As we enter the world of global financial markets, Japanese financial institutions will be challenged globally and domestically. Profitability problems are widespread and structural.

The 1980s were good for the financial services industry in Japan, mainly because of the relative strength of the economy.

The changing macroeconomic environment, combined with anticipated deregulation, reveals the need for Japan's financial services companies to restructure.

Notwithstanding the present structural problems, we believe Japanese institutions can continue to play an important role in the global arena. In order to do so, however, Japanese financial institutions will require bold new strategies, redefining the traditional bases to avoid competing in low-profitability businesses.

Strategic Alliances

Building world-class capability may require strategic alliances with other strong players, for microeconomic reasons. The cost of building global capability everywhere is just too great.

Some of the most important conditions favoring banks during the 1980s drove key strategic moves of financial industries' competitors. The stock market boom created a very cheap capital source for Japanese banks.

Regulated deposit rates in Japan guaranteed a stable level of domestic profitability, at least in the early part of the decade.

These factors combined to create a favorable environment for international equity investments. Also favored were lending or guaranteeing loans in great volumes and at low margins. This was critical to the growth of Japanese balance dheets during the 1980s.

Japanese banks earned a great deal of money because of superior funding and capital costs on a global basis. These loans ballooned balance sheets and earned a large volume of earnings.

Rented Balance Sheets

But they did not create sustainable relationships. Governments and corporations around the world rented Japanese balance sheets.

Another less dramatic trend, but one that may ultimately be more relevant to the future of the industry, is the move of Japanese banks to support Japanese customers as they were forced to build manufacturing capacity abroad.

The 1980s were also very kind to the securities industry. Again, regulated prices at home - along with the stock market boom - created high guaranteed profitability for securities firms. Low Japanese interest rates caused capital to flow aborad in massive quantities.

Japanese securities firms were the window to the world for Japanese investors. The tremendous appetite of these investors for product abroad created a huge competitive advatage for securities firms.

These factors provided the the incentive and the clout to become big players in the U.S. treasuries market. Japanese securities firms also gained efficient, low-cost access to the Euromarkets.-

Enter 'Globalization'

The beginning of global trading encouraged Japanese firms to build a worldwide distribution network, spawning the term "globalization."

The 1990s is a very different world for banks and securities firms:

* Collapse of the bubble economy, with rising rates, ended the boom and reduced capital outflow.

* Emerging deregulation of deposit rates and, potentially, the commissioned structure in stocks.

* Loan losses and the over-hang of future loan losses if the real estate market sags further and loan losses extend to consumer loans.

* The need for banks, for the first time, to comply with fairly strict international capital standards.

* Customer sophistication growing among both issuers and investors.

* Excess capacity in most financial services markets around the world.

Sails Out of Wind

Because the wind was so strong for so long, there are low margins; and too many people, too many machines, and too many offices everywhere. In the United Kingdom, for example, everyone during the 1980s was an investment banker, a banker, or a consultant. Not any more.

Key proprietary advantages led globalization: cheap capital for banks and proprietary investor access. These are now gone as proprietary strengths.

Performance pressures are both one-time - as in the case of loan losses - and structural, in the case of restructuring the business based on international capital standards and declining domestic profitability.

The problem with fundamental returns on stockholders' return on equity are substantial enough to challenge the ability to grow at all, either internally or in the domestic marketplace. These pressures signal the need for restructuring to improve returns on equity.

In the absence of new capital, the sustainable growth rate of any institution's profit, assets, and equity is given by the real return on equity multiplied by the retention rate.

Capital Rules

The minimum standard is 8% for Tier 2 capital ratios for regionals, city banks, and long-term credit banks. In the event of major loan losses and/or another substantial decline in the stock market, the banks will need to find equity the way the American banks have, by selling off major portions of their portfolio and restructuring balance sheets.

Among the businesses that Japanese institutions would call international are three fundamentally different types: international domestic, global operating and information, and structured finance and capital markets with both global and domestic elements.

International domestic businesses are clearly not global. Their basis for success is totally within regional borders. Customer needs and cost structures are local.

Retail financial services and middle-market banking are examples of domestic businesses. The stakes of Mitsubishi with the Bank of California or the Bank of Tokyo with Union Bank of California or Dai Tchkanio with CIT are all examples of investments in domestic businesses internationally.

Shortage of Synergies

The core elements of these businesses are domestic and regional to the United States environment. There are few, if any, synergies with Japan.

For global operating and information services, the infrastructure to support the business is network-based and economies of scale can be achieved globally. Examples of these businesses are international payments clearing, global custody, and certain segments of the cash management business for multinationals with complex cash flows and multicurrency accounting needs.

Structured corporate finance and capital markets are partly global and partly local. They are global due to increasing need for integrated international products and distribution, but local because of the need to manage investor and issuer relationships domestically.

As the 1990s unfold, Japanese financial institutions will need new sources of competitive advantage in the international arena. "Me too" strategies will not be successful in a difficult market environment.

Redefining the Rules

The challenge for Japanese institutions is to redefine the rules to avoid direct, incremental competition with well-positioned players.

The economics of international domestic businesses are regional, not global. Japanese institutions cannot bring proprietary strength to the domestic market. Major consolidations are underway, due to excess capacity in the domestic market places.

Any institution with a regional banking business will need to invest more and more to drive that consolidation or, ultimately, to sell to one of the winning institutions.

The consolidation race is clearly on in the United States with the recent regional mergers of Chemical Bank and Manufacturer's Hanover in New York and the Bank of America and Security Pacific in California.

European Community consolidation and restructuring has begun as well. With further deregulation in Japan, consolidation will also occur.

Any regional player abroad is at risk unless he is driving the consolidation. There is no way to change the economics of domestic businesses to make them more differentiated and global. As a consequence, international domestic plays, at least at the margin, will not be an attractive opportunity.

Global operating and information service businesses have global economies of scale but are commoditized and relatively undifferentiated.

Upside to Game

Playing the game the traditional way has very limited upside. If there is a play, a bold, differentiated strategy is required. Increasingly, cost-based and commoditized implies margin reduction so that consolidation is likely. Since most Japanese institutions are not a competitive factor, to make a scale- based play would be difficult.

One area that may have merit is electronic data interchange, concerned with automation of payments and accompanying paper flows between corporations. A key characteristic of EDI is elimination of paper work, replaced by structured information in electronic form.

EDI has a big potential upside for corporations. It helps optimize working capital utilization. It simplifies payment and receipt functions. It offers substantially lower cost and error rates. And the benefits are greatest for international payment.

It could be particularly attractive to Japanese corporations because of their typically close relationship with suppliers. Their manufacturing and distribution systems are highly integrated so it would be logical to extend that integration into the payments arena.

Traditionally, banks have not pursued EDI because it undermines historical sources of profitability: lower free balances on current accounts, lower float, less lending potential. Of the major players, only Citicorp is pursuing the business actively.

Value-Added Attack

The fact that EDI attacks traditional banking value-added is less of a downside for Japanese institutions, since they do not have any major international payments networks to defend.

Banks would have great incentive to restrict the concept to international business, to limit profit downside in the domestic market. This idea leverages the global economies of scale of a present network player and seeks to play in the higher-value service customization and tailoring of services to corporate customers.

How much money is in it for the key service providers? We don't know yet; we are in the early stages of discussing these ideas with leading edge banks. But we do know enough to know that it's worth thinking through.

In structured finance and capital markets the challenge is to achieve and maintain strength as differentiated service providers, but to compete increasingly on a global basis. This arena is one of future attractiveness, based principally, at least as a starting point, on the strong relationships Japanese financial institutions have with their current customers.

Shrinking Margins

Relationships are the key to success in the corporate finance and capital markets arena because pure product plays gets state very quickly. Great product ideas are copied quickly so life cycles are shorter and shorter, due to intense competition for intellectual capital.

The business becomes commoditized and the margins shrink. Relationships create value for everyone.

The value added in structured finance or financial engineering is in designing customized financial solutions to enhance yield or reduce risk for investors or to reduce risk and lower financing costs for issuers. The value is in tailoring ideas to suit specific client needs.

Japanese financial institutions have very strong traditional relationships with corporate customers, the envy of the U.S. banking environment. This is due to mutual shareholdings, strong credit-based relationships given the historical lack of nonbank financing alternatives, and people flow between the financial institutions and corporate treasuries.

Relationships with investors are very strong, as well. Strong traditional relationships with the Japanese customers are a key starting point.

The rationale for building relationships with non-Japanese customers is less compelling and more limited. The prior lending connections abroad were not relationship based.

Touch Competition

Corporations and municipalities rented Japenese banks' credit ratings and balance sheets for short-term financing - and now there's tough competition for large corporations everywhere. Japanese financial institutions have not traditionally been skill-based players, so non-Japanese companies are probably not presently a lucrative source of business.

Large Japanese corporations and institutions are among the most global and sophisticated in the world and will likely be the most demanding of financial services suppliers over time. The treasurers themselves will build sophisticated financial engineering skills, issuers will raise capital where cheapest in whatever currency is required, and the concept of home country will diminish over time with more autonomous country presence.

As the companies become more demanding, traditional bases for advantage will decline. Declining credit ratings relative to corporations and constraints of the Bank for International Settlements will no longer permit intermediation or the traditional lending business.

Japan will no longer be the automatic low-cost funding source. Even now, there are a few constraints on funding internationally. Japanese multinationals now have a large demand for financing and refinancing, increasing capital costs and balance-shee-tconstrained relationship banks.

Potential Threat

These trends are potentially threatening for Japanese financial institutions if foreign banks can access Japanese corporations.

World-class capability, economically, means financial engineering skills, ability to adapt ideas rapidly, and distribution in foreign markets. Evidence from 20 years of history of American banks is that building a global capability to serve domestically headquartered multinationals is very tough.

There is no foreign domestic business to help pay for the result in cost base. It's difficult to build distribution for capital markets products and structured paper in a foreign country.

In general, U.S. banks have tried and failed - with the possible exception of Morgan Guaranty Trust Co. A potential solution is joint ventures with high quality domestic players around the world to optimize the economics of a global newtork.

A useful tool for thinking carefully about investments abroad employs three simple concepts of strategy:

* Know the key success requirements in the businesses you're playing in and how they will change.

* Evaluate your strenths critically, relative to those success requirements, and make others compete where you are strong.

Japanese financial institutions will be challenged both globally and domestically. Widespread structural profitability problems exist in large part because the traditional sources of strength - low cost of capital and proprietary relationship access - are being challenged.

The returns on equity of the financial institutions signal a difficult restructuring task ahead, likely to involve both international and domestic operations.

Building world-class capability will almost certainly mean teaming up with others, given the fundamental economic requirements of these businesses.

GARY M. TALARICO

Senior Vice President Financial Services Group Lehman Brothers

Gary M. Talarico is a senior vice president in the financial services group, investment banking division, of Lehman Brothers. Mr. Talarico is responsible for investment banking services to Japanese financial institutions and selected U.S. commercial banks.

Mr. Talarico joined Lehman Brothers Kuhn Loeb in 1983. He spent 1985 to 1988 in the Japan investment banking department, in Tokyo, returning to New York in 1989.

Prior to joining Lehman Brothers, Mr. Talarico was assistant to the director of the Japan desk at the U.S. Trade Representative Office, part of the Office of the President. From 1980 to 1982, he worked for Yamaichi Securities in Tokyo.

During his four years in Lehman Brothers' Japan investment banking department, Mr. Talarico was responsible for developing the firm's investment banking relationships with Japanese financial institutions and selected japanese corporations. He is experienced in a broad range of transactions, including financing in the U.S. and Euro markets, private placements, restructuring, and mergers and acquisitions.

In the past year, Mr. Talarico has advised several Japanese banks regarding specific acquisitions in the United States. He has lived and worked in Japan a total of seven years and is fluent in Japanese.

Mr. Talarico holds a master of arts degree in international economics and Asian studies from the Paul Nitze School of Advanced International Studies of the Johns Hopkins University, and is a member of the SAIS advisory board.

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