MW-09 -- More Than Meets the Eye

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

Issue No. 9
Tuesday, December 10, 2002

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Viewpoint: More Than Meets the Eye

The Bottom Line:

o Criticized as being over-hyped, the Financial Revival Program
suffers from being watered down and vague in the end -- an
all-to-familiar result during the Heisei Malaise -- but it
also does appear to have a bite almost as loud as its bark.
The proof is in the reaction it has drawn from the major

o Since the flurry of activity that produced both the Financial
Revival Program and the Industrial Revival Corp., the banks
have suddenly got religion in that there is a renewed sense of
crisis that is pushing them to implement countermeasures,
ostensibly aimed at accelerating NPL disposal.

o MoneyWatch has serious doubts about the effectiveness of the
Industrial Revival Corp. Assuming that the Financial Revival
Program is at least partially effective, while the Industrial
Revival Corp. is not (at least as regards fostering NPL
write-offs and revitalizing "recoverable" firms as opposed to
merely propping up zombie companies) the net result could be
what the opponents of the Financial Revival feared, i.e.,
exacerbated deflation, a rush of bankruptcies and downward
pressure on an already faltering economy. That cannot be good
for stock prices.

o Thus, whether the latest government steps are enough to stave
off yet another March crisis remains to be seen.

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Stocks Go Down, Down, Down and Risks Go Up, Up, Up
From a peak in early 2000 when the Topix barely cleared 1,700 for the
fourth time since 1994, it's been a one-way downhill street for the
Japanese equity market. Ironically, the worst perpetrator of this rout
was not the beleaguered banks, but the evaporation of the growth myth
in Japan's high-tech sector. The worst part of the sell-off in the
banks came later, as the aftermath of Japan's mini bubble pulled
stock prices below the break-even levels of the banks' portfolio
holdings of cross-held securities.

Thus, after narrowly avoiding a March crisis this year, the
government and the banks by October again found themselves between a
rock and a hard place. Responding to claims that his reforms were
largely ineffective, Prime Minister Junichiro Koizumi canned the head
of the Financial Services Agency (FSA), replacing him with Heizo
Takenaka, a fast-rising economist from the private sector who was
already effectively in charge of economic and fiscal policy.

After spooking the stock market and the banks through leaks to the
press of a "no pain, no gain" reform program to force the banks to
accelerate bad loan disposals, Takenaka and the Koizumi administration
announced their "Financial Revival Program" on October 30. Rather than
alleviate investor fears about the viability of bank stocks, the
program only re-accelerated the sell-off in bank stocks, which had
begun following a modest rally as the result of a rash of
announcements in late 1999 that produced the present big four banking

As usual, the flurry of activity and press leaks leading up to the
announcement of the Financial Revival Program built up investor fears
and expectations that the Japanese government was finally moving to
"put the pedal to the metal" on bank reform. The actual release of the
program, as usual, proved anti-climactic. The more onerous proposals
that had been floating around in the press, such as more clearly
defined "management responsibility," stricter treatment of deferred
tax assets and "nationalization" appeared to have been significantly
watered down. Indeed, the announcement itself was delayed at the last
minute, due to strong resistance to certain wording in the program
by the ruling party. Died-in-the-wool reformists were disappointed,
and the Street began to suspect that yet another aggressive reformer
had been shot down by an inbred, entrenched political system that is
jealously guarding against change.

The program was initially criticized as having been "defanged"
because it lacked specificity, which does not mean that it goes easy
on the banks. Every proposed action in the program has significant
implications for the banking industry. Under the new program, the
classification of loans to large borrowers will be standardized
among lenders, the assessment criteria for loans requiring special
attention will be stricter, and a new discounted cash flow (DCF)
valuation method will be introduced for the calculation of loan-loss

Even the time periods assumed (i.e., how many years are considered
when gauging the possibility of irrecoverable debts) will be
extended. Heretofore, loan-loss reserves were made based on a one-year
forward time frame for "normal" loans, and a three-year forward time
frame for "special attention" loans. Moreover, the banks will have to
report the current market value of previous debt-equity swaps and
record any valuation losses that result.

As of the end of fiscal 2001, the major banks had "special attention"
loans of 11.3 trillion yen. With the introduction of discounted cash
flow evaluation, the required loan-loss reserves are expected to be
revised up at least 10 percent and require additional reserves of at
least 1 trillion yen. A lengthening of the time period considered for
irrecoverable debts and the recording of latent losses on debt-equity
swaps could well make this number even larger.

The Work Schedule
The "work schedule" was the FSA's attempt to more clearly define
exactly what it meant in the program and to give an idea of the
implementation time schedule it had in mind. It appears that the
authors of the work schedule learned a valuable lesson about tactics
from the tiff they had with ruling party politicians over the
program. This time they were able to get the "work schedule" out
without any portions of it being seriously tampered with by opposition
politicians. It also became evident through reports about the meetings
the FSA had with bank officials that, at least in the FSA's mind, the
conversion of preferred shares into regular voting shares was
essentially an operational question, not a legal question. Moreover,
the Koizumi administration, through chief cabinet secretary Fukuda,
have signaled that bank nationalizations are a definite option and
legally possible under the provisions of Article 102 of the
Deposit Insurance Corporation Law.

However, the government (particularly financial services minister
Heizo Takenaka) has gone out of its way to allay investor fears that a
bank nationalization would mean investors get left holding bags of
worthless slips of paper that used to be bank stocks. Investors still
remember clearly what happened to the value of stocks held in
Long-Term Credit Bank (revived as Shinsei Bank) and Nippon Credit Bank
(revived as Aozora Bank).

A major uncertainty that remains, however, is just what criteria the
government would use in determining that a bank should be dubbed a
"special support financial institution." Reading through the program
and related documents, one gets the distinct impression that becoming
a "special support financial institution" is something that bank
management would want to avoid at all costs. For one, the FSA promises
to "vigorously" pursue management responsibility. In addition, when
individual financial institutions incur financial difficulties and/or
a shortage of capital, "special support" will be expeditiously
applied. While more details are skimpy, senior vice FSA minister Ito
did indicate that banks would be subject to "special support" when
a) management conditions are such that emergency countermeasures are
required, b) when the bank itself applies for public funding, and
c) when the preferred shares held by the government and converted into
regular voting shares exceed a specific percentage of outstanding

Measures with Bite
The Financial Revival Program, while watered down from initial
proposals, still has plenty of bite regarding the banks. Within this
fiscal year:
A) The FSA has already requested stricter and more reasonable
assessment of deferred tax assets,
B) Harmonization of loan classifications among the banks for
large borrowers will be implemented,
C) Discounted cash flow valuations will be introduced for
calculation of needed loan-loss provisions,
D) Management will be required to verify the accuracy of bank
financial statements, aka the Sarbane Oxley Act in the US.

It remains to be seen whether the FSA and Takenaka can achieve their
goal of reducing the nonperforming loan (NPL) ratio of major banks by
half (it is currently more than 8 percent), or in other words, writing
off by fiscal 2004 over 13 trillion yen of nonperforming loans, which
continue to grow faster than the current pace of NPL liquidation. One
thing is sure, however: Despite virulent resistance and hostility by
the banks to the Financial Revival Program, Takenaka and his program
have their undivided attention now. Yes, if nothing else, the program
is a stern call to action for the banks. This message has apparently
not gone unnoticed by the banks. Since the FSA starting the ball
rolling on the program, there has been a sudden pick-up of activity by
the banks regarding their NPLs and capital ratios.

On December 5, Mizuho Financial Group announced a new reorganization
program under which as much as 5 trillion yen of NPLs will be
separated from banking operations and transferred to a new entity set
up to recover loans and oversee the restructuring of distressed
borrowers. The group now believes that having a single entity to
handle loan collections and borrower restructurings will facilitate
quicker reduction of bad loans.

MoneyWatch's question is, why couldn't the group have initiated this
and other bolder measures when the three-way merger that created
Mizuho Financial was announced?

On December 3, the bank also announced that it was considering a
capital increase in preparation for accelerated NPL disposals that
would likely push its capital ratio below the required 8 percent. It
will be holding an emergency shareholders' meeting in February,
apparently because it cannot wait until the June regular shareholders'
meeting to get approval to issue capital.

Also on December 5, Sumitomo Mitsui Financial (SMF) announced that it
is considering acquiring Aozora Bank. What SMF is really after is a
means to bolster its equity capital ratio, as Aozora's core equity
capital ratio is 12.7 percent, while SMF's is more like 5.3. Thus
purchasing Aozora would boost SMF's capital ratio by some 0.5
percentage points.

On November 25, UFJ Bank announced that it would be forming a new
company within the fiscal year into which 1 trillion yen of NPLs of
small- and medium-sized companies would be transferred. Since the
new company will be a subsidiary of UFJ and be reflected in
consolidated accounts, the issuance of preferred stock will work to
boost the bank's regulatory capital ratio.

On November 22, the Nikkei reported that major banks were stepping up
efforts to secure sufficient funds for the fiscal year-end in March of
next year. A handful of major banks are reportedly rushing to obtain
funds for the fiscal year-end and apparently raised their offered
rates in order to secure the money. The financial institutions are
rushing to secure funds "because we cannot shake off our broad
concerns about how depositors may respond" to a possible financial
crisis toward the fiscal year-end, according to an official at a major

It is apparent that the Financial Revival Program and plunging
values in bank stocks have jolted the banks into responding,
albeit incrementally. But whether this is enough to stave off yet
another March crisis remains to be seen. Moreover, assuming that the
Financial Revival Program is at least partially effective, while the
Industrial Revival Corp. is not (at least as regards fostering NPL
write-offs and revitalizing "recoverable" firms as opposed to merely
propping up zombie companies) the net result could be what the
opponents of the Financial Revival Program feared, i.e., exacerbated
deflation, a rush of bankruptcies and downward pressure on an already
faltering economy. That cannot be good for stock prices.

-- Darrel Whitten

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