This summer McKinsey, the western management consulting group, is busy with a new type of job. As the banking restructuring gathers pace, McKinsey has been quietly advising several large Japanese banks on their future strategy. This project marks a striking break with tradition: although Japanese banks have used outside consultants before for overseas operations or logistical problems, they have almost never asked them to comment on their core business.

This move highlights the degree of business pressure that has been felt by Japanese banks over the past year. The crucial question in the next year will be whether this pressure is about to unleash a new shake-out of the sector - or simply leave the banks wedded to their old strategies. This issue is critical because Japan's banking problems are now moving into a new phase. During most of this decade the main task has been getting an accurate assessment of the banks' bad loans, and then assembling sufficient capital to deal with them.

This issue is now - slowly - being addressed. In fiscal 1998, for example, the government used ¥7,450bn of public money to boost the capital bases of 15 large banks, and the banks themselves raised an additional ¥2,000bn of funds. The banks then used this to make reserves for ¥10,000bn of their ¥21,000bn of "problem" loans.

These dizzy sums certainly do not mean that the problem is yet resolved. Brian Waterhouse, of HSBC Securities, for example, estimates that the real total of problem loans for the leading banks is nearer ¥50,000bn, of which ¥17,000bn will turn bad and need to be written off. This higher figure partly reflects the fact that more bad loans are emerging as the economy remains weak. The implication of this, he argues, is that another ¥7,000bn of reserves will be required - forcing more injections of public funds.

Given that Mr Waterhouse also calculates that the aggregate bad loan total this decade for the large banks has been around ¥61,000bn, ¥7,000bn is not insurmountable. And the funds do exist now: the government earmarked ¥25,000bn for capital injections, of which ¥17,000bn remains. "There is now light at the end of the tunnel," concludes Mr Waterhouse.

The big question now is whether the banks will actually be able to find a viable business base once they have been cleaned up. The reason many banks plunged into disastrous real estate lending in the 1980s was that the businesses which had sustained them between the 1950s and 1970s were faltering. Unless they change strategy now, removing their problem loans will simply replace a crisis-laden banking system with an anaemic one.

The crux of the problem is that too many banks are chasing the same business. Traditionally, the sector has been divided into three main categories: "city" banks, which performed retail business and corporate lending; "long-term credit banks" which performed longer-term lending through the issue of debentures; and "trust" banks, which acted as asset managers and custodians. Capital market functions, by contrast, were performed by brokers.

"Big Bang" is now tearing down these barriers. Although this gives each institution more flexibility, it also creates more competition in every niche. Almost every large bank, for example, now declares that it wants to develop asset management services. Although this has not yet driven down profits in asset management, the saturation in the corporate lending market or underwriting market has created wafer-thin margins.

The government insists that it is now pressing the banks to act. In exchange for receiving the injection of public funds the banks all unveiled sweeping cost-cutting measures last year. They have pledged, for example, to reduce their workforce by 15 per cent a year. Some consolidation has also occurred: by next year the number of "large" banks will have dropped to around 15, from 21 three years ago, due to a wave of closures and mergers.

eanwhile, there are signs that some banks are now starting to develop a clearer business focus. A number have sharply reduced their overseas branches after concluding that they could not compete with US and European groups. Some are retrenching even further: Daiwa, for example, has decided that it will now become a "super-regional" bank rather than a national group.

Some banks are also developing a clearer retail or wholesale niche: Sumitomo has effectively decided that it cannot compete in the securities markets independently and concluded an alliance with Daiwa Securities. Sanwa, to cite another example, is quietly developing a retail niche.

Thus far few banks have tackled one of the most fundamental problems dogging the sector, namely the vast quantity of low-yielding assets that remain on their books.

Listening to outside consultants such as McKinsey might appear an encouraging step. What is needed now, however, is action.


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