Japan: A game of catch-up

Daiwa Securities has gone through an irritating few months. When the $1 billion bond-trading loss at Daiwa Bank’s New York branch became public in October, the securities firm began to feel the repercussions too. But the two firms are not in any way connected. In fact, Daiwa Bank used to be a part of, and is still close to, Nomura, Daiwa Securities’ greatest rival.

In London, Daiwa Securities’ officials had to chase away cameramen from the BBC mistakingly camped outside the firm’s eye-catching building in King William Street. One senior executive of Daiwa Securities recalls that he received many letters from business contacts commiserating with him on the scandal. “I don’t know how to respond,” he laments. “If I write back, these people will be so embarrassed they’ll never do business with me again.”

Such annoyances aside, Daiwa Securities has every reason to feel pleased with its progress over the past 12 months. Profits from the London operation reached £9.4 million ($15 million) in the April-to-September half-year, according to figures published by the Nihon Keizai Shimbun newspaper. Says Alex Monnas, deputy chief executive of Daiwa Europe: “Over the past five years, we have slowly been building a portfolio of enduring businesses in London. We haven’t completed the process yet, but the development has finally started to pay off in terms of profitability.” In New York, too, Daiwa has been more consistently profitable than the other three big Japanese securities firms [see table at end of article].

Indeed, all the big four firms had a decent year in international business in 1995. Nomura and Daiwa remained in the top 10 of Eurobond lead managers. Nomura was up two places to fourth; Daiwa rose one place to seventh. Even Yamaichi – virtually ruled out of contention for major international mandates a few months ago – rose to 17th place on the back of a $2 billion deal for Sweden at the beginning of December.

The Japanese have made inroads in other areas, too. Nomura achieved a number of breakthrough deals that suggested, almost for the first time, that it is capable of winning major non-Japan related business. In the UK, for example, it was part of the GRS Holding consortium that bought one of the rolling-stock leasing companies sold by the government. Nomura provided the debt for the deal, and will eventually securitize the lease receivables. In Vietnam, it is financing an industrial zone in Haiphong. It monopolizes the lead managing of bond issues by Baltic states: it brought the debut issues of both Latvia and Lithuania in 1995, and is rumoured to be planning a Deutschmark issue for the Estonian capital Tallinn in January.

The securities houses’ greatest successes this year, however, have come from selling large bond issues into Japan. With bank deposit rates in Japan little over 1%, Japanese retail investors discovered in early summer that they could make better returns, with little extra risk, by buying sovereign Euroyen bonds. By the autumn, investors were becoming more adventurous, buying Eurodollar and Euro-Australian dollar paper.

Suddenly, the Japanese securities houses had a bonanza on their hands. They were able to provide the cheapest funding available in the market to many of the world’s largest borrowers. Consequently, Daiwa and Nomura jointly led a ¥550 billion (then worth $6.3 billion) three-tranche Euroyen deal for Italy in May – the largest-ever Eurobond. In October, Daiwa again brought Italy to market for $1.5 billion in dollars, reflecting the shift in Japanese investors’ preferences. In May Nomura was the first to reintroduce Brazil to the market after January’s turbulence in Latin America. Nikko’s highlight was probably a ¥100 billion deal for Argentina in August.

The Japanese know this windfall won’t go on for ever, but they are prepared to enjoy it while it lasts. Says Monnas: “We don’t see an early end [to retail-targeted issues]. But we are not budgeting, or basing our medium-term strategy, on this lasting very long.” Although there is no sign of interest rates rising in Japan, redemptions in 1996 will not be as large as last year. Redemptions of all personal assets by individuals are predicted to total ¥35 trillion in the first quarter and ¥32 trillion in the second, according to estimates by the Yamaichi Research Institute. Those are still large figures, but well down on the ¥50.4 trillion in the last three months of 1995.

Indeed, there are signs that selling Eurobonds into Japan is already getting harder. Daiwa’s Italy dollar deal saw a lot of flowback a month after placement, as investors sold to take advantage of the capital gain they had obtained from the sudden fall in the yen. In December, the Nihon Kinyu Shimbun, an influential trade newspaper, reported that the sales staff of the securities houses were up in arms at having to sell excessive amounts of bonds from high-risk sovereign issuers to retail investors. The paper quoted one broker as saying: “Some individuals do not even know that the value of bonds changes as a result of price fluctuation … Some countermeasures must be taken against possible trouble with individuals.”

Masashi Kaneko, co-chairman of Nikko Europe, agrees that the Japan-targeted deals have got too big. Between $200 million and $1 billion is the ideal size, he suggests. “It behoves all of us to do the right issues for the right borrowers at the right price,” he argues.

But these are the niggles that come from success. In general, business for the Japanese houses is in far better shape than 12 months ago. When Hitoshi Tonomura, head of Nomura’s international business, was brought back to London by the firm in April to shake up the European operation (he had headed London in the 1980s), he found an institution in disarray. “My reaction was that we had a lot of talented people not well organized,” he recalls. “There was a lack of communication. Everything had gone wrong.”

Nomura suffered from high overheads (partly because of its palatial building near St Paul’s Cathedral), little focus and poor morale. Since then, Tonomura has reduced staff in London from 700 to 600 (and throughout Europe from 1,500 to 1,200). He has cut fixed overhead by 16%, and begun linking pay more closely to performance. He says there is “a little bit more room for rationalization in continental Europe” where he “may close one or two offices”.

But Tonomura’s most dramatic move was to pull out of market-making in French government bonds and UK gilts (markets that his Japanese competitors are still in). “We wanted to show clear lines of focus,” says Tonomura. “We got rid of businesses where we thought we couldn’t exercise our advantage. When we joined the gilt market, we thought it would be an important way into the Eurobond market. But it turned out not to be.”

Reassessment

The other securities houses, except Nikko, have been pruning too. At Daiwa, Monnas says his budget last year was 12% less than in 1994 – and he came in 2.5% under it. At Yamaichi in London, new chief executive Kenkichi Nakajima has even been sending expatriate Japanese staff back to Tokyo. The number of Japanese staff in London has fallen from 40 to 32 in six months.

But the Japanese did not react to their difficulties merely by cutting costs. All four firms have gone through a process of reassessing their fundamental strategies. And all four have come to roughly similar conclusions. First, that they should not rely purely on Japan-related business, because this has always shown a tendency to dry up just as they came to depend on it. Second, that they should leverage off their large capital bases (even Yamaichi, the smallest of the four, has more capital than Morgan Stanley) and do more proprietary trading. Third, that each overseas operation needs to develop its own local independent business lines that are autonomous of Tokyo.

The advantage of last year’s upsurge of Japan-targeted bond issues is that it will give the London operations the breathing space to build up these other businesses. “London has become the main centre for sourcing investment products to supply to clients in Japan,” argues Nikko’s Kaneko. “We intend to reinvest some of the profit from that to strengthen other areas such as bond and equity distribution in Europe and Asia. We have to build on top of the pipeline between Europe and Japan a sustainable local business – that happens most naturally with trading.” With that aim, Nikko recently employed Brian Berry from CS First Boston to be co-head of sales and trading.

Nomura has the most sophisticated trading operation of the four. A team of asset traders led by Simon Fry – also a former CS First Boston employee – has had some success in structuring transactions for on-sale, mainly to banks. After one year’s operation, Tonomura says Fry’s team has “started to make a very good return” – a view echoed by Nomura’s rivals. At Daiwa, Monnas has built up a market-directional proprietary trading operation, but also wants eventually to develop a credit trading business on the same lines as Nomura’s.

It is in New York, however, that proprietary trading plays the greatest role. This is mainly because there is very little other business the Japanese houses can do in the US: there are few underwriting opportunities, and Japanese investors no longer buy treasury bonds in the volumes prevalent in the 1980s. “We have taken a hard look at what we should be doing in the US,” says David Sexton, vice-chairman of Yamaichi International (America). “We recognized that our most significant asset was our big capital base. You have to use the capital aggressively for your own account.”

Yamaichi has followed a policy in the US of poaching teams of traders. In 1994, it brought in a four-man team from Swiss Bank Corporation with a risk-arbitrage strategy in takeover stocks; last year it found a group from Lehman which uses a relative-value approach across a broad spectrum of instruments. “The common thread is that these are analysis-based arbitrage strategies,” says Sexton. “We are not interested in market-direction trading.” After a disastrous year in 1994, Yamaichi just returned to profit in New York last year.

Daiwa has also struggled to find a winning formula for its US operation. “New York is our biggest headache,” admits Yoshio Maruyama, general manager of the international investment banking department of Daiwa Securities in Tokyo. “They can’t do underwriting business, so they need to find new types of business that they can do on their own. We want to make New York an independent house that doesn’t rely on the Japanese head office.” But, he admits, “we haven’t yet found a business that could be the pillar of the US operation.”

But it is not just in trading that Japanese houses want to build. Nomura, in particular, has had some success in entering new investment banking businesses. It has focused on securitization – a business that has almost no synergy with Japan (where securitization is, in practice, prohibited). In New York, Nomura worked with Olympia & York on a securitization of the World Financial Centre. In London, in addition to the rolling-stock lease deal, in August it bought 1,700 pubs from brewers Courage and Grand Metropolitan for £240 million with a view to securitizing the assets.

Now that the securities houses have proved they can win big Eurobond mandates, they want to extend their distribution capabilities beyond Japan. “We really want to sell foreign bonds overseas,” says Hitoshi Ishihara, deputy president of Yamaichi in Tokyo. “London still relies too much on the Japanese market.” Nomura and Daiwa have gone furthest to overcome that reliance on Japan. Nomura’s small December Eurodollar issue for Lithuania was sold predominantly outside Japan, for example. Daiwa also has a good track record with placing paper from issuers such as the National Bank of Hungary to a wide range of investors.

These deals point to a surprising conclusion: emerging markets are becoming the Japanese houses’ strongest niche. While western corporates, for example, see Japanese firms as second-tier players, for Asian and eastern European borrowers, Nomura and the others, with their access to the large Japanese investor base, look at least as prestigious as large US or European investment banks.

The recent spate of Japan-related deals will reinforce that positive image. “We think we’ve built up a good profile with issuers,” says Daiwa’s Monnas. “That’s valuable. It opens the door to other business.” Daiwa’s profile in eastern Europe helped it win a joint lead-manager role with HSBC Markets on the privatization of Poland’s Bank Gdanski last month.

Despite these successes, the Japanese securities houses still lag behind their US and European competitors in many areas. The Japanese are still nowhere in privatization. The Gdanski deal was just about the only leading role (apart from regional lead-managerships) played by any Japanese house in an international equity offering last year. Their derivatives expertise is negligible. Few major western companies deal with them. They don’t touch M&A (apart from the handful of Japan-related deals). In equities, they have a steady business in selling Japanese equities to western institutions, and a tiny business selling US and European equities in Japan – but nothing else.

The wisest Japanese investment bankers recognize that the fundamental problem is management style. Japanese firms have generally failed to promote good foreign executives, and communication between different offices is poor, even non-existent. The Tokyo head office monopolizes decision-making, ceding little power to London or New York.

Tonomura at Nomura in London acknowledges the shortcomings. “I’d like to make some changes to the overall management structure,” he says, “but you have to deal with cultural differences between Japan and the rest of the world.” Some things are moving on. For example, Fry now reports to the head of bonds in Tokyo and not to Tonomura. “This is the first time at Nomura that someone has reported directly to Tokyo,” says Tonomura. The London office, he reports, now cooperates better with New York.

Slowly, too, senior non-Japanese executives are gaining a limited amount of power. Max Chapman, formerly chief executive of Kidder Peabody, is co-chairman of Nomura in New York and, by all accounts, has a certain degree of autonomy. Nikko in London appointed Michel de Carvalho (previously of CS First Boston) as co-chairman, alongside Kaneko, in April last year. De Carvalho says the arrangement is working well: “I have felt a total openness on all matters – even the most sensitive. Personal chemistry is much more important in our business than nationalities.”

So can the Japanese claw their way up into the top tier? Much will depend on how Japanese investors behave. Since 1990, Japanese institutions have been reducing their holdings of foreign securities – these are now about 7% of assets, down from 15% five years ago. But big changes are under way in the pensions market in Japan. New, more adventurous, fund managers are winning business. Returns from domestic investments have been dire. Nikko’s Kaneko, for one, thinks this will spell a big increase in overseas investment over the next five years. “That’s good news for the London, New York and Asian offices of Japanese securities houses,” he argues.

The big hope for the Japanese is that a growing institutional investment base in Japan will allow them to win a range of international investment banking business. “It’s not so different from the situation US investment banks were in five or 10 years ago,” says Kaneko. “They were able to build business in Europe on the back of their natural US investor base. There’s no reason we shouldn’t be able to do the same.”