Financial Sector

April 2002

A Financial Services Agency (FSA) panel issued a draft of accounting standards requiring companies to adopt asset impairment accounting. The draft contains a timetable calling for full adoption in fiscal 2005, while granting a 2-year grace period that will allow companies to adopt asset impairment accounting on a voluntary basis from fiscal 2003. Asset impairment accounting requires companies to recognize a loss in their income statements to write down the carrying value of a fixed asset if the fair value of that asset has dropped significantly below the amount recorded on the balance sheet. The standard targets land, factories, buildings and other forms of property, plant and equipment. The introduction of asset impairment accounting will force companies to confront the bad assets left languishing on their balances sheets after the collapse of the bubble economy of the late 1980s. The impact of asset impairment accounting will hit not only real estate companies and construction firms that purchased land at inflated prices during the bubble years, but also manufacturing firms with excess production capacity. The panel hopes to draw up a final set of standards this summer, after evaluating opinions received on the exposure draft. (April 19, the Nihon Keizai Shimbun)

Of the 149 companies that the Financial Services Agency (FSA) examined in its special inspections, 71 corporate borrowers were downgraded, while 34 companies, more than 20%, were judged to be "in danger of bankruptcy" or "virtually bankrupt." The FSA, which released the results of its special inspections, targeted big corporate borrowers that have at least a 10 billion Yen loan balance and that have experienced a significant decline in their share prices or a sharp downgrade in their credit ratings. The agency teamed up with banks and private-sector auditors to jointly reassess corporate borrowers classified as sound or as requiring special attention, a category that does not require banks to set aside a large amount of loan loss reserves. In particular, they zeroed in on general contractors, real estate companies, trading houses and non-bank financial institutions, industries that received a large amount of loans that have essentially gone sour. Of the 149 companies subject to the inspections, 98 were in these business sectors. While the 149 borrowers collectively owe banks 12.9 trillion Yen, the total amount of loans at the 98 firms was 10.05 trillion Yen. The FSA downgraded corporate borrowers to "those in danger of bankruptcy" or "virtually bankrupt." Those who had not made much progress in their business improvement plans, were very likely to fail; or were in the process of devising rebuilding plans, including potential loan waivers from banks, but could not put them into action by the end of March. Of the 34 companies assigned to this category, 26 were from the four industries that are in deep trouble, such as construction. Their total loan amount is 3.3 trillion Yen. As a result of the latest FSA action, banks are now required to dispose of such loans within three years by selling the loan claims to the Resolution and Collection Corp. or by other means. (April 13, the Nihon Keizai Shimbun)

According to the Financial Services Agency (FSA), nonperforming loans at the nation's major banks increased by 4.7 trillion Yen to reach 7.9 trillion Yen as a result of its special inspections of their loan portfolios limited to large borrowers. The increase caused the major banks to book an aggregate net loss of 4.1 trillion Yen for the fiscal year ended March 31 after disposing of 7.8 trillion Yen in losses on bad debt. Given that the special inspections only covered part of their loan portfolios, Japan's leading banks still have a long way to go before putting their finances in order. The FSA's special inspections, conducted from November to the end of March, targeted 149 corporate borrowers of at least 10 billion Yen whose share prices have recently plunged or whose credit ratings have been sharply downgraded. Among these borrowers were 98 companies in the four struggling industries of construction, real estate, retail and non-bank financing. These companies had borrowed a total of 12.9 trillion Yen. Before the FSA's inspections, most of them were classified either as "sound borrowers" or "those requiring attention," meaning that banks were not required to set aside a large amount of provisions. But the special inspections forced major banks to downgrade their internal classifications for 7.5 trillion Yen in loan claims to 71 companies. As a result, nonperforming loans doubled to 7.9 trillion Yen for 79 companies. Especially, loans to borrowers classified as "in danger of bankruptcy" or worse swelled to 3.7 trillion Yen for 34 firms. Banks are required to remove loans to "borrowers in danger of bankruptcy" from their balance sheets within three years by selling off these loans or forcing the borrowers into legal proceedings for liquidation. The major banks wrote off far larger losses on bad loans than earlier projected in fiscal 2001. Mizuho Financial Group posted a 2.41 trillion Yen loss, up 230 billion Yen from its November forecast, while Sumitomo Mitsui Banking Corp. took a 1.55 trillion Yen charge against the loss, up 550 billion Yen. Although the combined core business profit turned out to be 4 trillion Yen which was better than earlier projection, this was not enough to offset their losses on bad loans, pushing Japan's seven banking groups into the red on a net basis. Nevertheless, major banks maintained capital ratios of 8% or higher, the indication of sound finances for banks engaging in international operations. The Daiwa-Asahi Bank group's ratio stood at around 8.5%, the lowest among the seven banking groups. The capital ratios of other banking groups exceeded 10%. FSA Minister Yanagisawa stated that major banks' finances "are not in a state that needs another public fund infusion". But bad-loan losses could increase further in the current fiscal year and beyond if the stricter standards applied to large borrowers are used to assess the finances of small and midsize businesses, analysts say. (April 13, the Nihon Keizai Shimbun)

After being hit by huge charges resulting from the disposal of nonperforming loans over th past years, Japanese banks, especially major lenders, will continue to face the same problems. Over the nine years through fiscal 2000, the nation's banks took some 75 trillion Yen in charges after disposing of bad loans. At major banks, such charges have been much higher than their core business profits in recent years. Fiscal 2001 charges at major banks, estimated at 7.8 trillion Yen are about twice their core business profits. The situation is unlikely to improve for banks as long as the economy remains in deep trouble and banks continue to be forced to dispose of bad loans. All of the major banks have an optimistic outlook for this fiscal year. "Write-off charges will not be larger than our core business profit," says an official at Sumitomo Mitsui Banking Corp. But in the past, such optimism turned out to be mistaken. The banks had projected a combined 1.9 trillion Yen in fiscal 2001 loan loss charges in May 2001, but that figure snowballed to 6.5 trillion Yen as of Sept. 30 and to 7.8 trillion Yen as of March 31. One major factor for the huge increase in charges is the FSA's special inspections, which focused on ailing large-lot corporate borrowers. However, reserves set aside for loans extended to smaller businesses remain insufficient. After the FSA released the results of its special inspections of corporate borrowers, credit-rating agency Standard & Poor's Corp. noted that the increase in bad loans at major banks was smaller than expected, and that under present condition it is difficult to restore the credibility of Japanese banks. Daiwa Institute of Research predicts that this fiscal year banks will likely incur loan loss charges of more than 6 trillion Yen. If banks' fiscal 2002 core business profits are about the same as those of last fiscal year, then they will lack about 2 trillion Yen in covering charges. If banks book huge losses this fiscal year, they will be in desperate need to replenish their capital bases. This may rekindle public debate if a new round of injections of taxpayers' money is needed to avoid a situation in which banks fall into an undercapitalized state. (April 13, the Nihon Keizai Shimbun)

The Financial Services Agency (FSA) plans to appoint specialist inspectors to each of the 12 major banks to improve its supervisory capacities and boost bad-loan disposal. The inspectors will seek to improve the banks' reporting of nonperforming loans by monitoring the share prices and financial health of their major corporate borrowers. The FSA is hoping the new inspection regime will boost the confidence of global financial markets in the banks' disposal of nonperforming loans. The plan is modeled on the U.S. system of having officials stationed at each bank on a full-time basis. The FSA plans to have the Diet revise the Banking Law to allow it to assign experienced inspectors to each major bank. The inspectors will attempt to ensure that the banks correctly classify corporate borrowers in terms of their creditworthiness in line with the FSA's inspection manual and also to reflect changes in their financial performance, credit ratings and share prices. In addition, the inspectors will ascertain whether the banks classify borrowers and assess nonperforming loans in accordance with the FSA's findings from periodical inspections concerning the creditworthiness of borrowers. The 12 banks are expected to book 7.9 trillion Yen in loan-loss provisions for fiscal 2001, up from their previously released estimate of 6.5 trillion Yen. The increase in estimated bad-loan expenses is a result of special inspections conducted by the FSA since last October using stricter classification standards. The special inspections reportedly covered 149 of the banks7 major corporate borrowers, which have suffered from both falling share prices and deteriorating credit ratings. (April 11, the Daily Yomiuri, the Japan Times)

IMF urges Japan to undertake reforms. Japan's problems can be blamed on years of neglect, and lasting economic growth will remain elusive until it squarely tackles the root causes of its woes. IMF chief economic Kenneth Rogoff said that Japan must undertake structural reforms to overcome its problems of deflation and a banking system loaded with bad loans; issues that have weighed on the world's second-richest economy, which is now into its third recession in a decade. Rogoff made the comment in connection with the lender's latest World Economic Outlook, which will be published in full next week before the IMF's spring meeting. Rogoff's deputy, David Robinson said that Japan could learn a lesson from Switzerland, New Zealand and Britain, all of which suffered a series of recessions in the 1970s. There are countries where there were significant structural issues and as a result you saw this pattern not of a long depression，but rather of a series of recessions in close proximity to each other. IMF released the analytical papers on its Web site to garner more coverage for that aspect of its WEO publication. Most of the focus on the WEO is on the lender's latest global growth forecast rather than the IMF's more esoteric economic studies. In its study of recession, the IMF found that the current global recession is fairly typical. With the United States, Japan and Europe all in recession, many economists, including those at the IMF, had characterized the latest slump as unusually synchronized. The IMF's latest report found that conventional wisdom was not backed up by the numbers. (April 11, the Daily Yomiuri)

The adoption of fair value accounting standards for long-standing cross-shareholdings is expected to spur management reform in market values and sever the interdependence fostered by these mutual shareholdings. Adjusting the balance sheet to provide an accurate reflection of the changing prices of financial instruments is part and parcel of an international move toward valuing both assets and liabilities at fair value. Management in corporate Japan is being forced to confront two issues: the need to improve the efficiency of how they employ assets and the risk of holding cross-shareholdings over the long term. Applying fair value rules to cross-shareholdings is the centerpiece of Japan's accounting "big bang," which is aimed to bring Japanese accounting standards closer in line with international norms. The globalization of capital markets and the inflow of investment money from overseas is putting strong pressure on Japanese companies to repair their balance sheets. The Enron accounting scandal in the U.S. is only turning up the heat on companies to provide a more transparent picture of their asset holdings. Fair value accounting rules prevent companies from using unrealized gains on shareholdings as a type of reserve available to smooth out earnings. It also eliminates the room to hide unrealized losses, forcing companies to take a hit to earnings if stock prices fall sharply. The market is likely to raise increasingly penetrating questions about the wisdom of continuing to cling to cross-shareholding relationships, which take away funds from core operations and carry the risk of price declines. In hindsight, there is an emerging consensus here that cross-shareholding relationships, in which companies and banks are expected to remain silent and stable shareholders in each other, created a vacuum in corporate governance and contributed to a protracted slump in corporate earnings. But improved balance sheet health is expected to restore the confidence of investors. Corporate relationships based purely on business transactions, not interlocking shareholding ties, will raise management efficiency. Management reform driven by a strong awareness of return on equity and return on assets will accelerate, according to an analyst. (April 10, the Nihon Keizai Shimbun)

Special inspections of the Financial Services Agency (FSA), which placed large-lot borrowers of major banks under strict scrutiny, has forced some ailing companies to go under. The failure of major supermarket operator Mycal Corp. last September prompted the FSA to conduct special inspections. Until Mycal eventually collapsed, loans to the retailer were classified as those "requiring close monitoring," consequently providing no warnings that the firm was in danger of collapsing. Mycal's failure generated the suspicion that banks used lax standards in classifying their debts. Distrust in bank management grew, and the FSA was under fire for its serious oversight. The special inspections led more struggling borrowers to go under. In December, midsize general contractor Aoki Corp. filed for court protection under the Civil Rehabilitation Law. Prime Minister Koizumi called Aoki's failure "telling evidence that structural reform is progressing smoothly." However, ambiguity persists about the standards used to decide to let ailing companies go under. The FSA at its own discretion can decide how hard it will pressure a bank to promote the disposal of bad debt. Partly because of the fears of a financial crisis, Daiei Inc.'s main banks scurried to put together a bailout plan for the giant retailer despite the possibility that they will be criticized for putting off the resolution of the problem. Among general contractors, Fujita Corp. avoided filing for bankruptcy by compiling a creditor-led workout plan, while Sato Kogyo Co. was forced to resort to a court-led bankruptcy procedure. (April 10, the Nihon Keizai Shimbun)

Government officials continue to give differing statements concerning the injection of public funds into Japan's banks. The Financial Services Agency (FSA) will announce the average capital ratio banks secured as of March 31, and FSA Commissioner Shoji Mori insists that it will be around 10%. His comments may be aimed at erasing fears of a financial system meltdown. Bank of Japan Governor Masaru Hayami has repeatedly warned that banks may fall short of capital and he has insisted on preparing to inject banks with public funds. Minister of State for Economic and Fiscal Policy Heizo Takenaka's stance is unpredictable. As he has repeatedly said that the decision should be based on FSA inspection results, FSA officials are concerned about the conclusion that Takenaka will draw from his recent announcement. Liberal Democratic Party Deputy Secretary-General Kazuyoshi Kaneko warns that banks must try to raise the transparency of their management. Citizens may not be satisfied with the inspection results. They will expect banks to disclose details of their accounts, including how much loan loss reserves they set aside," he says. The FSA plans to continue special inspection of banks to urge for cleaning up their finances, but the future remains uncertain. Meanwhile the financial system may become unstable again since consumers are pickier about banks, now that a cap on guarantees has been reintroduced on bank deposits. (April 10, the Nihon Keizai Shimbun)

Major banks will release FSA-requested data on April 12. Sumitomo Mitsui Banking Corp., UFJ Bank and other major banks are expected to release on April 12 a limited amount of financial data, including information on losses from bad loan disposal and capital-to-asset ratios, for the year ended March 31. The early release of some fiscal 2001 data comes in response to a request by the Financial Services Agency (FSA). The FSA wants banks to publicize business results reflecting the consequence of the agency's special inspections, which focused on the banks' heavily indebted corporate borrowers. The agency itself will also likely announce the results of such inspections on the same day. It apparently aims to submit evidence of improved stability in Japan's financial system to the meeting of the Group of Seven finance ministers and central bank governors starting on April 19, where Japan's financial situation is likely to be on the agenda. Mizuho Bank, Bank of Tokyo-Mitsubishi, Daiwa Bank, Asahi Bank, Sumitomo Trust & Banking Co., Chuo Mitsui Trust & Banking Co., Sumitomo Mitsui, and UFJ will each release data on core business profit/loss, pretax profit/loss, net profit/loss, loss from cleaning up soured loans, capital-to-asset ratio, and appraisal gain/loss on securities holdings for fiscal 2001. Combined losses from fiscal 2001 bad debt disposal at these banks are expected to exceed 7.5 trillion Yen, over 1 trillion Yen more than projected in November. But the total latent losses on securities portfolios are estimated to have dropped to about 1 trillion Yen at the end of March, down from over 3 trillion Yen at the end of September. (April 4, the Nihon Keizai Shimbun)

Deposit insurance limit puts pressure on banks. Japan's depositors now face new financial risks as the days of full guarantees on bank deposits have ended with the introduction on April 1 of a ceiling on deposit insurance offered by the government in cases of bank failure. Time deposits will only be guaranteed up to 10 million Yen, with a limit to be applied to ordinary deposits in one year's time. As depositors naturally become more sensitive to the financial health of their banks, financial institutions may come under greater pressure to clean up bad loans and become more profitable. The imposition of limits on deposit insurance could, however, act as a destabilizing factor on the entire financial system if it forces a number of banks in bad financial shape against a wall. The Financial Services Agency (FSA) has made considerable effort to make the banking system less vulnerable, closing down hopeless small lenders and urging weak banks to merge. Minister Yanagisawa of FSA has pronounced the banking system well prepared for any development that might arise from the deposit insurance ceiling. There are, however, still many banks that are far from healthy. The agency should do more to ensure that the new limit produces positive results and does not lead to a banking crisis. Banks should be put under greater pressure to disclose more information about their financial standing, while the FSA would be well-advised to carry out even more rigorous bank examinations to ensure that the data disclosed properly reflects reality. When a bank that has enough capital according to the figures it has published suddenly goes under, investors and depositors feel deceived and lose confidence in the quality of information put out by banks. More important, of course, is accelerating the process of sorting out the bad debt problem, which is dogging virtually all private lenders, from big banks to credit associations. A March fiscal year-end financial crisis that many had feared has not materialized, thanks to a rebound in stock prices. But much of the recovery of the market should be credited to the new restrictions on short selling. The fundamental weakness of the banking system remains unchanged. Analysts and market players will watch closely to see whether a recent round of FSA inspections of financial institutions has the effect of encouraging these banks to make more thorough disposal of bad loans. Inspectors have looked at bank balance sheets, paying special attention to liabilities and the success of efforts to dispose of bad loans. A concern shared by many is the question of whether the inspections are as rigorous as Prime Minister Koizumi has called for them. The government should not hesitate to inject additional public funds into banks at risk of seeing their capital fall too far. It is clear that the responsibility in such cases lies with bank management and shareholders. Equally crucial are efforts on the part of the banks themselves to dispose of bad debt and regain profitability. Japan's banks need to break free from the traditional approach and refashion themselves into innovative and efficient institutions that produce the kind of profits seen in many Western countries. (April 1, the Nihon Keizai Shimbun)