Economy, No.10  Feb. 3, 2012


The financial sector has reached freezing point

Photo : Kuratsu Yasuyuki

Kuratsu Yasuyuki

More than three years have passed since the collapse of Lehman Brothers in the fall of 2008, and it has been two and a half years since the U.S. economy–which was hard hit by the collapse–bottomed out of its economic downturn. During these periods, despite difficulties in dealing with nonperforming assets, major financial institutions in Western countries have somehow managed to cope with the crises, aided by public money and business restructuring. However, they have not fully recovered. Indeed, their ailments appear to have exacerbated by the fiscal crisis in Europe, which began in Greece.

This precarious situation has become apparent in the wave of layoffs instigated by financial institutions since the summer of 2011. In August 2011, when the financial markets were on high alert in the face of the uncertain outlook of Greece and the U.S. fiscal problems, financial institutions in Europe and the United States announced redundancy plan totaling approximately 60,000. While major financial institutions continued to announce plans for further staff cutbacks in September 2011 and beyond, financial institutions have already reached the freezing point even before winter has begun.

Two main factors have prompted Western financial institutions to take these measures. First, they are suffering from the aftershocks of the collapse of credit, mainly in the real estate industry. Second, they share the view that a v-shape recovery in demand for financing and in the volume of financial transactions is unlikely to occur for some time in the future. Moreover, in addition to the strict capital requirements imposed by the Basel Committee, major banks are now also required to increase their capital following the decision made at the G20 summit. Since deregulation in the 1980s, major banks had enjoyed a long period of expansion. But in a 180-degree policy shift, they are now looking to restrain their activities. This is a major turning point in the history of the financial market.

In Europe, the market has started to distrust Italian fiscal situation, which follows the case of Greece. In the United States, deliberations on policies to reduce the deficit have stalled. With uncertainty in these capital markets, banks are facing difficulties to raise enough capital.. The first and foremost thought in the minds of bank managers is to sell off assets. Some banks have in fact already started to sell their project finance, real estate financing, asset management, and other businesses. It is almost certain that this trend will accelerate in 2012 and beyond.

How have major Western financial institutions ended up in such dire circumstances after producing bonanza just a few years ago? It is true that the sub-prime loan crisis originating in the United States in 2007 and the fiscal problems emerging from Greece in 2010 triggered turmoil in the financial markets. But these events share a core issue: the imprudent growth in financial transactions over the last ten years. Put simply, the problem is the sprawling amount of debt, which has gone well beyond acceptable levels.

The financial markets today look as they have begun to collapse under the weight of the accumulated debt that the markets themselves have created. The only solution is deleveraging, or reducing the amount of debt. A number of major media outlets have been focusing on the aspect of strengthening banks’ capital. But what is really needed is to slash banks’ existing assets, or the debt owed by borrowers.

Japanese banks offer a sense of stability

While Western financial institutions are facing a major turning point, Japanese financial institutions are relatively stable. Of course, Japanese banks and securities companies face a difficult management environment, given a slump in demand for financing and a sluggish stock market. But they sustained relatively little direct damage from the sub-prime loan crisis and Greek fiscal crisis. The Japanese banks that managed to escape from the quagmire of nonperforming loans in the 1990s with an injection of public funds have gradually resumed overseas investments. Major securities companies have also adopted new strategies to focus on Asia.

Today, Japanese banks’ nonperforming loan ratio is one of the lowest in the world. Banks in the United States are still facing the negative legacy of mortgages, and those in Europe are suffering from a double whammy: nonperforming loans and a drop in the value of government bonds. Chinese banks, meanwhile, are hugely piling up potential nonperforming loans. Although the amount of nonperforming loans has also been increasing gradually in Japan, given the effects of the earthquake and the sluggish local economy. Nonetheless, the impact of these loans is small in Japan compared with those of overseas.

One of the reasons for the strengthening of the yen is this soundness of the Japanese financial system. Media reports emphasize that the recent rise of the yen reflects the fact that the yen has become the only choice left for investors who baulk at riskier alternatives. However, this explains only one third of the ongoing events. The second factor is the easy money policy that has been almost blindly adopted by the United States, while the third factor is Japan’s strong manufacturing industry, high real interest rates, massive overseas assets, stable financial system, and other positive factors, which are strongly appealing to overseas investors.

The fact, in particular, that a relatively sound balance sheet of Japanese financial institutions appears to be underestimated in Japan.

This underestimation reflects the absence of any success stories in the recovery strategies produced by the managers of Japan’s financial institutions. These managers have carried out a number of plans since finally ridding their institutions of bad debt. However, they blundered in their strategies for the consumer finance business, stumbled over the problems in unsecured loans to small and medium enterprises, failed to produce meaningful results from the acquisition of U.S. financial institutions, and were unable to come up with effective strategies in Asia. Although they have secured reasonable earnings, a majority of these earnings often come from trading of government bonds.

In this environment, and with a need to reduce their assets, financial institutions in Europe and the United States have been approaching Japanese financial institutions with offers to sell their businesses and assets. Following a decision taken at the latest G20 summit, Japan’s three mega banks will be required to increase their capital. However, the burden of this is relatively small for Japanese banks, as they need only raise their capital ratio by 1.0%, compared with 2.5% for JP Morgan, HSBC, and other banks. Although Chinese financial institutions could be strong potential buyers, Western banks have built strong ties with Japanese banks over the last several decades, and are likely to feel more confident in dealing with Japanese.

Moreover, the tide is running in favor for Japanese financial institutions. With the decline in the creditworthiness of financial institutions in Europe and the United States, the relative credibility of Japanese financial institutions has been raised. This is more of a windfall than the credit they recently earned. Nonetheless, it is a fact that some major overseas companies have started to turn to Japanese financial institutions as fund providers.

In these circumstances, some have begun to argue that if anybody can rescue the world from the ongoing crises, it could be in fact the Japanese financial institutions. Although the mainstream market opinion is that emerging economies will save the developed countries’ economies, Japanese financial institutions may indeed have their own role to play.

Even with these favorable trends, however, if Japanese financial institutions simply adopt strategies that are mere extension of the past policies, they are likely to repeat the same mistakes. This turning point in the history of finance is also a turning point in the history of economics.

Aiming at bolstering its overseas investment banking business, Mitsubishi UFJ made a 9 billion dollar investment in the autumn of 2008 to save Morgan Stanley, which was on the verge of collapse. Yet three years have passed since this investment, and Mitsubishi UFJ has only found international capital market businesses weakening to a much greater extent than it had anticipated. Nomura Securities, which acquired the Europe, Middle East and Asia Division of Lehman Brothers, has also failed to produce decent results. Even Goldman Sachs, the leading investment bank, reported losses for the July-September term. In this environment, expectations of strong results from the investment banking business have been withering.

That aside, we cannot simply expect the growth potential of the commercial banking business. As described above, in light of the fact that the priority is to clean up balance sheets in developed economies, demand for new financing is unlikely to grow for the foreseeable future. Yet financing opportunities in emerging economies in Asia and elsewhere are set to rise in the future. With Western financial institutions reticent about lending, this financing will be made in local currencies or in major currencies such as the U.S. dollar and euro. As a result, Japanese financial institutions, whose base currency is the yen, will have a critical disadvantage to grasping these opportunities.

In the financial sector, both investment banks and commercial banks reached an impasse. The only sector that shows growth potential is the asset management business. But this is an area in which Japan’s institutions are out of touch. Consequently, some think that the best option for Japanese financial institutions is to strengthen such an acquisition strategies. However, it is almost impossible for Japanese institutions with limited financial management skills to manage savvy overseas institutions. In this respect, Japanese financial institutions are very different from Japan’s manufacturing companies, who possess the world’s most advanced technologies.

Japan must look a decade ahead for inspiration

Does this mean that Japanese financial institutions lack the qualities needed to save the world? This question can only be answered by understanding the outlook of the global economy and changes to the financial market in the future. Viewing the outlook of the global economy in a simplistic manner, developed economies will continue to struggle with slow growth, the relative strength of the U.S. dollar will decline, and emerging economies will gain in strength. The financial business will change in line with these developments. In the course of this change, acquisition strategies that rely on the ample money alone may not be that successful.

Even if the U.S. economy continues to grow slowly, the international currency system dominated by the U.S. dollar is unlikely to change drastically in the future. There are no eligible currencies to replace the U.S. dollar. However, it is almost certain that the global financial market will gradually shift to a system based on three major currencies: the U.S. dollar, euro, and Chinese yuan. As this happens, it is inevitable that the presence of the yen, which remains unsupported by an effective currency strategy, will decline. On the other hand, having multiple currencies for international settlement will impose an additional burden on corporate financial management. As a result, the business sector will show more interest in the concept of a currency basket, as it is far easier for them to manage foreign exchange risks.

Certain European countries and emerging economies have already been engaged in extensive discussions related to the currency basket. This reflects increasing distrust of U.S. financial policies and the U.S. dollar since the collapse of Lehman Brothers. Many recall that in 2009, China drew attention of the world when it proposed to specifically make the SDR, the Special Drawing Rights of the International Monetary Fund (IMF), as the center of the reserve currency system. The IMF is actually reviewing that possibility.

The SDR is a currency basket that comprises the U.S. dollar, the euro, the pound, and the yen. It has no notes or coins, and not tradable in the financial markets. The SDR was created in 1969 to supplement the reserve assets of member countries, and only functions as a claiming right that can be exchanged for the four currencies mentioned above. Still, it can potentially be used as an accounting unit. China has in fact already purchased IMF bonds denominated in the SDR.

To avoid misunderstanding, I would like to point out that a currency basket does not mean that a sovereign country discards its own currency and adopts a common currency. Japan will never abandon the yen, and the United States will never give up the U.S. dollar. Rather, a currency basket is a currency that is used for trade settlement or foreign currency reserves. It is close to the Bancor, the supranational currency that John Maynard Keynes conceptualized in the 1940s.

For Japanese companies too, transactions in the SDR are more reliable than those in the U.S. dollar. For example, even if the value of the U.S. dollar drops after the Federal Reserve Board (FRB) adopts radically easy monetary policies, the value of the euro or pound may rise, but the value of the SDR will hold fairly firm. European countries, China and certain other countries have begun to think that this type of currency basket system is more beneficial than a currency system that is always exposed to fluctuations of the U.S. dollar. Brazil and other emerging economies have also started to support the currency basket system. Naturally, the United States, a country which former French President Giscard d’Estaing once said possesses “exorbitant privileges”, has been ignoring these developments.

The Japanese government has not changed its policy of following the stance of the United States, but Japanese financial institutions need not to follow the same course. While Western and Chinese financial institutions are preoccupied with the problems of their own countries, Japan has the time and energy to look at developing the necessary infrastructure for the currency basket system.

This does not have to be the SDR. The important thing is to start experimenting with a new market. We can learn from the experience of European financial institutions which started to use the European Currency Unit (ECU) in the capital market in the 1990s.

If Japanese banks or securities companies stick to doing business in the yen, opportunities for overseas businesses will be limited. If so, Japanese financial institutions will be far from saving the world, and they will inevitably find themselves falling behind totally.

The Japanese financial industry needs new inspiration in developing the infrastructure of a currency basket system with an eye to a decade to come. I believe such bold action will enable the industry to achieve two goals simultaneously, strengthening its own management foundations and stabilizing the global economy.

Translated from “‘Sekai keizai wo sukueru’ hogin no anadorenai jitsuryoku (Japanese Banks Have the Potential to Save the Global Economy),” Voice, January 2012, pp. 70-74. (Courtesy of PHP Kenkyusho)