Policy Update 011

Toward Reconstruction of Banks: Can Public Bailout of Resona Bank Become Model Case? (Part 2) - Rebuilding of Governance System -

TSURU Kotaro
Senior Fellow, RIETI

In Part 1, I evaluated the government's bailout scheme for Resona Bank, focusing on the treatment of deferred tax assets and the process leading up to the government's decision to infuse public funds. In Part 2, I would like to discuss, in examining the bank's restructuring plan which was unveiled on June 10, whether the Resona case can become a model for bank reconstruction, with particular regard to the process of government involvement, the handling of shareholders' responsibility, the introduction of the so-called "committee system" in management structure, and the pursuit of new business models.

Scale and Method of Recapitalization Raising Concern over Banks' Moral Hazard

Amount of public funds poured into bank is too generous
To rebuild its capital base, Resona applied for public funds to the tune of ¥1.96 trillion (with which Resona's consolidated capital adequacy ratio would go up to around 12.2%). The amount was determined in line with a recommendation by the Financial System Management Council, which stresses the need to secure a "capital adequacy ratio of well over 10%" in order to "wipe out anxiety among depositors, other bank customers and market players." What probably lies behind this decision is the judgment that Resona's capital adequacy ratio needs to be raised to a level comparable with that of well-to-do regional banks. Injections of public funds into banks in the past were problematic because the amounts of funds deployed were too small and the same scheme applied to all the major banks regardless of the differing degrees of financial soundness between them. In this light, it is important to implement sufficient recapitalization while tightening the assessment of management responsibility. Furthermore, it would probably be insufficient action for the government to inject funds only to the extent of raising the bank's capital ratio to 4%, a minimum requirement for domestic banks. However, it would be excessive and might even induce moral hazard to pour in public funds of an amount that would push up the capital adequacy ratio of a troubled bank to the same level as those of top regional banks.

Shareholders have not taken sufficient responsibility
When the Long-Term Credit Bank of Japan and Nippon Credit Bank were nationalized under the Financial Reconstruction Law, a 100% capital reduction was implemented in both cases with shareholders' equity in the respective banks written down to a zero value. The government then acquired these shares, leaving the shareholders with no rights. Here, it can be said that the shareholders of the two failed banks took their fair share of responsibility. However, in the case of Resona, it was determined that a practice known as "draw down and then replenish capital" would be implemented, under which Resona would first reduce its capital to cover losses carried forward and then recover it through public funds. Capital reduction is achieved by offsetting the amount of losses with the amount of paid-in capital and reserve. As this is just a reclassification within the "shareholders' equity" section of the balance sheets, neither the net amount of shareholders' equity nor the number of shares is affected. That is to say, because the amount of net asset per share remains unchanged, such a practice would theoretically have no direct impact on share prices. A write-off of accumulated losses is normally conducted as a means to paving the way for the resumption of dividend payments, thereby easing fundraising from the market. But when this is combined with capital increase, the number of shares will increase and this will inevitably affect share prices through the dilution of share values. Yet, under the scheme employed for Resona, shareholders are virtually pardoned of their responsibility. The scheme - though designed this way for the sake of deterring detrimental impact on the stock market - lacks fairness. It is unfair because, if the public funds eventually turn out to be irrecoverable, the scheme is as good as Japanese taxpayers giving "subsidies" to Resona shareholders. The financial authorities seem to believe that the scheme is justifiable because Resona shareholders are forced to take responsibility in the form of the suppression of dividends. But when a company skips or reduces dividend payments, despite having made enough profits to pay them and still have some left over, it will simply increase the company's retained earnings, which is of benefit to share prices, thus, not serving to force shareholders to take responsibility.

Rebuilding of governance: Importing new breed of managers from outside
Among the conditions for allowing the injection of public funds, the rebuilding of governance is the most important. The question is whether or not a new management team, which is to replace the existing one, will be able to implement a new management strategy, breaking free from the bonds and obligations of the past (transfer of management control). In Japanese banks, however, it is often the case that even if the whole management team resigns, it will be simply replaced by another set of managers who hold ideas and management policy identical to those held by their predecessors. As long as the new management team is composed of those who have been internally promoted, it tends to be just another copy of the old one. Therefore, the resignation of a management team does not necessarily lead to the improvement of a bank's governance. With the acquisition of controlling voting rights in shareholders' meeting, the financial authorities have now undertaken the responsibility of delivering good governance to Resona. But they, too, lack the know-how to bring about fundamental improvements on the management of a private bank. This has been a major dilemma in reforming a bank's governance, as a measure accompanying the infusion of public funds.

In its restructuring plan announced on June 10, assuming a large scale capital infusion amounting to nearly ¥2 trillion, the Resona Group pledged to reduce its expense ratio from being the highest among major banks to a level equivalent to that of other banks (by making a 30% cut on overall personnel costs, including the temporary suspension of bonus payments, slashing the number of employees by some 15%, etc.). Also, as a key measure for rebuilding its internal governance system, the plan called for the introduction of the "committee system" - a new management system in line with the revised Commercial Code effectuated in April - to both Resona Holdings, Inc. and Resona Bank. Under the new system, three committees of board directors - respectively in charge of nomination, auditing, and remuneration - will be formed with outside directors making up the majority of each committee. Along with six others who will serve as outside directors, Eiji Hosoya, vice president of East Japan Railway Co. and vice chairperson at Japan Association of Corporate Executives (Keizai Doyukai), has been named as representative chairman of both the holding company and bank.

The introduction of "new blood" from outside, those who are free from the bonds and obligations of the past, is a way to provide a quick cure when carrying out drastic management reform. Takeovers are one good way of doing this. As is the introduction of outside directors, which although it may turn out to be a dangerous drug, can bring about a similar effect with the replacement of a chief executive officer who has a bad track record. However, because the adoption of the committee system is not mandatory but optional under the revised Commercial Code, even companies that are badly in need of outside directors to carry out management reform may not necessarily choose to implement the system. Worse than this, the greater the need for outside directors, the greater the resistance the incumbent management may put up in protecting their own interests. Therefore, in order to maximize the governance function of outside directors, it is desirable to force companies to accept them. In this context, the bailout scheme for Resona will likely solve some of the dilemmas encountered in past public fund injections because the government, who possesses the controlling stake, is able to implement a governance system to indirectly control the bank's management by setting up the aforementioned three committees and selecting professional managers from outside.

What kind of personnel should be recruited from outside?
The question is what kind of personnel should be recruited from outside the bank. Unlike the United States, Japan does not have a well-established "market for corporate control" and it is not easy to find those capable of reconstructing management. In recruiting personnel from outside, there are two important points that need to be taken into consideration. First of all, in the case of banks, it would make little difference if a new manager was recruited from within the Japanese banking industry. Such a manager may be knowledgeable about the banking world but probably lacks innovative ideas, having come from an industry where herd mentality pervades. It may be an idea to seek talent from other non-manufacturing sectors that have gone through drastic deregulations or privatization. For instance, Michio Matsui, who used to work for Nippon Yusen Kaisha (NYK Line) and is now president of Matsui Securities Co., which has achieved rapid growth with its online brokerage business following the "Big Bang" deregulation of the securities business in Japan. In his book, Matsui said that his experience in the shipping industry in the 1980s when the industry went through drastic liberalization, helped him navigate his firm, keeping the brokerage house on a steady course of growth, when riding on the wave that was the liberalization of the securities industry. Another idea is to look for someone with experience in the same industry but in a different country (foreign financial institution). A manager with such a background is not only rich in expertise but also capable of the kind of management that is free from past practices and obligations, or unaffected by Japanese "common sense". President Carlos Ghosn of Nissan Motor Co. is a typical example of such a person but they do not necessarily have to be a foreigner (eg. Shinsei Bank President Masamoto Yashiro). From all of these viewpoints, the six external directors of Resona do not necessarily fulfill the above conditions. But expectations can be pinned on Chairman to-be Hosoya, who demonstrated a strong capability in pushing forward the breakup and privatization of the state-owned Japan National Railways, and I wait with expectation to see how he will once again prove his ability in reforming Resona, a member of the sector that has long been sheltered under the protective wing of the government, just like JNR used to be.

Can Resona's Restructuring Plan Become a Model Case for Bank Revitalization?

With a series of arrangements made for Resona Bank, the key question now is whether the bank can create a business model for increasing profits. Let me illustrate this with an analogy of restaurant management. With its facilities and interior fully renovated and upgraded to match those of high-class restaurants (recapitalization), the restaurant reopened with a completely new team of chefs (replacement of management team). But the question is whether or not the restaurant will be able to serve truly excellent cuisine (a new business model) to satisfy customers and increase profits. The Resona Group has evolved into what it is today by absorbing or merging with other banks to create a loose network of regional banks under the banner of offering locally oriented services. As it turned out, however, the outcome is nowhere near a super-regional bank, an intended goal, but rather, an "alliance of the weak" with none of the component banks likely to survive on their own. The financial authorities should take this reality seriously as a lesson and warning signal to its administrative policy of promoting mergers among regional financial institutions. The government's "monitoring team," which has been created to keep an eye on the management of Resona, and the Task Force on Financial Issues, which directly reports to the financial services minister, would be able to play certain roles with regard to the improvement of asset quality and cost reductions. When it comes to the key question - the rebuilding of a business model - however, it is a totally different story. For the moment, Resona has laid down a policy to place emphasis on customer-oriented approaches, such as increasing loans to small and midsize firms. But it is necessary to further in on strategically important areas, a task that involves the re-examination of the group-wide business structure and heretofore customer relations.

Meanwhile, an important watershed for the government, which is to come following the infusion of public funds, is the implementation of an "exit" policy, to decide on the timing of terminating public involvement. This is a question that also affects the recoverability of the public funds. The "exit," referred to here, means the government's selling off of Resona stocks that have been purchased for some ¥2 trillion. However, given the scale of shares involved, it would not be easy to sell them on the market unless the bank's performance goes up substantially. That is to say, it is quite difficult to find the "exit". Therefore, as long as the bank's performance remains unfavorable, the government will not be able to back out. Also, even if the government manages to sell off Resona stocks, it may end up with massive losses as a result of falls in stock prices. In this light, the LTCB-type bailout through outright nationalization might have provided an easier way out.

In past relationships between Japanese banks and regulatory authorities, the fact that both sides were reluctant to take responsibility for the problem of nonperforming loans (NPLs), posed a major obstacle for solving the problem. Applications for public funds were left up to the decision of individual banks and bank managers were not fully scrutinized for their management responsibility when seeking recapitalization. As it turned out, all the major banks received capital injections of insufficient amounts. Therefore, even when implementing measures to pre-empt possible financial crises, it should be necessary to have a mechanism under which both bank managers and shareholders are to take responsibility, in a substantially drastic manner, in return for the forcible injection of public funds into needy banks. The latest case of Resona's has established such a mechanism of forcible recapitalization, and for this the scheme deserves some credit. But it was the "decision" by the auditing firm that has enabled the government to implement this scheme. It would be a lie to say that there has never been a "behind-closed-doors collusion in the name of tacit agreement" among auditors, banks and government officials concerning the handling of bank's books. As exemplified by the Enron Corp. debacle in the U.S., however, even an internationally renowned accounting firm such as Arthur Andersen LLP can fall once a major fraud is exposed. Also, the government authorities, having broken away from the "convoy system" of bank administration, would not try to protect the bank to the bitter end. It was probably on the recognition of such a changing environment that the accounting firm stood up to fulfill its responsibility and secure its own survival. This "brave action" by Shin Nihon & Co. surely paved the way to changing "collusive relationships under which no one dares take responsibility."

Can the virtual nationalization of Resona be a model for bank reconstruction in the future? The seven-member management team recruited from outside the bank holds the key to this question. Once Resona adopts the committee system, will they be able to rebuild an effective governance system that maintains strong discipline over the bank's operating divisions through the audit committee? Will they be able to demonstrate a capability for exploring new business models? And will they be able to make a "brave decision" just like Shin Nihon & Co. did to fulfill its responsibility? Only when the new management team fully performs in all these roles, will the bailout scheme for Resona be able to become a model case, compensating for the negative effect (moral hazard) caused by "excessive" recapitalization and tepid treatment of shareholders' responsibility.

>> Original text in Japanese

June 16, 2003

June 16, 2003