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(C) The Financial Times
LTCB: derivative deals at risk
By Gillian Tett in Tokyo
Investors holding derivatives contracts with Japanese financial institutions such as the troubled Long Term Credit Bank of Japan (LTCB) may not be fully protected under Japanese law if an institution collapses.
The concern has arisen because Japanese law does not yet guarantee that the "netting" of counterparty derivative contracts will be respected if a bank or broker collapses. Netting is the process by which the different losses and profits between creditors are offset against each other and paid off in one lump sum.
Japanese officials say the loophole will be plugged by legislation introduced as part of Big Bang financial deregulation designed to bring the country into line with global standards. But this legislation will not come into effect until December.
The legal uncertainty is causing unease among some international investors because of mounting concern about the health of some Japanese financial institutions.
The Financial Supervisory Agency (FSA), Japan's banking watchdog, says the gross notional volume of derivatives contracts held by Japanese banks totals Y2,090,000bn (œ9,000bn) - although the actual "netted" position of actual losses or profits would be far smaller.
Most of these contracts are covered under an agreement forged by the International Swaps and Derivatives Association. Bankers believe that in the event of a collapse the Japanese courts would uphold any netting agreement. However, this is not stipulated under local law and there has been no precedent to date, they say.
Yoshinobu Yamada, analyst at Merrill Lynch said: "The lack of a legal framework would make dealing with the derivatives problem complicated [in the case of a collapse]. This uncertainty undermines confidence."
Christopher Well, a lawyer with White and Case, the US law firm, added: "There will be a collective sigh of relief in December when the lingering doubts are eliminated. But there are questions now about whether a trustee could reverse a netting agreement now."
The issue of derivatives has become particularly controversial because parliament is debating LTCB's future. LTCB is in merger talks with Sumitomo Trust and the government is expected to inject at least Y500bn of public money to ensure the merger is consummated.
The political opposition says public money should not be used to save LTCB but the ruling Liberal Democratic party insists that a collapse of LTCB would create a systemic risk because of its derivatives exposure.
The degree of LTCB's derivatives risk is disputed. LTCB says it has reduced its exposure from Y51,500bn to Y40,000bn between March and July, and adds that most contracts are "plain, vanilla" contracts, such as swaps in the yen market. Some government officials conclude therefore that unwinding the contracts would be a relatively simple matter.
However, the FSA has indicated that LTCB's exposure is nearer Y80,000bn and some bankers fear the exposure may contain complex structures which would be difficult to unwind. "It could lead to a very negative reaction in the markets," says one Bank of Japan official.
Most western bankers believe the government will rescue LTCB but many have been re-examining their derivatives contracts with Japanese institutions. One lawyer with a US investment bank yesterday said: "We assume that the government would protect us in the last resort, since we are all in the same boat. But until December there will be an uncertainty, however small."
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