Japan's Brokers Rethink Structured Loan Sales Amid Regulatory Pressure

Japan’s largest brokerage firms are reassessing their approach to selling structured loans, particularly those involving repackaged Japanese government bonds (JGBs), following a tough stance from the country’s financial regulator. The Financial Services Agency (FSA) has launched a clampdown on the $67 billion market, prompting caution across the sector.

Nomura Holdings Inc. is currently reviewing its strategy regarding repackaged JGBs, with a spokesperson confirming that the firm is deliberating internally about its future approach. Similarly, the brokerage units of Mitsubishi UFJ Financial Group Inc. and Mizuho Financial Group Inc. are also reassessing their involvement in this product, which has come under increasing scrutiny from the FSA.

This shift in focus follows comments from a senior FSA official, who raised concerns about the growing volume of repackaged JGBs being purchased by local banks. While these products comply with Japanese law, regulators have warned that their complex nature and opaque pricing could pose significant risks. Some buyers may lack the necessary risk management practices, potentially exposing them to substantial losses should market interest rates move unfavorably.

Toshinori Yashiki, director-general of the FSA’s strategy development and management bureau, highlighted concerns over the inability to mark repackaged JGBs to market, a key feature that differentiates them from traditional securities. Without the requirement to reflect paper losses, the true value of these instruments can be difficult to assess, adding an additional layer of risk for investors.

In response to growing regulatory concerns, the FSA has reached out to major global securities firms, including those in the US, Europe, and Japan, requesting details about their dealings with regional banks. However, an FSA official declined to provide further comment on the matter.

A spokesperson for Nomura acknowledged the regulator’s concerns, emphasizing that the firm is carefully considering its position on these products. “We are deliberating our approach internally,” said Shigehiro Tomita, a representative for Nomura Holdings.

Repackaged JGBs, which are often bundled with derivative contracts to enhance returns, are a popular product sold to regional lenders. These banks, which typically lack the scale and expertise of larger institutions, find such products appealing as they offer tailored cash flow and reduce the complexities of derivatives trading. However, Tomita cautioned that these products carry similar risks to traditional fixed-rate bonds, including the possibility of negative spreads, where returns could fall below the cost of deposits.

Mizuho Securities Co. and Mitsubishi UFJ Morgan Stanley Securities Co., which are jointly owned by Japan’s largest lender and a major US investment bank, have also indicated they are reviewing their sales and risk management policies for structured loan products. Both firms stressed the importance of monitoring market conditions to ensure that clients are fully informed of potential risks.

Despite the heightened scrutiny, regional lenders continue to be major consumers of repackaged JGBs, which offer relatively high returns in a low-interest-rate environment. The products gained significant traction in 2022, when Japan’s interest rates began to rise in response to policy changes by the Bank of Japan. This shift has made the products particularly attractive to regional banks, which face limited revenue streams and limited exposure to international markets.

However, the market for repackaged JGBs has cooled in recent months as lending rates in Japan have begun to rise. According to Hiroshi Toyoda, an executive director at Daiwa Securities Group Inc., the market is showing signs of slowing down, with no indication of overheating as seen previously.

The average lending rate among Japan’s major regional lenders reached a nearly nine-year high of 1.11% in December, although it has slightly decreased since then, according to data from the Bank of Japan.

Daiwa Securities has expressed its commitment to responding appropriately to the evolving market conditions and customer needs. Similarly, SMBC Nikko Securities, the brokerage arm of Japan’s second-largest banking group, emphasized its ongoing efforts to ensure clients are equipped with the necessary tools to manage risks associated with structured loans.

As regional lenders continue to rely heavily on securities investments to bolster their earnings, the market for structured loans and repackaged JGBs remains an essential pillar of their investment strategy. The 62 major regional lenders in Japan generated ¥631.7 billion in interest and dividends from securities investments in the six months ending September 30, the highest in over 15 years, according to the Regional Banks Association of Japan.

Despite the regulatory pressure, industry analysts suggest that if repackaged JGBs are no longer viable, sellers will adapt and pivot toward other financial products. “If repackaged JGBs become no good to sell, they’ll think of something else,” said Hideyasu Ban, an analyst at Intelligence.

The future of Japan’s structured loan market now hinges on how regulators balance risk management concerns with the needs of regional banks, which continue to seek profitable investment options amidst Japan’s demographic and economic challenges.