Brief Overview Of Trends In The Uk Us And Japanese Financial Markets

Banking markets around the world have been subject to an enormous degree of structural change since the early 1980s. This structural change has been associated with: increasing competition, both within and across sectors, and from the capital market; the impact of new technology, which is facilitating competition from new entrants; deregulation; increased diversification and merger activity and, more recently in the UK, the de-mutualization of segments of both the life assurance and building society industries.

These trends have impacted forcefully on the UK banking sector. Following the intensification of competition in both corporate sector lending and international banking in the late 1970s, UK banks sought to diversify their business in order to maintain their profitability. In 1981, for example, UK banks entered the mortgage market in a significant way as part of an increased focus on the domestic retail banking market, and in 1986, following 'Big Bang' in the London stock exchange, a number of the large UK clearing banks diversified into investment banking activities. More recently UK banks have diversified into insurance, and particularly into life assurance as part of a worldwide trend towards bancassurance. In common with banks around the world, UK banks have dramatically increased the contribution to profits emanating from 'off-balance sheet' business and fee income.

At the same time as banks have been diversifying into other areas of the financial services marketplace, however, other institutions have simultaneously been diversifying into areas which were hitherto the exclusive preserve of banks. Following the deregulation associated with the 1986 Building Societies Act, for example, UK building societies were able to offer unsecured loans, credit cards and money transmission services as well as life and general insurance, unit trusts (mutual funds) and so on. The recent 1997 Building Societies Act has removed most of the remaining restrictions on building societies' activities. More recently, insurance companies such as Standard Life and the Prudential have obtained banking licences, as have a number of large supermarkets and retailers. Furthermore, relatively new 'non-financial' entrants into the financial services marketplace, such as Virgin and Marks and Spencer, are now offering a range of financial services such as credit cards, unit trusts, pensions and so on.

The competitive pressures operating in banking markets have produced a wave of mergers and consolidations in recent years. In the UK we have witnessed the mergers of Lloyds Bank and the Trustee Savings Bank (TSB) and the contested takeover of the NatWest Bank by the Royal Bank of Scotland. Hence, against this backdrop of increasing competition and a trend towards diversification, consolidation and rationalization, the study of costs and efficiency, and in particular economies of scale and scope, is clearly very relevant in the context of UK banking.

It is also highly relevant to US banking, as it is in the US where the consolidation movement has been most pronounced. Between 1980 and 1998, for example, there were 8,000 bank mergers involving $2.4 trillion in acquired assets, and the total number of banks in the US declined from 14,407 to 8,697 over the period (Rhoades, 2000).

The 1980s also witnessed a trend towards so-called megamergers in the US banking industry, that is, mergers and acquisitions in which both banking organizations have more than $1 billion in assets. This trend was stimulated by the removal of many of the previous intrastate and interstate banking restrictions and continued through the 1990s. Towards the late 1990s, however, a trend towards even larger-scale mergers emerged. Berger et al. (1998) refer to these as 'supermegamergers' and define them as mergers and acquisitions (M&As) between institutions with assets of more than $100 billion each. As Berger et al. point out: 'Based on market values, nine of the ten largest M&As in US history in any industry occurred during 1998, and four of these - Citicorp-Travelers, BankAmerica-Nations Bank, Banc One-First Chicago and Norwest-Wells Fargo - occurred in banking' (p. 3).

Perhaps the highest profile of these supermegamergers was that between Citicorp and Travelers, which is also symptomatic of a trend towards mergers across different sectors of the financial services marketplace. The merger created a banking group with total assets of about $700 billion and an estimated customer base of over 100 million customers in about 100 countries. Furthermore, this merger has been hailed by many analysts as a new model in the form of the first truly global universal bank, where the term 'universal banking' refers to a bank which provides a full range of commercial banking, investment banking and insurance services. In terms of the relative contributions of the two parties to producing this global universal bank, Travelers offered investment services, asset management, life insurance, property and casualty insurance, and consumer lending. Citicorp on the other hand was a well-established large US commercial bank which also boasted the industry's largest credit card portfolio at more than $60 billion after acquiring AT&T Universal Card Services.

A further significant feature of the Citicorp-Travelers merger was that it was approved by the US regulators despite the fact that it breached the spirit of the 1933 Glass-Steagall Act. This legislation was enacted in the wake of the banking crises of the Great Depression and effectively prohibited universal banking by preventing commercial banks, investment banks (securities firms) and insurance companies from participating in each other's business. Although Congress had considered the repeal of the 1933 legislation many times over the last 20 years or so, and even though the legislation had been partially circumvented via the bank holding company legislation, this supermegamerger provided the impetus for a concerted attempt to overturn the depression era restrictions, given that a US commercial bank - Citicorp - was allowed to merge with the second-largest securities firm in the US - Travelers.

The final result was the Financial Services Modernization Act 1999. A key feature of this legislation is that it repeals the restrictions on banks affiliating with securities firms contained in Sections 20 and 32 of the Glass-Steagall Act. Furthermore, it provides for the creation of new 'financial holding companies' under Section 4 of the Bank Holding Company Act. Once created, these holding companies can engage in a statutorily provided list of financial services including insurance and securities underwriting and merchant banking activities. It seems highly likely that this legislation will pave the way for further large-scale universal bank mergers in the future. Indeed, the recently announced merger between J.P. Morgan and Chase Manhattan is a $30 billion deal creating the third largest bank in the US after Citicorp-Travelers and Bank of America with combined assets of about $660 billion. The merger will also push the combined bank towards the so-called 'bulge-bracket' of large investment banks.

Furthermore, the global nature of recent and prospective US universal banking mergers is likely to prompt similar mergers in other countries around the world. In recent years, for example, we have witnessed the merger of Union Bank of Switzerland (UBS) (which had previously acquired the UK securities firm Phillips and Drew) and the Swiss Bank Corporation, and future European financial sector mergers may well involve cross-border acquisitions, given the impact of the euro and the single European market in financial services.

The Japanese financial system is also currently experiencing a phase of significant structural change and consolidation. In part this reflects a legacy of relatively poor profitability and the problem loans associated with the bursting of the 'bubble economy' of the late 1980s. It also reflects the impact of deregulation and increasing competition from abroad. These pressures have produced a wave of mergers, both across hitherto fragmented segments of banking and financial markets and across the traditional keiretsu structures. During 1999, for example, a planned three-way amalgamation was announced between the Long Term Credit Bank, Industrial Bank of Japan, and two large city banks, Dai-Ichi Kangyo and Fuji Bank. The resultant single holding company (Mizuho) will represent the world's largest banking group (by assets) with combined assets in excess of ¥ 141,800 billion, and will account for about 25 per cent of the Japanese retail and corporate banking market. Mergers have also been announced between Sumitomo Bank and Sakura Bank, Bank of Tokyo-Mitsubishi and Mitsubishi Trust and between Sanwa, Asahi and Tokai Banks.

The poor performance of Japanese banks in recent years was caused by the interaction of a banking system which had focused on volume (growth in assets) rather than profitability up to the early 1990s, and the impact of major asset-quality problems which arose following the collapse of the Japanese bubble economy in 1990. For a full exposition, for example, see Hoshi and Kashyap (1999), Harui (1997), Craig (1998) and Hall (1999). In brief, the banking sector was used as an instrument of industrial policy by the Japanese government, recycling Japan's savings in order to provide Japanese industry with very low-cost investment funds. The quid pro quo to the banks for providing low-cost funds was the infamous 'convoy' system, whereby any bank facing financial difficulty could rely on the government to organize a rescue by other financial institutions. This created significant moral hazard in the banking system - Japanese banks largely ignored borrowers' credit quality when making loans and did not price loans according to risk. With low margins prevalent, the focus of Japanese banks was on the volume, rather than the quality, of their loan book. Furthermore, as a large proportion of bank shares were owned by Japanese corporations (who were also borrowers), there was little pressure from shareholders for banks to improve their profitability. A lax regulatory regime, poor disclosure standards and a weak culture of corporate governance also contributed to Japanese banks' ability to maintain their poor performance.

By the early 1990s, however, the Japanese banks began to feel the impact of the collapse of the bubble economy in Japan. They had undertaken a large amount of collateralized lending during the 1980s and the collapse of the asset bubble drove many borrowers into bankruptcy and eroded the value of collateral held against the loans. This led to severe asset-quality problems at Japanese banks. Unfortunately, the low levels of profitability meant that Japanese banks were unable to make adequate provisions against these bad loans. The initial response from banks and the regulatory authorities was one of forbearance, hidden behind weak disclosure standards. Only as time progressed and asset prices failed to recover did the Japanese banks begin to admit the true extent of their bad-loan problems.

The interest in analysing costs and efficiency in the Japanese banking sector is therefore driven, in part, by the need for the sector to increase its profitability. The need for Japanese banks to increase profitability is almost self-evident. On almost any measure, their profitability is low. For example for the years 1993/94 to 1997/98, the return on assets at major Japanese banks averaged -0.1 per cent, compared to an average of + 1.2 per cent for the 22 largest US banks. Core profitability (operating profits before provisions) over total assets over the same period was + 0.7 per cent at Japanese banks, but + 2.1 per cent at the US banks.

Pressure on the Japanese banking sector to increase profits is also coming from reforms to the Japanese financial sector, commonly known as 'Japanese big bang'. This is a series of reforms designed to open up and modernize the entire Japanese financial system. The deregulation and increased disclosure will lead to more pressure from shareholders on banks (and indeed all other Japanese companies) to increase returns.

The Japanese government is also putting pressure on Japanese banks to increase their profitability. In March 1999, the Japanese government injected capital totalling ¥7.5 trillion ($60 billion) into 15 of the largest Japanese banks. One condition of the capital injection, however, was that the banks were required to draw up plans to show how they would increase profits (out to 2002/03). The Japanese government expects the banks to repay these funds within about ten years.

The ability of Japanese banks to take advantage of any potential economies of scale in order to increase profitability has improved dramatically, however, since the change in the regulatory regime in June 1998. Under the old regime, the role of each type of bank within the financial system was tightly defined, and little competition occurred between banks. The government maintained the structure of the system using the convoy system. As such, it was extremely rare for banks to merge, or to fail. As a result, Japan is commonly viewed as 'overbanked'. Under the new regulatory regime, however, the Japanese authorities are much more willing to see banks break out of their traditional role. They have encouraged the merger of some of the larger banks, and have allowed other banks to fail. They have indicated that further failures (particularly of smaller banks) would not be stopped.

Finally, in 2000, at the time of writing, the Japanese financial system is witnessing the first cross-sector alliances. In October 2000, for example, Dai-Ichi Mutual and Yasuda Life Assurance (in itself a unique link-up) announced that they would be asking other Japanese financial companies, including banks such as the newly created Mizuho, to join their planned alliance.

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