SMBC officially buys Nikko Citi units for $7.9 billion

In one of the most significant deals of the year for the Japanese securities sector, Citigroup has offloaded its Japanese retail securities unit as well as part of its wholesale operations to a Japanese mega-bank for ¥774.5 billion ($7.9 billion). The deal with Sumitomo Mitsui Banking Corporation (SMBC) was confirmed on Friday evening after being leaked to the media earlier in the week.

The total consideration is made up of ¥545 billion ($5.5 billion) for the target's assets and ¥201 billion in cash, which is held by Nikko Cordial Securities and will flow back to Citi. The US bank is also selling ¥28.5 billion worth of listed Japanese shares to SMBC.

Nikko Securities and Travellers (later to become Citigroup) originally set up a wholesale banking joint venture in 1999. When Nikko Securities ran into an accounting scandal in 2008, Citi took over the whole group for $13 billion.

Citi said in a press release issued Friday that SMBC has acquired Nikko Cordial Securities, the retail brokerage arm, as well as the domestic debt and equity underwriting functions of the wholesale investment bank known as Nikko Citigroup.

Nikko Citigroup lost ¥16 billion ($161 million) in the 2008 financial year, which ended March 31, 2009, after an ¥8 billion loss in the previous financial year. Nikko Cordial Securities earned ordinary income (that is, income exclusive of capital gains) of ¥22 billion in financial 2008, and ¥51 billion in the prior financial year.  

Before this deal, Nikko Cordial Securities was 100%-owned by Nikko Citi Holdings, while Nikko Citigroup was 49%-owned by Citigroup Global Markets and 51%-owned by Nikko Citi Holdings. Citi is maintaining its ownership in Nikko Citigroup, as well as in Nikko Asset Management and Nikko Principal Investments.

The upside for Citi is a $2.5 billion boost to its tangible common equity (now considered a better indicator of a bank's capital strength when compared to total assets than the Basel-inspired tier 1 and 2 ratios), although Citi will recognise an after-tax loss of $200 million on the deal. It also keeps the global business arm of the former joint venture -- at a time when Japanese companies have been venturing abroad in record numbers, and when even slow-moving giants like Mitsubishi UFJ Financial Group have acquired the domestic operations of Morgan Stanley Securities. SMBC itself injected $1 billion into Barclays in June 2008, while Mizuho has invested in Merrill Lynch.

"SMBC is essentially buying the domestic underwriting and distribution capacity. Citi will keep the global business (follow-ons, IPOs and debt issues) and the global mergers and acquisitions advisory business," said a Citi lawyer at the press conference on Friday. In other words, Citi is keeping the institutional business, including institutional sales and trading, securities lending and prime brokerage.

Ironically, Citi is now back where it started: in the same position as other foreign banks, such as Goldman Sachs, which have not engaged a local partner to tap the retail market. However, it's possible the required business model for Japan has changed.  

Competition in the global investment banking area has shrunk with the disappearance of Bear Stearns and Lehman Brothers, and the weakening of UBS and Merrill Lynch. It's possible that this area could become more attractive than the domestic markets, which are in a dire state: issuance volume in Japan's domestic equity capital markets (ECM) dropped to $70.8 billion in the first quarter of 2009, the lowest volume since 2003 and accounting for under 4% of global ECM volume, according to data provider Dealogic.

And while domestic retail distribution is usually regarded as the holy grail of investment banking in Japan, given the strength of the Japanese retail bid, this is changing too. In financial 2008, the domestic retail market joined the broader economy in a major slump. Ehsan Syed, securities firm analyst at Fitch Ratings in Japan, says: "Retail brokerage is no longer the profit centre it was in the past, due to the arrival of online brokers such as Monex Securities and equity platforms such as Kabu.com and JapanNext. This makes commission from the sale of investment trusts and asset administration fees all the more important."

The hope of companies like Nomura, which acquired the non-US operations of Lehman Brothers last year, is that they can expand abroad to tap global opportunities, which they consider more promising than Japan's stagnant home market. The theory is that Nomura will tap its retail client brokerage for the sale of international investment trusts and bonds from fast-growing areas like China and India to a much greater extent than before. If Citigroup forges close ties with SMBC, it could follow a similar strategy.

On the other hand, it's difficult to see the upside for SMBC in getting involved in a domestic securities business at this stage, especially given its recent losses and its need to raise $8 billion in new capital. It already has an institutional business in the form of a 40% stake in Daiwa Securities SMBC, and its own (very small) retail brokerage (SMBC Friend), as well as its stake in Barclays. All these might be difficult to manage together.

This latest acquisition also looks like bad news for Daiwa Securities SMBC. Daiwa is not linked to its own bank and relies on SMBC for much of its funding, according to one financial consultant who wishes to remain anonymous. If SMBC decides to merge its new unit with its JV to save costs, Daiwa might have no choice but to acquiesce. It's difficult to see how the two firms can avoid bumping heads in pitching for mandates otherwise.