MW-28 -- The Resona Holdings Bailout

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 28
Tuesday, May 20, 2003


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Viewpoint: The Resona Holdings Bailout

The Bottom Line:

o Domestic investors are heading for the exits. They're
investing record amounts of money overseas, and who can blame
them? The domestic stock market is imploding, bank interest
rates are essentially zero, property prices keep falling, and
their pensions are also threatened with the ongoing crisis in
Japan's national and private pension systems. Even their
insurance policies are suspect, as the balance sheets of life
insurers are intricately linked to the balance sheets of the
nation's fragile banks.

o The bailout of Resona Holdings indicates that the battle for
reform has not been completely lost, nor have Heizo Takenaka
and the bank "hawks" completely been stonewalled by the banks
and their LDP supporters. This time, it was the auditors who
blew the whistle on the "smoke and mirrors" of deferred tax
assets currently being counted as a significant part of
regulatory capital. But it is also yet another confirmation
that the balance sheets of Japan's major banks remain severely
under-capitalized in real terms.

o Rather than representing a "catharsis" that will lift the pall
of the banking sector and Japan's stock market, the bailout is
likely to add short-term downward pressure to stock prices as
everyone re-examines the real capital adequacy ratios of the
major banks (of course, everybody knows the banks are
essentially tapped out). Over the medium term, the Resona
"shock" is positive only if it is perceived to represent the
beginning of a full-scale cleanup of bank balance sheets. We
have been here before -- twice to be exact -- with no lasting
improvement. Thus investors can be forgiven if they take the
latest capital infusion skeptically.

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The Resona Holdings Bailout
Japanese Investors Head for the Exits

Domestic investors made net purchases of foreign equities and bonds
worth 23.34 trillion yen in fiscal 2002, the most since fiscal 1981,
when relevant statistics were first compiled. Net foreign stock
purchases by domestic investors topped 4.5 trillion yen and net
foreign bond purchases came to just over 18.8 trillion yen. The
previous record total was nearly 21 trillion yen, set in fiscal 1986.
In other words, "smart" Japanese money is abandoning Japan ... and who
can blame them? The domestic stock market is imploding; the packet of
tissues customers receive from the pretty girl at the bank window is
worth more than the annual interest on their time deposits; property
prices keep falling; and major banks are joined by insurance companies
when it comes to being in serious financial trouble. The risk capital
of Japanese savers is imploding, and their retirement nest eggs are
also shrinking.

Japan's public and private pension funds are in crisis because of 13
years of a bear market in stocks, with three consecutive years of
negative returns more recently. Returns just keep getting worse. Over
the past 12 months, Japanese government bonds are up 4 percent, while
the Nikkei index has lost something like 27 percent. The government is
now moving to allow the major insurance companies to "change the
rules" and break their prior promises of assured returns in order to
stay solvent.

The Japanese government belatedly responded to a near meltdown in the
financial system in October-November 1997 with a "comprehensive" bank
bailout plan. Under enormous international pressure, then prime
minister Keizo Obuchi belatedly embarked on a massive bailout of the
banking system that was finally passed into law in October 1998, a
full year after the near meltdown. The eight related financial-system
safety-net bills (including the Financial Revitalization Law and the
Financial Function Early Strengthening Law) provided for up to 70
trillion yen in funds -- an amount equal to 12 percent of Japan's
economic output -- to ensure the viability of Japan's financial
system. (That commitment dwarfs the amount of money spent on the US
savings and loan crisis.) These funds were to be lent to the Japan
Deposit Insurance Corp., which set up four special accounts: one to
cover the cost of nationalizing insolvent lenders; another to help
banks that were hurting but are not technically insolvent; and two
others to cover depositors in the event that there are any bank

Once a safety net was in place, the government then moved to deal with
Long-Term Credit Bank of Japan and Nippon Credit Bank of Japan, the
two biggest bank failures in the 20th century. Long-Term Credit Bank
was then sold to a US consortium led by Ripplewood Holdings and was
relaunched as Shinsei Bank in March 2000. Today it basically
represents the only success story in Japan's decade-long attempt to
clean up its banking sector.

In March 1999, Japan's major banks "accepted" public-fund injections
of 7 billion yen. Then, there were still 17 "major" banks the
government ostensibly deemed "too big to fail." Given the capital
infusions, the government insisted that Japan's banking problems had
been solved to the extent that the capital infusions were ostensibly
used to write down nonperforming loans (NPLs) and offset losses on
cross-held equity holdings. But the banks had only begun to disclose
"risk-managed" loans from March 1998, and observers were already
pointing out that "official" balances were substantially understating
the real extent of NPLs, which were estimated to be as high as 118
trillion yen circa late 1998.

This notwithstanding, the government and bank management pretended
that the situation was improving and the "bulk" of the NPL problem was
being solved through more stringent reporting requirements and audits,
continued liquidation of once-substantial stock holdings and
consolidation, which had reduced the 17 "too big to fail" banks in
1999 to four major banking conglomerates. In reality, however, the
balance sheets and, particularly, the capital of the banks continues
to deteriorate as NPLs pile up faster than the banks could afford to
write them down and falling stock prices erase not only unrealized
asset values but the value of regulatory capital as well.

The Role of 'Vapor' Capital
Increasingly, the reported capital of the major banks consisted of
capital that was either hostage to stock prices (i.e., the value of
unrealized equity holdings that was included in Tier II capital
values), or "vapor capital" that was included in Tier I capital in the
form of deferred tax assets. Deferred tax assets are not "real"
capital, but merely tax credits against future earnings, and future
earnings are something that the major banks have proven incapable of
producing over the last several years. As real capital continued to
depreciate, the relative value of "vapor capital" accounted for an
ever-growing proportion of Tier I capital. The temptation, of course,
was to fudge calculations of these deferred tax assets to make
reported capital look better. By March 2002, average Tier I capital of
the major banks was 5.4 percent. Without deferred tax assets, core
capital had already shrunk from 2.4 percent in 1999 to zero. In other
words, the major banks in aggregate had already tapped out their
"real" capital and were essentially running on "vapor" capital.

Still pretending that the problems in the banking sector were
improving while they were actually getting worse, the government
allowed the Financial Function Early Strengthening Law that was used
to bolster the capital of the major banks to expire in March 2001.
That left Article 102 of the Deposit Insurance Law as the only means
of pumping new public funds into an ailing bank. But this provision
was actually aimed at extraordinary situations where there was a run
on a bank or domino-like failures such as seen in November 1997 -- in
other words, a real financial crisis. But the financial authorities
fully believed they would never have to evoke it.

But Heizo Takenaka and his bank reform "hawks" believed that something
should be done to head off another banking crisis before it occurred,
most likely because Japan would not be so lucky in avoiding another
financial crisis as it was in November 1997. Thus, the whole precept
of the Financial Revival Program was to proactively move to address
the still serious structural problems in the banking industry. The
hawks firmly believed that a solution to the problem would not be
forthcoming unless the government moved to proactively boost the
capital bases of the major banks in much the same manner as US
president Franklin Roosevelt did when he purchased the preferred
shares of stock in 40 percent of his country's banks during the Great
Depression. Then, the recovery period took a long time and didn't
really end until World War II, but once the capital injections were
made, US bank capital-to-asset ratios stabilized and stock values
began to rise again. In addition, once these holdings were sold, the
government made up most of the US taxpayers' money.

But despite all the hoopla about possible recapitalization of the
major banks with public funds as Heizo Takenaka and the Financial
Services Agency were introducing the Financial Revival Program in
October of last year, the scenario put forward by the Japanese
government, the banks themselves and Japanese bank analysts was:

(1) The major banks would be able to successfully complete
their capital increases;

(2) None of the major banks would experience a regulatory
capital shortage at the end of the fiscal year;

(3) No infusions of public capital or conversions of
government-owned preferred shares into regular voting shares
would occur within fiscal 2002;

(4) The major banks would be able to avoid insolvency and
nationalization; and

(5) There would be no "March financial crisis."

In other words, the scenario was that it would essentially be a repeat
of what happened in fiscal 2001 -- a war of "attrition." Stock market
participants would realize that a crisis has been yet again avoided,
the bank sector's risk premium would decline, and there would be a
rally in the stock prices of the major bank stocks.

Bank stocks had begun a renewed plunge following Takenaka's assignment
as the new minister for financial services, and his detractors claimed
that he had unnecessarily created an illusion of a "financial crisis"
with his hard-line proposals that would essentially force the banks to
take additional infusions of public capital. The banks circled the
wagons, prevailed heavily on their supporters within the Liberal
Democratic Party (LDP) and stonewalled the more stringent proposals in
the new Financial Revival Plan.

Keidanren chairman Hiroshi Okuda then set off a tsunami of speculation
when a certain English newspaper quoted him as saying that one of
Japan's major banking groups could be nationalized. While the
statement was later denied by Okuda and the Keidanren, this sent
domestic and foreign investors to speculating that a "special crisis
management bank" would be used to nationalize one or more of the
banks. The banks subject to nationalization by the "special crisis
management bank" would be those banks in danger of default and which
have net negative equity. Depending on how the numbers were counted,
this could easily have been any of the large banking groups, with the
possible exception of Tokyo Mitsubishi.

If a special crisis management bank were used, the value of regular
voting stocks in the bank could basically become zero. The other
definition that investors had of "nationalization" was one where the
government would conduct capital infusions by converting the preferred
shares they currently hold into regular voting shares, the result
being that the government would in some cases own more than 50 percent
of the bank. From an investor standpoint, the implications of the
"special crisis management bank" and the "50-percent-plus government
ownership" scenarios were dramatically different. While the former
implies a "zero stock value scenario," the latter is basically a
dilution of ownership. However, even under the latter scenario, many
investors remained concerned about how shareholders (not management)
would be required to assume responsibility.

Basically, the very vagueness of the word "nationalization" made
investors nervous. The other word that made investors nervous about
bank stocks was the sudden introduction of a "special support
financial institution" in the Financial Revival Program. While
"clarification of management responsibility" had already been written
into the program, nothing was mentioned about "shareholder

Mad Scramble to Bolster Capital
Just as the banks were successfully stonewalling financial services
minister Takenaka's efforts to implement pro-active capital infusions,
they were only a short time later suddenly scrambling to shove some 2
trillion yen in capital increases down the throats of investors, or
more commonly, their major corporate clients. While they had won the
skirmish with Takenaka, they had not necessarily won the war:

(1) The Financial Services Council was expected to formulate a
new framework for capital infusions;

(2) the council's conclusions, drawn from deliberations
regarding the appropriateness of deferred tax assets used for
regulatory capital, were expected sometime between June and
July; and

(3) Japan's Institute of Certified Public Accountants was
increasingly resisting the fact that they were being pressured
by banks to bend their numbers in a way that would favor the

While the banks had managed to limp through yet another "March
crisis," it was clear that they were by no means out of the woods yet.
Indeed, the implication remained that the next turning point in the
banking sector was still ahead -- perhaps as early as the second or
third quarter of 2003.

Attempted Bait and Switch
Meanwhile, there was real concern developing behind the scenes that at
least one or more of the major bank groups was suffering from a
serious shortage of regulatory capital. The LDP and the major business
lobby groups were trying to turn investors' and the media's attention
toward the pain being caused by plunging stock prices and to
intensified criticism of not only the Koizumi administration's lack of
progress in reforms, but of growing criticism that the
administration's reform efforts were indeed a cause of the
deteriorating economic climate and the plunging stock market. In their
panic to avoid another potential financial crisis, the LDP pulled out
all the stops, making proposals for blatant price-keeping operations
by the public pension funds in the stock market and demanding major
reversals of current value accounting as well as delays in the
introduction of impairment accounting, all the while pushing ever
harder to find a replacement for Koizumi's "pain before gain"
policies, or in the very least the replacement of Takenaka.

Essentially, the LDP's "reflationary" policies were a reversion to
the old guard; they tried to bend rules and ignore fundamental
economics while dishing out as much "pork" as possible to the major

Resona: The Auditor Did It
Resona Holdings, along with the other major banks, appeared to have
skated through the March-end reporting period, after having issued
preferred shares to bolster their capital. But on May 12, the head of
the Japan Institute of CPAs reportedly wanted to consult with the
Financial Services Agency (FSA, headed by Takenaka) about the banks'
business results. What he was referring to was the fact that, from the
onset of May, Resona Holdings' management had been negotiating
heatedly with their auditors. Their auditors wanted to present a much
more conservative view of future earnings forecasts, and to
significantly revise downward estimated deferred tax assets. Takenaka
refused to confer with the head of the accounting group, stating only
that the audits would be "checked after the fact."

Resona Holdings had anticipated that its capital ratio as of the end
of March 2003 would be over 6 percent. After the revisions by the
auditors, however, the reported capital ratio of Resona Bank had
shrunk to just 2.07 percent, and Resona Holdings' capital ratio had
fallen to 3.78 percent -- well under the 4 percent required to do
business in the domestic market. At the same time, Resona Bank,
instead of reporting a net profit as originally anticipated, would
report a 1.54-trillion-yen deficit; the red ink at Resona Holdings
would rise from 290 billion yen to 838 billion yen as the bank would
dispose of 1.161 trillion yen of unrealized losses on equity holdings.

The harder line now being taken by Japanese auditors reflects: a)
pressure from the FSA to abide by the Financial Revival Program
guidelines; and b) significant pressure to demonstrate independent and
responsible auditing procedures give the scandals in the US that
resulted in the Sarbanes-Oxley Act and related actions to tighten
corporate governance and to raise the bar for corporate auditors and
lawyers. Indeed, while the major banks had managed to stonewall
official approval for some of Takenaka's more stringent banking reform
proposals, Takenaka was, under the surface, putting more teeth into
the procedures that would serve as the implementation vehicles for
these new measures.

Good Connections No Longer Enough
The CEO of the Resona Group, Yasuhisa Katsuta, came from Daiwa Bank
and was the driving force behind the formation of Resona Holdings,
which consists of Resona Bank, Saitama Resona Bank, Nara Bank, Kinki
Osaka Bank and Resona Trust and Banking; Resona has become Japan's
fifth largest banking group. Katsuta's strategy was to create a "Super
Regional Bank" out of "a coalition of the weak" that would focus on
medium and small-sized companies' financing needs. Because his
strategy fit in well with the government's plan to clean up the
regional banks, particularly those Kansai-based banks, he enjoyed the
support of the financial authorities in these efforts and was well
connected to a broad group of politicians and bureaucrats. But as is
true of the other major banking groups, merely achieving scale by
throwing several companies together under one roof and schmoozing with
key politicians and bureaucrats is not good enough. Resona's "top line
growth" strategy was doomed from the onset because no matter how much
the bank wanted to build its loan book, the demand from industry for
borrowed capital was actually shrinking. Meanwhile, new NPLs continued
to pile up and unrealized losses on equity holdings swelled, creating
structural deficits. In other words, the strategy of improving the
balance sheet through top-line growth was untenable from the onset.

Resona accepted upwards of 2 trillion yen from the government,
ostensibly to set apart the bank's "good" and "bad" debts to be
managed separately and to get the capital ratio back up to around 10
percent. The FSA will assign a management monitoring team to the bank,
while Katsuta and the senior executive officers of Resona Holdings
will be required to resign. Kenji Kawata of Saitama Resona Bank
(considered one of the healthier entities in the group) will become
the new CEO, while a new chairman is expected to be brought in from
outside the company. As for shareholders having to bear some of the
loss, Takenaka has been quoted as saying that "there will be no
capital decrease to have shareholders bear responsibility. This is not
nationalization; it is support with public capital. Dividends will be
determined after a better assessment of the bank's capital condition."

Banking Sector Catharsis?
Now that Resona management has bit the bullet, there are some who may
suggest that this will represent a catharsis that will lift the pall
over the banking sector and Japan's stock market. Money Watch has
heard these claims before, first in 1998 and 1999, and periodically
thereafter, when the banks repeatedly declared that the "bulk" of
their bad loan problems are now behind them. We also heard them again
recently when the banks circled the wagons to oppose Takenaka's
financial revival proposals. But rather than representing a final
solution to save Resona, this new round of public funding is just the
beginning of the survival game. The Resona Group is still considered
one of the weakest of the major seven banking groups in Japan, and it
had already received around 1 trillion yen from the government in two
previous rounds of fund injections, apparently with no lasting
positive effect. Nor is Resona particularly unique with regards to
their shortage of capital. No, giving the banks more capital is not a
final solution. It only serves to bolster public confidence in a shaky
banking system and to buy time for the major banks to clean up their
balance sheet problems -- problems that bank management has been
proven incapable of solving over the past 10 years. It is not, as
Keidanren chairman Okuda insists, "a Resona-specific incident."

Stock market participants will be watching: a) how the Resona
recapitalization works; and b) how it will affect the management of
the other major banks. Over the short term, it is likely to add
downward pressure to stock prices as everyone re-examines the capital
adequacy ratios of the major banks, which are very thin in real terms.
It was only recently that market participants were speculating about
the financial health of Mizuho Financial Group and UFJ Holdings for
the same reasons. Over the medium term, the Resona "shock" is positive
only if it is perceived that it represents the beginning of a
full-scale cleanup of bank balance sheets.

Resona's failed strategy of trying to grow the top line first and
clean up its balance sheet second also reflects the current debate
under way about how to eradicate deflation. That is, should government
policy focus on reforms first, then reflation (the "pain before gain"
camp) or on asset reflation first then reform (the "gain before pain"
camp)? Money Watch believes that restoring sound bank capital ratios
and stabilizing the financial system (through proactive, preventive
capital infusions and related policies) will not only remove the
immediate risk of a financial crisis, it will also work to help
alleviate deflation and indeed work to prevent the deflation spiral so
feared by all as the precursor to a major depression.

-- Darrel Whitten

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Written by Darrel Whitten

Edited by J@pan Inc staff (


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