Financial Sector

January 2002

In fiscal 2002, the Ministry of Home Affairs will liberalize the terms under which municipal bonds are publicly offered by 28 major local governments, including 12 big cities. Full liberalization will take place in fiscal 2004. Under current regulations, the issue terms employed by the Tokyo Metropolitan Government are applied to 27 other municipalities. Although the ministry does not officially acknowledge the difference in creditworthiness of municipalities, the deregulation is likely to accelerate a trend toward selective investment. Municipal bonds currently issued by 28 bodies, including the Tokyo government and the city of Yokohama, already trade at different prices on the secondary market according to the value of issuance and the fiscal condition of the issuing government. In one example of such differentiation, the yield on bonds issued by financially ailing Osaka Prefecture stands 0.3-0.4 percentage point above the rate on central government bonds. Bonds issued by the Tokyo Metropolitan Government, by comparison, have a yield gap of less than 0.1 point. Timed for the liberalization of issue terms, the ministry will also create a system in which more than one municipality can jointly issue bonds. (January 25, the Nihon Keizai Shimbun)

The Financial Services Agency (FSA) plans from fiscal 2002 to require financial institutions to check the identity of customers who engage in large-lot cash transactions. Japanese banks currently conduct ID checks of customers who make cash transactions of at least 30 million Yen voluntarily under the rules set by the Japanese Bankers Association and others. The FSA intends to lower this minimum threshold to 5 million Yen and make the practice mandatory by enacting new legislation. The move is in line with international efforts to deny funding to terrorist organizations under the U.N. Convention on the Suppression of Terrorist Financing. These efforts have gained momentum since the Sept. 11 terrorist attacks on the U.S. The new legislation would apply to transactions at banks and other deposit-taking financial institutions, as well as securities companies. Under the legislation, financial institutions would be required to identify customers who open savings accounts and make large transactions like cash withdrawals. In the U.S., financial institutions are required to conduct ID checks of customers who make cash transactions of at least US$10,000, or about 1.3 million Yen, and to notify the authorities of these transactions. The FSA is considering to impose penalties such as fines against violators of the new law to ensure compliance. Transactions subject to the ID checks would include the purchase of a large amount of non-registered discount bank debentures at a bank or cash redemptions of these instruments in large volumes. Large cash withdrawals from personal savings accounts and cash transfers of deposits for real estate transactions would also fall within the purview of the envisaged law. Discount bank debentures can now be traded without disclosing one's identity. Since many wealthy individuals include these in their asset management portfolios, they could oppose the proposed measure. One FSA proposal would require those who want to make large-lot cash transactions to present an ID document with a photo, such as a driver's license or passport, to authenticate their identity. The FSA has begun consultations on the new legislation with the Japanese Bankers Association, and aims to submit a bill to the current Diet session. (January 23, the Nihon Keizai Shimbun)

The Financial Services Agency (FSA) will conduct a thorough inspection on whether securities companies are properly separating the management of their own assets and assets entrusted to them by customers, ahead of the introduction of a 10 million Yen cap on deposit protection in April. The FSA believes it necessary to establish a system under which brokerages manage customer assets more safely, to lure more individual funds into the securities markets. Securities companies are required by law to separate the management of customers' assets, such as securities and cash, by such means as depositing them at trust banks. Under the system, such assets will be refunded in full in case a securities company goes under. Past inspections by the FSA and the Japan Securities Dealers Association found that most securities houses properly separate the management of customer assets. Since some, mainly foreign brokerages, violate the rules, the FSA plans to severely punish violators. (January 21, the Nihon Keizai Shimbun)

The Financial Services Agency recently launched a second round of special audits at the nation's major banks. The focus of the audits will be borrowers of loans over which the agency disagreed with banks/auditing firms about their classification during the first round of inspections last November and December. Some banks have failed to comply with the FSA's guidelines, which were released after the first inspections, as is clear from their earnings reports for the six months ended Sept. 30. The second round of audits is likely to result in a call to beef up reserves even further. The goal of the audits is to make bond ratings, stock prices and other market valuations come into line with the audits of the banks' assets. The Council on Economic and Fiscal Policy recently came out with a reform promotion program. The plan aims to encourage banks to eliminate bad loans from their balance sheet and to beef up reserves to cover shaky loans, thereby alleviating market concerns over excess exposure. The second round will be based on assets as of Dec. 31, the same date as the banks' own internal audits. The banks will be expected to implement recommendations for the earnings reports for the year through March, meaning increased reserves set aside to cover loans the FSA places in a lower (riskier) category. (January 21, the Nihon Keizai Shimbun)

New rules will help financial institutions sell bad loans. The Deposit Insurance Corp. and the Resolution and Collection Corp. (RCC) will alleviate for major Japanese banks to dispose of nonperforming lending by changing the rules under which the organizations use public funds to buy bad loans. The two groups disclosed the new rules, which reflect the Jan. 11 revision to the financial reconstruction law. The revision allows the RCC to buy bad loans from banks at the market price of the underlying collateral. Until now, most bad loans were purchased at 60% of the value of the collateral as appraised by real estate experts. When gangsters unlawfully occupied property put up as security, the value of the collateral was reduced further by up to 35%. Under the new rules, bad loans will be bought at 70-100% of the value of collateral estimated by realty appraisers. The value of property occupied by gangsters will additionally be reduced by up to 10%. If the value of collateral is estimated at 12 billion Yen, the purchase price will be up to 12 billion Yen under the new rules, compared with the previous price of up to 7.2 billion Yen. As the new rules will likely raise the purchase price of bad loans, financial institutions are expected to step up efforts to sell nonperforming lending to the RCC. Major Japanese banks are currently offering to sell the Deposit Insurance Corp. and the RCC bad loans with a total principal of just under 500 billion Yen. (January 21, the Nihon Keizai Shimbun)

A key panel of the Welfare Ministry has already started to study the next overhaul of the public pension system. Although the public pension system underwent its last revision in 1999, the Social Security Council has been concerned that the demographic assumptions of 1999 are proving to be overly optimistic. Japan's public pension system has two basic layers: 1) a base national pension that covers the self-employed and homemakers, 2) a government-managed pension plan for corporate employees. Both layers are fundamentally pay-as-you-go systems, in which contributions by the current generation of workers pay for the benefits being received by retirees. With Japan facing a falling birth rate, the 1999 revision set in motion an effective 5% reduction in the second-layer pension for corporate employees, which will be phased in over several years, as well as a premium hike phased in over a period of 25 years. However, the key projections used to determine the size of the benefit cuts and contribution increases are not panning out. There are fewer workers to pay into the pension program for corporate employees and the monthly incomes that determine premium contributions are lower than forecast. The single biggest issue in the review by the Social Security Council would be how to deal with a commitment made in the 1999 revision to raise the portion of baseline national pension benefits, which are funded by tax revenues. Currently, premium contributions cover two-thirds of benefit payouts, with tax revenues funding the remaining one-third. The 1999 revision specifies a goal of raising the tax-funded percentage to one-half. However, the crucial question is how to come up with the extra tax revenues. In fiscal 2001, the government contributed some 5.3 trillion Yen to pay national pension benefits. Raising the percentage to 50% would require the government to produce another 2.4 trillion Yen. The government's burden would swell to about 10 trillion Yen in fiscal 2010, according to ministry projections. A second big issue is how to ensure that more women are paying contributions to the public pension system. The discussion will start with a proposal to lower the thresholds above which part-time workers would be required to make contributions to the second-layer pension for corporate employees. (January 17, the Nihon Keizai Shimbun)

The Security Analysts Association of Japan has revised investment performance assessment standards for use by asset management companies when reporting to customers. The new standards, which bear a closer resemblance to international guidelines, will make it easier for foreign fund managers to enter the Japanese market. The revisions are also expected to prompt more Japanese fund managers to become active abroad. Although the association's standards are voluntary criteria and have no binding force, they contribute to the accuracy and consistency of performance data offered to customers by fund managers. The revisions call for monthly assessment of investment performance based on market prices, time-weighted calculation of realized gains and dividends and year-by-year disclosure of performance in the past five years based on the same method, among other requirements. The association formulated the previous set of standards in June 1999. According to a survey by Daiwa Institute of Research Ltd., 38 fund managers, mainly investment advisory firms and trust banks managing funds for corporate pension plans, were using the standards as of the end of October last year. The association aims to put the new standards into effect on Oct. 1, after gaining certification from the Investment Performance Council that the revised standards are in line with the Global Investment Performance Standards set by the international forum of experts. (January 16, the Nihon Keizai Shimbun)

Japan's Economics Minister, Takenaka suggested that Japan may consider setting an inflation target as a way to fight deflation. At a press conference in London, he also said that Japan should change its tax system to promote investment rather than savings. Japan must move in the direction of supporting people who take the risk of undertaking challenges. Minister Takenaka said earlier that the Yen's current value especially reflects Japan's economic fundamentals, a signal that Japanese monetary authorities are comfortable with the fall of the currency in exchange markets. The Yen's level should be determined by market forces and Tokyo has set no targets for its value. Takenaka expects the Japanese economy to recover after September, but warned that the recovery would be fragile unless economic fundamentals are strengthened. In his speech at the Royal Institute of International Studies in London the Japanese Minister said that structural problems underlie persistent economic weakness in Japan, which plunged into another recession at the end of 2000 following a modest recovery in 1999. (January 13, the Japan Times)

The revised financial reconstruction law has been effective to promote the disposal of bad loans at financial institutions by reinforcing the functions of the Resolution and Collection Corp. (RCC). Ahead of the revised law's enactment, the RCC received requests from some 70 financial institutions to purchase 2,300 problem loans worth more than 450 billion Yen. In addition, there are about 20 cases subject to RCC study at the institutions' request on whether debtor companies can be rehabilitated. The revised law enables the RCC to raise the price at which it buys bad loans, since the low level has so far discouraged financial institutions from selling problem lending to the governmental debt-collection body. In the past, loans were purchased at 60% of the value of collateral as estimated by realty appraisers. In cases where the collection of debt was deemed especially difficult, in case of gangsters occupation of property, the value of collateral was further reduced by up to 35%. Purchase prices were set much lower than market prices to avoid secondary losses to be borne by taxpayers. In fact, the RCC has so far purchased bad loans at an average of only about 4% of their book value. Last November, the RCC set up a 50-man team to prepare for increased purchases of bad loans. The revised law also gives the RCC a greater role to play in corporate rehabilitation. The RCC collects debts by either liquidating property taken as collateral or rehabilitating debtor companies. The revised law states that the RCC should strive for the prompt rehabilitation of debtors if it is deemed possible. The RCC will study whether debtor companies can be reconstructed by referring to several criteria such as the management's determination to save the firm, competitiveness of core businesses and growth potential of sectors they belong to, and cash flow. Although the management of companies chosen for rehabilitation will be required to resign, the RCC will allow them to stay in office if there are no viable successors. To objectively sort out debtor companies for rehabilitation or liquidation, RCC will set up a screening committee of around 15 experts, including lawyers, business consultants and its own directors, to study each case in detail. A securities analyst points out, however, that less than 10% of debtor companies in bad-loan cases brought to the RCC can be rehabilitated. In addition, an executive of a major bank said that banks will not sell the loans of companies that are capable of being rehabilitated. In fact, the reconstruction of companies in most bad-loan cases brought to the RCC by financial institutions is considered difficult as they are categorized as "virtually bankrupt." (January 11, the Nihon Keizai Shimbun)

The Japanese economy should begin to see some glimmers of growth during the second half of the 2002-2003 fiscal year, but prospects will be stymied by the major structural reform Japan must face to foster a sustainable recovery. In a speech to the Japan Society in New York, Heizo Takenaka said that growth is still set to be minus 1% for the current fiscal year, while growth in the following fiscal period is likely to be around 0%. Although these figures are indicating that the Japanese economy will continue to be stagnant in the second half of the next fiscal year, hopefully there will be some signs of recovery. Takenaka attributed the persistent weakness in the Japanese economy to structural problems, especially the non-performing loan problems, which some economists estimate to be 150 trillion Yen. Structural reform is the key to fundamentally solving the problems besetting the Japanese economy, referring specifically to deregulation, fiscal reform and reform of pension and medical insurance systems. Many private analysts believe Japan is already in, or on the verge of another major banking crisis, largely due to a reluctance by the government to force banks to deal with non-performing and problem loans on their books. Deflation in the economy is fed by a non-functioning banking system, which in turn weighs on overall risk appetite, prompting a freeze in spending both by corporations and households. Breaking this vicious circle is seen as crucial to dragging Japan back onto a growth path. Takenaka rejected suggestions of a banking crisis, although the government is ready to inject emergency capital into the banking system if necessary. In the case of risk or crisis, the government is ready to take any kind of action, very flexibly and boldly. If a capital injection is needed, the decision will be made by the Financial Services Authority. Many economists reckon the Bank of Japan`s monetary policy options are relatively limited, with interest rates in Japan already effectively at zero, particularly in the absence of serious structural reform. (January 10, Dow Jones)

The Financial Services Agency (FSA) is likely to allow, as an exception, banks to have stockholdings in excess of their shareholders' equity if such holdings are the result of a merger or other restructuring move. The agency set a limit on bank shareholdings to take effect from the fiscal half ending September 2004, and is now concerned that the limitation could hamper reorganization of the financial industry. Banks will be permitted to have excess shareholdings due to mergers involving them or their subsidiaries. Banks holding shares above the ceiling will be required to submit to the FSA for approval a plan stating a time frame to reduce the holdings below the limit. Although the agency will not stipulate the time by which the holdings must be reduced, it will make a judgment on whether the plans are appropriate. The limitation was initially set to make the Japanese financial system less vulnerable to fluctuating stock prices. As part of similar efforts to mitigate the impact of the unwinding of banks' stockholdings on the stock market, the government will set up a stock purchasing body, tentatively called Banks Shareholdings Purchase Corp., by the end of January to buy shares from banks. (January 10, the Nihon Keizai Shimbun)

The FSA intends to shorten, in fiscal 2002, the time between on-the-spot bank inspections and notification of the results to less than two months, down from the current six months. By facilitating the inspection process and toughening audits with an increased number of inspectors, the regulator aims to force banks to clean up their bad debts quickly. Currently, the agency takes six months to inspect large banks and about four months for smaller regional banks. Specifically, the FSA plans to focus on credit/liquidity risks and other factors critical in gauging the financial health of banks, and will inform the banks of the results of the priority inspection first. The agency thinks the shorter inspection period will lead to earlier disposals of bad loans, by enabling banks to increase loan loss reserves in the same fiscal year, when the inspection is conducted. As a result, banks' financial statements would more accurately reflect their assets. Faster notification of inspection results would also give banks more time to devise measures to enhance their capital bases, which have been eroded by the bad debt disposals. The FSA is expected to have 44 more bank auditors in fiscal 2002, bringing the total number to 404. The increased staff will allow the agency to conduct special probes targeting loans extended to specific large borrowers, as well as regular annual inspections of major banks. Regarding regional banks, the agency has already started biannual inspections of those with weak financial positions. (January 9, the Nihon Keizai Shimbun)

The heads of four major business organizations said that Japan should accelerate efforts to dispose of banks' bad loans and consider injecting public funds into troubled banks to prevent any financial disorder. According to Mr. Imai, Chairman of the Federation of Economic Organizations (Keidanren), private capital investment remains sluggish, but if an extra budget is enacted, the economy may be bolstered slightly. Hiroshi Okuda, chairman of the Japan Federation of Employers Associations said that Japan now threatens to enter a deflationary spiral. He urged the government to take measures to create jobs and consider tax breaks for homeowners. It may be inevitable for the government to inject public money into troubled banks to prevent financial disorder, according to Mr. Yotaro Kobayashi, chairman of the Japan Association of Corporate Executives. Mr. Nobuo Yamaguchi, chairman of the Japan Chamber of Commerce and Industry expects the nation's GDP to contract 0.5% or 1% this year. The leaders also voiced support for the structural reforms championed by Prime Minister Koizumi. (January 8, the Daily Yomiuri, the Japan Times, the Nihon Keizai Shimbun)

Prime Minister Koizumi stressed the progress made under his structural reform initiative since he took office last April, but failed to offer the details of his plans for averting a financial crisis. The prime minister said he would work on comprehensive tax reform designed to revitalize the private sector and vowed to take any measures to prevent a financial crisis. As for growing fears of credit risks resulting from a series of bankruptcies, Koizumi tried to assure the public that the government is ready to take necessary action. He reiterated his resolve to flexibly deal with a situation that might lead to a financial crisis, leaving the possibility of injecting additional public funds into banks. Under the revised Deposit Insurance Law, which went into effect last April, the government can tap into an emergency fund of 15 trillion Yen to deal with a financial crisis. In case of a chain of bank failures or a widespread credit crunch, the government is to convene a meeting of a council on financial crisis management chaired by the prime minister. If the council determines that the financial credibility of a certain region or the nation as a whole is seriously threatened, the government can tap into the public funds to inject capital into banks and give full protection on deposits. However, clear standards to use the funds, with respect to the degree of deterioration of banks' management, and specific procedures have yet to be mapped out. Koizumi made it clear that he regards comprehensive tax reform as the key to economic structural reform. He said that raising the consumption tax, a sensitive issue that could cause public outrage, will be open for discussion at the Council on Economy and Fiscal Policy meeting starting from this month. Koizumi met with Hideyuki Aizawa, chairman of the Liberal Democratic Party's Research Commission on the Tax System and agreed that the government and the LDP will both begin discussions on tax reform from February, although the LDP usually starts compiling tax reform plans around November each year. Koizumi has not set clear instructions concerning tax reform yet. He is being urged to cut taxes to revitalize the economy, including making progressive tax rates on income less steep and conducting tax cuts on capital investment. At the same time, Koizumi needs to raise taxes for fiscal reconstruction, such as lowering the minimum taxable income and raising the consumption tax. Stressing that he kept his promise to cap new government bond issuance at 30 trillion Yen in the fiscal 2002 budget, Koizumi also dismissed the criticism that he compiled an austerity budget at a time of deflation. The prime minister, however, stopped short of offering specifics as to how he plans to achieve sustainable economic growth. (January 5, the Nihon Keizai Shimbun)

Gearing up for the introduction of government bond strips in fiscal 2002, the Ministry of Finance (MOF) has decided not to impose withholding taxes on strips. Discount bonds carry an 18% withholding tax at the time of issuance, and one view inside the ministry was that the same withholding tax should apply to the creation of government bond strips. However, the MOF ultimately concluded that it has to give precedence to removing a potentially crippling impediment to the development of a healthy market for strips in Japan. The ministry is worried that imposing a tax burden would give investors an incentive to simply hold standard interest-bearing bonds. Strips, in effect, are zero-coupon securities created by stripping, or separating, and repackaging the interest and principal payments of an ordinary bond. The withholding tax on discount bonds will not apply, with the proviso that the holders of the strips are corporations, whose identities are easier for tax authorities to confirm. The MOF has also decided that corporate holders of strips will be required to combine unrealized gains or losses on strips with other income in calculating corporate taxes. (January 4, the Nikkei Financial Daily)

The government's Council on Economic and Fiscal Policy is poised to start examining proposals in January for a new income taxation system that would tax all forms of financial income at a relatively low uniform rate. The proposed dual income tax system, which draws a clear line between financial income and earned income from work, would eliminate any progressive element in taxation of financial income. The plan would also allow investment losses to be offset against any other form of financial income and will boost economic recovery by creating incentives in the tax system for investment in stocks and other financial assets. At the behest of Prime Minister Koizumi, the council will start considering fundamental tax code revisions for fiscal 2003 and further. The idea of a dual income tax system, actually used in Sweden and other northern European nations, is backed strongly by council members from the private sector. It also fits squarely with Koizumi's structural reform drive, which is holding up as one its goals changing the postwar bias in the tax system toward savings over stock market investment. The current tax code is based on a mix of 10 different categories of income, including salaries and wages, interest, and real estate. The categories have a confusing array of rates: interest income on bank deposits is taxed at 20%, for example, while discount government bonds carry an 18% withholding tax. Stock dividends are taxed at 20%, while in principle the capital gains rate on sales of stock will be 20% from 2003. The dual income tax system would clear away the tangle of categories and rates, creating a single, uniform rate for all forms of financial and investment income. Any investment losses would be calculated as part of the total taxable base for financial income, thereby lightening the final tax burden and reducing the risks associated with investment. Unlike taxation of earned income from work, financial income taxation would be non-progressive, meaning that investors would not face higher rates of taxation the more financial income. The Ministry of Finance has a different aim, targeting over the long term a comprehensive system of income taxation that would encompass all forms of income. The government's Tax Commission took a cool stance on the idea of a dual income tax system in an interim report issued in 2000. (January 3, the Nihon Keizai Shimbun)

The FSA will allow banks to sell annuities in fiscal 2002. The agency has finalized plans for a broad easing in fiscal 2002 of restrictions on bank sales of life insurance products. The FSA is now consulting with both the banking and insurance industries to allow banks to sell annuities over the counter to retail customers and to lift restrictions limiting the life insurers whose products banks are permitted to sell. The agency hopes to increase convenience to consumers by letting them purchase insurance products with savings components at bank branches. It is feasible that the move will help to spur a strengthening of ties between the banking and insurance sectors. Deregulation of bank sales of insurance products kicked off in April 2001, when the way was opened for banks to sell three types of nonlife insurance products, as well as one type life insurance product designed to cover mortgage repayments. However, the FSA retained tight restrictions that let banks sell mortgage coverage only from their own life insurance subsidiaries or from life insurers under the same holding company umbrellas. These restrictions will be dropped altogether. The agency is also targeting annuities because banks already sell investment funds, which gives them enough of a track record to head off potential problems in ensuring policyholder protection. Banks are likely to sell both fixed annuities, which guarantee fixed payments in the future, and variable annuities, for which payments hinge on investment performance. The timing of the deregulation is still under negotiation, but with the preparations that banks will have to make to acquire the necessary licenses for staff to sell annuities, the chances are high that the easing will not formally take place before October 2002. (January 1, the Nihon Keizai Shimbun)