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Archegos loss, risk control issues may force Nomura to rethink US strategy

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Archegos loss, risk control issues may force Nomura to rethink US strategy

The future of Nomura Holdings Inc.'s wholesale business in the U.S., the company's second-biggest revenue source, has been thrown into question as the fall of U.S. hedge fund Archegos Capital leads to billions of dollars of potential losses and exposes internal risk control issues, analysts say.

The biggest brokerage in Japan is among a handful of major financial institutions hit by the massive unwinding of leveraged bets by Archegos since late March. In addition to Nomura's own estimate of potential losses of around $2 billion, equivalent to around 70% of its net profit for the three fiscal quarters ended Dec. 31, 2020, it also shelved a $3.25 billion bond sale while its credit ratings are downgraded or under review.

"They [Nomura] would be stricter about allowing themselves to deal with family funds, reducing the levels of risk allowance for such a business," said Natsumu Tsujino, Mitsubishi UFG Morgan Stanley's senior analyst. "That could slow down its equity transactions in the U.S."

Nomura's U.S. wholesale business, which trades stocks and bonds and offers investment banking services to institutional clients in North America, has been a major driver of the company's earnings recovery since its last net loss for the October-December 2019 quarter.

The dependence on revenue growth outside Japan is a result of years of ultralow interest rates at home. More than half of household assets were held as cash or bank deposits, 28.4% were allocated to insurance and pension funds, 9.6% to securities, 3.4% to investment trusts and 1.4% to bonds as of March 2020, according to the Bank of Japan. Nomura, alongside many other Japanese financial institutions, have increasingly allocated money to overseas markets, particularly the U.S.

The Archegos incident "is surely forcing Nomura to review all its U.S. transactions with family funds and to stop doing business with new such funds for a while," said Shingo Ide, chief stock strategist at NLI Research Institute.

It is not the first time Nomura's overseas strategy has come back to bite it. Nomura acquired Lehman Brothers' assets during the 2008 financial crisis, and it was followed by years of cost increases and write-downs.

Rising star, rough ride

In the fiscal third quarter ended Dec. 31, 2020, net revenue of Nomura's U.S. wholesale business totaled ¥80.5 billion, up 9% from a year ago but down 15% from the previous quarter. In the company's presentation materials, it said the slowdown was mainly due to its rates business, while securitized products grew significantly.

The segment was second to its retail broking business in Japan, which had a net revenue of ¥98.2 billion. The company's total net revenue for the quarter was ¥402.1 billion.

Revenue from the U.S. equity segment was also Nomura's fastest-growing equity operations outside Japan, nearly doubling to ¥51.6 billion in the July-to-September quarter of 2020 from ¥26.6 billion the previous year, according to analysis by Mitsubishi UFG Morgan Stanley.

Nomura is likely reviewing its risk management practices under direction of CEO Kentaro Okuda, who headed its U.S. operations in 2017 and 2018, analysts said. Nomura declined to comment, only reiterating its March 26 statement that it will continue to take appropriate steps to address this issue.

The financial regulators in the U.S. and Japan said they would investigate the scale of the problem following the Archegos incident and find out whether more banks are involved.

Creditworthiness questioned

S&P Global Ratings said it would review Nomura's risk management system from the viewpoint of credit concentration and validity of hedging. For now, it kept its ratings on Nomura at BBB+ with a stable outlook, adding the potential loss will not immediately burden its credit ratings due to the group's profitability.

Japanese rating firm Rating and Investment Information cut its rating on Nomura to A from A+, while Moody's changed its outlook to negative from stable, maintaining its ratings at Baa1.

"Credit ratings, especially those from global credit ratings agencies like S&P, Moody's and Fitch, directly affect Nomura's ability to do wholesale business as most counterparties require a certain level of credit rating to do transactions that are not settled immediately, such as swaps," said Michael Makdad, an analyst at Morningstar.

"So, even a change in outlook from stable to negative will require Nomura to be more cautious in order to maintain its ratings. That said, the global [rating agencies] have not cut their ratings, so unless they do I think the impact won't be terribly huge."

After Nomura flagged the potential losses and canceled the bond sale plan on March 29, Mitsubishi UFJ Morgan Stanley and J.P. Morgan cut their ratings on the Nomura stock to neutral from overweight, and to underweight from neutral, respectively.

Mitsubishi UFJ Morgan Staley cut its earnings estimate for Nomura for the fiscal fourth quarter ended March 31 to a net loss of ¥145.1 billion, reversing a previous estimate of ¥74.9 billion of net profit. J.P. Morgan slashed its net profit forecast for Nomura for the entire fiscal year ended March 31 to ¥199.3 billion from ¥283.3 billion.

As of April 21, US$1 was equivalent to ¥108.09.