The terrorist attack on in New York and Washington, DC on September 11 immediately rocked global markets. Japan was especially hard hit, with the benchmark Nikkei 225 Stock Average falling 6.6% to below 10,000, its lowest point in 17 years. And Topix, the institutional benchmark, also crashed below 1,000.

This disaster comes at a particularly delicate time: the end of September marks the halfway point of the first year in which banks must value their books wholly on market prices. Japanese banks hold massive positions of equity cross-shareholdings, a legacy of post-war relationships that were inflated to dangerous levels in the bubble economy of the 1980s. The stock owned by Japanese banks is now believed to consist of about 45% of the market capitalization of the Tokyo Stock Exchange. 

They are also allowed to count these cross-shareholdings as tier 1 capital, which means that their book assets will devalue and their capitalization will be jeopardized. Already troubled by massive bad loans, narrow margins and ultra low interest rates, the carnage in the local stock market is threatening Japan with massive bank failures, nationalizations or full-scale taxpayer bailouts. A negative response could cement Japan's descent into recession. With American consumer confidence in a rout, it is vital for the global economy that Japan fixes this festering problem.

Analysts are hoping that the truly dire outlook will force the Junichiro Koizumi administration to take meaningful action. But in fact the Financial Supervision Agency (FSA), headed by the dynamic minister of financial affairs Hakuo Yanagisawa, already mooted one idea earlier this year: what about an exchange-traded fund (ETF)?

ETFs are listed securities representing an underlying fund, which replicates a benchmark index. They trade just like stocks. So they are essentially index shares that combine the benefits of a mutual fund with a listed stock. Authorized participants (usually brokers) create or redeem ETF units by delivering baskets of shares mirroring the underlying index to the ETF manager – this is known as in-kind redemption and creation, as opposed to cash. ETFs appeal to institutional investors, hedge funds and retail investors alike, as they are convenient and very cheap.

This is not a short-term solution. Japan faces an immediate crisis, and has so far reacted by pumping liquidity into the money market. Senior government officials have indicated another bailout is likely. This may help stabilize the sector but does nothing to solve its underlying problem of overexposure to stocks. In the run up to the end of March 2002, the end of the fiscal year, mark-to-marketing could still push some banks into insolvency if losses on equities plus bad loans prove too great. Tokyo's markets may recover in time but until banks' dependency on counting stocks as tier 1 capital leaves them vulnerable.

Market players, both foreign and domestic, report that the FSA has been asking a lot of intelligent questions about the workings of ETFs. The spectacular success of the $3.8 billion Tracker Fund of Hong Kong (TraHK) managed by State Street Global Advisors seems to promise a way out. In 1998 the Hong Kong government intervened in the local stock market to ward off currency speculators, and it needed a way to dispose of these holdings without disrupting the market. It also wanted to put stocks in the hands of retail investors and broaden the market. The Tracker Fund achieved those objectives, helped by pledges of additional units for investors who held it for the long term.

This success was noted across the region, and for a while it seemed every government – including China, South Korea and Taiwan – wanted to do the same. But structural issues in these countries quickly returned local regulators to reality. But Japan, in theory, has the size and liquidity for ETFs. Indeed, major ETF managers such as SSGA and Barclays Global Investors (BGI) have been working with regulators for two years to introduce onshore ETFs. Japan actually had a prototype of an ETF in 1998 based on the (rather obscure) Nikkei 300 managed by Nomura Securities, although it flopped after an initial burst of interest.

The FSA understands, however, that the Hong Kong situation is completely different. The Tracker involved only one party (the government) that had a liquid portfolio of blue chips, one that mirrored the Hang Seng Index benchmark. Retail investors bought it because it was cheap. In Japan, such a fund would be made up of myriad cross-shareholdings that do not necessarily adhere to any index. Furthermore banks are most eager to get rid of dog stocks, not the sort of thing that will tickle the fancy of a typical, conservative Japanese saver.

Before the FSA can make a solid decision about whether an ETF is a viable solution, they must first determine exactly what kind of fund of bank cross-shareholdings can be mustered. The FSA has proposed that banks cannot count these stocks as tier 1 capital as of 2006 – which brokers estimate is the equivalent of up to 200% of remaining capital for the largest banks. This means banks must sell up to Y13 trillion in assets to meet the proposed requirement.

The FSA has been urging banks to dispose of assets – a process that will no doubt accelerate following the terrorism-inspired market falls. In January 2002, it also intends to establish a Stock Purchasing Agency (SPA) as a fallback for banks. The idea here is that banks that prefer not to sell assets to the market directly will be allowed to sell them to this government body. This may appeal not only to banks that face massive losses on stock sales, but also to those wishing to minimize market impact and allow banks to sell large chunks of assets at a time.

Once the SPA is sold assets, then the government will have to decide what to do, and at present an ETF is one possibility. But whereas the SPA is anticipated to open doors in January, action will take time. It is anyone's guess how many assets banks will elect to sell to it. Although many banks will shy from selling stocks cheaply to the market, the SPA comes at a price: banks selling to it must also become SPA shareholders.

Furthermore, there will be a 8% ceiling and floor on the value of any asset sold to the SPA; this means if the market rallies and the SPA sells those shares to the market at, say, a 15% premium to what they bought them at from the banks, it will only provide bank shareholders an 8% return, with the government pocketing the difference. This mechanism is supposed to keep banks from taking advantage of the SPA's good offices.

This means that the SPA is not necessarily going to attract many assets, certainly not those most likely to gain value in the future. Furthermore, if banks have until 2006 to unload their cross-shareholdings, it is difficult to say when the FSA would seek to liquidate the SPA holdings. And most important, no one has a clue of what the SPA's portfolio will look like – but it is likely to consist of the most illiquid and unloved Japanese stocks. 

"This is the big dirty secret in Japanese finance," said one fund manager before the crisis in America. "Everyone knows there is a problem, but how big? It must be bad, because no one is dealing with it."

Nonetheless, the government can move swiftly at times. BGI and SSGA had been trying to get the necessary regulations passed to let them launch ETFs, and their plans had faced one delay after another. But in March, the Liberal Democratic Party released a reform platform that included promoting ETFs, along with other measures such as launching defined contribution schemes and permitting employee stock ownership.

Suddenly the fund managers found the government was drafting new listing rules for ETFs, and in July domestic brokers introduced a wave of them. BGI followed up in August with a series of its own.

The first step is done – ETFs are in the market, although they are marred by settlement problems. If the FSA decides to push on with ideas for an ETF to emerge from the Stock Purchasing Agency, then players such as BGI and SSGA hope to provide assistance. The trickiest part will be optimising SPA portfolios to resemble an index as well as creating a mechanism to leak these into the market with minimum disruption. Domestic ETF managers have no experience, so while they may prove to be excellent managers and promoters of such a fund, foreign experts are likely to play a role behind the scenes.

Many questions linger, but three are urgent. First, will anyone want to buy a portfolio consisting of illiquid stocks? This depends on how well a portfolio can be tweaked to resemble a portfolio. Some ETF managers also note that Japan desperately needs high-yield alternatives, so there will be at least some kind of demand.

Second, what kind of index will be appropriate? Unfortunately the FSA, in authorizing ETFs, required its approval of any index. So far an ETF may only be based on four: the Nikkei 225, which is the retail staple; the Nikkei 300; Topix; and the new Standard & Poor's Topix 150.

The problem with the Nikkei 225 is that no institution tracks it. The Nikkei 300 is obscure. The S&P Topix 150 is too new to have a following. And Topix, which should be the obvious benchmark, is too big, with nearly 1,400 constituent stocks. The nature of ETFs, which create and redeem units based on matching baskets of stocks, means that Topix is quite difficult to replicate.

Furthermore, FSA rules appear to require an index must be 100% replicated before creation or redemption of ETF units can occur, making optimisation hard (although BGI has been given exemptions). Given the likely unusual nature of bank cross-shareholdings, a Topix-based ETF seems difficult to create or even optimise. One answer, of course, is to create new indices, and the FSA is considering authorizing this.

Third, ETFs require a futures market so that arbitrageurs can play off the fund's price versus those of the underlying securities. Liquid securities ensure that spreads remain tight and the ETF is accurately priced. If the underlying securities are illiquid – as seems likely with some bank-owned stocks – or there is no efficient futures market on a specially created index, then the ETF will experience considerable tracking error.

Any solution to Japan's cross-shareholding nightmare remains uncertain. The current crisis environment may spur the FSA to change quickly, but the structural impediments and vast size of the cross-shareholdings mean there will be no magic bullet. ETFs remain a very useful tool for the government, and Japan may yet enjoy a success akin to the Hong Kong Tracker Fund, but it will only be one part of the answer. Its viability depends on the immediate measures the government takes to keep the banks from failing in the wake of the terrorist attacks in America.

A more in-depth look at this subject and Japan's new ETF market will appear in the October 2001 edition of PensionsAsia magazine.