJ Bank and The Bank of Tokyo-Mitsubishi. Regardless of which financial group UFJ Bank will ultimately align with, it is for sure that Japanese banks will be reorganized into three megabanks.

The Rapid Advance of Bank Reorganizations, Inclusive of Regional Banks, Is Taking Place

   Reorganizations are not limited to major banks, such as city banks. There is large-scale consolidation taking place that involves small- and medium-sized banks, such as regional banks, as well. Full bank deposit protection will come to a complete end in 2005. This includes bank accounts used for settlement purposes, such as ordinary deposits. Once the government guarantee of 100% of bank deposits comes to an end, the upper ceiling on deposit refunds will become limited to 10 million yen per depositor.

Foreign Exchange Rates (Spot rates)

   It is expected that this will make the selection of banks an even more difficult decision for customers. There is also the possibility that there will be a massive outpouring of deposits from banks that have unfavorable compositions of finances, and there is concern that this may cause chaos in the financial industry. The consolidation of small- and medium-sized financial institutions, such as regional banks, is rapidly advancing with such circumstances in the background. The Japanese government is requesting that banks aggressively dispose of their bad loans and restore the soundness of the compositions of their finances. The government is taking the policy of giving operational guidance to banks that are unable to meet an equity ratio of 6 percent, which is the standard of the Bank for International Settlements (BIS) for domestic business operations, and in some cases, ordering the suspension of business.


Policy Measures Taken to Prevent Bank Bankruptcies

   The rapid reconstruction and development of the Japanese economy after World War II was supported by industrial groups that centered on banks. The Japanese government's financial administration, dubbed the "convoy system," provided banks with utmost protection. Under this system, banks backed corporate business activities by actively providing loans to group industries in line with the government's industrial policy. This system created a uniquely Japanese financial practice called the "main bank system," a system that supported Japan's high economic growth.

Goverment Bonds Yield to Subscribers (10 Years)

   The convoy system represented the basic policy of the Japanese financial authorities to keep banks from going into bankruptcies. Under the convoy system, banking policy administration kept in pace with the "slowest ship;" in other words, banks with the least profitability. This meant that even the least efficient bank was able to survive.
   For many years, it was believed that a bank would never become bankrupt in Japan. Furthermore, while the government protected banks, it also implemented restrictions on interest rates and took measures in order to concentrate household savings to banks. In other words, executing a low interest rate policy set the interest rates on deposits lower than they really would have been, and the money that gathered at banks at these low interest rates was then supplied to industries in order to support capital investment and other corporate business activities.

A Unique System for the Flow of Funds Created Under Government Guidance

   The government also controlled the flow of funds by clarifying the roles to be played by different types of banks, such as city banks, long-term credit banks, trust banks, regional banks and mutual banks. For example, the three long-term credit banks in Japan had restrictions on the number of branches they could open, but they were given the special privilege of being allowed to issue bank debentures. Long-term credit banks used the long-term funds collected through bank debentures to take on the role supplying companies with long-term funds for use in capital investments. Meanwhile, banks such as regional banks, which had a vast amount of excess cash, used their funds to purchase bank debentures, etc., and helped to create the unique system under government guidance for the flow of funds.

Headquarters of Mizuho Financial Group, Inc.
Headquarters of Mizuho Financial Group, Inc.

   The convoy system, however, began to crumble in the 1990s. The myth that banks would never go under came to a complete end with the collapse of Hokkaido Takushoku Bank, Ltd. This was followed by the bankruptcies of two of the three long-term credit banks - the Long-term Credit Bank of Japan, Ltd. and Nippon Credit Bank, Ltd. - and they were placed under state control. Major reorganizations took place in the Japanese financial services industry triggered by the failure of these three banks. In 1998, public funds were poured into banks that could not meet an adequate equity ratio, and banks used the funding to advance their disposal of bad loans. Measures were taken to restore fiscal soundness and improve operations.
   Further reorganization of the financial services industry took place during this process, such as the virtual state control of Resona Bank, Ltd. The reorganization of the financial services industry is now beginning to enter its final stages.

Damage Caused by the Liberalization of Interest Rates

   Why, then, did such large-scale reorganization of the banking industry take place?
   The financial system unique to Japan played an extremely large role during the process of the country's post-war economic reconstruction. After the end of World War II, an extremely idiosyncratic financial system, which consisted of the government's low-interest rate policy and the main bank system, was established in Japan in order to restore Japanese industries through limited funds. This system was made possible by government control over the financial services industry and closure of the market. However, once Japan became the second largest economy in the world and began posting massive current account surpluses, it became substantially difficult for Japan to maintain a closed financial system of this kind. Moreover, it also became difficult to upkeep government control over interest rates as corporate and domestic finance areas developed. Liberalization of the financial services system and the internationalization of the yen was a path that Japan could not avoid going through for the country that had matured.
   The liberalization of the financial services system began through pressure from the United States. A concrete schedule for the liberalization of interest rates and the internationalization of the yen was decided after the Japan-US Yen Dollar Committee was established in the mid-80s to promote such liberalization and internalization.
   The liberalization of interest rates had a great negative impact on the earnings of banks, which had up to then enjoyed excess-profits under regulated interest rates. Furthermore, another major change in the environment surrounding bank management came about from the fact that companies began increasing fund procurement through the capital market instead of relying solely on loans from banks. It decreased the profit margin between interest rates paid on deposits and interest rates received on loans. Banks could not longer secure profits, as in the past, simply by making loans to companies.

Matters Made Worse by the Bank of International Settlement's Regulation on Equity Capital

Tokyo Main Office of Sumitomo Mitsui Banking Corporation
Tokyo Main Office of Sumitomo Mitsui Banking Corporation

   As if to make matters worse, the Bank of International Settlement (BIS) decided to introduce a regulation related to the equity capital of banks. Through this regulation, an equity ratio of 8 percent needed to be maintained in order for banks to continue international operations. Furthermore, even domestic operations would not be permitted if a bank did not meet an equity ratio standard of 6 percent. Japanese banks, which are generally undercapitalized, met such standards by adding on the unrealized capital gains of the client shares they owned, as main banks, in great amounts.    Changes in the business environment, which took the form of reductions in profit margins and declines in financing demand by companies, compounded by the introduction of the equity capital regulation by BIS became the driving forces that accelerated the reorganization of the Japanese financial services industry.

Major Financial Deregulation brings about a Bubble Economy

   After the Plaza Accord, the Japanese government implemented major credit relaxation in order to counteract the deflationary effects of the stronger value of the yen. This brought about an economic bubble in Japan, and land and share prices rose abruptly. With the increase in the latent value of stocks through the rise in share prices, new demand for bank loans, such as loans for use in land speculation, increased. Banks also aggressively began investing in real estate in order to compensate for the lowered demand in companies' normal funding needs. However, the Bank of Japan shifted to a tightening of Japan's money policy, and share and land prices went on a downspin. As a result, Japanese banks were saddled with vast amounts of nonperforming loans in the 1990s. Furthermore, the fall in share prices brought down the equity ratio of banks and had a critical influence on the management of banks. Another factor that placed an enormous burden on the operation of banks was the need to set aside great amounts of reserves in preparation of a state in which nonperforming loans became irrecoverable.

Credit Crunch Brought About by Banks' Need to Achieve an Adequate Equity Ratio

   Banks that could no longer meet the equity ratio standard endeavored to maintain the ratio through such measures as counting in taxable loan-loss reserves that had been set aside. However, differences in interpretation with finance authorities over its authorization, etc. also arose, and many banks were placed in a predicament. Banks were forced to scale back assets in order to achieve the equity ratio standard, and they began taking measures such as curbing new loans and making recovery of loans from companies.

Headquarters of Mitsubishi Tokyo Financial Group, Inc.
Headquarters of Mitsubishi Tokyo Financial Group, Inc.

   This brought about a credit crunch in the Japanese economy and had the aspect of inhibiting general business activities of Japanese companies. Banks that were unable to meet the equity ratio standard despite such measures were forced to either seek public funding or face government takeover. Financially unstable banks and banks with massive amounts of nonperforming loans explored mergers with banks that had sound financial content, while financially stable banks acquired such problem banks.

Japan's Big Bang Financial Reforms Implemented in the Late 90s

   After World War II, the Securities and Exchange Law prohibited a financial institution from conducting banking activities and securities services together. A feature of Japan's post war financial system was that there was a double "fence" placed around its financial institutions. As mentioned earlier, segmentation was created between banks. At the same time, a barrier was also built to separate banking and securities. This was possible because of the existence of financial administration that restricted competition between financial institutions. However, while such a uniquely Japanese financial system was permissible during Japan's development, it already started showing signs of being inconsistent by the time Japan's economic restoration was completed.

Officical Discount Rates

   Financial deregulation took place in the United States in the 1970s and in the United Kingdom in the 1980s. In addition to the liberalization of interest rates, liberalization of the operations of financial institutions as well as deregulation of foreign exchange regulations, etc. also advanced in Japan. The fence that separated banking and securities operations was also lowered, and banks and securities companies could enter the other's field by creating a subsidiary. Furthermore, Japan's Big Bang financial reforms, which followed the example of financial liberalization in the U.K., were also implemented in the late 1990s. The liberalization of the Japanese financial industry was virtually completed from the viewpoint of the financial system.

Three Key Points towards the Future

Point 1
Can Earnings Be Secured in Retails?

   With Japan's Big Bang financial reforms, major Japanese banks established holding companies and expanded, from banking services, to include new business fields such as securities and trust services. Being unable since the 1980s to secure sufficient revenues from its conventional loans operations, banks made an effort expand the income made through service charges and commissions. Among others, banks are seeking to create a profit stream in securities services through investment banking services, such as underwriting. Meanwhile, they are also beginning to focus their strength on fields such as small-scale consumer loans - something that had been left to consumer finance companies up to then - as well as housing loans.

Average Interest Rates on Time Deposits New Receipts / Deposits of no less than 10 Million Yen

Point 2
The Development of High-risk Financial Products, Such as Derivatives, an Issue

   An issue in terms of investment banking services is the development of high-risk products such as derivatives. Japanese banks have fallen behind the banks of the United States and Europe in such investment banking services. Furthermore, a massive capital base that can withstand risks is necessary in order to perform investment banking services. It was circumstances such as these that created a need for megabanks in Japan. What's more, Japanese banks also needed to turn into megabanks in order to develop their international operations.
   As mentioned earlier, the four current megabanks will eventually converge into three megabanks. This will mark the end of the reorganization of the Japanese financial services industry, and new strategies will probably be unfolded in order to recover the major competitive gap that has developed with Western megabanks in the past 10 years.

Point 3
Can Japanese Megabanks Compete with Those of the West?

   The global financial services industry has become a battle between megabanks. The consolidation of banks is not something that is happening in Japan; it is a worldwide trend. While many Japanese banks in the 1980s were ranked in upper positions among banks of the world, they were forced to retreat from the international stage due to the sharp changes that took place in their environment after the bursting of the economic bubble in Japan.
   Resona Bank has already shifted to exclusively domestic operations. The consolidation of UFJ Bank with another Japanese megabank will probably take place sooner or later. That means that there will only be three Japanese banks that can develop overseas operations. The big issue of the 21st century will be how the consolidated three megabanks will be able to establish a foundation and compete on the international arena again. This will probably result in the dawn of the development of new international operations for Japanese banks.

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