Collateral damage wounds Japan

Only a few weeks ago, Japanese banks appeared "rich with capital and willing to spend", says Economist.com. Mitsubishi UFJ Financial Group scooped up 21% of Morgan Stanley for $9bn, for instance. But now, while they have largely avoided toxic securities, they have suffered "collateral damage" amid the crunch-induced global flight from risk.

The sliding Japanese equity market has turned the spotlight on banks' substantial holdings of local equities. These cross-shareholdings comprise about 3% of the value of the Japanese market, reflecting the fact that banks and borrowers tend to hold stakes in each other to cement ties, notes Yuka Hayashi in The Wall Street Journal. As equity markets fall, banks' capital cushions are being damaged. MUFJ, for instance, is now sitting on a notional loss of 630bn ($6.5bn) on its share portfolio after a 40% fall in the stockmarket since June when its unrealised gains on the stocks were 1.8trn, according to KBC's Kristine Li. The market falls since June have wiped almost 1% off aggregate capital ratios, says Lex in the FT. MUFJ now plans to raise 990bn and others look poised to follow. All this is "a big blow" to investor confidence, as investors had previously assumed Japanese banks were relatively safe and had no immediate need to raise capital, says Li.

The government is set to step in by spending around 10trn on banks' equity holdings particularly the shareholdings of hard-hit small banks and is contemplating loosening accounting rules to soften the blow to banks' capital from writedowns. No wonder, then, that banking stocks led the Japanese markets lower this week. On Monday, the Nikkei 225 hit a 26-year low, while the broader Topix index is at levels last seen in 1984.

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Renewed uncertainty over the banks is yet another headache for the Japanese market. It is suffering disproportionately from hedge fund sales as it is more dependent on foreigners than most developed markets. And a surging yen will hurt exporters while the domestic economy continues to weaken. Still, on the plus side, the market is incredibly cheap, with valuations the lowest in a generation most stocks are trading at under book value. For those tempted to take a long-term punt on equities, at present it remains the most appealing of the developed markets.