Less Share-Sharing

A new accounting standard puts another dent in corporate cross- holdings -- the glue holding many Japanese keiretsu together.

Under mark-to-market accounting, as opposed to Japan's now common book-value accounting, assets such as securities are reported at their market value rather than at book value, i.e. at how much the assets are currently worth rather than at how much they were purchased. Since last April, listed companies have been required to report assets for trading purposes at market value. Cross-holdings and other long-term securities were exempt until the following fiscal year starting April 1, 2001.

Cross-holdings are a unique custom of Japanese industry, in which companies and their business partners (such as affiliates, banks, insurers, and suppliers) hold shares in each other to cement business relations. Japan's keiretsu are typically interlocked by these arrangements.

However, as companies will be required under mark-to-market accounting to revalue cross-holdings if unrealized losses are 50 percent or greater, they are now under pressure to sell off those cross-holdings whose share prices have under-performed in order to improve balance sheets. The unwinding of these cross-holdings shifts the supply-demand balance and becomes a negative factor for stock prices.

Cross-holdings have traditionally provided companies with a base of stable shareholders, preventing takeovers and shielding management from shareholder pressure. This has contributed to Japanese companies' relatively low emphasis on dividends, shareholder meetings, and investor relations in general. Cross-holdings have also kept the float (the number of shares available for trading) of many issues small, leading to problems of illiquidity and price volatility.

The Financial Services Agency (FSA)'s introduction of mark-to-market accounting rules is part of broader financial system reform efforts aimed at providing greater financial transparency and designed to conform to international accounting standards. So while some worry that unloading of cross-holdings in advance of the new accounting rules will dampen an already weak stock market in the short term, most investors welcome the reform for the long term.

Sales of cross-holdings tend to be seasonal, concentrated towards the end of the fiscal year. But the change in accounting rules comes as no surprise, and the process of unwinding for some companies began years ago. About one-quarter to one-third of all outstanding shares in Japan are now thought to be cross-held, down from about half in 1995.

The companies that are subject to the unwinding are domestic-demand issues with heavy cross-holdings. These tend to include the banks and traditional industrials, rather than the high-tech and small-cap companies. However, not all firms will necessarily decide to unwind their cross-holdings, and other factors such as earnings performance and economic conditions may have a greater impact on share price than the unwinding.

Banks have been the focus of concern. While banks in many other countries are restricted or forbidden from holding stocks, banks in Japan are heavily invested in equities and thus exposed to the risks of the stock market. (Banks hold about 20 percent of all listed stocks in Japan.) In fact, banks are the biggest owners of cross-held shares, but a quote from the annual report of a major Japanese bank best describes how difficult it may be for banks to extricate themselves from these cozy ties. The quote reads in part:

While the Bank has been seeking gradually to reduce the amount of its investments in equity securities, it is constrained in its ability to do so. Large sales of equity securities by the Bank could result in substantial declines in the market prices for such securities, and could result in sales of the Bank's common stock held by the issuers of such securities.

Banks are subject to maintaining a minimum capital adequacy ratio, which gauges credit risk. But under mark-to-market accounting, banks would have to subtract some 60 percent of any unrealized securities losses from equity capital, reducing their capital adequacy ratios. The FSA believes that Japan's 16 major banks will be able to maintain capital adequacy ratios of over 10 percent, well above the 8 percent minimum required by international standards. But if banks fail to meet the minimum ratio, they face the possibility of credit rating downgrades and may have to resort to requests for capital injections from public funds.

A drop in the market value of their holdings will hurt banks in other ways too. Banks have been using profits from securities sales to write off bad loans, but they will be less able to do so if stock prices continue to fall (in mid-February, the Nikkei was already at a two-year-low). Even under former accounting rules, banks must register losses if stock prices at fiscal year end are 50 percent below their book value. Many stockholdings are believed to have reached that level; with securities losses affecting the bottom line, banks may be forced to reduce or postpone dividends.

With motives more political than fiduciary, politicians from the ruling Liberal Democratic Party had proposed postponing the new accounting rules or even using public money to prop up the stock market. Finance ministers and other opponents, however, have taken the bold initiative to reject such interventionist policies. Perhaps we can look forward to continued reforms that will help make Japan less of a peculiarity in the global markets.

Augie Tam is the founder of GaijinInvestor.com. He can be reached at augietam@gaijininvestor.com.