Thu, May 02, 2002 page19

• Size means protection -- the strategy of Japan's bank mergers

  • By Patrick Smith / BLOOMBERG
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  If you can think about Japanese banks briefly without worrying about the looming problem of non-performing loans -- and I acknowledge this is a challenge -- the question is just what these institutions will look like when the mess is at last cleaned up.

  Japanese banks have been consolidating at a phenomenal pace since the crisis of the late-1990s. The new names tell it all: Mizuho, Mitsubishi Tokyo Financial Group, UFJ Holdings Inc, Sumitomo Mitsui Banking Corp. None of these entities even existed a few years back. Where once there were 21 major city banks, there are now eight. And it isn't over yet. The announced goal has been six. It's likely that in the end there will be four major Japanese institutions, and some analysts think it may even come down to three -- Mizuho possibly being the final casualty.

  Time for an interim report card, then. And we have an interesting one from James Fiorillo, senior analyst for financials at ING Baring Securities. "Consolidation," his latest piece of major research, is a thoroughgoing look at the operations, management, and strategy questions facing these big new boys on the block. It's the subtitle that draws attention: "Why it's not helping the banks." Fiorillo is as smart as they come among the foreigners dedicated to sorting through Japan's banking sector, and he's not impressed with what he sees. "Three years into the process, the consolidation of Japan's big banks has yet to yield any of the promised returns," Fiorillo begins.

  It's a failure of focus, in Fiorillo's view. The new banks are looking at cost-cutting, for example, when the problem is not costs but low returns on gross assets, since so much of revenue comes from lending and so little from fee-based business. As Fiorillo points out, Japanese institutions are well ahead of leading US and European banks in terms of their "OHRs" -- the ratio of overhead to gross operating income.

  The loan problem has been a major distraction. Banks are worried about asset quality and capital adequacy ratios when they ought to be doing long-term strategic thinking -- most of which is done at the Ministry of Finance in any case -- and consolidation has done nothing to improve things. Post-merger efficiencies -- combined staffs, systems, and so on -- have been elusive, as the computer failures at Mizuho this month demonstrate.

  "Mergers have been rushed, defensive alignments driven by pressure from financial regulators and markets, not strategic considerations," Fiorillo concludes.

  This is the kind of tough thinking that makes Fiorillo less than man-of-the-year among some of Tokyo's financial bureaucrats.

  But amid all the detail and analysis in this commendable work, two things interest me most: what is not there at all and what is there and not said.

  The report is problematic primarily because it lacks the perspective of history. It assumes no cultural dimension in the analysis of economic institutions -- and therefore isn't aware of the cultural bias implicit in its pages. The cost of these lapses is the absence of any notion of strategic design -- and who is doing the designing. The report is, altogether, a very American piece of work.

  "The assumption is that Japanese banks can be understood entirely in the context of shareholder priority," a banking analyst in Tokyo tells me. "It's very Anglo-Saxon -- as if these banks were free-standing financial institutions given to purely rational management and maximum return on equity. They're not. They're different."

  Fiorillo's report, to take one example, starts with the announcement in 1998 of broad plans to merge major banks under the then-new Financial Services Agency, now headed by another not-quite-man-of-the-year, Hakuo Yanagisawa. Fiorillo comes in 13 years too late.

  The restructuring of Japan's banking sector was devised by the Ministry of Finance -- if not quite advertised in neon -- 17 years ago, and it isn't scheduled to end until 2010. View the exercise as a 25-year project, as they do at MOF, and you have some idea of why there is a vast gulf between the alarm of outsiders as to the current state of the banks and the apparent shrugs of top Tokyo bureaucrats.

  Equally, it's important to recognize that the bank restructuring process is not market-driven. It has been plain all along that the MOF has no intention of opening the financial sector, which it views as a strategic industry, completely to market forces. The non-performing loan problem has certainly left its mark on the strategic design, but the plan put in place in 1985 is in fact still going through. From this perspective, the loan problem is a bump in the road.

  Fiorillo's report is evidence of the process now in motion.

  It is simply missing a theory as to the finished look. Japan may be slowly accepting competitive principles, but the MOF settled years ago on Germany's "Allfinanz" model -- universal banks.

  That is the story embedded in the elaborate chart Fiorillo furnishes at the end of his report. But Fiorillo seems to be looking more for vertical integration than horizontal.

  Only tentatively does Fiorillo conclude that the process might not be over. "Further integration with the insurance sector after the demutualization of life insurance firms seems to be in the cards as well," he writes. If I'm correct as to the strategic direction of things, there is no "might" in this. It's all in the bureaucratic sausage machine already.

  "Overcapacity is a particularly devilish problem for Japanese banks," Fiorillo writes, "because, in our view, it does not mean too many banks, but that banking plays too large a role in the country's finances relative to capital markets."

  Well, overcapacity does mean too many banks, last time I looked. The term Fiorillo may be looking for is intermediation -- too much bank credit in the economy. And once banks go to the universal model, the disintermediation process Fiorillo finds lacking will take place -- but precisely because the banks will have moved from simple lending to offering everything under one roof. This will have fundamental implications for Western institutions operating in the Japanese market.

  "In our view, there has been no major change in the mindset of Japanese bank management," Fiorillo says. "That is, bank management does not appear to have been driven by the quest to maximize shareholder value through these alliances."

  That is quite correct: Shareholder value is not on anybody's radar screen in the somewhat Confucian world of Japanese banking.

  Why, then, the quest? "The quest, we believe, has been for size in order to ensure some degree of protection from financial regulator and markets."

  That is not quite correct. The protection sought is primarily from foreign competition, and it is desired by both the banks and the strategy-making bureaucrats at the Ministry of Finance. Look again at that press conference in August 1999, at which the merger to produce Mizuho Bank was announced. In his remarks on the matter, Masao Nishimura, then president of Industrial Bank of Japan, one of the three banks to merge, was subtly but unmistakably anti-foreign in his celebration of the new bank's power and strength. Nishimura retired last month as chairman and co-chief executive at Mizuho Holdings Inc.
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