Japan is now competing in sophisticated global financial markets in which capital is king, thanks to the guidelines issued by the Bank for International Settlements in 1988.

Capital is not only king, but in Japan, it is scarce. The Japanese economy is a bursting bubble - particularly in the stock market arena. Profits have become more important than total assets.

Japan is moving from a centralized to a deregulated financial system. Progress has been measured. Some westerners would say that it's been slow, but the pace of change appears to be accelerating.

Skeptics, however, wonder whether the changes in Tokyo will be substantive. Or will Japan simply return to business as usual? Japan has an unprecedented opportunity to prove the skeptics wrong.

Credibility is key to success for a deregulated free market. In that scenario, perceptions clearly are important. This is particularly the case in banking, an industry that, by regulation, suggests a leveraging factor of 12 to 1 with assets mostly illiquid.

Investors would like to think that markets are fair, that regulators are effective, and that financial institutions are successful but also conservative: well managed, well controlled. In a very real sense, banking is the ultimate confidence game.

Based on recent developments, some investors may be wondering: Are the markets rigged? Are the regulators and the external auditors asleep?

The recent scandals in both New York and Tokyo raise similar questions: Is senior management incompetent? Or, worse yet, corrupt? We may wince at these questions, but they represent legitimate concerns.

Given these perceptions, it is no wonder that investors are wary. At 22,500 during the recent American Banker*Bond Buyer conference in Tokyo, the Nikkei was down almost 40% from its high of 36,000. Volume is down, too, with small investors remaining on the sidelines.

Lack of credibility has also taken its toll in the United States. The price-earnings ratios of U.S. bank stocks, while improving, have remained lower than those for manufacturing companies.

How do we restore credibility? In a free-market economy, credibility demands transparency.

Let's consider some of the dimensions of transparency.

Law and Regulation

Administrative guidance works best in a simple, domestically focused environment. National firms don't enjoy advantages over foreign-owned firms in such simple, domestically focused environments. All players understand how the system works.

In a global financial services environment, on the other hand, clearly articulated rules are required. Only with such articulated rules will foreign-owned firms feel they are less likely to be disadvantaged. The playing field must appear level.

In the United States, there is a threat of retaliation against countries perceived to be discriminating against U.S. financial institutions operating in their markets.

The Bank of Japan has abolished window guidance, but there seems to be some uncertainty as to whether this abolition will be retained. To the extent that reregulation becomes necessary, the new rules should be clear to all participants in the market.

In Japan, accounting principles need to be further developed, better articulated, and enforced. As a starting point, consideration should be given to the International Accounting Standards promulgated by the International Accounting Standards Committee.

Recently issued standards for banks are impressive, considering the committee's past history. They represent a reasonable starting point and, in this instance, the standards committee has eliminated a number of alternative approaches in accounting for the banking industry.

Full Disclosure

Clearly an important element of transparency, full disclosure enhances credibility in the marketplace. Experience has shown that it only hurts for a little while.

In 1975, I participated in the development of what is now commonly accepted disclosure in the U.S. banking system. Prior to 1975, the term "nonperforming loans" was not used.

A major bank in New York, went before the Securities and Exchange Commission during the real estate problems of the mid-1970s. In that era, the problems were centered in real estate investment trusts, or REITs.

The SEC was determined that the bank disclose, in one form or another, additional information about the quality of its loan portfolio. A number of suggestions were put on the table, including disclosure of classifications of the portfolio as established by the federal regulatory agencies. These agencies have a standard classification system that is used for every bank.

The problem? It was against the law to disclose that material. The SEC was quite frustrated and suggested taht we try again. Someone remembered the practice of ceasing to accrue interest, once a loan became past due for more than a certain time - the so-called "nonaccrual loan" system.

We all went back to find the clerk responsible for nonaccrual loans. Until that point, no one had focused on that area of bank accounting. We found the clerk sitting in a corner, diligently keeping track of a statistic that, until that point, no one had cared about. Suddenly, he became the hero of the day.

We had no legal prohibition against disclosing that amount, so we decided to put into the registration statement the bank's nonaccrual loan total at the end of 1975. The number had actually been increasing from 1973 to 1975, and that fact alone scared off some investors. The registration statement was pulled just before it became effective. This is all publicly known information, not tales out of school.

Yes, it hurt the bank for a little while. Shortly thereafter, though, the industry moved forward to embrace the concept of disclosure of nonaccrual loans. That concept was broadened to encompass other aspects of the loan portfolio.

The broader term, "nonperforming loans," soon replaced "nonaccrual loans" and has been with us for 15 years. From my point of view, it's one of the most positive advances that the U.S. banking industry made in the direction of full disclosure and transparency.

For the banks in Japan, disclosure of nonaccrual or nonperforming loans obviously starts with establishment of a nonaccrual policy. Standardization of that policy has been very helpful in the United States.

Credit Concentrations

Another worthwhile element of U.S. disclosure began in the early 1980s, when the crisis in loans to developing countries hit us.

When Mexico defaulted on its interest payments in August 1982, everyone scrambled to find out how much U.S. exposure was involved. Other countries followed suit, shortly thereafter.

Considerable debate ensued on how much banks should disclose about their investments in LDC debt. Eventually, some rules were developed that have been followed ever since.

Bank stocks suffered during the 1980s, in large measure because of the perception that they had serious problems with their LDC portfolios. But I don't think the problem in the stock market arose because of what was disclosed; rather, the disclosure made it evident that these problems were, indeed, serious.

Reserve Adequacy

Comprehensive information about reserve adquacy should include disclosure of the accumulated reserve or provision for loan losses at yearend, along with disclosure of the movements in those reserves during the yearend, that is, additions, loan chargeoffs, and recoveries.

Banks in many countries still hide their reserves. The International Accounting Standard for Banking came out very strongly in favor of disclosure of hidden reserves, but this disclosure has yet to be adopted uniformly throughout the world.

Chargeoff Practices

It's not appropriate to compare reserve levels from one bank to another unless you also know the extent to which banks are aggressive - or not so aggressive - in charging off bad debts.

A bank that never charge off a loan until it is a bsolutely dead as a doornail obviously needs a larger reserve than a bank that charges off loans based on an early indication that losses are probable.


Off-balance-sheet exposures have grown dramatically. Many of the major banks in New York have more in total off-balance-sheet exposure than they have in total assets on the balance sheet. On the surface, this appears to be true if you add up the numbers in the footnotes. But, generally speaking, we're dealing with the notional principal amount of interest rate swaps, for example - a totally misleading statistic.

As we consider disclosure of off-balance-sheet risks, we need to grapple with the question of how to measure those risks. The true risk in an interest rate swap ought to be disclosed to the public. These questions are being dealt with through experimentation and studies in the United States by the Financial Accounting Standards Board.


A very important concept in banking, given its gearing ratio of 12 to 1, is the liquidity of a financial institution. It is common practice in the United States to report the maturity profile for both the loan portfolio and the investment portfolio.

Comparable information with respect to a bank's liabilities is of equal importance. In a very real sense, money-center banks define liquidity as the ability to borrow money in the financial markets.

Disclosure of a bank's philosophy of managing and controlling liquidity would also improve transparency.

Operating Results

To understand a bank's business, we need a clear view of the results of operations, as portrayed in the income statement. Few banks actually disclosure much about separate lines of business. An exception is Citicorp's annual report, which breaks its business into retail and wholesale sides. This approach gives a much clear picture of the components of the income reported each year.

Nonrecurring Items

If occasional asset sales, for large amounts, are buried in the income statement, it is not possible to determine how a bank's recurring core business has performed. To the extent that those sales occur, they ought to be disclosed.

Similarly, Japanese banks have changed their accounting to recognize foreign currency transactions. Full disclosure of the impact of that change on the reported income for the year is an element of transparency that is essential to a full understanding of the bank's operating results.

Loss Provisions

Losses, from loans or other sources, should be spelled out clearly. This will permit the reader to understand the extent to which, over time, a bank has incurred credit losses -- whether growing or stable, small or large -- in relation to its overall business endeavors.

Management Strategy

A softer element of disclosure is a bank's strategy of management, which should also be clearly articulated. The strategy should be realistic, particularly in view of the institution's competitive position.

Many of the disclosures I read sound alike: Some banks still want to be all things to all people. That's simply unrealistic. More and more, today, banks realize that they must focus their business strategy on finding the niche in which they can really be profitable. It's also important to the investor to know an institution's business strategies.

Internal Control

In many important respects, we're moving toward a more deregulated financial services marketplace. But taking off all the shackles, removing all the regulations, can potentially result in disaster. In a deregulated, transparent environment, effective internal compliance takes on added importance.

The most important single element of compliance, in my view, is an institution's internal control environment. That environment must absolutely demand a commitment to the highest standards of ethical practice.

That ethical commitment must come down from the very top of the organization -- the chairman of the board, the president, the managing directors. They must not only articulate it, they must live it and support it by their actions. Encouragement and reward must be offered for open dialogue with the staff; and, conversely, visible punishment should be meted out for noncompliance with internal policies and controls.

Those policies and controls need to be comprehensive, realistic, and clearly understood by all employees of the bank. They need to be enforced. Policies and procedures should be living documents -- not just manuals gathering dust on a shelf.

Internal Audits

I'm not an expert in Japanese banking or industry, but it is my impression that the internal audit function in Japan could be substantially upgraded. Enhanced authority for the internal authority for the internal auditor is an important element to this upgrading.

An effective internal audit function will require expanded staff with appropriate training and experience, along with independent reporting lines that allow the internal auditor to gather information and report findings without undue pressure from superiors.

Credit Review

In some banks, the credit review function is combined with internal audit. In others, it is broken out separately because credit review requires specialized skills. While the mandate may vary from bank to bank, the goal of credit review is usually to assure that assessment and monitoring of the loan portfolio is effective and thorough. In the United States, where many banks have failed, poor credits are the primary cause of those failures.

The legal compliance function itself can be separate and distinct from internal audit and credit review. The United States has many laws and regulations that are different for the banking than for the securities industry. In addition, laws and regulations will vary from one country to another.

Monitoring Compliance

Banks are regulated in many ways that do not initially appear obvious. Thus the need for someone in a position of authority, with legal training, to monitor compliance with laws and regulations.

External Surveillance

If, in fact, we're moving toward greater deregulation, this can also be a prescription for disaster without adequate external surveillance.

Bank examiners fulfill a worthwhile function. The U.S. program is very comprehensive, and certainly it has been beefed up in the past few years as a result of the S&L and banking problems.

An interesting contrast is the United Kingdom, where the Bank of England has no examiners at all. Japan is somewhere in between those two extremes, with a modest program of 150 examiners at the Bank of Japan and another group at the Ministry of Finance.

The key to successful bank examination is training of the staff. Banks have many new financial products and sophisticated computer programs. In Japan, the examiner's role should likewide be enhanced.

The external audit is another important element of surveillance. There are approximately 7,000 certified public accountants in Japan. This compares with 350,000 CPAs in the United States, but our population is only double Japan's - not 50 times greater.

CPAs in Japan undoubtedly require enhanced training, just as bank examiners do, if they are to be an effective part of the surveillance system. They need to identify the high risks inherent in banking and to understand auditing techniques for new financial products.

An additional element to the external audit issue is cultural - enhancing clients' expectations of their external auditors.

Another element of improved external surveillance is the possibility of cooperation between regulators and external auditors. It's a requirement in the United States.

At the conclusion of a bank audit, we external auditors are required to sit with the bank examiners and client officials to discuss the results of our audit and the results of the regulatory examination - to make sure we all understand the problems at a particular institution. The United Kingdom enacted a banking act in 1987 that requires an even greater degree of coordination between the Bank of England and the external auditors.

The Bank of Japan might consider beginning a dialogue with Japan's independent CPAs to discuss these matters.

Transparency is essential in a free market system. But what about some realities of life? One reality is the cost-benefit equation.

Human and financial resources will be needed to satisfy some of my suggestions for transparency. Who should pay? The taxpayers? Individual financial institutions?

In summary, I believe that Japan needs to open up society a bit by becoming more transparent. I recognize that this will take time, but I am encouraged that progress will be achieved.

Japan must press forward on these transparency issues, not just because the skeptics are watching, but because enhanced credibility in a global free market requires it.

The perfect system has yet to be developed. Clearly, we don't have one in the United States, but greater transparency surely can be achieved in banking.

J. Thomas Macy has been chairman of the world financial services practice at Price Waterhouse since 1989. He joined the firm in 1958 and became a partner in 1972.

The financial service practice accounts for approximately 20% of Price Waterhouse's worldwide fee income. It provides consulting on accounting, auding, tax, management, and regulatory matters.

Clients include major international and domestic commercial banks and thrifts, investment banks, securities firms, securities and commodities exchanges, insurance companies, investment management companies, central banks, financial institution regulatory and supervisory agencies, and multilateral funding and development agencies.

Since 1972, Mr. Macy has served successively as lead engagement partner with Chemical Bank, Bankers Trust, and J.P. Morgan. he is currently lead engagement partner for the World Bank and its affiliate, the International Finance Corp.

Mr. Macy was chairman of the Banking Committee of the American Institute of Certified Public Accountants from 1983 to 1986, having been a member since 1980. He testified before the Senate Banking Committee in 1986 on the deductibility of bank loan loss reserves and before the House Banking Committee on various aspects of the LDC debts situation in 1988.

His bachelor's degree is from Dartmouth College and his master's from Amos Tuck School of Business Administration. Mr. Macy was also a member of the financial instruments advisory committee on disclosures of the Financial Accounting Standards Board, and is a member of the New York State Society of Certified Public Accountants.

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