Japanese Banks Use Credit Derivatives to Temporarily Shrink Their Balance Sheets


Following Mr. Takenaka's arrival at the FSA and with mandated stiffer (albeit watered down) NPL evaluations inevitable, Japan's major banks have turned to credit derivatives to shrink their reported asset bases that are counted in regulatory capital ratios. In essence, the bank sets up a SPC (special purpose corporation), pays a set premium for receiving protection against default, and investors hold the bonds issued by the bank-linked SPC. If loan losses are realized, the principal of the bond is reduced. In effect, the bank is able to transfer the credit risk to investors, and has achieved the equivalent of selling the credit without the mess of dealing with the borrower and other creditors.


However, these credit derivatives are not the rosetta stone for dealing with NPLs. It is only a temporary respite. The redemption period for the bonds issued is rather short, at 2.5 years in the cases already used, and after the bonds are redeemed, the banks reported balance sheet and capital ratio reverts to where it was before the credit derivative was initiated. In other words, the banks are merely buying time. Of course, once the first bunch of bonds mature, they could be rolled over into another program--thereby creating a rolling "tobashi"--i.e., continuing to put off the realization of losses that should have been taken long ago. Moreover, the cost of these programs to the banks cannot be ignored, and to break even net-net, the bank would have to earn enough additional interest income to offset the increased cost.


It is likely the banks will try to reduce their reported asset base by the amount they expect they will have to make additional provisions for under stricter NPL classification standards, at least so they can squeeze past the next March reporting period without having to take additional losses for loan-loss provisions. The fact is that they are approaching the limits of the DTA (deferred tax assets) they can count as Tier 1 capital.

New Industrial Revitalization Organization Becomes Political Football


A key component of the Koizumi Administration's anti-deflation measures is a new industrial revitalization organization which is supposed to be on the other side of accelerated NPL disposal efforts. METI and the MOF are already fighting to gain the pole position in determining how the new Agency operates, while the Council on Economic and Fiscal Policy, lead by the Koizumi Administration, maintains the organization cannot be handled by a single ministry or agency. The CEFP does however foresee the body's guidelines for assessing whether individual companies can be revived will be similar to the standards used for a revised Industrial Revitalization Law, which is slated to take effect in April 2003. The Economic Ministry plans to release draft standards by the end of November, then negotiate with related ministries and agencies before finalizing.


The MOF was alarmed over proposals to merge the RCC and the Development Bank of Japan, and to have the RCC buy NPLs at book value instead of their real economic value. METI, operating under the current Industrial Revitalization Law, are the ones that gave Daiei successive bail-outs. The Koizumi Administration fears that, in the wrong hands, the new Agency would merely be another vehicle for protecting Japan's debt-ridden losers. The Tax Agency wants to hear no talk of tax incentives for rehabilitating companies, as 70% of Japan's companies currently pay no tax anyway.