There have been major changes to accounting standards in Japan which, by the time they have all been implemented will have brought Japanese accounting standards broadly into line with international norms. These changes are comprehensive and include the introduction of fair value--or mark-to-market--accounting. This last change, although seemingly innocuous will be particularly powerful in its impact.
But What Has All This To Do With Derivatives?
The introduction of mark-to-market accounting requires listed Japanese companies to record their holding of marketable property assets and securities at current market value rather than at book value. This means that balance sheets will no longer be buttressed by assets valued at inflated bubble economy levels. But most crucially profit streams will become exposed to movements in equity markets, as the definition of securities includes the cross shareholdings which bind members of Japan's Keiretsu and other business groupings. These are substantial in Japan, accounting for perhaps 40% of all shareholdings.
The unwinding of cross shareholdings is undoubtedly one of the factors behind the recent weakness of Tokyo stock prices, not least as foreign buyers who had been soaking up much of the unwound cross held shares coming onto to the market have been notably absent over the past few months.
Hence there has been much talk about how best to unwind these cross shareholdings without further depressing the market. Where possible firms with mutual shareholdings have been seeking arrangements that are effectively straight swaps. But derivatives can also play their part.
Many corporates with large shareholding disposal programmes have been actively seeking to hedge their equity exposure as they embark on their share sale process. Often they have effected this through the use of call options. Thus if the market falls they have at least benefited from the premium earned at the time of the sale of the call option and if the market rises and the option is called by the purchaser then the shares have been successfully disposed of, but without further dampening an already weak market.
Financial institutions have also been combining a similar strategy with stock lending, thereby gaining both the option premium and a lending fee. Certainly many market observers have been reporting an increase in such call option trades over the past year or so. Moreover even for firms that do not wish to sell down their equity portfolios, the increased profit volatility which will result from having to revalue portfolios and book these changes though the profit and loss account will significantly increase the attractions of hedging. Allied to this and flowing from the realisation of the full extent of the weakness of many Japanese financial institutions, there has also been an increase in the use of credit derivatives which has allowed investors to sell the risk of entering into a transaction with a Japanese bank. This market has been cyclical, rising and falling with the changes in perceptions of the true financial state of the country's banking sector. However the underlying demand is there.
The Flip Side
In the same way that Japanese banks and corporates must book the true value of their equity portfolios they must also report the true market value of their derivatives positions. And there is concern that this will only serve further to expose the weakness of the banks in particular. So it has been reported that the Japanese Bankers' Association (zenginkyo) has been lobbying the accounting standards making body, the Japan Institute of Certified Public Accountants, for a further delay in the introduction of the mark to market requirement for derivatives. This is in addition to the one-year delay already secured. The original delay was portrayed as in response to difficulties arising out of the consolidation of the Japanese banks around three or four major groupings, but most market observers suspect that this was only a smokescreen to cover up for the ineffective hedging strategies of the major banks, most notably macro hedging. Now the bankers' representative body is suggesting the deadline be extended further, perhaps indefinitely.
This may get the banks at least part way out of the short-term crunch they are under from greater disclosure requirements, but with the Japanese economy continuing to deteriorate, with serious consequences for the size of the non-performing loans problem, the Japanese financial system will have to face the music sometime.
This week's Learning Curve was written by Ross Kerley, in the financial advisory services division at PricewaterhouseCoopers in Tokyo.
