Making progress

The recovery in Japan’s banking sector means that country’s banks are closer to meeting the minimum capital adequacy requirements of Basel II than was anticipated even 12 months ago. However, challenges remain, particularly with regards to data. By John Rumsey

The decade-long struggle among Japanese banks to pull themselves out of the plague of crises that beset the sector in the 1990s has previously caused pundits to predict that the nation's financial services firms would be laggards among the Group of 10 countries in implementing Basel II. However, there are recent signs that Japan may be on track to have a Basel II framework in place on time after all.

Until recently, Japan watchers painted a bleak picture in which a weak macroeconomic background compounded the banking sector's well-publicised difficulties of non-performing loans (NPLs), complex cross-shareholdings, weak reporting standards and a lack of transparency. Furthermore, Basel II was seen as likely to increase sensitivity to economic cycles, implying that in a downturn, they would cut lending, with grave macroeconomic implications. All in all, the difficulties facing Japanese banks in meeting Basel II seemed both intractable and insurmountable.

But the recent flurry of activity by the Financial Supervisory Agency (FSA) to prepare internationally active banks, together with a rapidly improving economic background, is challenging these perceptions. And that means that it is time for a cautiously positive reassessment of Japan's Basel II prospects.

Japan has opted for a timetable more or less in line with other G-10 and developed Asia-Pacific nations, says Hajime Yasui, director and head of regulatory advisory services at the financial service division of PricewaterhouseCoopers in Tokyo. The FSA is keeping pace with the European Union and has published draft work on pillars I and III, says Yasui. Within the scope of Basel II, the FSA has been relatively cautious and flexible in its approach. However, it has not mandated which banks must use which approach, unlike Australia or the US.

Instead, the regulator has set the end of March 2007 - the fiscal year-end in Japan - for the introduction of the foundation internal ratings-based (IRB) approach and March 2008 for the advanced IRB approach and the advanced measurement approach (AMA). An official at the FSA thinks that some 30 banks will implement the IRB but that "very few Japanese banks will be able to implement the advanced IRB" by the 2008 date. It is said that not only mega banks but also a few trust and/or regional banks are trying to implement the advanced approach at the starting point. The difficulty, however, even for the mega banks, is that they will be hard-pressed to compile data that stretches back seven years because they are the product of mergers, Yasui says.

Bank of Tokyo-Mitsubishi (BTM), Japan's biggest bank, has said that it wants to move to the advanced IRB. Sumitomo Mitsui Banking Corporation (SMBC), the third largest, plans to implement foundation IRB in March 2007 and advanced IRB as soon as practicable, says an official at the bank. SMBC has nearly finished its preliminary data gathering for the database and is wrapping up with work on project finance and its low-default portfolio. However, questions remain regarding the calculation of risk assets, says the official. The details with regard to the assumption of parameters and methods of verification of the models by the regulator are still not clear. Therefore, the reliability of each bank's adopted method of calculation of risk assets is not guaranteed - the regulator may require changes, and the banks are asking for clarification from the regulator.

In the meantime, the FSA is assessing the quality of data from applicants for the IRB approaches, but the official says it is too early to indicate whether the data is of sufficient quality for it to give permission to any or all banks to implement the IRB approach. On the credit risk side, the FSA has mandated a capital adequacy requirement of 8% for banks active in Japan and abroad and 4% for those active in Japan only.

Within that, one of the most important changes to be introduced is a lowering of the risk weights to small and medium-sized enterprises and individuals from 100% to 75%. In addition, the wider parameters for NPLs - defined as more than three months of non-payment - could be adjusted according to provisions from 100% to a range of 100-150%. The risk weight for corporates will vary according to their credit ratings, moving from a fixed 20% to anywhere between 20% and 150%. The risk weight of mortgages will fall from 50% to 35% and banks and securities firms' exposures will also vary from 20-150%.

There are other changes too. The treatment of equity investments will be flexible. For investments acquired after September 2004, banks will be free to choose different approaches to the calculation of risk-weighted assets from a menu of choices. There will be minimum provisions, with 200% to publicly traded equities, 300% to private equities and 100% to investment in equities as part of a long-term customer relationship under the probability of default/loss given default approach.

The FSA has also worked hard to push internationally active banks to reduce their level of NPLs. A law was passed in 2000 that, under certain conditions, allows corporations to transfer shareholdings to related corporate pension funds. This has forced banks to unwind complex positions and re-employ the capital. This move has gone hand-in-hand with a strengthening national economy, which has shrunk NPL levels by more than half over the past four years from some ¥43 trillion in 2001 to ¥17.9 trillion at the end of this March. "They have gone from crisis level to a normal level," says Yasui.

The thorny issue of the level of deferred tax assets (DTAs) is finally being tackled too. According to a report by Douglas Skinner of the University of Chicago, the level of DTAs peaked in 2002 at as much as 60% of equity at the largest banks. The collapse of Resona Bank in 2003 focused minds on the issue, he argues. Experts say DTAs now account for some 30% of banks' tier-one capital, with significant variations from bank to bank. The FSA has stepped in to control the use of DTAs in banks' calculation of tier-one capital. It will be gradually reduced, with the upper limit set at 40% from the end of March 2006, 30% from the end of March 2007 and 20% from the end of March 2008. Even so, that compares poorly with the US, where it can only constitute a maximum of 10% of tier-one capital.

These regulatory changes and the better economy are having a dramatic effect on the health of Japanese banks' balance sheets. Mizuho Financial Group, the country's largest bank, reported that its tier-one capital ratio improved from 5.75% on March 31, 2004 to a preliminary 6.19% on the same date in 2005, as its claims against bankrupt and nearly bankrupt companies dropped by half from 0.6% to 0.3%. And in fiscal 2003, the costs for reducing bad loans fell to one seventh of the levels in fiscal 2002 (from ¥2.11 trillion to just under ¥300 billion).

The unexpected speed of the recovery in the banking sector certainly means that Japan is closer to meeting the minimum capital adequacy conditions of Basel II than was anticipated even 12 months ago. The significant progress that has been made means that some Japanese banks are already looking for the next step beyond regulatory capital requirements, according to Soshi Ebisuda, manager at Moody's KMV in Tokyo. They are now looking at techniques to improve economic capital management, such as active portfolio management, Ebisuda notes.

Nevertheless, challenges remain. The drop in the use of DTAs in calculating tier-one capital is certainly healthy in the long run. In the short run, however, it means that banks will need to replenish equity to bolster their tier-one capital. That is likely to happen of its own accord. Provided the economy continues to recover, banks' profitability will continue to improve and their share prices will increase. Raising equity through capital markets is also more attractive than it has been for years, with the Nikkei 225 stock index at four-and-a-half-year highs of around 14,100. Still, if the economy worsens, banks may find it difficult to meet the FSA's new regulations on DTAs.

In operational risk, the FSA official currently anticipates that several banks will apply to implement the AMA approach, although it is still uncertain whether all of these banks will be qualified for adopting the AMA as from the end of March 2008. The main worry for Japanese banks is the threat of natural disasters, especially earthquakes. The instances of fraud are relatively low in Japan compared with other G-10 countries, and Japan has argued that it should not have to use the same standards as other countries in this area. Banks are undertaking scenario analysis to assess operational risk, which remains a new area for them.

On pillar III, the FSA is working to encourage greater transparency and disclosure. In March, the FSA launched a consultation to decide what information banks will need to disclose, including capital adequacy ratios, risk profiles, tier-one ratios, and credit, market and operational risk. The FSA is incorporating these requirements into its national rule-making process. Already, Japanese banks have made great strides in improving disclosure, adding resources to the investor relations function and making chief executives and chief financial officers more aware of the importance of disclosure, says Yasui. This is a particularly pressing issue for Japan, where bank data on performance have often been mistrusted.

Indeed, Japan has long been one of the focal points for anxiety about the implementation of Basel II. The world has openly worried that the country's weak banking system and lack of transparency meant that it would apply the rules half-heartedly. Last year, Charles Calomiris, professor of finance and economics at the Columbia Business School in New York, used Japan to illustrate that it is possible to have a banking system that is part of the Basel process, yet still lacks a credible standard.
Given criticism of Japan's approach, it is ironic that the US is now dragging its heels. The announcement by four US regulators that they would delay implementation of Basel II by a year has caused concerns among fellow regulators. So far, Japan's FSA has stayed silent. But it could find itself on the side of virtue if it joins forces with the European Union to push the US to honour the earlier deadline. From scolded to scolder: that really would represent a turnaround.Risk