Japan’s biggest investment banks are reconsidering their sales of structured loans after the Financial Services Agency (FSA) announced a broad clampdown on the $67 billion market. Concerns over risk management and transparency have prompted major brokerage firms to reassess their approach, potentially disrupting a financial product that has been popular among regional lenders.
The FSA has expressed concerns about the growing exposure of regional banks to repackaged Japanese government bonds (JGBs), which are often bundled with derivatives to enhance returns. While these instruments comply with Japanese laws, regulators worry that some buyers lack the necessary risk controls, increasing the potential for financial instability.
In a recent interview, Toshinori Yashiki, director-general of the agency’s strategy development and management bureau, warned that the complex nature of these products makes it difficult to track risks. One major issue is that investors are not required to mark them to market, allowing banks to avoid reporting paper losses. This lack of transparency raises red flags for regulators, who have reached out to major U.S., European, and Japanese financial institutions for details about their transactions with regional banks.
The increased scrutiny follows rising yen interest rates, which have made structured loans both more attractive and more volatile. A sudden shift in market rates could leave investors with unexpected losses, a scenario the FSA wants to prevent.
In response to the regulatory pressure, Japan’s top brokerage firms, including Nomura Holdings Inc., Mitsubishi UFJ Financial Group Inc. (MUFG), and Mizuho Financial Group Inc., are reviewing their involvement in the market.
Nomura Holdings has acknowledged the FSA’s concerns and is reassessing its structured loan sales. “We are aware that the FSA is concerned,” said Shigehiro Tomita, a spokesman for the company. “We are deliberating our approach internally.”
Mizuho Securities Co. also announced plans to examine its sales structure. A spokesperson emphasized that the firm prioritizes offering products that align with clients’ needs while ensuring proper risk management. Similarly, Mitsubishi UFJ Morgan Stanley Securities Co., a joint venture between Japan’s largest lender and a major U.S. investment bank, has begun reviewing its sales and management processes to address regulatory concerns.
Repackaged JGBs have been particularly attractive to regional banks, which often lack the resources and expertise to build diversified investment portfolios like Japan’s largest financial institutions. These products offer tailored cash flow arrangements and help reduce the complexities of derivatives trading.
However, they carry risks similar to traditional fixed-rate bonds, meaning that if market rates rise, returns could fall below deposit costs, leading to losses for lenders. The recent regulatory focus has added another layer of uncertainty, making banks more cautious about selling and purchasing these instruments.
“We always base our product offerings on the needs of our clients while adhering to the FSA’s Principles for Customer-Oriented Business Conduct,” said Hiroko Matsumoto, a spokeswoman for Goldman Sachs Group Inc. Other foreign banks, including Morgan Stanley, JPMorgan Chase & Co., Citigroup Inc., and Barclays Plc, declined to comment on their involvement in the market.
The demand for repackaged loans surged in 2022 when the Bank of Japan (BOJ) made slight policy adjustments that led to rising interest rates. These products initially provided regional banks with relatively high returns compared to traditional lending. However, as Japan’s lending rates continue to increase, their appeal is starting to wane.
“The market is showing no signs of overheating as it once was,” said Hiroshi Toyoda, an executive director at Daiwa Securities Group Inc. He noted that repackaged JGBs are becoming less attractive as loan rates catch up with market trends.
The BOJ reported that the average lending rate among major regional banks reached a nearly nine-year high of 1.11% in December 2023 before slightly declining in January 2024. This shift is prompting some lenders to explore alternative investment strategies.
Several securities firms have indicated that they will modify their approach to structured loans based on market conditions and regulatory guidance.
Daiwa Securities, one of Japan’s largest brokerage firms, stated that it would adjust its product offerings according to customer demand. Similarly, SMBC Nikko Securities Inc., the brokerage arm of Japan’s second-largest banking group, said it would review its sales policies as needed. A company representative emphasized that SMBC Nikko is committed to helping clients manage structured loan risks effectively.
For Japan’s regional lenders, investment income has become a crucial component of their revenue streams, as traditional lending faces headwinds from the country’s aging population and economic challenges. Data from the Regional Banks Association of Japan shows that in the six months leading up to September 30, 2023, the country’s 62 major regional lenders earned a combined ¥631.7 billion in interest and dividends from securities investments—the highest in at least 15 years. This income accounted for nearly half of their total interest earnings.
In addition to repackaged JGBs, banks have been turning to other structured financial products, including interest rate and foreign exchange derivatives, structured bonds, securitized assets, and privately placed investment trusts. These instruments help them generate revenue despite limited loan growth opportunities.
The FSA’s scrutiny has raised questions about the future of repackaged JGBs. If regulatory pressure intensifies, banks and brokerages may seek alternative products to meet their clients’ needs.
“If repackaged JGBs become no good to sell, they’ll think of something else,” said Hideyasu Ban, a financial industry analyst. Given the innovative nature of Japan’s financial markets, investment banks are likely to develop new solutions that comply with regulatory expectations while continuing to serve regional lenders.
For now, market participants are in a wait-and-see mode, cautious about making significant moves until they have a clearer understanding of the FSA’s long-term regulatory stance. As the structured loan market faces increasing challenges, Japan’s investment banks must navigate evolving regulations while maintaining profitability and client trust.
The coming months will determine whether repackaged JGBs remain a viable financial instrument or fade into obscurity under mounting regulatory scrutiny.
