Japan banks shiver as auditors flex muscles

The fate of Japan's top banks may lie in the hands of auditors. That is one of the strongest messages from the past weekend, when the government stepped in to bail out Resona Holdings after the auditors refused to approve its accounts.

Accountants have had a bad press since 2001 and the dubious practices laid bare by the collapse of US energy trader Enron Corp but the Japanese team that stood up to Resona's management has done something to restore their reputation.

Some analysts said Resona, the fifth-largest bank in Japan with assets of 45 trillion yen ($389.2 billion), might have been singled out by the authorities pushing to make their financial reforms concrete and by auditors trying to assert themselves.

“The government was seeking an outcome for its banking reform and auditors had to send a clear message of their role,” said Ken-ichi Nagai, financial consultant at UFJ Institute, an affiliate of top-four bank UFJ Holdings “The auditors' image may improve after Resona,” he said. Pressure on banks has been growing since Financial Services Minister Heizo Takenaka unveiled stricter capital and asset assessments last October to restore the financial health of –and investor confidence in — the sector. One of his main targets was deferred tax assets (DTAs) — expected tax credits on loan-loss provisions — because Japanese banks have been relying on them heavily as capital in order to meet capital adequacy ratios, a key measure of their health.

The problem is that they only materialise as real assets when the borrowers that have taken up the bad loans in question are legally bankrupt and the bank itself has taxable profit.

Resona said that at the end of the business year in March its capital adequacy ratio had fallen below four per cent, the minimum needed to do business as a domestic bank, against a forecast 6.5-6.9 per cent.

It said that it had planned to book around 700 billion yen in DTAs but the auditors slashed that to 435 billion yen, accounting for two thirds of the decline in the capital adequacy ratio.

The bank then forecast a whopping loss of 838 billion yen for fiscal 2002/03, almost three times its previous forecast.

Japan's four biggest banks, the so-called megabanks, have less to worry about in this respect.

Resona's reliance on tax breaks in the form of DTAs was unusually high. DTAs accounted for 80 per cent of its core capital, whereas the proportion of DTAs in core capital at the four megabanks at end-September was around 50 per cent at most.

Officials at the top banks said their auditors had no qualms about their earnings projections, which they said were based on very conservative estimates.

Prodded by Takenaka, the megabanks have boosted loan-loss charges against risky borrowers, sharply cut their earnings forecasts and raised cash to make up for the capital erosion anticipated under tougher accounting rules. Mizuho Financial Group said it would not include about 800 billion yen in DTAs while UFJ and second-biggest Sumitomo Mitsui Financial Group said they would not report 400-500 billion each. Third-largest Mitsubishi Tokyo Financial Group already had the lowest DTAs of the megabanks, some 35 per cent of core capital.

But this doesn't mean the megabanks — which like Resona are struggling to clean up trillions of yen in bad loans and rebuild capital by boosting profit — are out of the woods.

“With deflation advancing and the Japanese and global economies short of breath, it is only a question of time before capital destruction surfaces as a problem at the four megabanks,” Ryoji Musha, chief strategist at Deutsche Securities, said in a note to clients.

“Government-guided bank reform can be called a success only after it has been implemented at the four megabanks,” he added.

Analysts said the longer-term implications depended on how the government proceeded with the bank's rehabilitation. “The government averted the worst for now but it remains to be seen if Resona, with state support, can change its business model to make a modest profit,” UFJ Institute's Nagai said. For some, the worst outcome would be if Resona simply became another “zombie firm”, kept alive by the state in the way many big, troubled borrowers keep going with bank loans.

Perhaps sensing a change, investors took the view that Resona's worst customers could no longer rely on bank largesse.

Shares in struggling condominium builder Dia Kensetsu Co, for example, hit a lifetime low of 40 yen on Monday before ending down seven yen or 12.5 per cent at 49 yen.

Dia earlier this month asked Resona Bank, a member of Resona Holdings, to forgive 35 billion yen of debt and swap another 50 billion yen for equity.

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