Japan's regional economies have suffered in recent years as Greater Tokyo has sucked money in from the length and breadth of the land. As the economic revival is felt across the country, regional banks are working on ways to improve their products and services, just as the megabanks move in on their territory.
As if anyone needed proof of the lag effect of the regional economy compared with Greater Tokyo and the other big urban centres, the Financial Services Agency reported that as of September 30 2005 the ratio of non-performing loans at the major banks was just 2.4% while the ratio at regional institutions stood at 5.2%.
Rural economies are improving, but balance sheet and business practice reformation at some of the regional banks is lagging. In addition, profitability is under pressure from escalating competition from the megabanks and some of the largest and most soundly financed and managed of the regional banks.
A Nikkei newspaper article of April 28 reported that the regional banks are rushing to devise countermeasures against the megabanks, which the paper said are cutting into their hitherto-unchallenged business of providing financing for small, local firms.
The enemy at the gates
The problem for the regional banks is that the big banks are trying to tempt those strong local companies away by a combination of attractive products and lower rates. The Nikkei noted that as a result, the average interest rate spread between lending and deposits at 64 regional banks shrank by 49bp from a year earlier to 45bp in the six months through September 30, 2005.
As the megabanks open more branches in the backyards of the regional banks, these local lenders are attempting to introduce new products. The Nikkei noted, for example, that listed regional lender Bank of Fukuoka had launched a loan to help ship owners build vessels, for which the lending terms are set based on profits expected from operating the ships.
The paper also reported that the largest regional bank, Bank of Yokohama, was extending loans that accept intellectual property rights as collateral and had been collaborating with the Development Bank of Japan.
Another, Higashi-Nippon Bank, which operates in the greater Tokyo area, had worked with Sumitomo Mitsui Financial Group to provide unsecured loans of up to ¥30m that do not require a third-party guarantor, with Sumitomo Mitsui guaranteeing repayment of 80% of the principal.
Cementing old ties
Indeed, some of the regional banks are fighting back through revitalising their relationships with some of their former money centre friends. When the Japanese financial crisis hit in 1998, it was a distressing time not only for the country's leading banking names but also for many of the regional banks with which Japan's top money centre lenders had built intimate ties over several decades.
Long Term Credit Bank, which failed in 1998, was one of those whose demise was felt harshly by many regional financial institutions that relied in considerable part on capital and expertise from selected money centre banks.
LTCB, for example, had partly funded itself on a regular basis through the issuance of debentures to many of the regional banks and in return, LTCB as a money centre bank provided them with centralised functions and other expertise.
"LTCB's relationship was at that time also formalised to some extent through cross- shareholding ties," explains Masamitsu Sotowa, deputy group head of the financial institutions team at Shinsei Bank. "That intertwining of financial fortunes meant that many regional banks also suffered when LTCB went under."
Shinsei reaches out to the provinces
However, all was not lost. Ripplewood took over the defunct LTCB from the government and, armed with fresh capital and new management expertise, LTCB was reborn as Shinsei.
Moreover, recognising that the bank needed to leverage off every one of its positive legacy relationships within Japan, the new management group made extra efforts to rebuild ties with the regional banks.
"Shinsei does not have the nationwide network that the megabanks enjoy," explains Sotowa. "That is partly why we made a concerted endeavour to partner with the regional banks in an original and mutually beneficial way. We offer the full range of funding services and are innovators of the latest corporate finance structures, whereas the regional banks have less sophistication, but enjoy access to a wide range of customers that otherwise we could not locate."
The main areas in which Shinsei operates with the regional banks are warehousing mortgages, investment in regional bank subordinated debt, structuring and advising on non-recourse lending and providing these banks with structured deposits.
Arbitraging residential mortgages
Another core area in Shinsei's business portfolio is warehousing mortgages for the regional banks, which need alternative solutions to improve their balance sheets. Most of the loans then find their way to a pooled multi-seller securitisation issuance vehicle that Shinsei has been perfecting since 2003, in the form of the Hydra series of RMBS.
"The arbitrage here is that Shinsei can buy the mortgages off the regional banks at one price and by pooling and then securitising through large issues can obtain a better price from the capital market," explains Sotowa. "In the meantime, while we hold the residential loans directly on our balance sheet, we have the expertise internally to hedge our exposures to interest rate and spread fluctuations."
Shinsei aims to deal with about half of the roughly 110 regional banks. These institutions have a maximum balance sheet of about $20bn on average and have a compelling need to offload their mortgages for diversified funding, especially as the pace of economic improvement accelerates and the residential housing market becomes more robust.
"The largest single pool we warehoused for one regional bank was ¥80bn in size, but that is an exception," says Sotowa. "The average deal can be really rather small, but it all stacks up in the warehouse to make a substantial deal when a new Hydra issue is launched."
The largest of the five Hydra RMBS issues to date was the fourth series, which emerged in the autumn of 2004 at ¥141.6bn. The issue securitised residential loans that Shinsei had warehoused for four regional banks.
By way of example, one of these banks, Momiji Bank, was created in May 2004 through the merger of Hiroshima-Sogo Bank Ltd and Setouchi Bank, both of which operated mainly in the Hiroshima prefecture. According to the Standard & Poor's presale report for the Hydra issue, as of the end of March 2004, the banks had a combined total of 2,604 employees, 167 branches and 278 out-of-branch cash services, with total assets of ¥2.69tr ($23bn).
S&P reported that the consolidated capital adequacy ratio of the two banks was roughly 6.1% and noted that following an injection of ¥40bn in public funds in the former Hiroshima-Sogo Bank, Momiji Bank had been making efforts to dispose of non-performing assets and to streamline its organisational structure, including branches and employees.
The other three banks whose mortgage loans Shinsei had been warehousing owned only about $17bn of assets at the time, an indication of how small each of them was.
Sotowa recognises that both parties benefit. "The relationship we have with them is therefore mutually complementary, as they gain access to fast and low cost finance and balance sheet capacity while we gain access to a regional residential mortgage customer that we could never attempt to reach through our fairly limited regional network," he says.
Sending in the experts
Another core area for Shinsei's relationship with the regional bank community is the non-recourse loan product. Shinsei has aligned itself with six regional banks and has advised on more than 100 transactions.
"We have also been instrumental in introducing mezzanine debt investors to the funding packages in which non-recourse loans have featured," explains Sotowa. "And we have helped arrange the syndicated senior loan portions of the deals. Customers of the regional banks are increasingly drawn to the financial solutions we can help provide and that is likely to continue to be the case as the property market improves throughout the country."
Doug Smith, head of Shinsei Bank's real estate finance, explains that Shinsei's skills are in arranging specialist funding, for example non-recourse loans for high growth property companies, whereas the bank might not actually want to hold those assets on its balance sheet.
Shinsei is therefore concentrating on accessing corporate customers through its regional bank relationship network for the purpose of advisory and deal execution, more so, perhaps, than for asset generation.
"This is where our close relationships with the regional banks come into play," Smith says. "These banks might help us source a relationship with a would-be borrower that has funding needs. Shinsei can then engineer financing solutions and the regional bank can participate in the funding, creating a great synergy between regional banks' relationships and local market knowledge and Shinsei Bank's non-recourse loan expertise."
Smith further explains that non-recourse lending is greatly dependent on valuations and the evaluation of data. "You need a large team to do this business effectively, including conducting the due diligence necessary before we can commit to a deal."
Partly for this purpose, the bank has established a subsidiary, Shinsei Real Estate Valuation Services, which provides real estate valuations for the bank's activities, therefore enabling it to keep the whole process in house and rely only on internal assessment to complement external data.
Evaluation of data vital
"We do of course obtain independent appraisals of the assets," Smith says, "but we rely exclusively on our expertise and underwriting ability at the end of the day. The next stage of course is to structure, document, set the price for and potentially distribute the loans. It is these skills that our regional bank partners can leverage to provide solutions to their clients that otherwise they may not have been able to."
By way of example, Shinsei announced a business tie-up with Kita-Nippon Bank in July 2004 and later reported the conclusion of a joint non-recourse loan for a real estate acquisition by lead equity investor Chuo Jyutaku Sangyo, a client of Kita-Nippon.
"This is a classic example of Shinsei providing our know-how and applying it to a client of Kita-Nippon Bank that otherwise we would not have access to," says Smith.
For the Chuo Jyutaku Sangyo transaction, both Shinsei's analytical and structuring expertise came to the fore. The three properties were placed into a special purpose company, which is a tax free vehicle, because it can deduct any amounts it distributes to the Tokumei Kumiai (limited partnership) investment vehicle that represents the originator's interest in the capital structure.
There is a nominal ¥3m of minimum regulatory capital required at the bottom of the structure, above which Chuo Jyutakuk Sangyo invested in the limited partnership. Above that is the mezzanine non-recourse loan provided by other financial institutions and then the senior non-recourse funding provided by both Shinsei and Kita-Nippon Bank.
The other core area in which Shinsei is going to focus on will be the subordinated residential and other mortgage paper held by the regional banks. Under new BIS rules due to be implemented in March 2007, if a seller holds the subordinated strip of, for example, mortgages it has sold off or securitised, then it will need to apply capital on a one for one ratio.
Sotowa explains that the regional banks have limited access to funding from capital markets. "So we are stepping in to buy up those subordinated strips and, like the residential mortgages themselves, we are warehousing this paper and then aim to repackage and on-sell the exposures," he says.
So far, Shinsei has included subordinated mortgage paper with the bulk of the other higher rated paper in, for example, the bank's synergy securitisation programme. "However," says Sotowa, "it is likely that we will sell off pure subordinated assets in a dedicated deal in the future."
Shinsei is also investing in regional bank subordinated debt. These liabilities, which crashed in value in the 1998 financial crisis, are now becoming more alluring to the large investors, as the economic recovery gains pace and as the shape of the regional banking industry becomes clearer as a result of consolidation.
There was a lot of paper issued in the late 1990s at very high returns by the regional banks and the bigger banks at that time. Much of that paper will be due for refinancing and Sotowa expects that Shinsei will buy up or refinance some of this paper.
The result of all these initiatives is that Shinsei Bank and its regional bank partners are poised to benefit from the economic recovery. "Rural regions typically follow the economic direction of major urban centres," Sotowa explains, "so we are now seeing some of the effect of the recent economic improvement gradually reaching those areas."