More than meets the eye: the financial revival program has been criticized for being watered down and vague; so why are the banks reacting so strongly to it? (Moneywatch).

FROM A PEAK IN early 2000 when the Topix barely cleared 1,700 for the fourth time since 1994, it's been a one-way downhill street for the Japanese equity market. Ironically, the worst perpetrator of this rout was not the beleaguered banks, but the evaporation of the growth myth in Japan's high-tech sector. The worst part of the sell-off in the banks came later, as the aftermath of Japan's mini-bubble pulled stock prices below the break-even levels of the banks' portfolio holdings of cross-held securities.

Thus, after narrowly avoiding a March crisis this year, the government and the banks by October again found themselves between a rock and a hard place. Responding to claims that his reforms were largely ineffective, prime minister Junichiro Koizumi canned the head of the Financial Services Agency (FSA), replacing him with Heizo Takenaka, a fast-rising economist from the private sector who was already effectively in charge of economic and fiscal policy.

After spooking the stock market and the banks through leaks to the press of a "no pain, no gain" reform program to force the banks to accelerate bad-loan disposals, Takenaka and the Koizumi administration announced their "Financial Revival Program" on October 30. Rather than alleviate investor fears about the viability of bank stocks, the program only re-accelerated the sell-off in bank stocks, which had begun following a modest rally as the result of a rash of announcements in late 1999 that produced the present big four banking groups.

As usual, the flurry of activity and press leaks leading up to the announcement of the Financial Revival Program built up investor fears and expectations that the Japanese government was finally moving to put the pedal to the metal on bank reform. The actual release of the program, as usual, proved anticlimactic. The more onerous proposals that had been floating around in the press, such as more clearly defined "management responsibility," stricter treatment of deferred tax assets and "nationalization" appeared to have been significantly watered down. Indeed, the announcement itself was delayed at the last minute, due to strong resistance to certain wording in the program by the ruling party. Dyed-in-the-wool reformists were disappointed, and the Street began to suspect that yet another aggressive reformer had been shot down by an inbred, entrenched political system that is jealously guarding against change.

The program was initially criticized as having been "defanged" because it lacked specificity, which does not mean that it goes easy on the banks. Every proposed action in the program has significant implications for the banking industry. Under the new program, the classification of loans to large borrowers will be standardized among lenders, the assessment criteria for loans requiring special attention will be stricter, and a new discounted cash flow (DCF) valuation method will be introduced for the calculation of loan-loss provisions.

Even the time periods assumed (i.e., how many years are considered when gauging the possibility of irrecoverable debts) will be extended. Heretofore, loan-loss reserves were made based on a one-year forward time frame for "normal" loans, and a three-year forward time frame for "special attention" loans. Moreover, the banks will have to report the current market value of previous debt-equity swaps and record any valuation losses that result.

As of the end of fiscal 2001, the major banks had "special attention" loans of [yen]11.3 trillion. With the introduction of discounted cash flow evaluation, the required loan-loss reserves are expected to be revised up at least 10 percent and require additional reserves of at least [yen]1 trillion. A lengthening of the time period considered for irrecoverable debts and the recording of latent losses on debt-equity swaps could well make this number even larger.

The work schedule

The "work schedule" was the FSA's attempt to more clearly define exactly what it meant in the program and to give an idea of the implementation time schedule it had in mind. It appears that the authors of the work schedule learned a valuable lesson about tactics from the tiff they had with ruling party politicians over the program. This time they were able to get the "work schedule" out without any portion of it being seriously tampered with by opposition politicians. It also became evident through reports about the meetings the FSA had with bank officials that, at least in the FSA's mind, the conversion of preferred shares into regular voting shares was essentially an operational question, not a legal question. Moreover, the Koizumi administration, through chief cabinet secretary Yasuo Fukuda, has signaled that bank nationalizations are a definite option and legally possible under the provisions of Article 102 of the Deposit Insurance Corporation Law.

However, the government (particularly financial services minister Heizo Takenaka) has gone out of its way to allay investor fears that a bank nationalization would mean investors get left holding bags of worthless slips of paper that used to be bank stocks. Investors still remember clearly what happened to the value of stocks held in Long-Term Credit Bank (revived as Shinsei Bank) and Nippon Credit Bank (revived as Aozora Bank).

A major uncertainty that remains, however, is just what criteria the government would use in determining that a bank should be dubbed a "special support financial institution." Reading through the program and related documents, one gets the distinct impression that becoming a "special support financial institution" is something that bank management would want to avoid at all costs. For one, the FSA promises to "vigorously" pursue management responsibility. In addition, when individual financial institutions incur financial difficulties and/or a shortage of capital, "special support" will be expeditiously applied. While more details are skimpy, senior vice FSA minister Tatsuya Ito did indicate that banks would be subject to "special support" when:

1. Management conditions are such that emergency countermeasures are required

2. The bank itself applies for public funding

3. The preferred shares held by the government and converted into regular voting shares exceed a specific percentage of outstanding shares

Measures with bite

The Financial Revival Program, while watered down from initial proposals, still has plenty of bite regarding the banks. Within this fiscal year:

1. The FSA has already requested stricter and more reasonable assessment of deferred tax assets

2. Harmonization of loan classifications among the banks for large borrowers will be implemented

3. Discounted cash flow valuations will be introduced for calculation of needed loan-loss provisions

4. Management will be required to verify the accuracy of bank financial statements like the Sarbane Oxiey Act in the US

It remains to be seen whether the FSA and Takenaka can achieve their goal of reducing the nonperforming loan (NPL) ratio of major banks by half (it is currently more than 8 percent), or in other words, writing off by fiscal 2004 over [Yen]13 trillion of nonperforming loans, which continue to grow faster than the current pace of NPL liquidation. One thing is sure, however: Despite virulent resistance and hostility by the banks to the Financial Revival Program, Takenaka and his program have their undivided attention now. Yes, if nothing else, the program is a stern call to action for the banks. This message has apparently not gone unnoticed by the banks. Since the FSA starting the ball rolling on the program, there has been a sudden pick-up of activity by the banks regarding their NPLs and capital ratios.

In early December, Mizuho Financial Group announced a new reorganization program under which as much as [Yen]5 trillion of NPLs will be separated from banking operations and transferred to a new entity set up to recover loans and oversee the restructuring of distressed borrowers. The group now believes that having a single entity to handle loan collections and borrower restructurings will facilitate quicker reduction of bad loans.

MoneyWatch's question is, why couldn't the group have initiated this and other bolder measures when the three-way merger that created Mizuho Financial was announced?

In December, the bank also announced that it was considering a capital increase in preparation for accelerated NPL disposals that would likely push its capital ratio below the required 8 percent. It will be holding an emergency shareholders' meeting this month, apparently because it cannot wait until the June regular shareholders' meeting to get approval to issue capital.

Also in December, Sumitomo Mitsui Financial (SMF) announced that it is considering acquiring Aozora Bank. What SMF is really after is a means to bolster its equity capital ratio, as Aozora's core equity capital ratio is 12.7 percent, while SMF's is more like 5.3. Thus purchasing Aozora would boost SMF's capital ratio by some 0.5 percentage points.

On November 25, UFJ Bank announced that it would be forming a new company within the fiscal year into which Yl trillion of NPLs of small- and medium-sized companies would be transferred. Since the new company will be a subsidiary of UFJ and be reflected in consolidated accounts, the issuance of preferred stock will work to boost the bank's regulatory capital ratio.

On November 22, the Nihon Keizai Shimbun, Japan's leading business daily, reported that major banks were stepping up efforts to secure sufficient funds for the fiscal year-end in March of next year. A handful of major banks are reportedly rushing to obtain funds for the fiscal year-end and apparently raised their offered rates in order to secure the money. The financial institutions are rushing to secure funds "because we cannot shake off our broad concerns about how depositors may respond" to a possible financial crisis toward the fiscal year-end, according to an official at a major bank.

It is apparent that the Financial Revival Program and plunging values in bank stocks have jolted the banks into responding, albeit incrementally. But whether this is enough to stave off yet another March crisis remains to be seen. Moreover, assuming that the Financial Revival Program is at least partially effective, while the Industrial Revival Corp. is not (at least as regards fostering NPL write-offs and revitalizing "recoverable" firms as opposed to merely propping up zombie companies) the net result could be what the opponents of the Financial Revival Program feared: exacerbated deflation, a rush of bankruptcies and downward pressure on an already faltering economy. That cannot be good for stock prices.