Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research

Financial Situation andManagement of Banking Sector
1. Introduction
In June of 2003, the structural reform package entitled “Basic Policies for Economic and Fiscal
Policy Management and Structural Reform 2003” was passed in the Cabinet. According to these
directives, the “Financial Revitalization Program” was launched and aimed to reduce the share ofbad loans in fiscal 2004 to half of the levels of fiscal 2002, and to have the bad loan problem
resolved by the same year. However, from fiscal 1992, banks have recorded credit costs totaling 88.2
trillion yen for bad loans, and it continues to be very difficult for banks to earn enough in profits
every year to dispose of the bad loans that exist now, as well as loans that may sour in the future.
In this study, we analyze the banking sector using recent data. First we use financial data up to
fiscal 2002 (at the end of March 2003) to analyze their fiscal health -- the profitability of the banks,
the bad loan situation, and their capital ratios. Then we examine such issues as the recapitalization of
the major banks, the business consolidation system in place for bank mergers, and the injection of
public funds into the banks.

2. Profit Structure of BanksFirst let us examine the profit structure of the Banking Sector (Table 1). The “Lending Margin”
item has been hovering around 10 trillion yen since fiscal 1992, and in fiscal 2002, it fell by 400
billion yen over fiscal 2001. “Other Revenue” would be all profits/losses outside of Net Interest
Income, less the gains and losses from sales of securities, and gains and losses from sales of realestate. This “Other Revenue” item had been fluctuating in the range between just over 2 trillion up to
about 3.5 trillion yen and had marked over 3 trillion yen for the years from fiscal 1995 to 1997
probably because as interest rates were declining, bond dealings were temporarily quite profitable.
This “Other Revenue” is rising again from fiscal 2000, and in fiscal 2002 this marked 3.6 trillion yen.
We believe that this is due to an increase in profits from bond dealing again. The total of these twoitems, Lending Margin and Other Revenue, are the Gross Profits earned from banking activities.
These profits have been steady from about fiscal 1998, and in fiscal 2002, they rose by about 600
billion yen. Operating Expenses peaked at about 8 trillion yen in fiscal 1996, and have begun
declining, marking 7 trillion yen in fiscal 2002. Most of this reduction in expenses are from lower
human resources expenses and suggest that expenses are falling from mainly the restructuring effortsof the banks. Another expense is the Loan Loss which is mainly composed of the loan loss reserves
and amortization of bad loans. By fiscal 1995, 97 and 98, they had risen to a massive 13.4 to 14
trillion yen. Loan Loss receded temporarily to between 6 and 7 trillion yen in fiscal years 1999 and
2000, but after the Special Inspections of the Financial Services Agency in fiscal 2001, banks
lowered their assessments of some of their borrowers, and the ol an loss provisions once again
increased to 9.4 trillion yen. In Fiscal 2002, the amount of bad loan disposals fell to 7 trillion yen.
After Loan Loss Charges have been deducted from Gross Profit before Loan Loss , we are left withthe profit from their core business, their Net Operating Profit. This figure has been negative from15

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Researchfiscal 1993, and although Loan Loss declined in fiscal 2002, it continues to be the case that Banks
are not earning enough with the profits from their core business to clear themselves of their badloans.
From fiscal 2001, Realized Capital Gains marked a large negative figure, and the Net Profit figure
also marked a large negative. This is believed to be due to two factors.

One, due to theimplementation of mark-to-market accounting, unrealized losses were recorded on share holdings.
Two, the losses recorded when stocks were sold 1 ） were also significant.
Thus, this shows that banks were not able to cover their Loan Loss with their Gross Profit.
Generally, we see the profit picture of the banks as being very harsh.

Table 1.

Profit structure of Banks (all banks basis)
trillion yen

Financial Year

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Lending Margin (A)

7.1

8.9

9.8

9.2

9.7 10.8 10.7 10.0

9.6

9.7

9.4

9.8

9.4

Other Revenue (B)

2.6

2.2

2.5

2.8

2.1

3.3

3.7

3.6

3.1

2.5

3.0

3.1

3.6

Operating Costs (C)

7.1

7.5

7.7

7.7

7.8

7.8

8.0

8.0

7.5

7.3

7.1

7.0

7.0

Salaries and Wages

3.7

3.9

4.0

4.0

4.0

4.0

4.0

4.0

3.6

3.5

3.4

3.2

2.8

Gross Profit (D)=(A)+(B)-(C)

2.6

3.5

4.5

4.3

4.0

6.3

6.4

5.6

5.2

4.9

5.3

5.9

6.0

Loan Loss (E)

0.8

1.0

2.0

4.6

6.2 13.3

7.3 13.5 13.5

6.3

6.6

9.4

7.0

Net Operating Profit (F)=(D)-(E)

1.8

2.5

2.5

-0.4

-2.2

-7.0

-1.0

-7.9

-8.3

-1.4

-1.3

-3.5

-1.0

Realized Capital Gains (G)

2.0

0.7

0.0

2.0

3.2

4.4

1.2

3.6

1.4

3.8

1.4

-2.4

-4.1

Net Profit (F)+(G)

3.8

3.3

2.5

1.7

1.0

-2.6

0.2

-4.2

-6.9

2.3

0.1

-5.9

-5.1

Asset

927.6 914.4 859.5 849.8 845.0 848.2 856.0 848.0 759.7 737.2 804.3 772.0 739.0

Outstanding loans

522.0 537.0 542.0 539.0 539.0 554.0 563.0 536.0 492.0 476.0 474.0 465.0 435.0

Notes:
1) 134 banks were included in this data: 7 city banks, 2 long-term credit banks, 8 trust banks, 64
regional banks and 53 second regional banks. Foreign banks were excluded from this analysis.
Also, figures were for banks on non-consolidated bases.
2) We classified the profit/loss items from the Income Statements as follows:? Lending Margin = Interest Income – Interest Expenses? Other Revenue = Fees and Commission Income + Trading Income + Trust Fees + Other
Business Income + Gains on Investment of Money Held in Trust + Other
Operating Income – Fees and Commission Expenses – Trading Expenses –Other Business Expenses – Losses on Investment of Money Held in Trust +Extraordinary Gains (Excluding Gains on disposal of Premises andEquipment) – Extraordinary Losses (Excluding Losses on disposal ofPremises and Equipment? Operating Costs = Operating Operating Costs (including deposit insurance premiums)? Gross Profit = Lending Margin +Other Revenue – Operating Costs
1）

The Shareholdings Restriction Law was enacted in November of 2001. This meant that banks and theirsubsidiaries were no longer permitted to hold stocks etc. to the same amount as their capital. (''Law concerning
Restriction, etc. of Banks' Shareholding etc). This is to be enforced from September 30, 2004, but if there is strong
rationale with approval from the competent Minister, this can be delayed for a maximum of two years.

16

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research? Loan Loss = Provision of Allowance for Bad Debts + Loan Write-offs + Other Operating
Expenses? Net Operating Profit = Gross Profit – Loan Loss
? Realized Capital Gains = Gains on Sales of Securities + Gains on Disposal of Premises andEquipment – Losses on Sales of Securities – Losses from Sales ofPremises and Equipment? Net Profit = Net Operating Profit + Realized Capital Gains = Income Before Taxes
3) In order to remove the effects of changes in accounting standards from these figures, we removed
deferred tax assets from total assets, and we also removed loan loss provisions from fiscal 2000
that are now listed in assets.
Source: “Corporate Finance Data Base” NEEDS-Financial QUEST

3. Bad Loans in Fiscal 2002
3.1 Outstanding Amount of Bad Loans
We define "bad loans" here as, of the receivables such as loans held by banks etc., those withwhich interest or principal are past due, or those loans that are feared to become past due. In Japan,
there are three definitions of bad loans: 1) Self Assessment Loans, 2) Risk Management Loans and3) Loans based on the Financial Revitalization Act. Self Assessment Loans represent the mostimportant standard because banks estimate their loan-loss reserves and the amount of write-offs
based on this classification. Risk Management Loans and Loans based on the Financial
Revitalization Act are disclosed. They are required by the Bank Act or the Financial Revitalization
Act. However Self Assessment Loans are not disclosed on an individual basis.
・Risk Management Loans
The total amount of risk management loans for all banks in Japan was 34.8 trillion yen in fiscal
2002, and this was 7.2 trillion less than that in fiscal 2001. However, if we compare this amount withthat in fiscal 2000 and fiscal 1999, it still remains very high (Fig.1).

17

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research

Figure 1. Risk Management Loanstrillion yen
45.0
40.0

Loans with concessionary terms

35.0

Loans in arrears for more than 90 days
Defaulted loans

30.0
25.0
20.0
15.0
10.0
5.0
0.0
1992

93

94

95

96

97

FY

98

99

2000

01

02

Source: Financial Services Agency
・Assets Classified by Self-Assessment
Table 2 shows that the total Self Assessment Loans amount to 71.1 trillion yen at the end of March
2002. This fiscal year, the Japanese FSA terminated the publication of this data, so we estimated theamount of classified loan data for March 2003 based on the disclosed bad loan data. According tothis estimation, the classified loan has declined to 64.8 trillion yen which still remains very high(Table 2).

Table 2.

Asset Classified by Self-assessment

Financial year
All credit exposure
Non classified loans (category I)
Classified loans
Substandard(category II)
Doubtful(category III)
Estimated Loss(category IV)
Source: Finance Services Agency

Mar-99
551.8
487.5
64.3
61.0
3.2
0.1

Mar-00
535.8
472.4
63.4
60.5
2.8
0.0

Mar-01
536.3
470.7
65.7
63.1
2.6
0.0

trillion yen
Mar-02Mar-03
511.6
472.6
440.5
407.8
71.1
64.8
67.8
62.9
3.3
1.9
0.0
0.0

Estimated by JCER(2003)

In fiscal 2002, Estimated classified loans amount to 64.8 trillion yen and Risk Management Loans
were 34.8 trillion yen. Since the classified loans are more broadly defined than disclosed bad-loans,the amount of classified loans is about twice as much as the disclose loan figure.
For example, borrowers which are deficit or have problems in financial condition although18

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Researchscheduled payment is carried out, have possibilities to be categorized classified loans. But they are
not Risk Management Loans.
However, there is a problem about laxness of standard “superior guarantee”. For example if theguarantee is from a non-dividend paying company which is listed on a stock market or an over -thecounter traded company, the asset guaranteed by this company may be considered non-classified
according to the Bank Examination Manual of the FSA.
3.2

Bad Loans Disposal of Bad Loans

Losses incurred from the disposal of bad loans for all banks in fiscal 2002 were 6.7 trillion yen
and 3.0 trillion less than fiscal 2001. However, the accumulated amount of the losses from fiscal
1992 amount to 88.2 trillion yen (Table 3).

Table 3. Disclosed Loan Losses of Japanese Banks (All Commercial Banks)
trillion yen
Financial year
Loss from bad loans(A)
specific reserves
write-off and loan sales losses
Cumulative amount of (A)Bad loans outstanding (B)Definition of B

Mar-93Mar-94Mar-95
Only for major banks
1.6
3.9
5.2
0.9
1.1
1.4
0.4
2.1
2.8
1.6
5.5
10.7
12.8
13.6
12.5
defaulted loans andloans with arrears

Mar-96

Mar-97

Mar-98Mar-99Mar-00Mar-01Mar-02Mar-03

13.4
7.1
6.0
24.1
28.5

7.8
3.4
4.3
31.9
21.8

13.3
8.4
4.0
45.1
29.8

13.6
8.1
4.7
58.8
29.6

6.9
2.5
3.9
65.7
30.4

6.1
2.7
3.1
71.8
32.5

9.7
5.2
4.0
81.5
42.0

6.7
3.1
3.5
88.2
34.8

defaulted loans,loans with arrears
for more than 6 months
and loans withconcessional interest
rates below ODR.

defaulted loans,loans with arrears
for more than 90 days
and loans withconcessionary terms(similar to SEC rule)

Source: Financial Services Agency and Bank of JapanThe depth of the problem is not necessarily defined by the amount of the bad loans being held. We
find it difficult to imagine no new bad loans occurring in the next year. Therefore, the true issue withbad loans is not the scale of bad loans, but whether the banks can generate enough profits every year
to charge off the existing ones and deal with the losses. In fiscal 2002, 6.7 trillion yen of bad loans
were disposed of, as we showed Table 1, where the gross profit was 6.0 trillion yen. In other words,
the credit losses incurred from disposing of the bad loans cannot be covered by the profits of thebank. Furthermore, this trend has continued for the past decade since fiscal 1993. If the banks holdenough shareholders’equity, and they can secure spreads large enough to cover defaults, and then theamount of the bad loans per se does not become a major issue.

4. Recapitalization of Major Banking Groups
The Financial Revival Program was launched in October 2002. Its objective is to construct astrong financial system in order to resolve the bad loans problem of the major banks. It consists ofestablishing a joint support system of the government and the Bank of Japan together to promotebanks’ taking loans off the balance sheet, make the asset assessment more stringent, and strengthen
the capital base of the banks. Table 6 shows the BIS ratios of The Major Banking Groups at March
2003. Here, Major Banking Groups are the Japanese biggest Holding Companies, with the asset of
more than 80 trillion yen. They are called the “four Mega Bank Groups”. At the end of March 2003,
19

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research
the BIS ratios for the large banking groups were all similar and hovered around the 10% mark (Table4). These are all above the required ratio of 8%, but there is a possibility that Recapitalization in2002 helped boost their BIS ratios .

Table 4.

BIS ratio of the Major Banking Groups (March 2003)
billion yen
Mizuho Financial
Group

Sumitomo Mitsui
Financial Group

Mitsubishi Tokyo
Financial GroupUFJ Holdings

Tier1 capital

(A)

3,495

3,256

3,129

2,560

Tier2 capital

(B)

4,681

3,396

2,966

2,129

Tier3 capital

(C)

0

0

30

0

(D)

143

239

38

72

Total risk-based capital(E)=(A)+(B)+(C)-(D)

6,847

5,979

5,968

4,617

Risk asset

71,824

59,16755,05046,3289.53%

10.10%

10.84%

9.96%

Subtraction Item(F)

Total risk-based capital ratio(E)/(F)×100

Source: Disclosure Material
The major banking groups then hammered out some plans to strengthen their capital base by theend of March 2003. Then on August 1 2003, a business improvement administrative order was
issued from the FSA to some banks that had received public fund injections. The reason cited wasthat these banks were not able to attain their earnings targets for fiscal year ending March 2003, andthe banks given the order were requested to submit a business improvement plan that includes
measures for profitability improvement. Although the content of the profitability improvement that
the FSA had requested to each banking group has not been disclosed, each group has since then put
forth a management revitalization plan that details their measures for improving profits and theirdividend policies.
At the end of March 2003, the BIS ratios for the large banking groups were all similar and aroundthe 10% mark. These are all above the required ratio of 8%, but this in large part is thanks to theirrecapitalization. Table 5 shows the various recapitalization measures taken by the large banking
groups and summarized how each of them has helped boost their BIS ratios. According to BIS
regulations, the sum of Tier II and Tier III capital can be included as regulatory capital up to thesame amount as Tier I capital. In this estimation, we assumed that Tier II and Tier III capital together
was the same amount as Tier I capital, and calculated how these recapitalization measures helped
boost the capital ratios on a consolidated basis .

20

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research

Table 5.

Recapitalization of the Major Banking Groups, and Estimated Increases in
BIS ratios (March 2003)
billion yen

Banking Group
Amount of
Additional CapitalMizuho Financial
1081.9118.5

Sumitomo Mitsui Financial
150.3

345.0

Mitsubishi
Tokyo Financial
293.7

UFJ Holdings
120.0

111.0

Increase in BIS
Tier1Capital
Ratio(percentage

1.7

0.8

0.5

0.5

Increase in BIS Capital
Ratio on Consolidated
Basis(percentage points)

3.3

1.7

1.1

1.0

MethodInvestors

Issuance ofPreferred Shares
Alloted to Third
Parties
Domestic Business
Partner Companies
etc.

Issuance ofIssuance ofPreference Shares Preferred Sharesin form of Private Alloted to Third
Placement
Parties
Domestic Business
Partner Companies Goldman Sachs
etc.

Issuance ofPreferred Shares
Public Offering

Issuance ofCommon Stock
Public Offering

Issuance ofPreferred Shares
Alloted to Third
Parties

Foreign
Institutional
Investors

Domestic andForeign Investing
PublicMerril Lynch

2.25%

0.88%

2.38%

n.a

4.50%

Issuance ofPreference Sharesin form of Private
Placement
Domestic Business
Partner Companies
etc.

Dividend Rates

0.25% - 3.0%

n.aIncrease in Dividends duetoRecapitalization(Expected)
(1)

20.2

n.a

14.5

2(CommonStock)

2.9

n.a

Dividends for Existing
Preferred Shares(2)

22.1

n.a

14.5

4.2

7.0

n.a

Total
Dividends(Expected forfiscal year ending endMarch 2004)(1)+(2)

42.3

n.a

29.0

4.2

9.9

n.a

Notes:
1) Expected dividend amounts for fiscal 2003 are from Management Revitalization Plans
2) Increase in dividends of Mitsubishi-Tokyo Financial Group are for 1) common stock.

We

assumed them to be the same as dividends in fiscal 2002 (4,000 yen per share). Dividend ratesof UFJ Holdings are according to the Nihon Keizai Shinbun (February 26, 2003)
3) Amount of additional capital from Preferred Share issuance of Mizuho Financial Group is paid up
amount as of March 28, 2003
4) Increase in BIS Tier I Capital Ratio = Increase in Tier I capital after recapitalization /risk-weighted assets
Increase in BIS Capital Ratio on Consolidated Basis = (Increase in Tier I capital * 2) /risk-weighted assets
Source: Disclosure Material and Management Revitalization Plans of the banking groups
The increases in capital for Mizuho Financial Group, Sumitomo Mitsui Financial Group,
Mitsubishi-Tokyo Financial Group and UFJ Holdings in fiscal 2002 were respectively, 1,200.4
billion yen, 495.3 billion yen, 293.7 billion yen and 231.0 billion yen. In addition, the effect that thisrecapitalization has had to improve the banking groups’ BIS ratios were estimated as 3.3, 1.7, 1.1
and 1.0 percentage points, and enhanced their ratios to a large extent in all cases for fiscal 2002.
Three out of the four banking groups elected to issue preferred shares, but the underwriters varied;some were domestic companies that the banks did business with and some were foreign financial
institutions. We do observe that the foreign financial institutions that bought the preferred shares will
be enjoying high dividend rates. The dividend payment amount for the new preferred shares thatwere issued in fiscal 2002 is as large as for the existing preferred shares for some banking groups.
21

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research
Although each of the banking groups is earning enough profit to make dividend payments, dividends
by nature are to be taken from profits earned, and so it is the most important matter that they
continue to be profitable in the future.

5. Capital Position of all Banks
To find the net capital account, we focus on the liquidation value of the banks and take theShareholder’s equity portion of the balance sheet and adjust the figure for 1) Estimatedunder-reserving -- the difference between Estimated required loan loss reserves and total loan loss
reserves outstanding, 2) deferred tax assets that need to be removed and 3) other items that require
adjustment. Here, we also deduct the preferred shares for public funds injection to find the net
capital account. The reason that we do this is that if these preferred shares are converted to common
stock and cannot be sold in the market, then they must be bought back. Thus, this lacks in the“permanence” that is required in the definition of the capital.
Table 6 shows the weak capital structure of Japanese banks. On the surface, the capital account of
all commercial banks was 24.8 trillion yen at the end of Mach 2003. However, this figure includes
10.6 trillion yen deferred tax assets that have no liquidation vale. In addition, there is sizable
under-reserving for bad loans in our estimation. If we subtract 5.4 trillion yen of under reserving for
March 2003 and 10.6 trillion yen of deferred tax assets and 1.3 trillion yen of other items from thecapital account, the Japanese banks would have only 7.5 trillion yen of capital. The government
provides 7.3 trillion yen of this capital. Thus, the net capital account is only 0.2 trillion yen.

Table 6.

Capital Position of all Banks (134 banks as of 2003)
trillion yen

DPublicCapitalInjections
E

F=A-B-C+D-E

0.0

2.1

0.3

21.3

4.0

8.9

0.4

6.3

14.8

35.6

5.8

8.2

4.1

6.9

18.9

March 31, 2001

37.6

7.5

7.3

-3.5

7.1

12.2

March 31, 2002

30.2

6.8

10.7

-2.0

7.2

3.6

March 31, 2003

24.8

5.4

10.6

-1.3

7.3

0.2

End of fiscal
years

Capital
Account

Estimated
Under-reserving

Deferred Tax
Asset

Other

A

B

C

March 31, 1998

24.3

4.9

March 31, 1999

33.7

March 31, 2000

Net Capital
Account

Notes:
Estimated under-reserving = Estimated required loan loss reserves – Total loan loss reserves
outstanding
Estimated required loan loss reserves = 1% * Category I loans + 20% * Category II loans+ 70% * Category III loans + 100% * Category IV loans
Other = (Unrealized gains on available-for-sale securities – Equivalent of Deferred Tax Liabilities) +Unrealized gains on derivatives – Revaluation Reserve for Land
Source: “Corporate Finance Database” NEEDS-Financial QUEST
Table 7 is the same table as Table 6 except the figures represents major banks only. The net capital
22

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Researchaccount follows the same trends as for all banks in Table 6. However, the net capital account fromend-March 2002 becomes negative figures. For this last fiscal year, they were in the red. When we
take into account the fact that the major banking groups increased their capital by almost 2 trillion
yen by end of March 2003, their net capital must have deteriorated by even more. It is critical thatbanks improve their profitability to get out of the red, and strengthen their capital.

Table 7.

Capital Position of major Banks (17 banks as of 2003)
trillion of yen

D

PublicCapitalInjections
E

F=A-B-C+D-E

0.0

4.7

0.3

12.7

3.0

6.6

2.8

6.2

6.8

23.9

3.8

5.7

8.8

6.5

10.6

March 31, 2001

24.2

5.3

5.3

-2.0

6.6

4.5

March 31, 2002

18.0

4.7

8.0

-1.2

6.6

-2.4

March 31, 2003

13.1

2.9

7.9

-0.5

6.6

-4.8

End of fiscal
years

Capital
Account

Estimated
Under-reserving

Deferred Tax
Asset

Other

A

B

C

March 31, 1998

14.7

2.4

March 31, 1999

22.8

March 31, 2000

Net Capital
Account

Notes: Major Banks are City Banks, Long-term Credit Banks and Trust Banks.
Source: Same as Table 6
We now look at the distribution of the capital ratios by bank. The number of banks that are in
negative equity have risen from 10 banks at end-March 2000 to almost three times their number to
29 at the end of March 2003.Thus, more than one fifth of all banks (134 in total) are in negative
equity. The result of estimation, The Net capital of banks in Japan has continued to deteriorate by
March 2003. And many banks had negative capital in our estimation.

Figure 2.

Distribution of Net Capital/Asset Ratio（End March 2000）（End March 2003）
70

70

numberofbanks

number
of
banks

60
50

60
50

40

40

30

30

20

20

10

10

0
〜 -2%

-2% 〜 0%〜0%2%City banks
Trust banks

2% 〜
4%

7

2

3

3

1

Long-term credit banks

4%〜
6%

0
〜-2%

6% 〜
City banks

1

Trust banks

2-2% 〜 0% 〜
0%
2%
5

2%〜
4%

Regional banks

6

12

23

21

Regional banks Ⅱ

3

21

29

2

2

Source: Same as Table 6
23

6%〜

1
3

3

Long-term credit banks

2

4% 〜
6%

2

Regional banks

2

10

15

25

12

Regional banks Ⅱ

1

8

22

18

3

1

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research

6. Accounting for Business Combinations in Japan and Dealing with Bank Mergers
6.1 Trends in Accounting for Business Combinations
After the year 2000, many banks – mostly among the major banks – in Japan merged. They havesecured resources for dividends and disposed of their unrealized losses on stock holdings by using
the gains from mergers. Currently in Japan there is no clear standard to be applied to businesscombinations, and so they have taken advantage of the fact that they have flexibility in theaccounting so long as it is within the guidelines of the Commercial Code2 ）. Using the example of the“reverse” merger (where the smaller company in a merger is the surviving entity) of Sumitomo
Mitsui Banking Corporation (SMBC) and Wakashio Bank, we make a comprehensive examination
below of the process of business combinations and the problems inherent in the accounting system.
6.2 SMBC-Wakashio Bank Reverse Merger
In March 2003, Sumitomo Mitsui Banking Corporation (the now defunct SMBC, capitalized at
1.58 trillion yen) and its wholly owned subsidiary Wakashio Bank (with 80.8 billion yen of capital)
merged. With this merger, Wakashio Bank became the surviving entity, and the name of the new
Bank became Sumitomo Mitsui Banking Corporation (capitalized at 560 billion yen). In this manner,with SMBC’s subsidiary becoming the surviving legal entity and the parent company becoming thedefunct entity, we call this a “reverse” merger. The two points to this scheme are as follows:(1)There is a capital-reduction (on paper) through the merger.
(2)There are merger profits that have occurred which are used to dispose of unrealized losses on
stock, and increase profits available for dividend payments.
With the merger, SMBC reduced their capital stock by 578.8 billion yen and their capital surplusby 826.7 billion yen (both figures are as at March 16, 2003, the day prior to their merger) (Table 8).
This was used to dispose of unrealized losses on securities (672.8 billion yen) and appropriated tocapital surplus 658.4 billion yen.

Table 8.

Composition of Shareholder’s of SMBC (now defunct)billion yen

Sumitomo Mitsui Banking Corp.
March 16 2003
(now defunct, unconsolidated(one day prior to merger)
Capital Stock
1,058
Capital Surplus
2,004
Capital Reserve
1,646
Other Capital Surplus
358
Retained Earnings-437
Revaluation Researve for Land
97
Unrealized Gains or Losses on-673
Available for Sales Securities
Total Shareholder's Equity
2,050
Source: Sumitomo Mitsui Financial Group Disclose Material

Merger Carry OverNet Assets Carried Over

-579
-827
-827
658
-

479
1,177
820
358
222
97

673

-

-74

1,976

We consider three alternative routes for SMBC to have taken and conduct simulations: 1) They
2）

After the “Exposure Drafts – Opinion of Establishing Accounting Standards for Business Combination” in August
2003, it was determined to apply Purchase accounting methods to business combinations.

24

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Researchtake a conventional route to reduce their capital (on paper), and use their Legal Reserve to cover
their unrealized losses and to generate a source to pay dividends, 2) Sumitomo Mitsui Banking Corp
remains as the surviving entity and they undergo a merger, and 3) Undergo their merger using thePurchase accounting methods to be applicable from April 2006. Our results show that the merger
method taken by SMBC this time was the most effective for them.
The Sumitomo Mitsui Financial Group, the parent company to SMBC, is expected to mark net
profits for the fiscal year ending March 2004 of 50 billion yen, and then the dividends for all shares
including preferred shares would amount to 46.4 billion yen. Therefore, we can see that the
Sumitomo Mitsui Financial Group needed an effective framework to make these large dividend
payments possible. However, this series of manipulations for this merger is not expected tofundamentally strengthen their financial foundation.
6.3 Motives for Sumitomo Mitsui Banking Group to Create Local Subsidiary in March 2003
On March 5, 2003, SMBC created a wholly owned subsidiary, Sumitomo Mitsui Banking
Corporation Europe Limited (with capital stock of US$ 1.7 billion). According to their press releaseof February 10, 2003, the Bank created the subsidiary to become the platform for their European
expansion and to raise the presence of the SMBC group in Europe. Also, according to theirannouncement of August 28, 2003, they state that if this is recognized by the UK banking authorities,
then they are permitted to open branches freely in the European Union, and that this was a decision
made from this perspec tive.
However, it is generally the case that banks expanding abroad establish branches rather thansubsidiaries. This is because if they choose subsidiaries rather than branches, then they need to build
a large capital base for the subsidiary, and that subsidiary’s credit rating will often be one notch
lower than the parent company causing their funding costs to increase. We have heard that the UKbanking authorities viewed this new Sumitomo Mitsui Banking Corporation (established through the“inverted” merger of SMBC and Wakashio Bank) as not merely a change in name, but considered
this a “consolidation” and applied the stricter standards to it and directed SMBC to establish thelocal subsidiary. By this “subsidiarization” of the branch, the amount of lending that may be done bythis new entity will now be determined as a share of the capital stock not of the parent company
SMBC, but the UK subsidiary. This may result in limiting the business that the Bank can do in the
UK. Moreover, this can also be interpreted as an attempt by the UK authorities, by requesting thesubsidiary to build its own capital, to separate the subsidiary from the operational risk of the parent.

7. The Injection of Public Funds into Resona Bank, and the Price Book-Value Ratios of
the Major Banking Groups
7.1 Injection of Public Funds
After 1997, with the instability in the financial system, there have been many laws created to deal
with the injection of public funds. These are called the Bank Recapitalization Act, and the Financial
Revitalization Act. The injection of Public Funds under the Bank Recapitalization Act and the
Financial Revitalization Act was completed by March 2001.
The Deposit Insurance Law established the Deposit Insurance Corporation in 1971. The role was toprotect depositors of failed financial institutions. The Deposit Insurance Law was amended to25

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research
provide for the prevention of systemic risk in the financial system from April 2001. Type 1 measureof Article 102 was applied for the first time to Resona Bank in May 2003.

Resona Bank is thebiggest bank under Resona Holdings. Resona Holdings is fifth largest group just after so-called four
Mega Bank groups.
We observed a few problems with the application of Clause 102 of the Deposit Insurance Law.
The five major issues were 1) The implementation of the early correction measures and the decision
to inject public funds under Article 102 of the Deposit Insurance Law were done on the same day, 2)
The public funds were injected before a stringent assessment of assets was conducted, 3) There wasan exchange of shares between the holding company, Resona Holdings and Resona Bank, 4) There is
the issue of shareholder responsibility, and finally, 5) The issue of how the injected amount wasdetermined. Going forward, should there be a second and third case when this act will have to be
applied, then the authorities should use their experience with this case to make improvements to theapplication of Article 102 of the Deposit Insurance Law.
The amount of deferred tax assets (DTA) was a major point of contention during deliberations
about the infusion of public funds. Deferred tax assets are assets that require that the future taxable
income to be reduced and the tax burden to be reduced to be recognized by the auditors.

Since

this is an entry whose amount depends on the future taxable income, the expected future profits
become a very crucial factor. Furthermore, this is an “asset” that holds no asset-like qualities in thecontext of liquidation value. The auditing firm for Resona Bank did not allow Resona to claim five
years of profits, but only three. As a result of this, Resona could not claim 260 billion yen of deferred
tax assets, and this resulted in their capital ratio falling below the 4% required by domestic standards.
Thus, the injection of public funds was required.
Banks have kept large amount of deferred tax asset in spite of the fact that most of them have been
losing money for the past 10 years. Table 9 shows the share of DTA in the core capital of major
Japanese financial groups. The DTA of other banking groups is also very large compared with its
core capital. If we apply US capital requirement rule that set the limit of DTA up to 10 percent ofcore capital, most major Japanese banks cannot comply with BIS capital requirements.

Table 9.

Ratio of Deferred Tax Asset in Core Capital of Major Japanese Banks（Mar 2003)

Core Capital (A)Billion yen
Mitsubishi Tokyo Financial Group
3,338
UFJ Holdings
2,665
Resona Holdings
635
Resona Bank
366
Saitama Resona Bank
155
Sumitomo Mitsui Financial Group
3,168
Mizuho Financial Group
4,322
Mitsui Trust Holdings
341
Notes: Net DTA = deferred tax assets - deferred tax liabilities.
Source: Disclosure materials of individual banks.
26

Net DTA (B)
Billion Yen
1,303
1,522
522
401
44
1,842
2,105
346

Ratio (B/A)
Percent
39.0
57.1
82.2
109.6
28.4
58.1
48.7
101.5

Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research
7.2 Price Book-Value Ratios (PBRs)
While the capital ratios of the bank continue to deteriorate, the stock prices of the major banks arerising. Here, we estimated some PBRs adjusted for dilutions due to the issuance of preferred shares.
We show these adjusted PBRs in fig 3. The adjusted PBRs have exceeded 1 for all banking groups,
and the average for all banks rose from 1.1 times at the end of March to 1.9 times at the end of
August. After the decision was made to inject public funds into Resona Bank on May 17th , theadjusted PBR has shown a clear rise. For one of the major banking groups, the PBR is close to 3
times. Of course, the stock price is not determined by net assets per share alone. However, in the
background of the adjusted PBRs, we sense a kind of moral hazard coming into play where thegovernment support to Resona Bank has caused calm among investors and the stock market has
become somewhat complacent.

Figure 3.

Adjusted PBRs (2003)

Times

3.5
Tokyo-Mitsubishi
UFJ
ResonaSumitomo Mitsui
MizuhoMitsui Trust

3

2.5

2

1.5

1

0.5

0
2003/01

03/02

03/03

03/04

03/05

03/06

03/07

03/08

03/09

Notes:
1) Adjusted PBR = ｛stock price *(Number of common stock at end of March 2003 + Adjusted
number of preferred shares)＋Total amount of non−convertible preferred shares｝/ Total capital at
end-March 2003.
2) Since we used the end-March 2003 total capital figures, we did not include the increase in capital
after March 2003.
3) To find Adjusted Preferred stocks, we took the book value of the preferred shares, divided
them by the initial convertible amount, and assumed they were converted.
Sources: “Stock Market Database” NEEDS-Financial QUEST. Disclosure material of banks

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Japan Financial Report No.9, October 2003
“The Profitability of Japanese Industries: Non-financial Sectors, Banks and Life-Insurance
Companies” Japan Center for Economic Research

8. In Conclusion
In this report, we used the financial statements for fiscal 2002 of all Japanese banks to analyze
their profitability, their bad loans, their capital ratios and their efforts to strengthen their capital bases.
We also pointed out some of the systems in banking as we looked at the Japanese merger accounting
principles.
In this analysis, there are five major issues as pointed out below that we find with the banks andthe systems related to banking.
First, banks are still not in good enough health to make adequate profits. These results in thesituation whereby the costs of writing off bad loans cannot be covered by the profits gained fromtheir core businesses.
Second is the declining capital ratio. If the banks are not able to make adequate profits, thencapital should decline. When we calculate the real capital using banks’ financial data, we find thatmany banks are in excess of debt.
Third is the bad loan issue. The resolution of the bad debt problem requires banks to be able towrite-off any bad loans incurred every year by their profit every year. However, the amounts of badloans to be written off continues to be at a very high level, and cannot be written off with the profits
made every year. Bad loans are not a major issue if the banks’ capital is plentiful and if they canmake up in sufficient margins the losses from the bad loans. However, for banks that are not able to
make large margins and are weakly capitalized, then bad loans are a very pressing issue. Moreover,
we do not see clear evidence that bad loans have shrunk over the past few years. Furthermore, there
is also the possibility that bad loans have been shifted to subsidiaries and to the public sector.
Fourth, regarding recapitalization moves and bank mergers, bank management needs to have aclear vision and be able to convince the public that the strategy taken is one that is truly necessary at
this point in time. We see a risk that the major banking groups’ may have taken future costs toolightly in their recapitalization efforts and merger strategies.
Fifth, there were issues with the public funds injected into Resona Bank. Rather than
implementing the Early Correction Measures, capital was injected into the Bank by applying the
Deposit Insurance Law. The authorities need to have more transparency in their procedures, and beable to justify their actions to the country.

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