Japanese banks caught playing a risky game

Having just emerged from a financial crisis, Japan again faces the risk of mounting bank failures – this time owing to their insatiable appetite for hedge funds.

That, at least, is the message coming from the financial regulator as it finalises guidelines that would force Japanese banks to increase substantially their capital reserves against their exposure to certain hedge funds.

The Financial Services Agency’s new rules, based on the Bank for International Settlement’s Basle II standards, will from next March force banks to provide increased information on the hedge funds they invest in or put aside higher reserves that would make those investments economically unattractive for many banks.

This requirement is particularly difficult to meet for the large number of regional banks that invest in funds of hedge funds or multi-strategy funds, and has triggered widespread redemptions and sales of hedge funds. In the past year, at least $4.5bn worth of hedge fund investments has been sold or redeemed by Japanese banks.

The changes are expected to deter further investments in hedge funds by any but the most well capitalised banks. If the new rules had not been as onerous, “we would have increased our exposure [to hedge funds] rather than reduced it”, says an official at one bank, which has sufficient capital to maintain most of its hedge fund investments.

The FSA’s proposals have triggered criticism that it is being unnecessarily stringent. Funds of hedge funds, which have been most hit by the new rules, are diversified and have low volatility, bankers argue. “It’s completely random,” says an insider at a leading bank.

For example, the new rules give a much higher risk weighting to hedge fund funds-of-funds than to private equity funds. But “that is seriously counterintuitive because [with private equity] you lock up your fund for seven to eight years”, says one banker.

By making it uneconomical to invest in many hedge funds, the FSA is robbing Japanese banks of the opportunity to learn the kind of sophisticated financial techniques they need to improve their performance in the years ahead, argues another.

The pending rule change has encouraged at least one bank to consider moving its hedge fund investment offshore.

However, given Japan’s recent history of bank bail-outs, the FSA might be forgiven for feeling nervous.

The regulator is concerned that the regional banks, in particular, are pouring money into products they do not understand. “People put their money in the bank because they believe it is safe. Is it OK to take those deposits and invest them in products they don’t understand?” says a senior official.

When the investment is in a fund of hedge funds, it becomes more difficult to see what the underlying investments are in, he points out. “Hedge funds don’t want to reveal what they are invested in, particularly market-based funds that trade daily,” the FSA official says.

It does not help that Japanese banks have been burnt by so-called “heaven-and-hell bonds”, or dual currency bonds that have been popular because of the high returns offered in the first few years but often lead to principal losses.

The regulator is also unhappy that the regional banks are not as focused on their core business of lending as they should be. Some Japanese regional banks have as much as Y1,000bn ($8.4bn) invested in marketable securities, against deposits of Y2,000bn to Y3,000bn.

Nevertheless, faced with strong criticism, the FSA is preparing to compromise by allowing banks to lower the risk charged to hedge funds by providing documentation showing that the fund is not invested in the riskiest products.

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