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International Trade in Financial Services: The lapanese Challenge RICHARD W. WRIGHT AND GUNTER A. PAULI Little more than a decade ago, the Japanese took the world by surprise with a frontal assault on world consumer electronics, automobile, motorcycle, and photographic markets. Those and other manufacturing industries in North America and Europe are still reeling from the Japanese onslaught, as the world seeks to better understand the scientific and managerial technologies with which Japanese firms catapulted so quickly to dominance. Today the Japanese are again on the move, and a second wave of Japanese competition is about to hit the western world. This time the target is services, and financial services in particular. Once again it appears that the West will be taken largely by surprise. How have the Japanese moved so quickly to the forefront of services sectors long considered the exclusive domain of westerners? Does analysis of the strategies they used so successfully in manufacturing sectors help us to understand their current competitive thrusts in services? What organiza- tional technologies do they have at their disposal? What sorts of responses are appropriate to the new international competition in services? This chapter addresses these important questions. THE DIMENSIONS OF SUCCESS Japan's sudden emergence at the forefront of international financial ser- vices is evident in many ways. As examples: The Japanese are now richer than Americans. Japan' s average per capita income topped $17,000 near the end of 1986, compared with $16,000 in the 187

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188 RICHARD W. WRIGHT AND GUNTER A. PA ULI United States (The Economist, 1 986a). They also save much more than others (The Economist, 1986b): 17 percent of their disposable income, on average, versus some 4 percent in the United States (Figure 11. Japan is the largest exporter of capital the world has ever seen. Due to the combination of high domestic savings and large foreign trade surpluses, Japan has exported almost $400 billion worth of long-term capital over the last three years, far more even than the Organization of Petroleum Exporting Countries (OPEC) in its heyday (Figure 21. And unlike the OPEC countries, which recycled their excess funds through deposits at major foreign-owned banks throughout the world, the Japanese resolutely funnel their international financial flows almost exclusively through Japanese financial institutions, thus providing Japan's banks and securities companies with a massive reserve of resources for their global strategy in world financial markets. Tokyo has become the world's leading financial center. The Tokyo Stock exchange has more volume already than all the exchanges of Europe combined; it recently topped even New York as the world's largest exchange, with a market capitalization of $2.9 trillion versus New York's $2.7 trillion (Echo de la Bourse, 19871. Even the comparatively minor Osaka exchange has soared past London to become the world's third largest, after Tokyo and New York (Time, 1986~. The seven largest commercial banks in the world are all Japanese and 13 Japanese banks rank among the largest 25 (Figure 31. This has all come about extraordinarily quickly. As recently as 1980 none of Japan's banks ranked among the world's top five in size of deposits, and only one (Dai- Ichi Kangyo) ranked among the first ten. 30 25 20 _d a) ~ 15 a) Q 10 5- o _ _1 ~ _~ / ~ Federal Republic of Germany United Kingdom - ~~ ~ Japan Hi. ~ in_ 1975 1 977 ~ United States 1979 1981 1983 1985 Year FIGURE 1 Personal savings as percent of disposable income. SOURCE: The Economist ( 19861.

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INTERNATIONAL TRADE IN FINANCIAL SERVICES 160 ~ Cn 140 O 120 CD 1 00 j 0 80 co ~ 60 . _ m 40 20 1983 1 984 1985 1 986 Year l 0 198 1 987 s6.8 _. : -:- :::.:. -~:- ..:-.: .-~ 145 ..:.: ~ ~ 1988 (eSI.) 135 189 FIGURE 2 Japanese long-term capital outflow, 1982-1988. SOURCE: Bank of Japan. However, growth in size is only one part of this remarkable success story. Japanese banks are capturing overseas markets in much the same way their manufacturing counterparts did earlier. They recently nudged out Americans as the world's largest international lenders, with $650 billion in loans out- standing, or nearly one-third of the total worldwide assets of banks (Figure 41. Their dominance in international lending shows no sign of abating. A recent report predicts that by 1990 Japan will have an astonishing $1 trillion in loans outstanding (Euromoney, 1985~. In addition to seizing major chunks of American and European commercial lending, Japanese banks are ex- panding very rapidly into new activities abroad such as leasing, trust banking, and securities underwriting. The four largest securities companies in the world are Japanese. Like their banking counterparts, Japanese securities companies have become in- creasingly dominant forces in their international activities. The "Big Four" Japanese houses (Nomura, Daiwa, Nikko, and Yamaichi) now rank as the world's largest. Nomura Securities Company, largest in terms of assets, is bigger even than the American giant Merrill Lynch, and vastly more prof- itable: its pretax profits for 1987 exceeded $3 billion. So huge is Nomura, in fact, that its market capitalization, or what the stock market says all its shares are worth, is ten times that of Merrill Lynch (Hector, 19864. Japanese securities firms are aggressive at home and abroad, both in ex- panding their securities business and in rapidly innovating into new product areas traditionally the turf of other financial institutions. They are becoming increasingly adept at using their financial clout to cut prices in U.S. and European underwritings, taking large chunks of new issues back to Japan,

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190 BankAmerica (US) Citicorp (US) Chase Manhattan (US) Barclay's (USA National Westminster (UK) Manufacturers Hanover (US) Banque Nationale de Paris (France) Banco Nationale del Lavore (Italy) JP Morgan (US) Western Bankcorp. (US) RICHARD W. WRIGHT AND GUNTER A. PAULI Assets as of December 31, 1970 in billions of U.S. dollars 1 970* 0 20 40 6.0 80 100 Ll I I I I I I I ~ I ......... . i::.2.:~:.: ..~ ~ $92 Dai-lchi Kangyo :: ~ (Japan) ..~ ~ ~.~ ~ 80 Fuji Bank ::.: .:::::.~::::.~. .:. ::: . .:::: A.:. . .:, (Japan) . ~ 76 Sumitomo ~ (Japan) .... ; * * :. . ~.. 49 Mitsubishi ::: ::: : ::: (Japan) ;; . . .:.:. .:.:.::: * * ...................... 40 Sanwa .~:~:~:. :~:~:~:~:. (Japan) :-:-:-. :-: --:-:-:-: .:~:~:~:. :: 39 :-:-:-:-:-:-:-:-:-:-: ............ ** Norinchukin (Japan) ...... . ~ 38 Industria7 ~ (Japan) .... .. . ~ 38 Credit Agricole :~::~::~:~.: Mutuel (France) ::.:.:.::::::i Citibank ................ 37 (Us) Banque Nationale de Paris (Frances * at 1985 prices adjusted by industrial countries' consumer prices ** as of September 30 Assets as of December 31, 1986 in billions of U.S. dollars 1 986 0 50 100 150 200 250 ....... ..... ......... .~ .: :: .:~.~:.~ :.~:.:~ ~ ~ :: ,........................... I:::::. ::: . : : : :: ~212 ...: .: :- :~ :~:~- ................................... .~. ~.~ ~. $205 :-.-:-:-.-:-:-: .-:::-:-:-:-.-:::-.-:::-:-:-:::-::::: :::;:;:~.;:;:;:;:;:;:;:;:;:;:;:; :;:;:;:;:;::;:: I:::::::: .::::. :~:~:~:~:~:~:~:~:~. t203 :-: :---:-:---:-:-:-:-:-:-:-:-:-:-: .:::::: . . ::.:. .:. .:. .:.:~:~:~:~:~:~:~:. ..................................... :~:~:~:~ :~~:~:~:~:~ A . :-:-:-- :-:-:-:-:-:-:-:-:-:-:-:-:-:-:~ :-: up 1 9 1 In:::::::: .~:~:~:~:~:~:. :::: ........................ ..,, . .:.~::~:s.*~ $162 , :-:-:-:-:- -:-:-:-:-:-:-:-:-:-:-- - :- ~ :~:~:~:~:~:~:~:~:~ .~:~:~:~:~:~:~ ~161 :-:-:-:-:-:-:-:-:-.-:-:---:-:-:---:-:-: .................... ...-.-.... . ~ $156 .... .. . . .... ;;; .-; - ; ;! :~:~:~:~:~:~:~:. :~:~:~:~:~:~.~: $146 :~:~:~:~:~:~:~:~:. .:::. ~ .:. .. ......... : - ~- , :.: :.:~.: ::. ::.~:. :~:~:~.~:~.~:~:~:~:~:. I::::: $144 :-:-:-:-:-:-:-:-:-.-:-:-.-:-:-:- .~.~.~.~.~.~.~.................. FIGURE 3 The world's largest commercial banks. Banks ranked by deposits in billions of U.S. dollars as of December 31, 1986. SOURCE: American Banker, company reports, Fortune. where their placement power enables them to dispose of their holdings quickly (for a recent account of their placement ability and diversification strategies, see Time, 1988~. Their profitability at home also allows them to expand into other lucrative activities abroad, as they embark on a path that will eventually make them truly global financial supermarkets. Japanese services firms are poised to become major players in other industries as well. Although attention in the West is focused at the moment on the dramatic rise of Japan's banks and securities companies, the Japanese are becoming major world competitors in other services areas also. For example, the world's largest transportation company (NYK) is Japanese, as

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INTERNATIONAL TRADE IN FINANCIAL SERVICES Japan United States France United Kingdom Federal Republic of Germany Italy Switzerland Canada Other 0 10 20 30 Percent 191 :;. :;:;:;:;:;:;. :;:; .:;:~.;:. ;:;. . . :;:;: . .;:;:;:;: .;;: .;:;:;. :;1 35% : :: ::::::---::---::-:-::---:~ :: -: ~ :::- , ; :::::::: ::::.::.:: ::: 16% ................... ~- .~:: :.. ~ 8% I_ ~ . 0~ r:::.~. um ~8% :-; ~ ; ;1 :. :..:.' 5% ~4% ~4% :.;: .:. ;.; .:. :~: ;i 1 4% -::--:: :---d 40 50 FIGURE 4 Worldwide assets of banks by ownership of banks (September 1987). SOURCE: The Economist; Bank for International Settlements, January 1987. is the largest life insurance company (Nippon Life), the largest tourism organization (Japan Travel Bureau), and the second-largest advertising agency (Dentsu). The successes of the Japanese banks and securities companies may be only the leading edge of impending Japanese competition in a much broader range of services. ELEMENTS OF COMPETITIVE STRATEGY Head-on global competition in the services industries is a relatively new phenomenon, with little in the way of reliable models or precedents. Tra- ditional models of industrial structure and manufacturing competition have limited relevance to service sectors, where the types of inputs and the nature of productive activity differ so from those of manufacturing. The Japanese financial services sector, however, has embarked on a strat- egy remarkably parallel to that which earlier placed Japan in the forefront of information technology and other key markets. Tracing their strategy for entering and penetrating the information technology market can provide use- ful insights into their current competitive challenge in financial services. Their overall approach may be characterized succinctly as the Termite Strategy. The Termite Strategy invokes no master plan, and no single leader to orchestrate the steps. Yet, just as termites act independently and create a significant common result, the Japanese financial services houses are all driving toward common objectives, each one seeking to maximize its strengths and minimize its weaknesses to the greatest extent possible, searching out the areas of greatest demand and paths of least resistance from competitors.

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192 RICHARD W. WRIGHT AND GUNTER A. PA ULI Under the Termite Strategy there is no big thrust for the target, no single front line, but thousands of small steps. The purpose of this section is to analyze those steps that the Japanese are and will be taking to dominate the market for financial services, through a comparison with their successful strategy in attacking the information tech- nology market. The paths are remarkably similar, and the consequences for unwary U.S. and European competitors may be equally unfortunate. Elements of the typical Japanese strategy may be summarized generally as follows: 1. Japanese firms identify segments of the targeted industry and choose an appropriate entry segment. They focus intensively on that targeted sector, flooding the market with goods or services of high quality and low price. 2. They join with foreign competition in other segments of the industry, where foreign know-how or technology is superior to that of the Japanese. These joint ventures enable Japanese firms to gain important expertise in their own market before competing head-on in foreign markets. 3. They build up a strong distribution infrastructure. 4. After having established themselves securely in foreign markets through high quality and low prices, Japanese companies are accused of "dumping." Protectionist political pressure from foreign governments allows them to raise prices. Higher prices mean higher profits to Japanese firms, as well as to local competitors, at the expense of the consumer. 5. Surplus profits from increased prices provide the capital for Japanese firms to manufacture or operate abroad rather than exporting Japanese prod- ucts or services. The Japanese ensure that high value-added operations remain at home in Japan, with mainly assembly-type operations abroad. Profits and expertise flow back to Japan, while low value-added jobs formerly lost to Japanese competition are reinstated abroad under the umbrella of Japanese investments. 6. Finally, the Japanese engage in takeovers to rescue failing companies abroad, and finance research and scholarships at leading western universities to secure access to well-trained young graduates. Table 1 summarizes the strategy and compares its successful application by the Japanese in information technology to the approach being taken in financial services today. This table captures succinctly the main elements of strategy discussed below. THE JAPANESE STRATEGY IN INFORMATION TECHNOLOGY Reconnaissance An appropriate target entry segment for any new market, from the Japanese perspective, would be one in which the financial resources of the competition

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INTERNATIONAL TRADE IN FINANCIAL SERVICES 193 TABLE 1 Japanese Business Strategies: The Comparison of Information Technology and Financial Services Information technology 1. Japanese firms enter the information technology market through high-volume pr~ce-sensitive semiconductor segment where competition has least resistance due to their focus on financial returns instead of market share. 2. Japanese fimns move into supplier contracts and original equipment manufacturers (OEM) agreements penetrating other segments of the information technology market such as personal com- puters, peripherals, office equipment . . . to acquire manufacturing expertise. 3. Firms first secure their market through independent distributors, then establish direct sales channels centrally controlled by the Japanese headquarters. 4. After acquiring a major market share Japanese fimns are accused of "dumping." Political agreements safeguard their market position and raise their profitability while western competitors feel that the "steamroller" has been stopped. The Japanese market will be "opened" for sophisticated chips the Japanese do not yet manufacture. 5. Japanese establish joint ventures and invest in new assembly lines, making sure that high- value-added operations remain in Japan, while overseas profits increase in relative importance. They also build the largest research and development institutes in the world. 6. Japanese firms consolidate their leadership position by rescuing bankrupt manufacturers, often at the demand of western governments, and even engage in hostile takeovers. They heavily finance fundamental research in artificial intelligence at leading western universities and channel the results back to Japan. Financial services 1. Japanese fines enter the financial services market through the government lending segment where margins are crucial and the governments' appetite seems insatiable. Huge balance of trade and savings are channeled to foreign governments, creating political goodwill. 2. Japanese finds join with financial houses in other segments of the financial services market, such as foreign exchange, trust and retail banking, leasing, to acquire financial engineering expertise. 3. Firms build up large infrastructure through representative offices and branches. Offices are managed by Japanese staff under direct supervision of Japanese headquarters. 4. After acquiring a leading market share, Japanese firms will be accused of "dumping." Political deals will "open" the Japanese financial markets, but these will be either saturated (e.g., banking) or where foreign expertise is most needed. 5. Japanese financial houses obtain banking licenses, primary dealer status, seats on the New York Stock Exchange and London Stock Exchange, and dominate the minor financial centers, all through bilateral deals. Profit and expertise flow back to Japan. They build their own think tanks. 6. Japanese fimns consolidate their market share by rescuing bankrupt financial houses and even make hostile takeover bids. They offer millions of dollars through university endowments to secure long-tenn access to well-trained bright graduates, more tailored to their needs. are insufficient to block Japanese penetration of that segment. Japanese firms seek an entry segment with high growth potential, because high volume is central to their success due to the huge capacity at their disposal through the captive, protected home markets provided by the large domestic economic- interest groups, or keiretsu (for a more detailed discussion, see Wright and Pauli, 1988~. An illustrative example of the structure of one of these large economic-interest groups is presented as Figure 5.

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194 + Mitsui ~ n~lt~nt~ Denki Kagaku Kogyo ~ Mitsui Sugar | Taito Co. | + Mitsui Aluminium + Mitsui Alumina + Mitsui Metal Processing 1 1' RICHARD W. WRIGHT AND GUNTER A. PAULI Fiber & Textile Toray Industries _ Chemicals Mitsui Toatsu Chemicals Eng neenng ~ ~ Mitsui Petrochem. Inds. Foodstuffs Nippon Flour Mills Nimoku-Kai Top 3 Leaders Mitsui Bank | Mitsui & Co. Construction Mitsui Construction Sanki Engineering _ Department Store Mitsukoshi' Ltd. hnance & Insurance Mitsui Trust & Banking + Mitsui Mutual Life Insur. Taisho M. &F. Insur. I Mitsui Real L I ~r ~ LEstate Dev. Paper & Pulp Oji Paper r Mining Mitsui Mining + Hokkaido Colliery & Steamships _ Onoda Cement Top 3 leaders Steel & Metals Mitsui Mining & Smelting Japan Steel Works | Parent Co. | => rubsidiaries or affiliates | | 7Nimoku-Kai members 1 ~ , + Mitsui Agriculture | & Forestry | | Toshoku Ltd. | | General Sekiyu | L - o Menka) | | + Mitsui Seiki I Kogyo . ~ ~ransportation & Warehousing | Mitsui O.S.K. I Lines Mitsui Warehouse + Mitsui Harbor | & Urban I Const. | - Electric & Machinery Mitsui Eng'g & S'bidg (Toshiba . Aircraft | Ind. | Corp.) | +Mitsui Miike | | Machinery l (Toyoto Motor Co. L | Joint Developments in New Industries | + Mitsui Oil Exploration + Mitsui Ocean Dev. & Engineering | I + Mitsui Development + Mitsui A~r & Sea Service | + Mitsui Knowledge Industry + Mitsui Leasing 8 Dev. l ' 1 1 FIGURE 5 Mitsuigroup. SOURCE: Industrial Groupings in Japan. Revised edition, 1980/198 1, Dodwell & Co.

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INTERNATIONALTRADEINFINANCIALSERVICES 195 Because price is used to capture a large market share quickly, it is important that the segment be highly price sensitive. They seek an area where there are few barriers to entry and where the entry risk to the Japanese is low. Finally, they seek a market segment that will open doors to the rest of the industry. These initial entry criteria are summarized in the first section of Table 2. A simplified outline of the information technology market could identify seven subsectors (see Table 2, second section): semiconductors (chips), per- sonal computers, minicomputers, mainframe computers, peripherals (e.g., printers and cables), communications equipment, and software. For their initial entry into the information technology market, Japanese firms were not interested in the software segment, where they had performed poorly in the past. Also, they were not in a position to undercut the leadership of cash-rich European and U.S. competitors such as Lotus, Microsoft, Log- ica, and Cap-Gemini-Sogeti who were setting world standards. This segment still has not been tackled by Japanese firms. The mainframe market, which even in Japan was dominated until recently by IBM, did not appeal to them either as an entry segment, nor did the personal computer (PC) market led by Apple and IBM. These segments became the secondary targets. Instead, the Japanese selected the semiconductor market as their first target in the information technology industry. Why? The U.S. competition was leading, but they were stand-alone companies, not integrated into large con- glomerates as Japanese companies are in their keiretsu groups, with their large captive markets. U.S. companies had to pursue competitive strategies predicated on short-term profitability, to satisfy the cash-flow and dividend targets set by private investors and venture capitalists. The Japanese could aim simply for volume; they had their captive markets within the keiretsu, and whatever sales they made outside their group could be priced on the basis of marginal cost. Moreover, the basic semiconductor segment provided an ideal springboard to other, more sophisticated sectors of information technology. The First Assault Following this initial game plan, Japanese chipmakers successfully un- dercut the semiconductor market with quality products at very low prices. (Refer again to Table 1, step 1.) The economies of scale reached by the extra sales abroad served, as expected, to accelerate their learning curve in pro- duction and applications. In contrast to its U.S. counterpart, the Japanese semiconductor industry is not a merchant industry. Of the semiconductors produced by Matsushita, for example, 80-90 percent are used within its own group of companies. The remaining 10-20 percent sold overseas allows them to recoup extra research and development costs, pays for the marketing of

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196 RICHARD W. WRIGHT AND GUNTER A. PAULI the chips, and perhaps most importantly helps them to get a feel for the information technology market on an international basis. Matsushita and the other large Japanese chipmakers were less constrained than their U.S. and European competitors by the huge capital investments needed to shift from 8- to 16- to 32- and 64-kilobit chips. There is almost always cash available in Japan's large industrial groups to expand production into areas of high demand. Moreover, the existence of guaranteed, stable internal markets within the groups lowers substantially the risks of large capital investments. The consumer sought low price and high product reli- ability, and the Japanese provided exactly that. They supplied a quality product in high volume at a low unit price. In the meantime the market kept on growing while a small number of competitors fought to maintain their share. Branching Out At the same time as the Japanese semiconductor manufacturers built up their market share in chips, forced prices down, and proved to clients that their product reliability was the best and their price the lowest, they were able to develop a parallel strategy of supplier contracts with original equip- ment manufacturers (OEMs) in other market segments, thus gaining valuable manufacturing expertise in related sectors (Table 1, step 21. Slowly but steadily Japanese firms began to penetrate not just the semiconductor market, but other related segments of the information technology market as well, such as microcomputers, peripherals, and mainframes. Parallel to this, the Japanese improved their distribution system (Table 1, step 31. The initial presence of Japanese firms through independent distrib- utors gave way to wholly owned subsidiaries for distribution and aftersales services. They then proceeded to consolidate their market position by re- placing U.S. computers with Japanese models in government agencies at home and in selected countries abroad. Hitachi, for example, offered 50-60 percent discounts in Japan, Brazil, Spain, and Australia. They knew that once they had obtained a major market share of the government sector in those countries, the private sector would follow, purchasing their computers at higher prices. After all, one has to be concerned about dumping charges while selling to the private sector, but governments will seldom object to receiving computers for less than cost. The Politics of Price Soon after, in the wake of increasing pressure from Japanese competition and the apparent need for western companies to enter into coalitions with the Japanese, the cry arose from European and North American manufac- turers: "The Japanese are dumping semiconductors." The Japanese invasion

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INTERNATIONAL TRADE IN FINANCIAL SERVICES 197 of the memory chip market between 1973 and 1975, and later on between 1981 and 1983 in the 64K memory market, triggered appeals for help, as the Japanese ability to underprice their competitors seemed unstoppable. On the basis of battles lost in the past, western companies such as IBM began to delegate production of their chips to the Japanese at the start of new projects, rather than fight a costly price war after large investments had been made in new production facilities. Governments were pressured to block Japanese firms from the semicon- ductor market and to levy extra taxes on their products. To avoid the em- barrassment of a dumping charge, the Japanese deftly resorted to "political engineering" (Table 1, step 4), working out an agreement on price and volume with the American private and public sectors. In the fall of 1985, the Reagan administration pursuaded Japan to sign a five-year agreement to stop dumping computer chips below "cost" (according to U.S. accounting standards) and to make its own semiconductor market more open to foreign manufacturers. However, the pact generated sharp controversy from the out- set over its side effects, and U.S. charges of Japanese noncompliance led to the imposition of special retaliatory tariffs in the spring of 1987. The outcome of the agreement was increased cost to the American con- sumer and increased profits for Japan. The chip deal between the United States and Japan resulted in an immediate average price rise of some 20 percent for semiconductors, with some chips even tripling in sales price. By forcing up chip prices in the U.S. market, the pact will handicap the com- petitive ability of other high-technology industries in the United States whose products contain semiconductors. Also, since the Japanese are no longer permitted to offer cutthroat prices on chips, they can increase their profit margins har~dsnmelv thanks to the largesse of western policymakers. ~ ~ , ~ Reaping the Profits This additional profit from the consumer permits the Japanese to invest in chip factories in the United States (Table 1, step 5) in much the same way that they began investing in automobile plants in the United States after similar experiences in the automotive industry. There, the Japanese accepted a voluntary automobile-restraint agreement on their exports that allowed them through the game of supply and demand to increase their sales price by some $1,000 per car. After three years this extra income generated from the American consumer permitted the Japanese to begin building assembly plants in the United States. However, the higher value-added elements of car design and manufacture remain in Japan, as do the project-engineering and the production and process skills that underlie competitive success the result of an implicit strategy of keeping the higher paying and higher value- added jobs in Japan. Then, for the sake of creating employment at whatever

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200 RICHARD W. WRIGHT AND GUNTER A. PAULI Japanese fimns have not tackled the financial services market through the mergers and acquisitions business this will be the last segment for theirs to attempt or through trust banking, because they are noted for their inex- perience in these sectors, both at home and abroad. Recognizing their limited know-how, they seek cooperative efforts in those areas. with the full sunnort of their ~oven~me.nt - . . - - Err -- - ~ _ c~ _ . ~ Rather, Japan's initial entry into the market for financial services has been mainly through government lending. (Refer back to the flowchart of Table 1 for the remainder of this discussion. ~ The appetite of governments for extra funds, their somewhat standardized approach to loan deals, and the high volume and price sensitivity of government lending, all provided the Japanese with sufficient justification to conclude that this was the place to start. Few competitors can satiate the cash needs of governments. In this highly price- sensitive market, the Japanese offered loans priced often only 1/16 of one percent over their cost of funds, quickly making them the favorite of gov- ernments the world over. The county of Los Angeles, for example, turned to the Japanese for a $250-million loan, as did the New York Job Devel- opment Agency for a $190-million loan arranged by Sumitomo. Japanese institutions always offer slightly better rates than any other banks, go for minuscule margins, and provide consumer satisfaction in much the same way they satisfied the person who bought his or her first Toyota at a discount price and got "hooked" on a quality product with a long-term warranty. , , ~ ~ ~ . . . Learning from Others With government lending well established for Japanese institutions, they have begun to join with foreign financial institutions in other segments of the financial services market, such as foreign exchange, stock exchange operations, and trust banking. They are actively acquiring expertise in much the same way that the information technology industry got a feel for the market through the OEM agreements. Meanwhile, behind the scenes, the Japanese government helps smooth the way wherever possible. For example, when trust banking was deregulated in Japan, the Japanese government required foreign entrants "to employ staff knowledgeable of Japanese trust business, particularly pension fund business." Yet how could any foreign financial institution have such expertise when the market had always been closed to them? With the traditional lifetime employment system and company loyalty in Japan, it was almost impossible for a foreign bank to hire away local experts. The only way to meet the requirement was to join forces with a Japanese trust bank: the foreigners offering their sophis- ticated know-how in return for an opportunity to participate in the market. Citibank teamed up with Yasuda Trust and Banking; Chase Manhattan and Manufacturers Hanover, with Daiwa Bank; J. Henry Schroeder Bank and

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INTERNATIONAL TRADE IN FINANCIAL SERVICES 201 Trust was bought by the Industrial Bank of Japan. The likely results were summed up succinctly by an American banker in Tokyo: "None of the foreign trust banks here are ever going to make much money, but the Japanese are going to learn everything there is to know about trust banking through the joint ventures." Branching Out At the same time, Japan's financial houses began building an impressive international infrastructure. In 1975 the Japanese banks had only 225 branches abroad, but by 1985 this had risen to 716, and these branches are well connected with their headquarters to secure efficient management of the operations worldwide. Sanwa, just to mention one, invested the equivalent of $8.4 million over the past two years in the Sanwa Overseas Banking Automation System. Here, once again, the intimate "family" relationships among companies within Japan's huge industrial groups play a central role. Financial institutions in Japan have immediate, proprietary access to state- of-the-art computer and communications technology from other industrial companies of their same group, rather than having to seek and acquire it at arm's length on an open market, as in the United States. This provides the Japanese financial houses a substantial edge in setting up an advanced tech- nology infrastructure. . Japanese financial institutions have also embarked on a dramatic series of acquisitions abroad to obtain new expertise and to gain market share. Their aggressive acquisition strategy has so far been limited in Europe to one particular case: the purchase of 52 percent of Banca Gottardo of Switzerland by the most profitable of the Japanese banks, Sumitomo. However, similar acquisitions are bound to occur as opportunities arise, particularly following the inevitable shakeout resulting from the recent "big bang" in London. Japanese moves to buy expertise and market share are much more evident In the United States. It is worthwhile enumerating some recent examples, because they provide insight into the bold strategy of the Japanese steps individually conceived and executed, although they all seem to form part of a major coordinated assault on the market: 1983: $475-million purchase of the Chicago-based commercial financing company Walter E. Helter by Fuji Bank; 1985: $520-million purchase of the Continental Illinois leasing subsidiary by Sanwa Bank; 1986: $500-million purchase of 12.5 percent of Goldman Sachs stock by Sumitomo Bank; 1986: $250-million purchase of the Bank of California by Mitsubishi Bank, which had previously acquired BanCal Tristate for $282 million; 1986: Bank of Tokyo purchase of California First Bank;

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202 RICHA RI) W. WRIGHT AND GUNTER A. PAULI 1987: Purchase by Nippon Life, the largest life insurance company in Japan, of a 13 percent stake in Shearson Lehman Brothers, the securities operation of American Express, for $538 million; and 1988: Nomura Securities' acquisition of a 20 percent stake in Wasserstein Perella, a leading mergers and acquisitions firm, for $100 million. The approach has been well targeted. Today, half of the 12 largest banks in California are Japanese owned. Seeking Greener Pastures Financial services closely related to banking and securities are next on the target lists of the Japanese. JCB, the dominant Japanese credit card, was launched in 1961 by Sanwa Bank when there were only 100,000 Japanese travelers abroad. It benefited for years by collaboration with American Ex- press. Today, with some four million Japanese traveling, JCB has abandoned the cooperative relationship with American Express and plans to compete with them directly. JCB is now represented in 30 countries with more than 25,000 outlets; within two years their infrastructure will spread over 60 countries and some 50,000 outlets. Leasing is still another area where the Japanese are drawing on expertise from others to expand abroad. Sanwa Bank led the way by enticing Dresdner Bank to join them in a joint venture with the Bank of China, for a major leasing firm based in Beijing. Japan's securities houses are expanding and diversifying even more ag- gressively than the banks. They have successfully obtained commercial bank- ing licenses in Australia, the United Kingdom, and Luxembourg; primary dealer status on the New York exchanges; and broad penetration of many smaller financial markets such as Amsterdam, Hong Kong, and Singapore. They were able to gain entry through well-crafted political moves and bilateral agreements, whereby the Japanese government offered certain inducements to foreign governments in return for major concessions to the Japanese houses abroad. A good example is the trade-off of two seats for British brokers on the Tokyo Stock Exchange, in return for a seat on the London Stock Exchange and a commercial banking license in London for Nomura Securities Com- pany. It is interesting to observe Japan's Ministry of Finance working so diligently to promote activities of Japanese financial houses abroad which would be prohibited to those same firms (as well as to foreign firms) by Ministry of Finance regulations at home. Future Steps Under the most likely scenario, we may expect soon to hear a crescendo of charges that the Japanese are "dumping" financial services. Indeed, the

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INTERNA TIONAL TRADE IN FINANCIAL SERVICES 203 chairman of Barclays Bank recently leveled an open accusation against them for doing just that. The Japanese are currently offering loans at only 1/16 percent over cost, and their fees for funds management are only 0.55 percent when the market standard is 1 percent. Pressure is mounting on governments in North America and Europe to negotiate "voluntary" restraint agreements with the Japanese in financial services, as was done in semiconductors and in textiles, steel, and automobiles before that. Also, just as with those other industries, protectionism in financial services will allow Japanese firms to raise their profit margins and to use the additional capital for extended joint ventures and straightforward acquisitions abroad, thus strengthening and fur- ther consolidating their global position in financial services. The expansion of Japanese global financial markets threatens North Amer- ican and European financial institutions. As long as governments, the con- sumer, and the sector concerned know that they have to face up to the Termite Strategy, it is possible to design effective counterstrategies. Unless U.S. and European policymakers understand this strategy, they will design the wrong policies, ask for protection that will not help, and seek cooperative arrange- ments that will result in the draining of national expertise. REASONS FOR CONCERN At first glance, it is easy for Americans and Europeans to shrug off or even to welcome the new Japanese competition in financial services. After all, if they are willing to supply us with large amounts of capital at cut-rate prices, why complain? Who isn't glad to get money cheaper? However, beyond that immediate boon to the consumer of funds, the potential con- sequences of Japanese dominance of global financial services are real and substantial. A first consequence is the obvious although often overlooked fact that the piper must eventually be paid. As the United States and other industrial- ized countries of the West move away from their traditional capital self- sufficiency or even capital export positions toward mounting external in- debtedness, so do their obligations for future payments of interest, dividends, principal, and service fees to foreign creditors mount relentlessly. Unless these payment obligations are matched by corresponding increases in real productivity a most unlikely prospect then more and more of our pro- ductive energy and that of future generations will be devoted to servicing external financial obligations. Moreover, as western economies become increasingly dependent on sus- tained financial support from outside sources, so they become more vulner- able to economic and political influences from abroad. Already, for example, the United States has largely lost its ability to manage domestic interest rates independently, for fear that lower rates would trigger a destabilizing outflow

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204 RICHARD W. WRIGlI T AND GUNTER A. PA ULI of Japanese investment capital. It is no exaggeration to say that the United States is becoming an "underdeveloping" part of the globe, slipping toward a position of financial dependence not unlike that suffered today by many lesser developed countries. Japan's influence goes well beyond government bonds and corporate securities. Business Week, in a recent survey, concluded that "Japanese companies are spending heavily to shape the way Americans view them.... The Japanese are also wielding political power from the grass roots to the top echelons of Washington" (Business Week, 1988~. Perhaps even more serious is the potential long-term threat to U.S. eco- nomic vitality and entrepreneurial spirit. As U.S. domestic financial insti- tutions fall increasingly under direct foreign control, which they will if current trends continue, the highest level, highest value-added financial skills- planning, strategy formulation, engineering complex financial packages, even finance-related technological developments will be increasingly centered in Tokyo or Osaka. Awareness and Complacency The worst enemy of the western economies is complacency. It is too easy to shrug off the Japanese financial challenge with the same platitudes used a decade ago as Japanese firms become increasingly important in manufac- turing industries, from watches and cameras to cars and information tech- nology: "It's a passing phenomenon"; "the Japanese can't really innovate"; "Japanese business is so culture-bound that it will quickly flounder outside of its homeland"; "U.S. and European managers are innovative enough to keep ahead of them." The growing Japanese presence in financial services may bring short-term economic and political benefits, but it also can have far-reaching implications in the longer run on national trade balances, the quality of employment, and national innovative abilities. Japanese firms do not often publicize their strategies and their competitive successes as western firms are prone to do. They prefer to keep a low profile; thus their expansion moves go unnoticed. However, it is time for western business and government leaders alike to open their eyes to the challenge of Japan's second wave, to acknowledge that there is a major new competitive challenge, and to reshape their com- petitive strategies accordingly. DESIGNING EFFECTIVE RESPONSES Our discussion of the Japanese strategy has identified some key organi- zational technologies and competitive elements underlying the success of Japan's financial services firms. Among the most significant are: (1) access to very large amounts of capital at very low cost; (2) stable, well-educated,

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INTERNA TIONAL TRADE IN FINANCIAL SER VICES 205 highly-motivated work force; (3) an ability of corporate managers to plan and target resources effectively; (4) a long-term profit horizon permitting Japanese firms to focus on long-term price-cutting and other market-share competitive strategies, rather than short-term profit; (5) large, stable internal markets and customers, through the keiretsu group relations; (6) direct access to state-of-the-art electronic and communications technologies, again through direct, proprietary access to other firms in their keiretsu groups; (7) government policies that both protect the home market and actively promote the position of Japanese financial institutions abroad. Some of these advantages clearly stem from cultural factors and institu- tional relationships that cannot be replicated readily by others. Nevertheless, U.S. and European financial institutions still hold a firm lead over the Jap- anese in many high-value-added areas of financial services. With careful responses on the part of both the financial institutions and governments, there is much that can be done to maintain U.S. and European leads in those areas and strengthen the general competitive position of western institutions. Creating a Competitive Edge Once western financial houses shed their complacency and accept that they indeed face a crisis, their first critical need is to define their strengths: the areas where their productive resources can be focused most profitably for the future. One of the great strengths of Japanese managers is their ability to target their competitive energies, focusing on specific niches where their potential strengths are greatest or where their competition is weakest. There are many high-value-added financial activities in which western financial institutions still have a clear-cut edge over the Japanese: trust banking, port- folio management, venture capital, mergers and acquisitions, swap arrange- ments, and engineering complex financial packages, to name a few. Given limited resources, North American and European managers should direct their energies toward these and other new niches that will certainly arise in the highly fluid environment of international finance. Keeping a step ahead of the competition will mean constantly scanning, innovating, and targeting new directions. U. S . and European financial houses certainly are creative enough to do this. After all, nearly all the significant innovations in financial services to date have originated outside Japan. The real challenge will be to shift quickly to the new, high-value-added activities as they open up, even at the cost of relinquishing portions of our more traditional markets. This will be difficult, as it will require Reemphasizing or even abandoning some familiar activities and markets in which both in- stitutions and individuals have strong vested interests. Nevertheless, the only alternative to focused change is to continue serving traditional markets behind increasingly restrictive protectionist legislation, raising the cost to consumers and ultimately eroding competitive abilities even further.

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206 RICHARD W. WRIGHT AND GUNTER A. PAULI Although better targeting will help, there is also more that managers can do to attend to the needs of their customers. Western firms cannot realistically hope to compete head-on with the Japanese giants in price competition: they lack access to the supplies of low-cost funds of the Japanese; and the demands of American shareholders and creditors for short-term profit performance preclude most financial houses from sustaining for substantial periods the low earnings that price-cutting usually implies. To compete with Japanese institutions, western financial firms will need to focus more on relationship services aimed at client loyalty, rather than on transactional services sus- ceptible to price competition. What this boils down to is a more market- oriented approach to winning and holding the loyalty of customers, be they individuals or corporations. If financial institutions provide optimal service within a long-term framework of confidence, most customers will not turn their backs for a mere one-half or one-quarter percent. More can be done also in the internal management of U.S. and European financial institutions, particularly in human resource management. One of the main strengths of Japanese competitors is their low labor turnover and the extremely strong loyalty of their employees. Cultural differences clearly preclude the same degree of company devotion in most western societies. There is, nevertheless, a great deal that can be improved in recruiting, train- ing, job security, and employee participation that could help U.S. and other western companies improve their long-term productivity. One of the greatest competitive strengths of U.S. and European institutions is a proven level of creativity and entrepreneurship. The ability to motivate personnel through new approaches, such as profit-sharing schemes that give larger numbers of employees a feeling of partnership and shared accomplishment, can be a key determinant of success in countering the challenge of the second wave. Building and maintaining an effective competitive edge will require also a significant reorienting of western shareholders and investors. The relentless demands placed on western financial institutions for short-term profit per- formance constitute one of the most serious handicaps in facing the Japanese. Whereas the best route to meeting the Japanese challenge is clearly not to try to match their price competition head-on, western financial services com- panies could nevertheless compete much more effectively if they were able to develop strategies based on long-term growth and market-share consid- erations, just as the Japanese do, thus enhancing their ability to engage the Japanese on their own terms where appropriate. Organizational Linkages At the same time western financial houses face growing competitive pres- sure to specialize their focus into niches of comparative advantage, they face seemingly contradictory demands for greater diversification of the services they offer. It is clear that consumers of services increasingly seek "one-stop

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INTERNATIONAL TRADE IN FINANCIAL SERVICES 207 shopping," i.e., financial services centers capable of providing a broad range of services, from straight financial loans and deposits to equity trading, insurance policies, currency swaps, and travel services. Japanese financial service institutions are diversifying rapidly to meet this demand, achieving economies of scope as well as of scale. Few individual western companies are yet equipped to provide such a broad range of services efficiently, re- gardless of size. One appropriate response is to form linkages with other home-based fi- nancial institutions offering complementary high-value services. This need not be done through formal mergers or acquisitions. Indeed, the recent spate of mergers and acquisitions in western financial services industry based more on leveraging balance sheets with undervalued assets than on any market strategy guided by complementarily has sapped the vitality of many com- panies by tying up huge amounts of capital in nonproductive stock purchases, as well as by demoralizing the organizations involved and causing a flight of personnel. What is needed, instead, are informal alliances among firms offering complementary financial services- i.e., banks, insurance compa- nies, brokerage houses, foreign-exchange specialists all linking up con- tractually to provide their own specialized services in combination with others. Such alliances will facilitate integration of financial services and the fusing of technology, thus improving both efficiency of the companies and services for their customers. The resulting increases in scale, scope, and efficiency can provide a substantial counterweight to the Japanese onslaught. A related type of alliance is with other cash-based service companies such as retail stores, aimed at securing access for financial services to new mass- distribution and even electronic-distribution channels. Such alliances help bring organizational economies of scale to the firms involved, increasing their productivity and better serving the convenience of their customers. Again, we have only to look at the highly diversified keiretsu groups in Japan to see how successfully diversification through collaboration among complementary, like-minded companies can enhance international compet- itiveness. Even more far-reaching may be cooperative working relationships among potential competitors of different nationalities, including the Japanese them- selves. In other words, one approach is to combine U.S. financial skills and marketing expertise with Japanese access to capital and placement channels, to provide the most efficient possible symbiotic combination of comparative advantages. At first glance, the idea of forming alliances with competitors may seem preposterous, but that is exactly what is happening in some man- ufacturing sectors, most notably automobiles. Who would have thought a few years ago that we would ever see the networks of global working alliances that exist today between General Motors and Toyota, for example, or among Nissan, Volkswagen, and Alfa Romeo? The important point here is that it

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208 R1ClIARDW.WRIGHTANDGUNTERA.PAULI is possible to achieve mutually productive working relationships on an in- ternational scale on the basis of cooperative agreements short of formal mergers or acquisitions, thus helping to maintain the independence and in- tegrity of each of the participating companies. A striking example of this collaborative potential between Japanese and westerners in financial services is American Express Company's recent sale of a 13 percent stake in its Shearson Lehman Brothers securities operation for $538 million to Nippon Life Insurance Company (Financial Times, 1986 and 19871. This follows Sumitomo Bank's earlier purchase of a 12.5 percent investment in Goldman Sachs for $500 million (although the latter deal excluded a direct equity link). The latest move brings together some of the most massive players in the financial services industry: American Express is one of the world's largest international financial services conglomerates; Nippon Life is the largest of Japan's huge insurance companies; and Shearson is the third-largest Wall Street investment bank. In a smaller but equally significant move, giant Nomura Securities Company paid $100 million for a 20 percent stake in Wasserstein Perella, a leading mergers and acquisitions specialist, moving the Japanese for the first time into the highly sophisticated mergers and acquisitions business (The Economist, 1988~. The trick in such cross-national collaborative arrangements is, of course, to ensure that the long-term gains to the two sides are really balanced. Too often in the past, such arrangements appear to have helped the Japanese gain significant competitive advantages by giving them access to valuable skills, while offering their U.S. and European partners little in return except short- term infusions of capital or potential market access of dubious value. A recent Harvard Business Review article (Reich and Mankin, 1986) on col- laborative arrangements with Japan concludes that The big competitive gains come from learning about . . . processes and the result of the new multinational joint ventures is the transfer of learning from the United States to Japan. There are indications that westerners are beginning to scrutinize much more carefully the trade-offs involved in collaborative arrangements with the Japanese. A major objective of Sumitomo's acquisition of 12.5 percent of Goldman Sachs to acquire skills in investment banking was thwarted, for example, when U.S. officials refused to permit Sumitomo to send trainees to Goldman's New York offices, on the grounds that such activity would violate the statutory separation of commercial and investment banking. Government Policies By identifying and pursuing new profit opportunities, by attending better to the needs of both customers and employees, and by forming effective

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INTERNA TIONAL TRADE IN FINANCIAL SERVICES 209 alliances with other services companies both at home and abroad, U.S. and European financial services firms can do much more to develop client re- lationships that are strong and loyal. Yet to sustain any real competitive edge, the private sector needs one other vital ingredient that Japan's banks and securities companies can safely rely on: a sympathetic and supportive gov- . ernment policy environment. This emphatically does not mean protectionism. It is clear from earlier attempts to cope with Japanese manufacturing competition that protectionism is not a viable long-run solution. Artificial barriers imposed by the United States against the import of low-priced Japanese semiconductors will be ultimately counterproductive to U.S. competitiveness in the higher value- added end of the inflation technology market, where U.S. firms still remain competitive. Similarly, the United States, which remains at the forefront of many high-value financial functions, has far more to lose than to gain from restricting the international flow of financial services. Instead, western governments should continue deregulating financial ser- vices at home, facilitating greater efficiency in their domestic firms. Recent moves in this direction by Canada and the European Community are en- couraging; but the United States lags far behind. Regulations limiting branch banking, and most particularly provisions of the Glass-Steagall Act, which segment the various types of financial services activities, handicap financial houses from achieving the scale and scope of activities needed in today's global competition. They are counterproductive and should be removed. western governments and again, Americans in particular will almost cer- tainly need also to relax current antimonopoly legislation to encourage the kinds of interinstitutional cooperation needed to square off against the con- centrated strength of the Japanese. At the same time, the U.S. government must continue striving to bring about the "level playing field" needed if U.S. institutions are to compete abroad on an equal footing with foreign competitors. This means, above all, continued relentless pressure on the Japanese government to allow foreign firms the same access to Japanese financial markets that Japanese houses enjoy abroad. Significant steps have been taken to open the Japanese market, but major differences of opinion remain as to what reciprocity actually means. U.S. financial services firms claim correctly" that Citicorp and Merrill Lynch are not permitted to do in Tokyo what Dai-Ichi Kangyo and Nomura can do in New York. The Japanese politely respond that they treat a Merrill Lynch in Japan exactly as they treat a Nomura: according to the Japanese book of rules. Finally, the U.S. government needs to do more to make accessible to U.S. firms the ultimate competitive advantage: low-cost capital. Current govern- ment fiscal policies, especially massive government deficit spending, serve to drive up interest rates in the United States, increasing the cost of capital

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210 RICHARD W. WRIGHT AND GUTTER A. PAULI to U.S. financial services houses and undermining their global competitive- ness. Monetary and fiscal policies leading to low inflation and low interest rates will ultimately be more helpful than any amount of protection or sub- . . SIC lest CONCLUSION Meeting the challenge of Japan's second wave will require bold new approaches by financial houses and governments alike, and most important, it will require an extraordinary willingness on the part of private and public sectors to work together. There is no clear-cut formula or set of steps that westerners can take to counter the Japanese challenge in financial services. However, by being aware of the Termite Strategy of what is happening, where the Japanese are likely to go, and how they intend to get there U.S. and European institutions can better prepare themselves to shape appropriate competitive strategies for the future, not only with respect to the immediate financial threat, but also with respect to the broader emerging challenges of international trade in services. REFERENCES Business Week. 1988. Japan's influence in America. (July 11):64-75. Echo de la Bourse. 1987. The brokers (April 23). The Economist. 1986a. Richer than you. (October 25):13-14. The Economist. 1986b. Topsy-turvy. (March 22):15. The Economist. 1988. Big wheels, small deals (July 30):78. Euromoney. 1985. Who's doing business. (August): 151. Financial Times. 1986. Nippon Life to pay $350m for Shearson stake (March 20). Financial Times. 1987. American Express hunts for a global advantage (March 25). Hector, Gary. 1986. The Japanese want to be your banker. Fortune (October 27):97. Reich, Robert B., and Eric D. Mankin. 1986. Joint ventures with Japan give away our future. Harvard Business Review (March-April):78. Time. 1986. Money masters from the East. (August 11):31. Time. 1988. Yen power goes global.(August 8):20-23. Wright, Richard W., and Gunter A. Pauli. 1988. The Second Wave: Japan's Global Assault on Financial Services. New York: St. Martin's Press.