LENDING A HAND TO GODZILLA

By Howard Chua-Eoan

THEY ASKED ME TO CONTINUE CONcealing the losses." With head bowed, the jailed banker in a gray, pinstriped suit read those words to U.S. District Judge Michael Mukasey. But Toshihide Iguchi's words last week reverberated far beyond the New York City courtroom. Not only was he pleading guilty to covering up the $1.1 billion in losses he had incurred for Daiwa Bank's New York operations (and personally profiting by more than $500,000). He was also implicating unnamed senior executives at the bank--the world's 13th largest--in a conspiracy with him to keep the catastrophe secret from the U.S. Federal Reserve Board. In London interbank lending rates jumped to reflect this latest blow to the Japanese banking system. Says Alicia Ogawa, an analyst at Salomon Brothers in Tokyo: "This new development serves only to increase distrust of Japanese banks."

The Iguchi confession was the second revelation last week to batter the once towering reputation of Tokyo's banking system. Three days earlier, Jim Leach, chairman of the U.S. House Banking Committee, had disclosed that the Fed had agreed to come to the rescue if a liquidity crisis beset U.S. subsidiaries of Japan's banks. The news provoked concern among government officials in both countries. Tokyo feared that breaching the agreement's secrecy would create financial-market anxiety by raising more questions about Japanese banking stability. The Fed's portrayal of the agreement as virtually risk free raised hackles in Washington. New York's Alfonse D'Amato, chairman of the Senate Banking Committee, wrote Fed chairman Alan Greenspan, saying such an arrangement "could place U.S. taxpayers in the inexplicable position of propping up, or even worse, bailing out, Japanese financial institutions."

The Iguchi confession and the Leach statement immediately made things tougher for Japan's banks by increasing their cost of doing business. Japan's banks are now usually charged a premium of 0.3% to 0.4% for their international interbank borrowing. After Iguchi spoke in court, however, the "Japan premium" nearly doubled for the more troubled Japanese banks. The premium had also edged higher after Leach revealed the existence of the Fed's agreement with Tokyo. The U.S. move had a double-edged effect--while it served to reassure financial markets of an emergency backstop for Tokyo, it also implied that Japan's banks must be in serious trouble.

The distrust of Japanese banks on the international markets has diverse and deep roots, even as the Ministry of Finance is taking dramatic steps to clean up the mess. The Daiwa case has shown how shoddy management can be in at least one major Japanese bank. Daiwa and the ministry waited too long to notify the U.S. of the losses, and the bank used shell companies to hide losses. Last week officials at Daiwa's Osaka headquarters would say only that Iguchi was asked to carry on simply to "prevent him from escaping." As a whole, Japanese banks have failed to divulge the extent of their bad loans. They have also failed to clear their books of huge amounts of real estate that have lost value since the property market's collapse. "It's a question of inefficiency," says David Atkinson, an analyst for Goldman Sachs in Tokyo. "The U.S. got out of its banking problems in three or four years, but in Japan this issue has been running for five years and it's not much closer to resolution than it was five years ago."

How might the U.S. be drawn into a Japanese bailout? If non-Japanese financial institutions become sufficiently alarmed about the Tokyo system's shortcomings, they may no longer choose to charge a premium on loans to Japan's banks but decide to stop making loans altogether. While the Ministry of Finance could handle the rescue of a major bank or even several at one time in Japan, a worldwide shutdown of credit to Japanese banks, however unlikely, would result in global financial catastrophe. That is the prospect that triggered Greenspan's offer of assistance from the Fed."This step is in the interest of both sides, an indication of the level of concern and preparation," says Steven Solomon, an expert on central banks.

To give its banks an emergency booster shot of liquidity, Japan would redeem a portion of the more than $100 billion in American government securities now held by the Bank of Japan, which the Fed would pay dollars for. The money would be used to shore up only the American subsidiaries of Japanese banks, not the parent companies in Japan, a point the Fed has emphasized in the hope of quelling political resistance in the U.S. Part of its rationale for the deal is to ensure an orderly liquidation of American securities held by Tokyo and Japanese financial institutions. Says banking consultant Edward Furash: "If the Japanese throw U.S. bonds on the market to reliquefy their banking system, that will raise interest rates, cause turmoil, inflation, and destabilize the financial system. America cannot afford to have a runaway bond market and higher interest rates."

Nevertheless, Senator D'Amato has called for a full report on Daiwa and exactly when U.S. authorities knew of the crisis. He remains critical of the Fed's "secret plan" to aid Japan. In fact, though, most such arrangements are kept secret. The Fed and the Treasury had briefed Leach on the plan, although both the Fed and the Japanese Ministry of Finance declined to send officials to Leach's hearing. Says a participant in the committee hearing: "Greenspan thought the banking issue was too sensitive to be discussed in that sort of public forum." He was probably right.

--Reported by Edward W. Desmond/Tokyo, Barbara Rudolph/New York and Adam Zagorin/Washington

With reporting by EDWARD W. DESMOND/TOKYO, BARBARA RUDOLPH/NEW YORK AND ADAM ZAGORIN/WASHINGTON