"Moving the Goalposts" Has Mostly Worked in the Banks' Favor


Faced, with new hard-nosed proposals to get them to accelerate the liquidation of NPLs and to clean up their loan books, the major banks pulled every political lever they had in opposing Heizo "hard landing" Takenaka's proposals in bank accounting rules. "You are forcing us to instigate a credit crunch!", they cried, and threatened to take Mr. Takenaka to court if his proposals saw the light of day.


What they did not mention is that the government has bent over backward to make life easy for them for the last 10 years. Whenever the situation deteriorated to the point that their cozy, comfortable positions were threatened, the government just simply changed the rules. Moreover, it has consistently understated the true conditions of their balance sheets in order to keep an unsuspecting saving public in the dark about their true financial position. The Bank of Japan aided and abetted in this charade by keeping the yield curve as steep as possible, and through regular purchases of JGBs that has virtually guaranteed the banks would make money on their bond holdings.


Since 1994, the government has successively introduced measures to make it easier for the banks, including liberalizing stock buy-backs and allowing treasury stock, allowing the banks to revalue their property and record the gains in equity, allowing them to use deferred tax assets on write-downs of NPLs for up to five years, introduced a stock buy-back organization, and have recieved infusions of public funds to the tune of over JPY9 trillion without the government ever demanding that bank management take responsibility for the massive destruction of market capitalization they have presided over for the past 10 years. The government has also succesively introduced more stringent restrictions on the short-selling of stocks, to try and keep hedge funds from too aggressively shorting the bank stocks, and created the RCC, which had access to funds through the Deposit Insurance. All of this in the name of ensuring the stability of the financial system, of which banks have traditionally been considered an itegral part.


True, the government also introduced market value-based accounting that forced them to revalue their securities holdings at market, but if the stock market had been on the upswing, this would have resulted in gains, not losses. It has also not allowed them to take NPL write-downs on a tax-deductible basis, instead forcing them to pay taxes first, then recording deferred tax assets. But all-in-all, the banks have remained a protected species, and have generally taken advantage of the government's largesse and patronistic attitude toward their restructuring.


For hard liners such as Takenaka at the FSA and Hayami at the Bank of Japan, it was time to get tough with the banks, and to wean them from the LDP's and the bureaucracy's pork barrel. For every time the government moved to aid the banks, it drained an equivalent amount out of Japan's potential GDP growth and the stock market. Instead of being the money multipliers for a healthy economic, the major banks became a black hole, into which liquidity in the trillions of yen was pumped in by the Bank of Japan, but nothing came out on the other side to aid the economy. Instead of providing funding to viable medium- and small-enterprises, their funding activities were mainly supporting deadbeat borrowers that were sucking the life out of the economy, rather than greasing the wheels of commerce that provided the underpinnings of growth in Japan's economy.


Since Q1/2000 when Japan's stock market was riding a TMT (i.e., internet, telecommunications, technology and media) wave, JPY296.76 trillion of market capitalization has been lost on the Topix, or some 44%. While the electronics and telecommunications sectors have respectively lost JPY54.1 trillion and JPY41.7 trillion (59% and 69%), the Topix banking sector trended basically flat during the TMT bubble, and subsequently fell almost as fast as the TMT stocks, by 53% in losing JPY23.3 trillion of market capitalization. In other words, due to the bank's structural problems, they have not contributed significantly to any rallies in the Japanese stock market (other than one-month short-covering surges), while they have contribued almost as much to the downside as the "bubble" TMT stocks have. The Catch 22 nature of the close linkage of their reported profits and balance sheet quality to the stock market is working only as a negative risk.

Takenaka Waters Down Proposals


After some of his own subordinates in the FSA leaked the contents of discussions on the bank clean-up package to the press in the process of proferring their own ideas, new FSA Minister Takenaka was blown aback by a storm of resistance from all sides. In meetings with LDP leaders, Mr. Takenaka signalled where he was willing to compromise on his much-feared proposals. First of all, the proposals are aimed at only the major banks as a start. Regional banks will be considered later. He was however firm in his belief that stricter audits of the bank loan portfolios for the largest borrowers should be done in the March 2003 accounting year. He also believes that the banks should be able to write off NPLs on a tax-deductible basis, while he is not prepared to waffle on the issue of DTA (deferred tax assets). Currently, deferred tax assets can be carried forward for five years, while he believes the carry-forward period should be one year, as in the US. Moreover, while the DTAs currently account for a significant amount of the banks' Tier 1 capital, he believes that DTAs should account for no more than 10% of Tier 1 capital. As for introduction of the stricter DTA rules, however, he is willing to wait until March 2004 for implementation. In addition, he is willing to allow that a sudden change in the rules, i.e., introduction of stricter DTA accounting and introduction of discounted cash flow analysis for evaluation of NPLs could result in the banks' needing additional public fund infusions. In this case, while bank management in principle should be held responsible for the mess, an exception could be made considering that it was the change in accounting rules that caused the bank to run out of capital, and thus bank management may not be taken to task. As for the preferred shares owned by the government, he believes they should be converted to regular voting shares. Rather than have the government attempt to manage the bank, however, as major shareholders the government could get new management in and monitor their performance with more stringent corporate governance. As for how the RCC would be used, the FSA's special project team would ostensibly consider this as the second step, with a final proposal expected to come at the end of November.

ISS to Develop Corporate Governance Rankings for Japan


Institutional Shareholder Services plans to begin a corporate governance ranking for Japanese companies by the second half of 2003, consisting of an evaluation of 51 items. The group is of the opinion that, given the accounting scandals in the US, global interest in corporate governance is on the rise. In Japan, the Government Investment Pension Fund (GPIF) and other public pension funds have already drawn up proxy voting guidelines, and are requiring their asset managers to develop their own in-house voting guidelines. The Japan Securities Investment Advisory Association has also set proxy voting guidelines for its members. Thus the trend for Japanese institutions is to also invest in those companies with good corporate governance.


While the ISS corporate governance evaluation items for Japan companies will be different than their US company guidelines, their US company evaluation criteria include the following: a) Board of Governors..1) is the ratio of outside directors high?, 2) does the compensation committee consist of outside directors?, 3) is the size of the board appropriate?, 4) does the board respond adequately to shareholder proposals?. b) Compensation for Board Directors. a) are stock option costs appropriate?, b) is the review of execution prices for options appropriate?, c) is board compensation linked to the compensation committee's recommendations?. 3) Quantitative issues, a) are there board member term limits?, 5) Director Stock Holdings. a) are board members stockholders?, b) are there rules regarding board member stock holdings?

If the Japanese Government Converts the Preferred Shares of the Banks, They Will End up Owning Them
>BR>
Another issue currently under consideration by the Takenaka group is converting the government's holdings of non-voting preferred bank stocks to regular voting shares. If these shares are converted, the government would own an average of 25% of the major banks' outstanding shares, and the ratio would exceed 50% in some cases. The government has already bolstered the capital of the major banks on two occasions--March 1998 and March 1999. The capital infusions at the time were made with certain rules attached. If the financial condition of the banks deteriorated and investors lost a significant amount of faith in the banks, the government had the option of converting these preferred shares into regular voting shares. Tokyo Mitsubishi has already repaid public monies received, while most of the preferred shares bought from Mizuho Financial are not convertible until one~two years from now. All the other preferred shares have past the lock-out period for the conversion of preferred shares into voting shares. For Mitsui Sumitomo Bank, the government would end up owning some 20%, while they hold the equivalent of 25% of UFJ Group. For Mitsui Trust Financial Group, the ratio is over 50%.

70% of Japan's Investment Advisory Firms are Ready to Vote Proxies


Reacting to proxy voting guidelines set up by public pension funds, the nation's assets managers are getting their internal organizations ready to be able to vote their client's proxies and to report back to them how they voted. According to a survey by the Japan Securities Investment Advisory Association, 70% of their members say they have completed the necessary internal preparations. At the previous June shareholder meetings, 50% submitted opposing votes, for issues such as generous retirement benefits, allocation of profits and elections of board members. The Association itself also began to require its members to be prepared to vote proxies this April. The Association however does admit that there is a lot more work to be done on internal preparations for proxy voting guidelines, systematic voting and reporting of the results.

Heizo Takenaka's Financial Reform "Cowboys"


The hand-picked committee to advise FSA Minister Takenaka on measures to accelerate NPL disposals is playing their cards pretty close to their chest. The council has now met over five times, but no details of the meetings have been made public. While no formal recommendations from the committee have been released, they are apparently considering bank capital infusions within the confines of current laws that provide for government funding when "the threat of a financial crisis" is present, as determined by the Prime Minister, as provided under Article 102 of the Deposit Insurance Company Law. They also apparently agree on using the RCC (Resolution and Collection Corporation) as the vehicle to seperate the bad credits from the good credits on the bank loan books, and to substantially expand the RCC's ability to function as a corporate restructuring vehicle, ostensibly by combining it with the Japan Development Bank.


The more controversial issues such as the use of DCF (discounted cash flow) methodologies to determine the true economic value of NPLs for loan-loss provisions, and a re-assessment of deferred tax assets to a maximum of 10% of core capital, may never see the light of day, or it will be over the dead bodies of the old iron triangle. If in the unlikely event they are introduced, a suitably long introduction period would be a given. To salve the pain of higher required loan-loss reserves, the team is considering making NPL write-offs that are now done with taxable income non-taxable. The CEFP is also recommending that NPL write-offs be made non-taxable, but the actual implementation will be after a round or two with the Tax Agency.

Tokyo Style; A Sudden Desire to Buy-Back Stock


Following a proxy battle with M&A Consulting's Mr. Murakami, Tokyo Style has embarked on an aggressive stock buy-back program. At their May shareholders meeting, the company agreed to repurchase 4% of outstanding shares, or 4 million shares, and next year intend to purchase a similar amount by the next annual shareholders meeting. In purchasing 4.18 million shares, they spent JPY4.3 billion in excess cash.


The sudden change of tact by management was encouraged by the banks and insurance companies. The banks need to reduce their strategic holdings of companies to within their core capital by September 2004, and a cash-rich company like Tokyo Style is susceptible to such sales.

Remaking Japan; 5~10 Years of Stagnation Away?


Today, Japan's economy is worse off than when PM Koizumi first came into office on the promise of substantial reforms. Over JPY100 trillion of market capitalization has been erased from the stock market. Yet the old iron triangle is still not ready to relinquish its grip on power, and Japan is not yet ready to take the pain of achieving the reforms that would put Japan's economy back on a solid growth track. There is little sense of urgency in the deeply entrenched bureaucracy, the upper echelons of the LDP leadersship, and in many old-line companies on the government and the banks' dole. Japan's mostly unchecked and unaccountable bureaucracy continues on autopilot, because the funds are still flowing from the huge pool of the nation's personal financial assets, much of it in the national pension system and in the postal savings system, which has been one huge piggy bank for the bureaucrats and politicians to play with. (William Pesek, Bloomberg)


All of the old iron triangle constituents vehemently oppose Mr. Heizo Takenaka's recipe for cleaning up the NPL mess. They claim that coming down hard on the banks without a clear and organized plan to offset the deflationary impact would result in a financial crisis and a deep contraction in Japan's economy. They are right in that the measures to ostensibly offset a hard landing for the banks are still fuzzy. The Council on Economic and Fiscal Policy (CEFP) has called for tax cuts of JPY2.5 trillion, and say that a comprehensive JPY5 trillion package of measures to support small and medium-sized companies, aid in the expected surge in unemployment and countermeasurs to restructuring and consolidate heavily endebted borrowers is required. Others like Richard Koo of Nomura claim that something more like JPY10 trillion is needed in fiscal stimulus to fill the current deflationary gap in Japan's economy, because; a) this is no ordinary recession, b) tax cuts wouldn't work fast enough, c) companies would become even more cautious about investing.


But to expect that fresh fiscal and monetary measures alone can cure the problem of deflation is like howling at the moon. Current price trends in Japan reflect the process of bringing Japan's prices in line with global levels. Falling prices are a phenomenon on the "new" economy. It is common to all developed economies that compete with developing economies. If a combined index reflecting Japan's consumer prices, unemployment rates and annual rate of stock market decline is compared with Europe and the US, Japan's deflation problems look less serious. Critics charge that Koizumi is only trying to impose pain without presenting a scenario for recovery. But leaving the cancer of bad loans unattended only makes matters worse, and seriously inhibits any efforts to kick-start Japan's economy.