Can Japan’s megabanks ignore the devil's whisper?


Lawrence White
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As their peers in Europe and the US struggle to adjust to the world post sub-prime, Japan’s megabanks find themselves in the glow of unaccustomed financial health. But how do they put their new-found advantage to best use? And can they ignore the demons that caused such huge mistakes in the past?

The CEOs speak out: Mitsubishi UFJ Financial Group
The CEOs speak out: Sumitomo Mitsui Financial Group
The CEOs speak out: Mizuho Corporate Bank

Teisuke Kitayama SMBC,
Terunobu Maeda Mizuho and
Nobuo Kuroyanagi MUFG
YASUMASA GOMI, CHAIRMAN and chief executive of Mitsubishi UFJ Securities, shares a laugh with colleague Tsutomu "Tom" Tanaka, a senior managing director graciously on translation duties for his boss, when Euromoney visits. They have a reason to be upbeat, despite the fact that the Japanese megabank they work for has once again missed out on the latest market fad by being too cautious. In a meeting room situated high in the Maronouchi building, itself perched between Tokyo Station and the Imperial Palace on some of the city’s most expensive real estate, Gomi sits back expectantly.

Tanaka translates: "Suddenly the whole world seems to be having a party, and Japan was the only country not invited."

For once this lack of involvement is cause for celebration: it might be more through conservative management than brilliant foresight that the Japanese banks have escaped the worst of the sub-prime crisis but they nonetheless find themselves in a strong position for the first time in more than a decade. Like a group of lost speleologists emerging after years underground, they have come blinking into the daylight to find a world that is much changed. Once-strong Wall Street names are shedding their superstar bosses as the scale of their own bad investments becomes clear; meanwhile the Japanese banks were underground patiently looking for a way out and more or less missed the whole fiasco.

As if on cue, Mizuho Corporate bank, itself the grateful recipient of overseas aid during the so-called ‘lost decade’ when Japanese banks almost collapsed under the weight of their bad debts and bloated bodies, announced on January 15 that it is investing $1.2 billion in Merrill Lynch. The once-proud bull has suffered more than many in recent months, and it came to Japan, among other countries, for cash. Finally rid of the worst of their non-performing loans and relatively flush with capital to be put to work, the megabanks look ready to try becoming true global players, just as everyone thought they would back in the booming 1980s. But have they really put the past behind them? Can these weariest of old dogs learn new tricks? Do they even want to, seeing what a mess certain clever schemes have made of financial markets in the past few months? Do they want to take on the whole world, or just a part of it?

Reading between the lines of Merrill Lynch and Mizuho’s press releases and talking to Mizuho’s management, it’s clear that while the Japanese firm would welcome Merrill’s help in growing its US business, no firm agreement has been reached. It’s also worth bearing in mind that Merrill Lynch has a prior engagement with a rival bank that might make it unwilling to favour Mizuho: a private banking joint venture in Japan with Mitsubishi UFJ. Hidetake Nakamura, head of Mizuho Corporate Bank’s international unit, says that Mizuho and Merrill have "no strategic agreement, but it’s understood by both parties that we’d like to increase collaboration in the future and I look forward to finding areas where we can work together".

Analysts and Nakamura’s counterparts at the other megabanks agree that an official tie-up is unlikely given the two firms’ differing business cultures, the fact that Mizuho’s investment does not give it any substantial voting rights, and the small size of the sum in relation to Merrill’s total market value. The real value of the investment is purely financial: the preferred shares will yield a juicy 9%.

Teisuke Kitayama, SMFG

"Our focus is Asia, although we’re also looking at the Middle East and Europe"
Teisuke Kitayama, SMFG

Two of the three megabanks were asked for help in the form of fresh capital by Merrill Lynch: asked if SMBC’s established relationship with Goldman Sachs might explain why it was not approached, Teisuke Kitayama, chairman of the board of SMBC, offers a blunt "I don’t know."

Nobuo Kuroyanagi, president and chief executive of MUFG, says that his bank was approached but decided not to participate.

"We have enough capital now to make any investments we’d like to make," he says. "But when we’re deciding whether to participate or not in a given deal the main concern is the likely effectiveness of that investment. Furthermore, we have a subsidiary in the US when our competitors don’t, so our strategies are likely to differ."

Sufficient capital there certainly is: the gap between Citi’s market capitalization and MUFG’s has narrowed from ¥12 trillion to ¥3 trillion ($27.7 billion), according to Kuroyanagi, giving weight to his claim in a press interview in 2006 that the then newly created Mitsubishi UFJ would one day rival Citigroup as a global player. The sheer size of the megabanks makes them potential contenders for such a role, but they have always struggled outside Japan and have been hindered, in the eyes of many, by an innate conservatism and a passive style of management that hinders dynamic growth.

The US does not seem to be the first priority: striking and symbolic it might have been, but Mizuho’s investment in Merrill might prove to be misleading for anyone looking to predict how the megabanks will seek to profit from their new-found position of strength. North America has historically been something of a graveyard for failed Japanese banking ventures, with Nomura’s recent exit from the RMBS business there the latest in a progression of aborted attempts to establish a long-lasting presence.

Asian focus

"Look what happened to Nomura in America," says Yuri Yoshida, a director at Standard & Poor’s in Tokyo. "They were among Japanese financial institutions the most deeply involved in the US, and when things went wrong there they took a huge Q2 hit to their results and exited the whole market. As for the megabanks, they are still probably holding on to some hard-to-liquidate assets related to sub-prime problems. However, the amounts are small relative to their total capital. Regardless, on a strategic level the number one lesson they should take is that they probably shouldn’t go into the US market now. The big players already there are too strong."

Instead of piling all their considerable resources into a risky bid for market share in the US, where they have little competitive advantage, it is clear from speaking to senior management at the megabanks that all three are looking a little closer to home.

"Our focus is Asia, although we’re also looking at the Middle East and Europe," says Teisuke Kitayama, president of Sumitomo Mitsui Financial Group (SMFG) and chairman of the board of its core commercial bank, Sumitomo Mitsui Banking Corporation (SMBC).

"The energy and natural resources markets are very strong at the moment," he says, "and we’re actively pursuing them; we’re also very interested in project finance, in ship and aircraft finance, in structured finance and in LBOs. In other words we’re selectively targeting the areas where a commercial bank could play a strong role."

"The decision to invest in Merrill Lynch was a constructive one that took advantage of market turmoil to secure a good deal"
Hidetake Nakamura, Mizuho Corporate Bank

Hidetake Nakamura, Mizuho Corporate Bank
In the past 12 months, all three megabanks have made a string of acquisitions and strategic alliances in Asia; Kitayama cites Sumitomo’s investment in the Vietnamese state’s export bank Eximbank as a prime example. MUFG, through group companies Bank of Tokyo-Mitsubishi and Mitsubishi UFJ Securities, has perhaps been the most active in Asia: highlights include investing ¥21 billion in a business alliance with Bank of China in 2006, spending ¥22 billion on Australian investment bank Challenger in October 2007, and putting a further ¥45 billion into Malaysia’s CIMB in April 2007. That last investment looks particularly enticing. MUFG has established a clear lead among the megabanks in the potentially lucrative new field of Islamic finance through this alliance in Malaysia, leading Japanese retailer Aeon’s pioneering Islamic issuance in January.

Mizuho has also been making deals and spending capital in Asia. On January 22, it announced the acquisition of the Russian subsidiary of Michinoku Bank for ¥7 billion, aiming to focus initially on Japanese firms in Russia before expanding its services to other clients. Three days later, Mizuho announced a tie-up with State Bank of India, the first such agreement between a Japanese financial institution and an Indian one. They will collaborate on syndicated lending, trade finance and infrastructure finance.

All this spending is proof of a consensus among megabank executives that they need to be more adventurous overseas. One traditional criticism has been the somewhat incestuous nature of the megabanks’ recruiting: senior executives tend to work their way up through long stints at the same firm, and part of the securities’ firms perceived lack of dynamism stems from the fact that their chief executives are usually transfers from the corresponding commercial bank rather than experienced investment bankers. Although bankers within and outside MUFG say MUFJ Securities’ Gomi is an unusually dynamic chief executive, his CV is nonetheless typical: he joined Mitsubishi bank in 1966, worked his way up through various branch manager postings, became chief executive of the commercial banking unit in 2001 before transfer to his present role at the securities subsidiary in 2004.

Foreign leadership

Now there are signs that senior managers at the megabanks have woken up to the fact that things must change; that outside perspectives might be helpful in breaking into foreign markets. And it is a Gomi hire at MUFJ Securities that best exemplifies these cautious first steps towards a more international executive board at the megabanks and their firms.

Joe Schmuckler, the 46-year-old new chief executive of MUFJ Securities’ international business unit, is an investment banking veteran hired from his role as COO of Nomura’s US business to lead his new firm’s international expansion. He is the first foreigner ever hired by MUFG at a senior executive level. Aside from his new position at MUFG, he is also working with another veteran player now seeking world domination: Schmuckler serves as campaign treasurer and CFO for senator John McCain’s campaign for the US presidency. News of McCain’s win in the Republican primaries in the state of Virginia was just breaking as Euromoney concluded a final interview with the hard-working Schmuckler, who says that his political activities do not interfere with his commitments to MUFG.

He has something of the politician’s forthright, easy manner and an ability to handle difficult questions with eloquent, polished answers: skills that will stand him in good stead as he attempts to reinvigorate the bank’s international business and reshape its corporate culture. He is often asked what firms he admires and what banks MUFG might look to emulate as it evolves. He has mentioned Goldman Sachs and Lehman Brothers in previous interviews, but is wary of being seen as wanting merely to copy them.

"Because of the size of our mother market," he says, "we have the necessary strong base to become a diversified global competitor in the financial services industry. We see ourselves as getting in among the world’s elite. What we need to do is to continue to develop our own culture, one that others want to mimic. When I mention firms like Goldman and Lehman, I mean that I think their partnership culture is the core of their success. That model allows you to make difficult decisions more easily, and it’s my aim to recreate within our much larger group that partnership environment where people think less about themselves and more about the firm’s interests."

Before they commit themselves more fully to international expansion of their commercial and investment banking activities, it is worth asking to what extent the megabanks have truly resolved their problems at home. For a start, as SMFG’s president concedes, they still do not possess the same ratio of tier-1 capital – an important measure of a bank’s core financial strength – as many of their overseas peers.

"We’re not yet as well capitalized as we’d like to be," says Kitayama. "Our method of paying back the public money borrowed during the financial crisis has been to buy back and then write down the preferred shares issued to the government. At the moment our tier-1 capital ratio stands at around 6.3%, and we would like to get that figure up to 8%, which would be in line with the major US and European banks."

SMBC’s tier-1 capital ratio is the weakest among the megabanks, with Mizuho’s standing at 6.97% and Mitsubishi UFJ Financial Group’s at 7.7%. There’s room for improvement in the megabanks’ capital structures, but analysts say the real challenges are to raise profitability, to move on from outdated business models that relied too heavily on corporate lending, and to become more than vast, sluggish lenders to companies in Japan.

"Losses from sub-prime-related securities at the megabanks could still be greater than expected," says Hiroshi Hisoda, chief analyst at Rating and Investment Information, "but they will not total much in comparison to what we’ve seen in Europe and the US. The megabanks’ overall financial status is improved, they have dealt with their non-performing loans and other issues but they are still looking for a business model fit for the 21st century."

Profits collapse

Beyond the consideration of capital adequacy, there is the question of just how profitable the megabanks are. Standard & Poor’s report Japan’s major banks see profitability downturn in 1H fiscal 2007 shows that profitability at the country’s six largest banking groups fell a whopping 45% on the first half of fiscal 2006. Sub-prime losses aside, one key factor is ominously described as "a decline in core operating profits". The traditional core business of the megabanks, financing Japanese corporations with loans, has been slow lately and the stock markets are stagnant.

Standard & Poor’s Yoshida explains: "When you look at the development of Japanese financial institutions you have to consider the history. The system worked by providing capital to manufacturing companies, which now get their money elsewhere. So the Japanese banks have to do business overseas, but it will be hard for them to convert from the mentality of serving Japanese corporates internally to an international investment banking model."

One potential revenue source is the much talked-about ¥1,500 trillion of money in household assets in Japan. The megabanks have been furiously marketing investment products to small investors and wealthy retiring baby-boomers but the impact of strict new FSA legislation on sales practices and recent market events has halted the sales of investment trusts, and the newly privatized post office bank threatens to be a formidable rival thanks to its network of more than 20,000 branches.

"If the megabanks really want to go into foreign markets, we would have to monitor that from a ratings perspective," concludes Yoshida, "because it hasn’t worked for them historically."

Finally there is the question, in the case of Mizuho’s investment in Merrill Lynch, of whether or not the Japanese firm’s corporate banking arm can afford to spend $1 billion overseas when its securities arm is cash-strapped and stuck in a troubled merger. Mizuho Financial Group announced in February that it would pump ¥250 billion into Mizuho Securities, in addition to the ¥150 billion it had already given the broker in December. Of all the megabanks and associated subsidiaries and joint ventures contacted by Euromoney, only Mizuho Securities declined to participate. Mizuho Corporate Bank’s Nakamura gamely answers the question of if his firm can afford to go shopping in New York at a time like this.

"Can we help someone overseas when we have an internal issue? The losses we announced group-wide were large amounts and we are taking it very seriously. That said, we Japanese banks are in a better condition than some of our competitors in the US and Europe, and I think actually the decision to invest in Merrill Lynch was a constructive one that took advantage of market turmoil to secure a good deal," he says.

An insider from a non-megabank securities firm tells a story that illustrates everything that many believe to be wrong with the megabanks and the culture of too-close ties to companies that they have fostered. It begins with a man walking into a bank. He is responsible for the financing of a struggling manufacturer and, like many men who walk into banks, he needs money. His firm, for a long time a respected household name, is in turmoil after decades of nepotism and lazy leadership finally take their toll. He is visiting one of the three megabanks, the one with which his firm has a longstanding relationship. The bank’s management listens sympathetically and offers a low but acceptable bid: ¥70 for each new share the firm issues. Later, our desperate treasurer is about to accept when an independent broker puts in a bid of ¥150 a share.

Nobuo Kuroyanagi, MUFG

"We have enough capital now to make any investments we’d like to make"
Nobuo Kuroyanagi, MUFG

Astonished and elated by this much higher offer, the treasurer returns to the megabank and tells them of the counter-bid. Meanwhile the broker waits patiently, expecting to win, having just offered double the previous bid.

But there’s a twist. It turns out our CFO used to work for the megabank he’s now visiting; he trusts them to help, respects their power, fears ruining the longstanding relationship between the two firms and angering his superiors. The bank’s man knows this and on hearing of the rival bid says to the CFO: "Well that’s fine, but you shouldn’t listen to the devil’s whisper."

The CFO accepts the megabank’s lower bid, and his company continues to struggle despite the fresh injection of capital.

"The bank knew the company’s situation so well, it knew exactly how far it could push it," says the broker. The megabank leveraged its size, its longstanding ties with its client and its extensive knowledge of the manufacturer’s business to secure favourable terms.

Does the manager of an overseas business unit work as hard as he can at the job if he knows he’ll be moved to another position in a few years? The practice of job rotation is endemic to Japanese corporations within the financial sector and outside it; the overseas operations of the securities firms in particular have tended to be run by directors on loan from Tokyo. Advocates say the system encourages the transfer of ideas from one business area to another and prevents the development of personal fiefdoms; critics say it merely inhibits the development of consistent, coherent business plans and encourages short-term thinking among managers.

"I think the critics are right," says Daiwa SMBC’s deputy president, Shuntaro Higashi. "But it’s an area we’re looking at and I believe we can make changes rapidly. The traditional employment system will be difficult to change but it’s certainly one reason for the weakness of some Japanese companies overseas. When we say we need to enhance, say, our London office, we know we’re going to have to pay a decent market salary to locals – perhaps exceeding what directors in Tokyo are paid."

For the securities firms, the key area in which foreign experience might prove most valuable is risk management. Mitsubishi’s Schmuckler says: "It’s not just a case of hiring a bunch of risk managers but of establishing a stronger system of internal controls and looking at how management conducts itself top to bottom. At Mitsubishi UFJ Securities we’re already incorporating practices and policies new to Japan, building an international culture, and I wouldn’t be able to do that without support from the rest of the group."

MUFG’s Gomi says at one point during his interview that the reason he didn’t invest in Merrill Lynch is because "we want to be bigger than them in five years". While he, Schmuckler and their counterparts at the other banks are keen to emphasize that they want to succeed on their own terms, using their traditional strengths and Japanese client bases to expand overseas, it’s telling that management at all three financial groups make repeated mentions of foreign firms when outlining their goals. Kitayama at Sumitomo Mitsui Banking Corporation and Higashi at the bank’s joint-venture securities firm Daiwa Securities SMBC seem to have given the issue particular attention: both make unprompted references to the same pair of UK banks when talking about their goals.

"When I was on the commercial banking side, and indeed now I’m here," says Higashi, "we used to say Daiwa SMBC’s benchmark should be the French banks, given their global presence relative to the size of the organization. Now we’ve seen Société Générale has a few issues, perhaps we ought to change that. The US investment banks are perhaps too large for us, but we could certainly look at Barclays, RBS or BNP Paribas as potential benchmarks."

His counterpart at the commercial bank echoes the thought: "Our models are Barclays and RBS," says Kitayama, "banks that have strong domestic consumer bases and pursue debt-related securities business very well overseas."

It’s important to mention that this benchmarking of themselves against successful foreign firms does not imply total admiration. The engaging, witty Higashi ends the interview on a note of caution, a reminder that conservative values have their place. It was, after all, a certain recklessness of spending and structuring that arguably caused the most recent financial crisis; it was their very caution that possibly helped the megabanks escape relatively unscathed. His colleague points out that now is not the best time to be comparing Japanese and foreign institutions anyway, with their recent pasts being so different.

Inevitable change

"I’m not blaming the foreign banks," says Daiwa SMBC board member Teruaki Ueda, "I think everyone in the world respects the system of high pay, high bonuses and aggressive tactics. But anyway globalization is an inevitable trend, and as global markets become more linked, Japan will not be able to keep its distinct tax system. As more Japanese companies become global, aligning corporate rules with global standards, the current tax system will become a barrier to doing business and to our transactions in the capital markets. Changes are inevitable, so we should act quickly. But of course we Japanese are not used to fast action."

Change in Japan tends only to come when crisis screams for it. The faltering banking system, the crippled and mistrusted broker Nikko Cordial, the recent spate of accounting scams, even the meteoric rise and scandalous fall of the bankrupt language school Nova... all of them tackled only when they couldn’t be ignored. Now, although the economy is still stuck in first gear, times are not so tough. The country’s three great banks are in a position to help revitalize that economy and make Japan once again a financial star of the east, if only they can avoid the devil’s whisper, withstand the mistakes of the past and the worst of the old ways of doing business.

"We have a good, clean society here," muses Higashi as he looks out of the meeting room over the endless sun-lit sprawl of Tokyo, "and people are generally happy. I think there are areas such as the environment and health where we can contribute to the world rather than being too money-greedy. Perhaps it’s hard for some to see the urgency of change in our financial environment."