(FORTUNE Magazine) – THE BOOM YEARS masked the squalor. From 1985 to 1989, Japan's stock market rose by 197%. Brokers and bankers were swimming in profits. To outsiders, at least, Japan's financial system seemed an exemplar of sound business practice. Now the market is down, way down, and the picture is decidedly less pleasant. Says Peter Tasker, a strategist at Kleinwort Benson in Tokyo: ''When the tide goes out, you see what's left on the beach.'' Stretched across Japan's financial landscape is an endless string of payoffs, mobster dealings, and pervasive fraud. The scandals have led to high-level resignations and loud cries for reform. But Japanese officials have been reluctant to order fundamental changes for fear of upsetting a financial system that has been so spectacularly successful in providing cheap capital to Japanese industry. Yet it is precisely because of that success, and the resulting growth in the size and complexity of Japan's markets, that the country needs so urgently to recast its regulatory framework. Its financial institutions, though enormous, are still operating as if they were alone in the world, with no global competitors. That's not so bad for Western financial firms, who in the short run will continue to grab business in Tokyo. But if Japan's giants continue to operate under outdated regulations, fraud and abuse are bound to increase. And if global investors lose confidence in Japan, nobody wins. The latest revelations -- which involve far more than the stock market -- show just how wide and deep the problem has become: -- Sumitomo Bank, Japan's second largest, lends over $1 billion to Itoman, an Osaka trading company headed by a former official of the bank. In early 1990, Itoman falls under the influence of unsavory characters and squanders nearly $2 billion in shady deals. Disgraced in part by the bank's links to Itoman, Chairman Ichiro Isoda resigns. This summer, three Itoman executives, including the former president, are arrested. -- Two of the country's top brokers, Nomura Securities and Nikko Securities, acknowledge having lent more than $250 million to a well-known underworld organization. Nomura Chairman Setsuya Tabuchi is forced to resign as a vice chairman of Keidanren, Japan's prestigious business association. -- Tax authorities leak information that Nomura and Nikko have been secretly reimbursing big clients for stock market losses. Nomura's top two executives resign, as does Nikko's president. Many other brokers are soon implicated. -- A Tokyo restaurateur, an actor, and some 20 companies borrow $1.9 billion from a number of financial institutions including Fuji Bank using fraudulent deposit slips as collateral. Toyoki Kobayashi, an aide to Finance Minister Ryutaro Hashimoto, helped persuade Fuji Bank to make some of the loans. Kobayashi resigns in August. An embarrassed Hashimoto may soon follow. -- Nui Onoue, 61, a mystic and restaurateur in Osaka, talks a branch manager at a local credit union into forging deposit slips for her. She uses the slips, later described by officials as clumsily made, to borrow about $1.7 billion from 12 institutions, including the prestigious Industrial Bank of Japan. Officials at Japan's Ministry of Finance, which regulates the nation's banks, are astonished at the magnitude of the fraud. Scandal is certainly nothing new to global financial markets. Look at Salomon's transgressions in the U.S. Treasury market (see preceding story), Germany's insider-trading furor, or even Drexel Burnham's long rap sheet of securities law violations. The situation in Tokyo, however, is more a systemic failure than the result of occasional outbursts of greed. As with most things in Japan, the explanation is not simple. Many of the recent headline-grabbing scandals are not even illegal under Japanese law. Payoffs from big brokers to clients are a violation of U.S. securities laws, but not of Japan's. Nor is it illegal for a broker or banker to handle hot money from gangsters, as it is in the U.S. Said a senior Japanese official to the swarm of reporters who pressed him on this matter: ''Gangsters have rights too.'' The lack of legal boundaries is a Japanese hallmark. Without clear rules to guide them, businesses are forced to rely on the country's ministries to steer them through the legal haze. The result: no public confrontations, just quiet suggestions from bureaucrats and quick compliance by companies. In the case of the Ministry of Finance, known as MoF, legal vagueness has been combined with tight regulation, which only seems like a contradiction. The MoF drew strict boundaries on what lines of business financial firms could engage in, but aside from setting fees and interest rates made few laws governing how they could operate within those limits. When the ministry devised its postwar plan, it decided not to leave the financial industry's development to the whims of competitive market forces. It limited how much banks could lend and to whom, and set interest rates as well. On the brokerage side, it fixed commissions at a fat premium to ensure the brokers' financial strength. In the 1960s it established licensing to control the number of firms. THE U.S. ONCE IMPOSED similar restrictions, including fixed brokerage commissions. But American regulators, eager to make the industry more competitive and efficient, opted for deregulation in the early Seventies. Such a need for efficiency has been building in Japan for a long time, but officials continue to follow a different agenda. Notes Robert Zielinski, an analyst at Jardine Fleming: ''Above all else, the financial markets are intended to provide a cheap source of financing for industry. That's MoF's priority.'' Kenneth Courtis, an economist and strategist at Deutsche Bank Capital Markets in Tokyo, puts it another way: ''In Japan, the stock market has been an instrument of policy rather than an object of policy.'' The distinction is important. American policymakers have responded to consumers' desires for a low-cost, efficient market, while Japanese officials have used the stock market to meet industry's need for low-cost financing. The MoF's tight controls have kept Japan's markets orderly, and the cost of capital low. But they have also created inequities among participants, which has opened the door to abuse. Take the brokerage industry. As the stock market spiraled up in the late 1980s, the big four brokers (Nomura, Daiwa, Nikko, and Yamaichi) filled their pockets with high, fixed commissions. As profits piled up, clients sought ways to recover some of that windfall. Says one Western broker in Tokyo: ''It seems quite reasonable to assume that if you are a big customer, and you know you're being overcharged on some things, like commissions, that you might look to get it back somewhere else.'' SO THEY DID. Big institutional investors began demanding guaranteed results. Flush with profits, and enjoying the rising market, brokers readily agreed, many promising returns as high as 8%. That was no problem until the stock market dropped, triggering huge compensatory payments -- and eventually scandalous publicity. The MoF's regulatory grip on the market has also stunted the maturation of major firms. Says Zielinski: ''Despite its size, this remains a very primitive market.'' The big four brokers account for nearly three-quarters of the new issue and equity underwriting business on the Tokyo exchange's first section, the equivalent of New York's Big Board. But by many accounts, they remain relatively unsophisticated. Their research, for instance, is often superficially bullish. This has hampered their efforts in the U.S. and Europe. At home, foreign firms are stealing market share and outperforming them as money managers. Also, by relying too heavily on MoF for legal guidance, they have failed to develop strong internal controls. Says David Pike of UBS Phillips & Drew in Tokyo: ''Japanese brokers don't understand the concept of conflict of interest. To them, any business is good business.'' No firm better symbolizes the high cost of such a protected environment than Nomura. With $8.5 billion in revenues in 1990, it is the largest brokerage in the world. Yet the company $ has long drawn allegations of insider trading, which it denies. Nomura's new chairman, Yukio Aida, is philosophical about his company's tainted image and the need for reform. Though the recent acts do not technically violate Japanese law, they are counter to common business ethics. Says he: ''Nomura is like a stream. Lately the stream has become dirty. We must make the water clean again.'' Few believe that Japan's life insurers and banks are any less polluted. The head of one Western brokerage firm that services some of Japan's big life companies gives a glimpse into their operational ethics: ''The life companies asked us to manipulate prices and trades so that they could shift some of their losses into next year. What they were asking us to do would be considered outrageous by Western standards.'' As for the banks, consider those two incidents involving fake deposit slips. Would any U.S. institution with even modest internal controls have fallen for such major fraud? Perhaps most worrisome, the lack of sufficient controls on the financial markets has left them vulnerable to penetration by the Yakuza, Japan's mob. Yakuza members often appear like characters out of Dick Tracy, with their broad pin-striped suits, elegant tattoos, and clipped pinkies (cut off to atone for violations of the gang's code of conduct). They are tolerated by the police, who let them run prostitution, gambling, and loan-sharking with little interference. But in the 1980s the Yakuza stepped beyond their traditional businesses into the financial markets. They have been accused of establishing links with brokerage firms in order to manipulate stock prices. The mobsters have also bought into companies, then demanded that managements buy them out at a fat premium, backing up their demands with physical threats -- Yakuza greenmail. The emergence of the Yakuza in Tokyo's financial system is one important reason why Japan needs to get serious about controlling its markets, first through passage of new laws and then through rigid enforcement. Prime Minister Kaifu has called for the creation of a U.S.-style Securities and Exchange Commission. While the SEC provides no guarantee against fraud or abuse, it is a solid first line of defense. The American Occupation did set one up, but the MoF abolished it in 1952 to consolidate its power over the markets. A new, independent Japanese SEC is a good idea. FINALLY, Japan needs a big dose of the kind of competition that deregulation would bring -- both among Japanese firms and from outsiders. Who can be surprised that clients expect a kickback from brokers when they are forced to pay inflated commission rates? So too, who can be surprised that Japan's big brokers have failed to develop into competitive worldclass firms? While feasting on high domestic commissions, they had no reason to. Says the head of the Tokyo office of one Western brokerage firm: ''Japanese brokers are out of touch, out of date, and the trend is moving against them.'' A system of negotiated rates in Japan would force them to become more professional and competitive -- both at home and abroad. The combination of less regulation and greater surveillance is the formula that Japan needs if it truly intends to modernize -- and clean up -- its financial industry. U.S. lawmakers forgot the second part of the formula when they deregulated the savings and loan industry. Without stiff, objective surveillance, deregulation runs amok. If Japan takes any lesson from America's lead in financial deregulation, it should be that.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: THE PARTY'S OVER The big decline exposed the problems.