Tightening controls

Private bankers have made substantial profits providing Japan's wealthy individuals with complex financial products in the past decade. And it's no surprise that Japan is a key target market. Nomura Research Institute estimates the size of affluent and high-net-worth individual (HNWI) markets in Japan as of 2005 to be 813,000 and 52,000 households, respectively. Under its definition, an affluent household has net financial assets of between Yen100 million and Yen500 million, and an HNWI household at least Yen500 million ($4.2 million).

But profits from these markets may be under threat, as the Financial Services Agency (FSA) is expected soon to introduce new rules aimed at ensuring retail investors receive sufficient protection when buying investment products from sometimes over-zealous salespeople. The Financial Instruments and Exchange Law, which replaces the existing Securities and Exchange Law, is set to be enforced in the third quarter of 2007, although the agency has yet to specify an exact date.

The rules, based on the UK's Financial and Markets Act 2000, were passed in June 2006 as a means to broaden the scope of regulatory framework and introduce stricter investor protections.

For example, all interests in trusts and collective investment schemes, such as funds, will be considered securities and as such governed under the new law, as will most derivatives instruments. At present, the Securities and Exchange Law regulates securities-related derivatives, while financial derivatives come under the directive of the Financial Futures Trading Law.

Motivation

The supervisor's move to tighten regulations was prompted for several reasons, says Naohiko Matsuo, general counsel and director for financial instruments and exchange law at the FSA in Tokyo. "The gist of these new regulations is that the appropriate products are sold to appropriate customers."

For the investor, the new regulations will close up loopholes in the system and put in place comprehensive and cross-sectional rules to allow users to invest with confidence. The rules are also there to enhance fairness and transparency in the market. A third reason would be for the expanded regulations to mirror those in other major jurisdictions, such as the European Union Markets in Financial Instruments Directive, to create a consistent regulatory framework.

Private banks believe the most significant change will be the FSA's new definition of what determines 'professional individual investors', which would exclude them from certain conduct rules. Currently, the agency has only defined 'qualified institutional investors'.

Matsuo says the full definition of 'professional individual investors' will be announced with the draft rules, but says the thresholds in Japan will be higher than the $1 million and EUR500,000 limits set in the US and the EU. He adds that the new rules on sophisticated investors would benefit private banks, which would be released from their duty to explain the risk and would also not have to conform to suitability rules. These rules stipulate that financial institutions are prohibited from soliciting products that are inappropriate for customers in light of their marital status, experience and wealth.

"Under the new law, it would be easier for private banks to sell risky products to those defined as professional individual investors, compared to the current regulatory framework," says Matsuo. "These investors are no longer bound under those rules and, at the same time, they are not protected by the FSA's code of conduct rules, so final responsibility rests on the client themselves."

Franaois Barbe, president of SG Private Banking in Japan, says the new rules for sophisticated individual investors is a very positive move, although he says the French bank will wait for the actual ordinance before evaluating its practical implementation.

On the wider changes, Barbe says: "They are a progressive liberalisation with much tighter controls, which will bring about many new changes in the financial environment. Such regulatory changes are not isolated to Japan. All over the world, we are seeing the willingness of regulators to better supervise these activities so as to ensure that investors do not have a nasty surprise at the end of the day."

But the new regulations will also mean more time and effort will need to be spent on internal controls to be in compliant with Basel II and other requirements. "The impact is quite heavy, because it means more work for legal and compliance," says Barbe. "And it also costs more for such internal controls."

Market observers in Japan say regulations to strengthen investor protections are long overdue. "Dubious business practices have been unfortunately common and going on for a while," says Stephen Church, principal at Tokyo-based research consultancy Analytica Japan. "Offering products on an essentially deceptive basis to wealthy individuals in Japan under the misleading term of private banking has been going on since the late 1990s." (See also Asia Risk, December 2006/January 2007, pages 62-63.)

The FSA has kept a close eye on private banking operations in Japan, and the new regulations look set to enforce that further. As recently as March 15, the agency issued a request that Credit Suisse's private banking arm should enhance its compliance and internal controls. Investigations found that in 2003, an ex-employee of the bank's Hong Kong branch went on business trips to Japan to engage in deposit-taking solicitation for the Hong Kong branch. The request ordered Credit Suisse's private banking division to stop violating regulations - such as those concerning solicitation of deposits - and to draw up better internal compliance rules, as well as educate its staff on its compliance regime.

Such warnings are not uncommon in Japan. In 2004, US bank Citi was forced by the FSA to close all four of its private banking branches after the agency uncovered "a number of acts injurious to public interests, serious violations of laws and regulations, and extremely inappropriate transactions", said the regulator in a statement on September 17, 2004. "This led us to conclude that continued future operations are inappropriate."

Church says Citi's private banking business had structured many foreign-exchange-linked products, where effectively the client was making a bet on the yen/dollar exchange rate. "Because they could not do better than the professionals, they ended up making very little returns on those products, often with lengthy lock-ups," he says.

Indeed there were reports that the bank had sold a 30-year lock-up product to a man in his 70s. According to the FSA statement, such tactics were driven by the excessive budget targets set by Citi's headquarters in New York.

Charles Prince, Citi's chief executive, apologised for bank's failure to comply with regulatory requirements in Japan, on October 25, 2004. He pointed to the consequences of a weak compliance and internal-control environment in Citibank Japan's private banking business, and a poorly executed governance and management structure for the businesses conducted from Citibank Japan.

Concerns over exotics

Exotic products sold in the market include power-reverse dual-currency (PRDC) notes and foreign exchange target-redemption notes (Tarns), which have also been popular with institutional investors. PRDCs are typically principal-protected and pay a high initial coupon, but expose investors to a potentially long lock-up period - often up to 30 years - of low coupons. Tarns, meanwhile, are typically floating-rate notes or inverse floating-rate notes that redeem early if the total interest paid to date reaches a certain target.

Often clients do not fully understand the risk that accompanies the investments sold by private banks, say market observers. "The biggest reason risky products such as offshore investments and structured bonds have become so popular among the high-net-worth-individuals and the affluent is the aggressive attitude of financial institutions," says Hiroyuki Miyamoto, senior consultant at Nomura Research Institute in Japan.

"There are some cases when customers buy such products without fully understanding the risks associated," says Miyamoto. "Therefore, customers that purchased such products without full understanding could have grounds for complaint in future when the currency or stock market move significantly."

Some market participants say private banks are not alone in pushing such products. "Brokers have been very aggressive and selling not only structured products and mutual funds, but other services related to the investment such as wrap accounts," says SG Private Banking's Barbe. "It is very much a sales-organised industry."

"They have been selling quite risky products for small amounts such as Yen1 million, which are quite popular with the retail market," he says. "But I'm not sure everyone completely understands the risk that comes with those investments. All financial institutions are bound to have disclosure papers and prospectuses, but having these documents doesn't mean the investor understands it. Some long-dated products, although capital-guaranteed, could carry the risk of large losses in the form of early-redemption or exchange risk."

Barbe says SG Private Banking makes sure complex products are only offered to investors who clearly understand the risk. "We sell them to a small population of sophisticated clients who are looking for longer-term investments that can return higher coupons for the duration of those notes," he says. "But we do not sell, or even propose them, to the majority of our clients." The bank offers complex products such as dual-range-accrual deposits or notes, constant maturity swaps, digital coupon deposits or notes, PRDCs and Tarns.

SG Private Banking reckons only about 10% of its 1,100 clients is sophisticated enough to have a strong understanding of such products. Even so, SG provides comprehensive explanations and would highlight the risk involved.

The same emphasis on matching the client with the right product also happens at MUML PB Securities, a joint venture between MUFJ Holdings and Merrill Lynch, which began business in May 2006. "We perform a strict suitability check on all our clients when considering products to include in their portfolios - whether risky or not," says a spokesperson. "Only if the individual client's risk profile matches will we consider any product inclusions."