Masao Nishimura, IBJ: Japan’s new leviathans

IBJ’s Nishimura has a revolutionary idea

Fuji’s plan: first restructure, then expand

In June 1989, at the height of the Japanese asset price bubble, Euromoney celebrated its 20th birthday. It accompanied this landmark with a series of predictions about the state of the financial markets in 1999. One that has seemed laughable for many of the intervening years was that Japanese banks would dominate the global banking industry. Under the headline, “the $604 billion bank”, we listed the keiretsu groupings of Sumitomo, Mitsubishi, Fuji and Dai-Ichi Kangyo, and argued that these groups would consolidate their many banking, leasing, insurance and asset management activities to become global financial hypermarkets.

For a time, Japanese banks did indeed top our rankings of the world’s largest banks, at least by assets; in 1992 the top four were Sumitomo, DKB, Fuji and Sanwa. But they missed the great revolutions in disintermediation, in derivatives and risk management and in information technology that allowed their US, and to a lesser extent some European, competitors to claim the spoils that come with true global universal banking. To be fair, they also lacked the direct and indirect government help that bailed out a number of their key international rivals.

In this June’s ranking, on Euromoney’s 30th anniversary, Japan’s banks were still large in terms of assets, but small in terms of just about everything else. Dwarfed in shareholders’ equity by US giants such as Citigroup and Bank of America and by Europeans including Deutsche Bank and UBS, by then the Japanese were in the throes of crisis. Fuji, Sanwa, Sakura, Sumitomo, Bank of Tokyo Mitsubishi and DKB had negative returns on assets and most had had to accept recapitalization assistance from the government.

In the meantime the country’s once great securities houses had also been laid low: Yamaichi, bankrupt; Nikko effectively an arm of Citigroup; Daiwa forced back to its home markets and explicitly tied to its keiretsu parent Sumitomo, and Nomura, once one of the world’s most profitable companies, now a multi-billion dollar loss maker forced into alliances with IBJ.

However, like all predictions, ours simply required a little flexibility on timing. The announcement on August 20 that Dai-Ichi Kangyo, Fuji and Industrial Bank of Japan were to merge in 2002 will create the world’s largest bank by assets. Its asset base of ¥158.2 trillion ($1.46 trillion) will make it more than twice as large as our putative $604 billion bank. It will have a market capitalization of around $64 billion – three times the size of the bank we envisaged. And, most significantly, will have the lowest operating expenses of its international peers and operating profits of ¥2 trillion – more than those of investors’ darling Chase Manhattan (see table).

The announcement has already triggered more consolidation: in October Sumitomo and Sakura announced that they too plan to merge in 2002 creating the world’s second largest bank, with assets of ¥98.7 trillion. Asahi and Tokai are also to join forces. Other deals will surely follow.

The reasons the banks give for the mergers are unsurprising: the need to invest more in information technology than one bank can afford; foreign competition following Japan’s so-called Big Bang; the drive for economies of scale in retail banking and the need to increase capital strength in the wake of the bad debt crisis that has forced all the major players into the arms of the government except Bank of Tokyo Mitsubishi.

However the speed with which the deals were done is surprising and reflects a dramatic change in the attitude of both the Japanese authorities and the banks’ own management. Euromoney visited Tokyo in August just days before the first merger announcement. At that time the senior management of Fuji bank had just returned from a series of international roadshows designed to show off how well the bank’s own restructuring plan was going. The bank’s capital position had strengthened; it had made substantial progress in addressing problem loans at both Fuji and affiliate Yasuda Trust; the unrealized gain/loss position on the bank’s securities portfolio had moved dramatically and favourably; and Yasuda Trust was to be consolidated as a Fuji subsidiary via a ¥300 billion capital injection. The bank had also only just formed Dai-Ichi Kangyo Fuji Trust & Banking, a joint venture with DKB. At IBJ, the talk was of the series of joint ventures with Nomura and Dai-Ichi Life that had been the core of the bank’s strategy for the previous several months.

But at the same time as Fuji’s chief of investor relations was pointing out how much smaller its problem loan portfolio was than DKB’s, just four key figures – according to Fuji president Yamamoto – had shaken hands on a deal that would make all the banks’ old plans irrelevant. The Sakura-Sumitomo deal seems to have been done as quickly and secretly. Sumitomo had scarcely dried the ink on an agreement to joint venture with Daiwa Securities when president Yoshifumi Nishikawa bumped into Akishige Okada, his opposite number at Sakura and mentioned the possibility of a tie-up. One meeting later the deal was done.

So what will the world’s largest bank look like and what will it do? According to IBJ president Nishimura, the bank aims to establish a global top-five position in banking, to maximize “corporate” (that is, apparently, “shareholder”) value, and to reorganize as Japan’s first true universal banking institution.

At first sight, the banks are a good fit. IBJ was long regarded as the country’s premier banking institution and is Japan’s largest wholesale lender. However, disintermediation and the lack of a retail presence had damaged the bank’s position and forced it to seek joint ventures with Nomura Securities to expand its investment banking, asset management and derivatives operations and with Dai-Ichi Mutual Life to gain access to a national branch network.

DKB on the other hand is one of the country’s largest retail institutions. It is the only bank to have branches in every prefecture in Japan and has a network of around 380 branches that are visited by approximately 815,000 customers a day. Add Fuji’s 290 domestic branches and the new institution has more than enough bricks and mortar to satisfy national retail demand. Only the merged Sakura/Sumitomo will have more.

Before the Sakura/Sumitomo tie-up, the new bank was looking to be top in deposits, loans, housing loans, foreign exchange and ATMs, ahead of either Bank of Tokyo Mitsubishi or Sakura. Even after the second merger, which creates an entity that is domestically similar in size, DKB-IBJ-Fuji will still be a formidable domestic player. It will be main bank to 32% of all listed companies, top lender in 29 of 31 industries, biggest underwriter of bonds and biggest player in the OTC bond markets. It would also on today’s figures be the third largest stock broker on the Tokyo Stock Exchange.

However, for all their domestic size, internationally the new institutions will be minnows. Before the mergers were announced all the banks involved were withdrawing from international business, both by volume of foreign lending and also in terms of their foreign networks. The most consistent theme in Japanese financial services is a desire to repel foreign competitors and consolidate domestic operations. Generating new international business is not a high priority. That said, Fuji and IBJ do have expertise in one or two specialist niches: IBJ is the world’s leading bank for copper projects and is also key relationship bank to the world’s oil industry. Fuji is a leader in US energy financing.

Central to the realization of these domestic aims is the – for Japan – revolutionary nature of the consolidation that is proposed.

Revolution number one: the operations of the three banks will be re-organized and run along business lines. To any non-Japanese observer there still seem too many, overlapping units – consumer banking, small and mid-size customer banking, corporate banking, public sector banking, international banking – but the fact that these units will cut across the old DKB-Fuji-IBJ organizations is revolutionary and marks a significant departure from previous banking practice in Japan.

Revolution number two: the final structure of the bank, to be in place by spring 2002, will be a holding company overseeing three separate units, again divided along business lines: the customer and consumer bank, the corporate bank and the investment banking and wholesale securities unit. Inside these new units will be rolled up all the many different banking subsidiaries and affiliates that in the past had their own separate identities and operations. No Japanese banks have ever been run in this way before.

Revolution number three: senior management admits that previous mergers in Japan have been mergers in name only. Instead of the ruthless cost cutting that has accompanied US mergers – in which anything up to 40% of the staff of the acquired bank has been made redundant – Japanese banks simply left in place the overlapping departments created by mergers. The need to rotate senior management posts between staff from each of the merged entities, all of which clung to their pre-merger corporate cultures, further undermined any advantages that could have been gained through the tie-ups. This time, say the top three, the lessons of the past will be learnt.

Indeed, so aggressive are the plans for cost cutting that analysts – in particular James Fiorillo at Barings in Tokyo – have criticized the merger proposals for being too ambitious. However, the banks have already had experience of downsizing: the restructuring plans submitted by, for example, Fuji to the Financial Restructuring Commission, contain substantial cuts in personnel expenses. The DKB-IBJ-Fuji merger will mean the loss of at least 6,000 jobs, a reduction in costs of ¥100 billion and a reduction in branch numbers of around 150.

Even if management is committed to these plans, success will be a long time coming. The new institutions will not be legally possible until 2002 because changes are required to both the tax code and to company law. This leaves at least two years in which the merger process could falter. Ironically the most likely reason for this would be an upturn in the banks’ fortunes. Japan’s banks were forced into the credit derivatives and CLO market by their balance sheet problems. Instead of seeing this as an opportunity to restructure their balance sheets, they simply engaged in an asset firesale and as soon as the government provided fresh capital, the restructuring stopped. If the economy and stock market recovers, it is conceivable that these proud institutions – IBJ was until very recently committed to independence and Sakura has been humbled by its rescue – will back away from the deals.

There are other issues. In the case of DKB-Fuji-IBJ the cost savings are planned over five years. This is hardly the speed at which the big US deals were done. Also, there is no precedent for a successful three-way merger of this sort. The one similar deal, in France, fell apart before it could be tried. However, the speed with which Citigroup, Bank of America and BancOne swallowed large institutions suggests that, with the right management, a three-way union is possible.

Can leopards change their spots?

Another risk is that Japanese banks have become accustomed to poor disclosure, to low-margin businesses and to low standards in information technology and risk management. As a spokesperson for one of the merging banks admits: “European investors were very sceptical about the deal because they have been burned before: banks told them they had fully disclosed bad loans, and then more were disclosed.” So can the banks be trusted to change their culture particularly if the economic environment improves?

And there is a significant risk in the timing of these deals. The US merger boom took place at a time when the banks were already fast recovering from their bad debt crises. The emerging-market debt, real estate and savings and loans crises were behind them; the banks were profitable; asset quality had stabilized and the market was growing. In Japan, the situation is almost exactly the opposite. Asset quality is still deteriorating, banking is not very profitable – Japanese banks’ net interest margin is around 1.5% versus 3.3% and their pre-provision income to risk-weighted assets is just 65 basis points versus 280bp in the US, and Japanese banks’ capital position is weak. Given their overwhelming reliance on very low margin loan business, it is hard to see how these banks – merged or not – will be able to generate sufficient profits to boost their capital bases. If the banks raise loan pricing too fast, their good customers will move to the bond markets. If interest rates rise too fast, their corporate loan portfolios will deteriorate further. If they try to raise prices by shrinking their loan portfolios they will exacerbate the recession. It is hard to see a way out for management.

And because of the structure of the Japanese economy, corporations’ reliance on bank lending, and so in turn banks’ reliance on the loan business, makes comparisons with the US banking industry of the early 1990s difficult.

Japan’s banks get 80% or more of their revenue from net interest income. Their value-added retail business, their putative new investment banking business and the other new sources of revenue they expect to create would have to be huge to significantly alter their business mix.

The banks will also find it difficult to turn retail banking into the cash cow that UK and US institutions have created. Although Japanese banks do not charge for many basic services that are important profit sources for US and UK banks, very low yen interest rates mean that imposing charges would be difficult: after charges, customers would suffer a negative spread on their accounts.

Corporate reforms more profound

Perhaps the most significant aspect of the mergers is where Euromoney’s prediction was most incorrect. In 1989 we believed that the new leviathans would coalesce around the keiretsu and that, by implication, these groupings would still be flourishing 10 years on. The new mergers cross over old keiretsu lines and may hasten the dismantling of the web of corporate cross-shareholdings that has dictated the relationship between banks and their customers for the past 50 years. Firstly, the new bank will own more than the regulatory limit in a number of corporations and will be forced to sell stakes. Second, with multiple keiretsu “parents” rolled up inside a single, new merged bank, the impediments to restructuring are dramatically reduced. One effect already noticeable in the bond markets is that the spreads of lower-rated corporations owned by merging banks are rising: the market is taking the view that the new banks will be less inclined to continue lending to their problem relations at traditional levels.

If that is true, then the real importance of the bank mergers may not be in the restructuring of the troubled financial sector itself, but in the loosening of the ties that for years secured but more recently strangled the entire Japanese economy.