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subsidiary of Sakura. It strengthens Sakura’s presence in its home area, the Osako – Kobe region of Japan.

However, given Sakura’s profile at the onset of the new millennium, it was clear a new alliance was needed to boost its capital strength, and to avoid being left behind in the trend towards forming mega banks. Sakura was aware it might be hit by a withdrawal of deposits from the bank, because, at the time, it was thought that the 100% deposit protection on retail deposits would be phased out by 2001.26 Sakura had hoped to interest Deutsche Bank, but after careful scrutiny of Sakura’s strengths and weaknesses, the German bank declined to make an offer. Sanwa Bank and Nomura were named as possible suitors, until Sanwa revealed it was to merge with the Asahi-Tokai group. In October 1999 came the surprise announcement that Sakura was to merge with Sumitomo Bank, to take place by April 2002. Sumitomo was considered one of the relatively strong money centre banks, though this is by comparison with quite a lack-lustre lot. Like the merger which had created Sakura in 1992, it was completed a year early, by April 2001.

Their activities complement each other. Sumitomo’s strengths were in wholesale securities and asset management. In 1999, Sumitomo and Daiwa Securities had agreed a joint venture, with plans to set up a ¥300 billion fund (with GE Capital) to finance corporate mergers and acquisitions in Japan. Daiwa Securities received a much needed capital injection, while Sumitomo could expand in investment banking. Sakura was an established retail banking presence, including the internet bank, Japan Net Bank, both relatively cheap sources of funds.

Unlike the other mega mergers, the bank holding company model was not used by Sumitomo and Sakura. The merger was more traditional with an exchange of shares, with Sumitomo absorbing Sakura. The new bank was called Sumitomo Mitsui, an immediate reminder that this merger involves two financial arms of competing keiretsu – Sumitomo and Mitsui. It will have a single chairman, with 30 directors. By contrast Mizuho planned to have three chief executives, two chairmen and one president, and most of these banks have boards in excess of 50 members. The plan was to begin providing joint services at retail outlets, through the ATMs and internet banking. The Sumitomo – Daiwa alliance will be integrated with the (relatively small) securities subsidiary owned by Sakura. Investment banking operations (e.g. M&As) were merged, along with trust banking and insurance operations. At the time the merger was announced, the plan was to shed 9000 jobs (about a third of the joint workforce) and close overlapping branches.

The merger has been described as a ‘‘defensive’’ one, for a number of reasons:

žAt the time of the merger (2002 figures), Sumitomo Mitsui was the second largest bank in the world measured by assets, following Mizuho Financial Group and Citigroup. Both

26 To stem the increasing tide of deposit withdrawals, in 1998 the government announced a temporary 100% retail deposit protection, replacing the maximum payout of ¥10 000 yen. When the full guarantee on time deposits ended in April 2002, it prompted large transfers of cash from time deposits to current accounts, cash or gold. To stop this from happening again, current accounts remained covered – until March 2003, and in 2003 the deadline was extended again.

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written off in earlier years, and big loan loss reserves are in place for the remaining risk assets. In 2003, problem loans were less than 5% of total loans, about a threefold reduction since 2002, and its Basel 1 risk assets ratio is around 12% – about 2% higher than the top four Japanese banks. It also has close connections with regional banks.

The 2002 financial results of the big four banks were dismal, and came with an announcement of a large increase in non-performing loans, equal to ¥26 800 billion, compared to ¥18 000 billion in the previous financial year. As a result, all the big four reported pre-tax losses. At the time, they were confident they would be in profit by 2003. However, in 2003, pre-tax losses for the four mega banks amounted to ¥4000 billion ($31.7 billion). Of The Banker’s top 1000 banks, three of these banks placed at the top for pre-tax losses. SMFG was in third place after Mizuho (first) and UFI (second).28 The results were due to exceptionally high provisioning for non-performing loans, and the new mark to market regulations caused a 30% fall in share prices. Banks had been hopeful they could generate revenue through higher lending margins (the average interest rate on corporate loans fell), fee income (increased by just 1%) and trust income (fell by 7%). Cost cutting, in the form of job cuts and branch closures, will have to continue. Sumitomo Mitsui was considered to be somewhat unique, because its exposure to several large (e.g. construction, property) companies leaves it in a comparatively weak asset position, and could overwhelm the effects of improved revenues and cost-cutting. The table below suggests SMGF has some way to go on cutting costs. At the time of the merger it was announced that 9000 employees (one-third of its workforce) would be cut from the payroll.

Source: The Banker, July issues, 1999, 2003.

SMFG, along with the other mega banks, are predicting profits for 2004. Many analysts think the banks will be plagued by ‘‘massive’’ non-performing loans for at least another two years.

Questions

1.In the context of this case, explain the meaning of: (a) imported deregulation; (b) zaitech;

(c)the EU’s application of ‘‘equal treatment’’ and its implications for Japanese banks;

(d)‘‘relationship banking’’ in Japan; (e) universal banking in Japan.

28 They were in prestigious company: Credit Suisse Group, West LB, Abbey National and Dresdner were also in the bottom 10 banks measured by pre-tax losses. Source: The Banker (2003), p. 180.

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10.5. Bancomer: A Study of an Emerging Market

Bank29

Relevant parts of text: Chapter 6 (currency, market, sovereign and political risk).

On 1 September 1982, following the moratorium on the repayment of foreign debt, a balance of payments crisis, the imposition of exchange controls and a substantial devaluation of the peso, President Jose´ Lopez Portillo nationalised Mexico’s six commercial banks. Over the next 9 years, the government channelled savings from these depository institutions to finance the national fiscal deficit. The management teams of banks remained under state control and given very little discretion over investment and personnel decisions. There was little scope for strategic planning. Instead, management’s focus was on making financial resources available to the government through deposit-gathering, in return for the right to levy fees and other charges on the bank’s depositors. Most of their assets were government bonds. Mexican banks had ceased to be the primary provider of market-oriented financial services to the Mexican public. While under state ownership and control, the Mexican banks were well capitalised and noted for their overall stability, sustained growth and profitability.

By the beginning of the 1990s, the Mexican economy had largely recovered from the dark days of ‘‘default’’, when the country announced it could no longer service its sovereign external debt. The Baker and Brady plans, together with IMF restructuring, had resulted in more realistic external debt repayments, via, for example, Brady bonds (see Chapter 6), an economy more open to foreign competition, privatisation and fiscal reform. The inflation rate fell from 30% in 1990 to 7% in 1993 – 4, with a reasonable annual GDP growth rate of 3 – 4%. Exchange rate policy was moving in the direction of a more liberal managed floating regime, beginning with a fixed peg in 1988 to a crawling peg, and in 1991, a crawling trading band.30 Net capital inflows in the early 1990s financed a current account deficit. President Carlos Salinas, elected in 1988 for a fixed 6-year term, took much of the credit for the economic transformation.

Given other sectors had undergone extensive economic reform, it seemed incongruous to have a state run banking system. The President was determined to introduce a range of financial reforms aimed at the development of a liberalised, marketoriented financial sector. In mid-1990, the Mexican Constitution was amended to permit individuals and companies to own controlling interests in commercial banks. A privatisation committee was created to oversee the sale of Mexico’s banks to private investors.

The Mexican Banking Law was enacted to regulate the ownership and operation of commercial banks. Under the Financial Groups Law (1990), the universal banking model was adopted. A range of diverse financial activities (including commercial and investment

29This case first appeared in the New York University Salomon Center Case Series in Banking and Finance (Case No. 18). Written by Roy Smith and Ingo Walter (1992). It has been edited and substantially revised by Shelagh Heffernan. Questions by Shelagh Heffernan.

30The peso could fluctuate within a band. Peso appreciation was fixed, but peso depreciation could move within a band linked to the inflation rate. Source: Beim and Calomiris (2001), p306.

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assessment, since for many years banks had been the conduit for savings to finance the government’s fiscal deficit. Even the key regulator, the Banco de Mexico, lacked the requisite skills and prudential rules to control bank risk taking.

Nonetheless, Bancomer undertook to improve its asset quality between 1989 and 1991. It absorbed a series of non-recurring charges and created reserves for loan losses which subsequently exceeded all the required regulatory levels. Bancomer’s profitability during 1989 – 90 reflected these charges and reserves, as well as the costs of refocusing the business and the impact of recent declines in the Mexican rate of inflation. As shown in Table 10.3, in 1989 – 90, real profits fell by 22% but grew by nearly 66% between 1990 and 1991. In common with other Mexican banks, Bancomer had a growing asset base, reflecting, among other things, impressive growth in the Mexican economy, strong demand for credit in pesos and dollars, and Bancomer’s increased market share in lending. As of 30 June 1991, assets totalled $24 billion.

Higher-quality credits made up 95% of Bancomer’s portfolio as of 30 June 1991. Pastdue, lower-quality credits made up 1.78% of the portfolio, compared to 2.79% the year before. Reserve coverage for lower-quality credits improved during the year. A credit review conducted by independent auditors concluded that Bancomer’s portfolio was appropriately classified. Bancomer was also well capitalised. In June 1991, the bank’s ratio of capital to weighted risk assets was 7.4%, exceeding the 6% minimum requirement for 1991 and the 7% minimum set for 1992. As can be seen from Table 10.1, the Basel ratio rose steadily throughout the 1990s.

In 1991, Bancomer’s net income was forecast to grow to about $400 million, an increase of over 50% in real terms compared to 1990. Its return on average assets was 2.21%, up from 1.84% in 1990; return on average equity was 24%. The net interest margin increased from 7.22% in 1990 to 7.4% in 1991, reflecting a shift from loweryielding government securities to higher-yielding private sector loans, together with lower-cost peso denominated deposits which made up a large portion of Bancomer’s funding base.

When privatised in October 1991, Bancomer had about 760 branches and held 26% of Mexican deposits.31 It was the second largest bank after Banamex when measured by tier 1 capital or assets. The government sold 51% (with an option to buy another 25%) to Valres de Monterrey S.A. (Vamsa), a publicly traded financial services holding company involved in financial leasing, factoring, warehouse bonding and broking, and one of the largest life insurance firms in Mexico. It was wholly owned by a very large Mexican conglomerate, Grupo Visa. Visa had a variety of holdings including a beverages company. PROA, a holding company, was controlled by the Garza Laguera family, which owned 86% of Visa. Another 11% of Visa shares were held by allied investors, and the remaining 3% by the Mexican public. The PROA group had experience, albeit dated, in banking, having owned Banca Serfin S.A., Mexico’s third largest bank, before it was nationalised. The Visa management group believed ties between Vamsa and the Bancomer group could produce substantial synergies by combining their factor leasing, insurance and brokerage activities.

31 ‘‘Mexico Sells 51 Per Cent Stake In Bancomer For $2.5bn’’, Financial Times, 29 October 1991.

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žAs the banks moved back into lending, the supervisory authorities were facing very large portfolios to be monitored at a time when they, like the banks, had little training or experience in risk management.

žThere were no experienced credit rating firms that could rate individuals or firms. Nor was there much credit history available, since the banks had engaged in so little lending up to this point.

During the privatisation period in 1990 – 91, Mexico’s business elite paid out $12.4bn for the banks – paying an average of 3.1 times book value – in the belief that the financial sector would grow by about 8% per year, double that forecast for the economy as a whole. Just as with Bancomer, most of the state owned banks were purchased by families owning large industrial concerns because they had the capital to pay out the 3 to 4 times book value for these banks. Connected lending was common given the wide network of firms they owned. In some cases, these loans were used as part of the capital to purchase the banks. To the degree that they were de facto undercapitalised, it aggravated the moral hazard problem – go for broke – especially in the period before, during and after the crisis. This group of industrialists also supported President Salinas and his liberalisation programme. Lax consumer lending would help create a feel good factor, which would be good for the PRI in the upcoming August 1994 election.

After the financial reforms but before currency crisis, all banks wanted to get on the credit bandwagon, causing loan rates to drop and rapid credit expansion in the household and business sectors. Loans to the private sector grew by 327% between 1989 and 1992.34 Commercial bank loans amounted to 10.6% of GDP in 1988 but by 1993, reached 34.5%.35 With virtually no economic growth, loan losses rose sharply, and provisioning increased. By 1993, there was mounting concern about the viability of the banks. Return on assets/equity remained positive but profits began to fall – Table 10.3 shows a 27% drop in real profits. A new competitive threat was the potential entry of Canadian and US banks (or subsidiaries of foreign banks based in these countries), which would be allowed to establish branches over 10 years, once the North American Free Trade Agreement was signed in 1993.36

The Mexican economy had slowed considerably in 1993. An uprising in the state of Chiapas, and two high level political assassinations of members of the PRI party (one was a presidential candidate) in 1994, intensified investor concerns about the country’s political stability. By March 1994, there was a net outflow of capital. To discourage capital flight, the government replaced its cetes (the Mexican equivalent of government Treasury bills) with tesobonos, which, like cetes, were payable in pesos but indexed to the peso – dollar exchange rate. Effectively the government had assumed the currency risk related to holding their bills, and this helped to stabilise the markets until November 1994. By this time the currency regime had moved from a crawling peg (1989) to a crawling trading band, two

34Cost of Credit is still too high after Privatisation-Banking, The Financial Times, 10 November, 1993, p. 6.

35Source: Beim and Calormiris (2001), p. 310.

36In 1993 (pre-agreement), Scotiabank (Canada) owned 5% of Comermex-Inverlat; and two Spanish banks Banco Bilbao-Vizcaya and Banco Central Hispano had a 20% shareholding in, respectively, Mercantil-Pobursa; and Prime-Internacional.