Hurdles & Rewards: Navigating Japan's Financial Services Market

January 23, 2008

Panelists
Masatomo Harigaya, Director of International Equity Sales, Nomura Securities International, Inc.

Brian Kelly, Chief Investment Officer, Asian Century Quest Capital, LLC
Alicia Ogawa, Director of the Program on Alternative Investments; Associate Director for Program Development, Center on Japanese Economy and Business, Columbia Business School

Moderator
Leslie Norton, Foreign Editor, Asia, Barron's

A distinguished panel of business and academic leaders met to share their views on the risks and promise of the Japanese financial services industry today.

Technology makes it increasingly easy to manage investments from virtually anywhere on the planet, said panelist Brian Kelly, who moved to Japan with his family in 1981 and lived there for 10 years, including a period working at the Tokyo Stock Exchange, before coming back to the U.S., where three years ago he founded the investment firm Asian Century Quest Capital.

Based in New York, his company has some 60 or 65 percent of its investments in Japan and also invests in Korea, mainland China and Taiwan, Mr. Kelly said. With tools such as voice-over-IP, "I can manage my portfolio from Brazil or Hawaii or Tokyo or New York, as the case may be, off my laptop. It's just a fact that technology allows us to do that today much more efficiently than we could have ever imagined as recently as maybe 10 years ago."

Exchanges in Hong Kong and Singapore have grown aggressively, and "the Chinese are quite determined to see the Shanghai Stock Exchange take a large role as well," Mr. Kelly continued. "Given the rapidity with which trading volumes have developed in these other centers in Asia, they've got a lot of momentum behind them and they have generated what is the key factor for most financial exchanges--liquidity."

"They don't have liquidity in Japanese assets, and I think there has been a complacency in Tokyo regarding Japanese assets being actually traded outside of Japan," he said.

"Japan had the largest commodity exchanges in Asia for a long time. Now those non-Japanese assets are arguably much more likely to be traded away from Japan and Asia in a way that could not have been foreseen as recently as four or five years ago." By the same token, he said, "If you speak to the managements of the Hong Kong Stock Exchange or the Singapore Stock Exchange, as I've done many times, they are able to clearly articulate a strategy [that] discusses taking market share and growing products--products that don't exist elsewhere in Asia today. And they have their sights set on products that could include Japan going forward."

Making Japan's financial markets more competitive has been discussed in piecemeal fashion for years, Mr. Kelly said, but as with many other countries, conflicts between tradition-bound and more innovation-minded groups in government have held back change.
In the debate over rules-based regulation (the U.S. model) versus principles-based regulation (Japan and the UK), "I'm certainly not saying that a principles-based approach is necessarily wrong," Mr. Kelly concluded. But in Japan, the opacity of regulation has been especially problematic. "A principles-based approach that isn't clear in terms of what the outcome would be if you did a certain act, until after the fact, creates a lot of uncertainty. And financial markets in particular don't like uncertainty."

"Japan is obviously having to face up to the reality that it is no longer the main economic power in Asia, or it is in danger of not becoming so," began panelist Alicia Ogawa of Columbia Business School, who spent 15 years as a banking analyst in Japan and was a managing director for global equity research at Lehman before joining academia.

Financial services is a high-value-added business that could help Japan deal with the problems of an aging population and shrinking industrial base, but the industry accounts for just 6 percent of GDP in Japan, versus 10 percent in the U.S. and 12 percent in the UK, Ms. Ogawa noted. "The Chicago Mercantile Exchange is open 23 hours a day and trades just about everything," whereas "the Tokyo Commodities Exchange is open six hours a day and is not allowed to trade rice futures."

The biggest hurdle to unlocking the potential of Japan's economy, she continued, "is Japan's success; and its success was largely due, I think some of us would admit, not everybody, to the heavy-handed guidance by the state."

Until very recently, "the banking industry was essentially an arm of state development policy. Its job was to gather up consumer savings and channel them to the industries that the government identified as promising. There was absolutely no risk pricing involved. There was no credit analysis. It was a convoy system, so everyone shared the pain as well as the rewards no matter how much value you were adding."

Growth was rapid, risks were limited, and "there was little transparency in disclosure of Japanese corporates, because the banks knew everything they needed to know. There was no reason for anybody else to know anything about it."

Cross-shareholdings "protected managements against market discipline; corporate governance was generally accomplished by an intervention from main banks and from the Ministry of Finance"; and private firms had to compete with huge public entities like Japan Post and the Government Housing Loan Corporation.

Although financial system reforms ranging from the deregulation of trading commissions to postal system privatization have accomplished much, "I think I'm more interested in the challenges that remain that cannot be deregulated away," Ms. Ogawa said.

Among these challenges, in her view, is the absence of a professional fund management industry in Japan. "At the heart of this is the personnel rotation system, which is at the foundation of most Japanese corporate environments," she said. "People spend a couple of years in one department and get rotated through another so you never really manage to pick up a specialization in any one thing."

In addition, "my observation, as a former manager of Japanese securities analysts, is that the education system doesn't necessarily encourage people to get very aggressive about questioning and about attacking assumptions."

Combined with this are "the lack of cosmopolitanism, the lack of English-language speaking ability; again, the lack of an entrepreneurial culture, which has to do with many things, including interest rates and regulation, but also, I think, this idea of taking a risk and asking hard questions; the cross-shareholding system and, again, what is the need to manage money actively if so much of it is held for non-investment purposes, for the purposes of keeping friends safe?"

Whether or not Japan decides to create a sovereign wealth fund is a complicated question, Ms. Ogawa said. However, "something like a Singapore GIC, which I think kick-started that country's domestic fund management industry by giving young people real responsibilities in managing the national money, taking the best and the brightest, on the assumption that they would quit and go out and start their own businesses--I think that is a model that Japan can learn from."

In an era of political stalemate, fund managers in Japan "can be a very important force in encouraging better asset allocation, better capital allocation," she declared. "They can reward companies for transparency; they can encourage the development of roles, which, believe it or not, really don't exist in Japan today, such as CFOs, chief technology officers, chief restructuring officers, IR people--all of which will encourage transparency.

"Sixty percent of TSE-listed companies have no outside director, and that's outside director, not independent director, which is a looser category; 350 companies listed on the TSE have a majority controlled by their parent company and therefore really may be operating that subsidiary not for profit maximization--the number in the U.S., by the way, is 23.

"So, again, I think the best thing that can happen to Japan in terms of the challenges and hurdles for reforming the financial industry is also its reward, which is the development of a vital fund management industry," Ms. Ogawa concluded.

"Lots of my clients are asking me when Japanese investors are coming in to the Japanese market," observed panelist Masatomo Harigaya of Nomura. "I think the answer is probably not until the Japanese corporates are changing their attitudes to the shareholders. Because Japanese investors--individual investors or institutional investors--they probably, consciously or unconsciously, understand that Japanese corporates are not friendly to them. That's why they actually keep the money under the mattress."

Indeed, "lots of individual investors are said to be very risk averse," Mr. Harigaya noted, "but I don't think so." Over 50 percent of household assets are still in bank deposits, but there are many ordinary, nonprofessional investors who put money into leveraged FX trades, and still others who travel to Dubai or Hong Kong to open stock trading accounts. With Japanese blue chips yielding dividends of only 2 percent, just 70 basis points over Japanese government bonds, there's need for "a kind of mid-risk, mid-return type of investment."

Japanese companies "always told the investors that their policy for the dividend is stable dividend," Mr. Harigaya said. "They don't really like to increase it or decrease it in a sunny day or rainy day." But "lots of investors want to have a better dividend when it is a sunny day, and they will probably say okay to have a lesser dividend when it is a rainy day."

Although return on equity in Japan is up over the last five years, the gains have come from better margins, not from greater capital efficiency, he said. Foreign investors need to pressure Japanese corporates on this, but "probably the foreign investors' pressure is not enough. So, in order to have a proper pressure to Japanese corporates, we need a proper Japanese asset management fund, and also [pressure from] pension managers."

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Moderator Leslie Norton of Barron's began the Q&A:

Mizuho's $1.2 billion stake in Merrill was the biggest international move by a Japanese bank since 1986, when Sumitomo bought a $500-million stake in Goldman. Will more Japanese banks be investing abroad in this way? Are there opportunities for Japanese financials abroad?

"Yes, I'm sure they will," but it's not certain the opportunities will be good ones, Ms. Ogawa replied.

"Of all the Japanese financial institutions, the only major one I can think of that's remotely global--so, this is kind of a backhanded compliment--is Nomura, which has had long-standing operations in London and the U.S. I would say I'm not sure how well integrated those are with head office," she added.

"The manufacturing industry has done a splendid job of bringing best practices from Tokyo into the U.S. and other places and the reverse. So, when you look at the car companies and you look at the electronics companies, it's been wonderful."

However, aside from Orix, which is a smaller firm, "I don't see any examples of the Japanese financial industry really going global and making it pay off in a big way," enfranchising local managers "and really making them a vital and long-lasting part of the organization."

What about the idea of a sovereign wealth fund in Japan--is this a good idea, and do you expect Japan to do this?

"The Japanese government, as far as I understand, has pretty much come out and said that they are not interested in active investment," Mr. Kelly answered. "So, it is my understanding that that is not likely to develop."

"However, I was intrigued by Alicia's comment" on the Singapore GIC as potentially a model for Japan, he said.

"And indeed the Korean government, who sits on I think about $200 billion, which is not nothing, is precisely going in that direction," Mr. Kelly continued; its system of mandatory pre-tax savings accounts now owns some 20 percent of the Korean stock market, "developing a domestic institutional investor class that didn't exist over the space of arguably about three years."

Ms. Ogawa added, "There are sovereign wealth funds already present in Japan through the back door of investment funds, through private equity funds or big hedge funds. But I think it will be very interesting to see how Japan does react to increased foreign direct investment of which there is very little in Japan now, particularly when it comes from sovereign wealth funds."

Traditionally, Japanese institutional investors have not spoken up for shareholder rights in a very vigorous way, but this is changing, Mr. Harigaya said. Thus the Pension Fund Association of Japan has advocated a policy that "if Japanese corporates fail to achieve 8 percent ROE within three years," association members will vote not to reelect the incumbent directors. If sovereign wealth funds are created in Japan, he added, he expects them to join in pressing for shareholder rights.

Questions from audience members followed:

What are your expectations in terms of new rules on the movement of your capital within Japan, rules on short-selling equities, and so forth?

Though a step in the right direction, "unfortunately it ends up being a trial balloon, and trial balloons have a history of getting shot down," said Mr. Kelly.

Consolidation of stock exchanges, "that's kind of a no-brainer that should have happened a long time ago" to wring out excess costs, however "I'm a little skeptical of the government's desire to welcome in lots of hedge funds," Mr. Kelly continued. "There has been a lot of double talk on this issue for a long time, and that's okay. But it is informative perhaps to note that amongst the most emerging of all markets in the world, India, the SEBI [Securities and Exchange Board of India] just came out and said in February we're going to allow short-selling"--this "is a big step forward."

The situation in Japan "reminds me of early attitudes in this country," in the U.S., commented Ms. Ogawa.

"I'm not sure that that's anything you can regulate until it's kind of a self-fulfilling vicious cycle," she added. "So, you can't get liquidity short, and maybe there's taxation issues as well and there's settlement issues as well, but at the same time it comes down to an issue of is a Japanese investment bank going to loan you the shares to short if they perceive there is a conflict of interest?"

In the UK and the U.S., insurance companies have played, and still do play, a key role in developing investment management theory and practice. What are the impediments, if any, to the insurance industry becoming a leader on this in Japan?

"There are no regulatory impediments," Ms. Ogawa responded. "It comes down to, are fund managers getting compensated for the returns that they generate? Probably not."

Moreover, "is there is a business school education available in Japan for securities analysts? No," she said. "I visited the financial program at Todai [short for Tokyo Daigaku, Tokyo University] in December and I was told that even a university like Tokyo University could not recruit or could not identify someone to teach a securities analysis course. It's not funny, because there aren't any."

"The problem in Japan, and it's a more in-depth topic that we can talk about over a much longer conversation, that there is no dynamic asset reallocation occurring in the Japanese financial services market," Mr. Kelly said.

"So, many people say, are Japanese equities cheap? Well, I'm here to tell you, Japanese equities are extremely cheap," with the 10-year bond's risk-free rate of 1.3 percent "way out of whack" with company earnings yields of 6 and 7 percent, he said.

Ms. Ogawa declared, "Forget about Japan--any country in the world, a premium that opens up like that, it's because of the increased agency costs that are perceived when there is no corporate governance, when there is no transparency of responsibility to shareholders. If insurance companies ganged up and said we want an accounting and we're going to hold you liable and we're going to vote out the CEO, then that premium would begin to change."

You're looking for change from the outside, but are you getting the best and the brightest people to come into the financial services industry?

Some young graduates in Japan are choosing not to take conventional, full-time jobs, Mr. Harigaya responded. In financial services, "we need more attractive options--for example, lots of freedom moving away from the already facilitated career path. I've been with Nomura for about 12 years already and I can do whatever I want thanks to the company's management. I really appreciate that freedom I have."

--Katherine Hyde