Foreign banks are expected to be big winners from the reforms sweeping Japan’s financial sector. This is not least because they are reckoned to be more adaptable than Japanese firms because of their experience of other deregulated markets and more flexible cost structures. “It is very easy for foreign financial institutions to make money in Japan,” says UBS Securities senior analyst Yukiko Ohara. “They are much more focused on return ratios, on getting value from unprofitable clients, and they have the technology to survey and maximize their profitability.”
Certainly there are signs of an upturn of interest in Japan from foreign institutions after almost a decade in which the trend has been towards withdrawal. One indicator of this is an increase in the number of foreign bankers employed in Japan.
Even firms which had previously written Japan off are swallowing their pride and rethinking their strategies. In January, for example, County NatWest repurchased membership of the Tokyo Stock Exchange (TSE), having abandoned it less than four years earlier. After bottoming out in 1995, the price of seats on the TSE has risen sharply. “Japan is flavour of the month again,” says Jacques d’Estais, general manager of Paribas Capital Markets’ Tokyo branch.
Foreign companies’ confidence is fortified by the limited adjustments being made by their Japanese rivals. Nevertheless, some Japanese firms are developing strategies to deal with the challenges and opportunities posed by the changes, which include gradual deregulation of commissions and the dismantling of long-standing barriers to the types of business they are allowed to do.
Spokesmen for a few Japanese commercial banks are for the first time beginning to sound convincing on the adoption of business strategies solidly based on return on equity. And a steady stream of announcements of joint ventures and wide-ranging partnerships between foreign and Japanese institutions suggests the imminent infusion of international expertise in ways previously unimaginable. One persistent rumour even has it that Merrill Lynch will merge with or take over Yamaichi Securities, although both parties have denied this.
However, while the big four Japanese securities houses may have the depth and resources to cope with the new environment, to many observers they seem too bogged down with past problems to make any rapid response. Most commercial and trust banks are still distracted by the aftermath of the collapsed bubble economy. Even the strongest banks, which have arguably been earmarked by the ministry of finance (MoF) as the vanguard of a new elite developing universal banking, are expected to face cultural problems in making a rapid adjustment. For smaller broking houses, the position is even bleaker. “Middle-sized firms have not made any downsizing or cost-cutting,” says Brian Waterhouse, senior analyst of Japanese financial institutions, at HSBC James Capel.
“There are going to be many losers and a small number of winners as far as the intermediaries are concerned,” says Keiichi Mitake, director of capital markets at Yamaichi Securities. Which institutions fall into which categories will depend on a number of factors.
Foreign banks will need to find enough new niches to justify their expansion in Japan, and Japanese firms will face even more complicated strategic decisions involving the abandonment of cherished cultural practices.
Only two groups are assured of a profitable return from the coming battle for position in Japan: those that supply the hardware needed to underpin a technological revolution in Japanese financial markets and those individuals whose skills will be in high demand as a result of deregulation.
The former group are the designers and marketers of the computer and communications equipment that Japanese institutions admit they desperately need to put an end to shuffling piles of manually-processed paperwork between rows of computerless desks crammed into open-plan offices.
The highly mobile individuals with trading, technical and marketing skills in the business areas that will grow as a result of deregulation are already on the move in Japan. “Whole teams will be up for sale, even if you don’t see the level of disloyalty you get in Europe or the US,” says Capel’s Waterhouse.
Meanwhile, lingering doubts remain about the speed of implementation of the reforms. Many of the proposed changes require passage through the diet (legislature) over the next couple of years. Reforms such as the abolition of securities transfer tax that require input from the tax bureau may face delays. “The bureau does not understand the business, but they are smart enough to know they are missing tax. The danger is that they may be overzealous,” says an investment banker.
Bankers also fear that MoF officials, who witnessed the dramatic decline in the retirement prospects of their counterparts in the ministry of trade and industry when its interventionist role was reduced, may obstruct reforms that might similarly diminish their role. The proposed remedy for such intransigence is to build a new less regulatory culture at the MoF centred on consumer protection.
Some observers base their confidence in the success of “reform” on the fact that it has become such a buzzword in Japan that it has acquired its own zoku, or tribe of supporters. Goldman Sachs’s Ishihara believes this may be over-optimistic and doubts there will be much pressure for further change to the financial markets other than from foreign firms.
However, it does seem that regulation is not going to be replaced with a cartelized business-as-usual approach. Indeed domestic firms may even lead the way towards a more competitve market. For example, commissions on over-the-counter stocks, which until recently were controlled by informal “administrative guidance”, have lately been transformed by the initiative of a small Tokyo broker, Matsui and Co, which cut its rates to half those charged under previous consensus scales. Competitors claimed that Matsui would be unable to make a profit on such trades. However, Paribas soon trumped Matsui by making a further 20% reduction on the old scale.
Despite criticism – even from Matsui – the move, according to d’Estais at Paribas, has been successful: “Volumes have increased a great deal,” he says. “Despite the cuts, total commissions are now higher than they were.” As a relatively new player in the listed equity market, Paribas also has a modern low-cost back office, so the increased business adds little marginal cost and is profitable, he says.
D’Estais believes that Paribas’s experience indicates that there is scope for US-style discount broking in Japan, a view shared by many other foreign investment bankers. US broker Fidelity has already obtained a licence which is expected to be used for this purpose. There is speculation that Charles Schwaab will follow. However d’Estais cautions against drawing too many parallels between the OTC market and the impending staggered deregulation of listed-equity commissions. Paribas’s willingness to cut rates reflected its low cost structure and the fact that it, like other participants in the market, provides an execution-only service with no research for OTC stocks. “For listed companies we will expect people to pay for research,” he insists.
Despite the attention that has been paid it, the deregulation of brokerage on trades of more than ¥50 million ($420,000), due to be implemented in April 1998, will probably be a phoney war. “People may be making more out of the freeing-up than they should because many of the big domestic institutions are already achieving discounted transactions offshore,” says a foreign investment banker.
Another foreign banker reckons institutional rates could fall to as low as seven to 10 basis points, in line with what is already paid by prime clients dealing offshore. Hiroyuki Yoshimura, general manager of corporate planning at Daiwa Securities, notes that commission on trades above ¥1 billion, which are already negotiable, now averages “almost zero”.
“The major domestic players could provide agency broking to institutions at virtually zero cost, wait for the destruction to take place and emerge from the bunker in a few years’ time and have the market to themselves,” says Andrew Simmonds, president of BZW Securities (Japan). In these circumstances institutional broking turns into a balance-sheet management, execution and market-making business, says Michael Bodson, managing director of Morgan Stanley Japan. “We know how to deal with that sort of environment when it becomes ludicrous. You have to manage the business on a portfolio basis. The question is, can the Japanese?”
Not too well, appears to be the answer – even without the impact of deregulation. “Very few integrated operations can be making money,” says Capel’s Waterhouse. He believes that one remedy Japanese brokers will have to adopt is more proprietary trading. Another possibility raised by Yamaichi’s Mitake – one that only a few years ago would have been heresy from any of the big four brokers – is that firms like his may decide to withdraw from businesses that have little long-term prospect of profitability.
In the new environment little intervention is expected from the MoF if some smaller brokers collapse, as long as this doesn’t affect systemic stability. “The impact of a small securities house failing is not going to be that large. I think the regulators are quite sanguine,” says BZW’s Simmonds.
Failures or enforced mergers are most likely if discount brokers fight for a significant share of the retail brokerage market. Retail only accounts for 30% of equity turnover but contributes at least 50% of equity commission income even at the big four Japanese houses, and substantially more at small and medium-sized firms.
According to the Big Bang timetable, retail brokerage rates will become negotiable from March 2000. In practice change is expected sooner, probably around October 1999. Most bankers expect that as a consequence there will be an increase in trading, but none of those interviewed expected an immediate compensatory lift for the expected halving of average commission income to 0.4% or lower. “You could see sustained 20% growth in turnover for five years,” says Morgan Stanley’s Bodson, and his is one of the more optimistic estimates.
Since the revenue side of broking is inherently unpredictable, Japanese brokers will have to focus on costs. “We believe the liberalization of commissions will seriously affect securities company profitability if they fail to adjust their operations,” says Japan Bond Research Institute director Yoshio Kubo.
By international standards brokers’ costs look high – from their operations on the Tokyo Stock Exchange, through the structure of their sales forces’ remuneration, to back office and settlement. Their ability to get costs under control will be the single biggest factor in the profitability of foreign operators, which already have the advantage of lower costs.
The most striking aspect of inflexibility in Japanese securities operations is the salary-based remuneration for equity salesmen. “There is still a reluctance to hire commission-only salesmen,” says Ikuo Nakajima, general manager of Tokai Maruman Securities. “The number has in fact been declining.” Getting rid of staff is not getting much easier either, especially for Japanese firms. “To reduce costs through head count will take quite a few years,” says Yamaichi director Keiichi Mitake.
The TSE’s own operations are technologically light years behind most markets. Reform will be needed to reduce leakage from on-market trading when off-exchange trading of listed securities is allowed early next year. Big savings will be needed if Japanese exchanges are to win back much of the turnover in selected Japanese stocks on, for example, London’s Seaq International, which alone is estimated at 30% of the total.
The top 150 stocks are still traded by open outcry but even the remainder are only nominally screen-traded, since they have to be executed via manual input by operators in the TSE head office. Questioned on why the terminals in brokers’ offices could not be used to post bids and offers directly on the system, TSE executives find themselves stalled at the problem of what to do with the redundant staff this would cause.
The TSE is also pessimistic about prospects for changes to clearing and settlement. “Ideally we would like to change the law to abolish paper and we would like to move to T+1 settlement,” Yoshiaki Kaneko, senior managing director at the TSE, says wistfully. But he admits the TSE’s electronic settlement system is still used for just 30% of trades five years after coming into full operation.
But if pure agency broking to institutions looks set to become as unprofitable in Japan as it is in most other markets, where do foreign securities companies expect to make money? Besides proprietary trading and market-making most highlight two areas: investment banking – including M&A – and fund management.
Both show some promise. Although it is still an uphill struggle getting Japanese firms to pay for corporate advice – and still harder to get them to take heed of it – many investment bankers claim there are signs that companies are beginning to appreciate the independence and overseas experience of big foreign firms.
Foreign firms expect to increase their share of capital raisings. Ten years ago issuers and investors ridiculed independent ratings agency Mikuni & Co for suggesting to issuers that varying credits should be priced differently, says Mikuni manager Mariko Kodama. Now, since the same people are coming back to the agency to take out subscriptions, foreign investment bankers expect to have an edge in a market where increasing differentiation will get a further fillip from the final removal of regulated issue standards.
In fund management the recent breakthrough of foreign firms in both wholesale and retail business is quite striking. According to George Curuby of fund management consultant Curuby and Co, a further sharp increase can be expected when past poor returns force Japan to switch to defined-contribution pension schemes rather than the present drastically underfunded defined-benefit schemes. In addition to the many foreign fund managers already based in Tokyo many more are rumoured to be carrying out new feasibility studies including Wellington, Vanguard, Dreyfuss and State Street.
Many of the new relationships being unveiled between foreign and local partners have capital-markets and/or fund-management business in mind. The tie-up between SBC Warburg and Long Term Credit Bank is unlikely to be the last such transaction. It is also seen as a significant step forward from previous tie-ups such as Barclays with Takugin and Bankers Trust with Nippon Credit Bank.
The deal envisages each institution taking a 3% cross-shareholding, and the immediate establishment of Japanese joint ventures in asset management and private banking. By early 1998 the two organizations will have merged their LTCB Securities and SBC Warburg operations in Japan to create a new investment bank. LTCB is also expected to trim its costs overseas through the relationship and SBC hopes for access to LTCB’s Japanese corporate client base. UBS’s Ohara believes a full merger cannot be ruled out if the relationship solidifies and LTCB’s bad-debt problems are clarified.
“Local attitudes to a Japanese firm being bought by a foreign firm have changed,” says Rob Stein, managing director of Deutsche Morgan Grenfell Capital Markets’ branch in Tokyo. However this doesn’t mean there will be a rush. Due diligence would be one problem, management another. “If a US house was to buy Yamaichi for example, how would they manage it?” says one analyst.
Others believe that despite the denials, Yamaichi’s current weakness does make it a candidate for a merger and that such a deal could be interesting. “Some of the 30-to-40-year-old Japanese staff at the big four are very disillusioned with the way business has been done and might welcome the change,” says a senior investment banker. Ultimately any deal would have to be relatively friendly. “If Yamaichi is to be involved in a merger it has to be positive for both sides,” says a Yamaichi insider, who believes that a merger is unlikely, but that if it should happen Credit Suisse First Boston is a more likely partner
Overall, however, there is a shortage of attractive partners. “Other than Kokusai, the second tier [of securities companies] are all ugly sisters,” says a foreign broker. There is undoubted interest in Kokusai. However its largest shareholder is Nomura and commentators are divided on whether Nomura would allow another firm to take control of it.
If mergers rather than joint ventures are the preferred route, cost factors may prove a hindrance. Kokusai has a market capitalization of around $2.5 billion. On the other hand Yamaichi’s capitalization has now fallen to around $3 billion – still about five times book value – but a level at which buyers taking a long-term view might be tempted. “Japanese financial companies are expensive on an international comparative basis, but not expensive in local terms against historical levels,” says a senior western investment banker.
An alternative tack for foreign houses, especially those with fund-management ambitions, may be to tie up with trust banks. In late September, for example, Citibank and Sumitomo Trust Bank announced plans to develop a joint investment product to be sold through the Japanese bank’s network. However commentators are divided on the wisdom of such a strategy, with several pointing out that in its deal with LTCB, SBC Warburg effectively cut its long-standing ties with one of the better regarded trust banks, Yasuda. “You don’t want the trust banks,” argues JP Morgan economist Jesper Koll. “No asset manager needs the expertise of a Japanese trust bank and relationships are not the issue as foreign fund managers are getting the business already.”
According to Shinji Okabe, senior vice-president at Moody’s Japan, the tip for foreigners looking for partners is not to set their sights too low. “Even the stronger players will look for alliances with foreign institutions,” he suggests.
Meanwhile one global bonus is to be expected for non-Japanese firms: a reduced presence of Japanese firms in overseas markets – and by extension reduced predatory pricing by them. “A substantial number of Japanese financial institutions will need to withdraw from foreign markets,” predicts Yamaichi’s Mitake. “There will only be five or six Japanese banks and five or six Japanese securities companies offshore.”
