Economic View: A culture shock Japan's banks will have to face
Tuesday 18 June 1996
In the coming months there will naturally be efforts to improve further the international regulatory system. There will of course be internal organisational changes in the Sumitomo group, the great sprawling conglomerate which is, among other things, the world's largest copper trader. But looking five years ahead, I think that the biggest impact of this story will be on the structure of the Japanese financial system. In particular, it will speed up the gradual and painful shift Japan is making from running a system based on relationships to one based on market transactions.
Sumitomo is special. It is one of the two or three best examples of the Japanese way of organising a financial and trading empire. Anyone who has visited the headquarters in Tokyo will have been struck not just by the display of corporate wealth - all large Japanese businesses show that - but by the self-confidence of the executives. I remember being told, some years back, about plans to expand in New York investment banking. The gist was that if the aim was strategically important, the group would simply buy its way in. It was the self-confidence of an elite: the crack troops of the Japanese commercial empire.
Of course the Sumitomo losses damage the reputation of the copper market and to some extent the regulators (though at least the scam was eventually nailed). But the visible damage is limited by the enormous resources of the group. It can take a loss of a billion or more. The problem is less one of money and more one of reputation, of self-confidence. In that sense these Sumitomo losses are quite different from the pounds 800m loss of Barings here in London or the pounds 900m loss at the Daiwa Bank in Tokyo.
Barings was never at the top of the UK ranking of merchant banks; Daiwa Bank (which is not connected to the better-known Daiwa Securities) was a long way down the Japanese banking league. The Sumitomo group, by contrast, is at the very pinnacle of the Japanese financial system, and Mr Hamanaka was one of its stars.
In the UK you still hear of an admiration for the long-term relationships between financial institutions and other commercial enterprises in Japan, in contrast to what some see as an excessively short-term, market-driven culture here. It is a fashionable line of attack from people who dislike the British financial services industry. But people who argue this are probably unaware that over the last five years Japan has gradually been retreating from its emphasis on relationships and rediscovering the importance of market signals.
The reason is simple: excessive emphasis on relationships seems to have increased the danger of making bad investment decisions. Many Japanese banks are technically insolvent, in the sense that they have so many dud loans and investments that their assets are worth less than their liabilities. This is the result of over-eager lending, frequently to associated companies, during the late 1980s. There are plenty of examples of banks making bad loans elsewhere in the world, so making lending errors is not unique to Japan. But relying not on the loan itself being profitable, but rather on the loan gathering some other advantage in a business relationship, has meant that the scale of the problem was much more serious than elsewhere. Cosiness between lender and borrower is fine when things are going well; but when they go badly, it can be catastrophic.
Most serious of all, the Japanese system encouraged people to ignore the market. Movements in asset prices were not taken into account on balance sheets, with both profits on assets and losses concealed. It was a culture which encouraged, three years ago, the support of the stock market by the Japanese government's price-keeping operation, or PKO, as it was called. It is not in any way to excuse Mr Hamanaka's trading methods to say that he operated in a culture where it was normal for market prices to be manipulated.
The best study in English of the damaging effects of the Japanese share cross-holdings was published a couple of months ago by the London investment boutique Smithers & Co, Share Price Determination in the Japanese Equity Market. The tables here are drawn from that report. As in other countries, since 1949 there has been a sharp fall in the proportion of shares held by individuals, declining from more than 60 per cent to little more than 20 per cent. As elsewhere the proportion of shares held by financial institutions has risen.
But Japan differs in two ways from other markets. First, these institutional holdings are not traded aggressively, with frequent reviews of performance, on behalf of savers. Instead they are held as part of a series of complex cross-holdings, largely for the benefit of the businesses concerned. Second, there is a further block of shares held directly by the business community: businesses own each other.
The result is that the proportion of shares held freely - that is by individuals, investment trusts and foreigners - is quite small. This group relies on dividends and capital appreciation for its return. The other group expects to get a return not just in financial terms, but also by other business benefits. These might include guaranteed purchases from suppliers, maybe more favourable prices - the mutual back-scratching that exists in business everywhere but which is particularly strong in Japan.
The right-hand graph shows how this "free float", the shares held by the first group, declined for most of the post-war period, and how this decline corresponded with a fall in the dividend yield. Only since the late 1980s has this process gradually begun to go in reverse. Dividend yields have started to climb, and the proportion of shares held by investors whose sole interest is to get a good financial return for their investment, rather than these other commercial benefits, has also risen a little.
The main point made by Smithers & Co is that the continuance of these cross-holdings means that Japanese shares are still over-valued, for too large a proportion of holders still seek a non-financial return, rather than demanding a better financial one. But I think there is a further point to be made, which is that at least some sort of turning point has been reached, and many Japanese firms no longer feel the system of cross- holdings and long-term financial relationships between companies works in their favour.
Solving the particular problem of the banking system will require some kind of state funding, though just what is still a subject of hot political debate. Obviously losses by the Sumitomo group hardly help, though these losses are in the trading arm, not in the bank.
But behind the "how do we bail out the banks?" question is a second one: "how do we reorganise our financial system so that it is more robust to shocks?"
It could take five years before we know the answer to that, but it seems highly likely that Japan will move much closer to the Anglo-American financial model. Many cross-holdings will remain, but there will be much greater transparency in these holdings and owners of assets will insist on much higher financial returns than they have received in the past. Back in the 1960s the return on Japanese shares was much closer to UK or US levels than it is now. The Japanese market used to give clear signals of value; what happened in the 1980s was not normality.
So I think the long-term impact of Sumitomo's losses on the Japanese financial system will be to push it faster towards becoming a proper transparent market: where prices, be they of copper or shares or property, are set by the market. The market will be allowed to signal whether things are over or under-priced, without the authorities or large corporations feeling that they should know better.
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