NBER WORKING PAPER SERIES SORTING OUT JAPAN'S FINANCIAL CRISIS Anil K. Kashyap ...

16 Pages·2002·0.23 MB·English

NBER WORKING PAPER SERIES
SORTING OUT JAPAN’S FINANCIAL CRISIS
Anil K. Kashyap
Working Paper 9384
http://www.nber.org/papers/w9384
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
December 2002
I am grateful to the University of Chicago Stigler Center and the Houblon-Norman Fund for research support.
Parts of this paper draw heavily on “Japan’s Financial Crisis: Priorities for Policymakers” that appeared in
Fixing Japan’s Economy (Japan Information Access Project). I thank the JIAP for permission to reproduce
that work. I am grateful to Robert De Young for providing the U.S. figures shown in Table 1. I thank David
Atkinson, Tim Callen, Takeo Hoshi, Jakob Lund, Joe Peek, Paul Sheard, Reiko Toritani, and especially
Mitsuhiro Fukao for helpful suggestions and comments on earlier drafts of the paper, however, I am
responsible for any errors. I also thank the experts who are listed in Table 2 for allowing me to publish their
estimates. Forthcoming in Federal Reserve Bank of Chicago Economic Perspectives 4th quarter 2002, pp. 42-
55. http://www.chicagofed.org/publications/economicperspectives/index.cfm. The views expressed in this
document are not necessarily shared by the Federal Reserve Bank of Chicago, the Federal Reserve System
or the National Bureau of Economic Research.
© 2002 by Anil K Kashyap All rights reserved. Short sections of text not to exceed two paragraphs, may be
quoted without explicit permission provided that full credit including, © notice, is given to the source.
Sorting Out Japan’s Financial Crisis
Anil Kashyap
NBER Working Paper No. 9384
December 2002
JEL No. G28, G21, G22, O16
ABSTRACT
This paper makes three contributions. First, I report information on the size of the Japanese
financial crisis. Drawing principally on work by Fukao (2003) and Doi and Hoshi (2003) I estimate
that the current taxpayer liability for losses incurred but yet to be recognized is likely to be at least
24% of GDP. Second, I explain why it has been so difficult to end the crisis. Third, I sketch the
likely ingredients of what will be required to successfully resolve the crisis. The overarching
principle is that Japan’s banks, insurance companies, and government financial agencies all suffer
different problems and require different solutions. But all three sectors are connected, and a failure
to tackle concurrently the problems of all three promises to doom any reform plan.
Anil K. Kashyap
Graduate School of Business
University of Chicago
1101 East 58th Street
Chicago, IL 60637
and NBER
[email protected]
Sorting out Japan’s financial crisis
Anil K Kashyap
Introduction and summary lease of the document had to be delayed multiple times.
In this article, I explain why a quick resolution to
Over the last decade, the Japanese economy has
this problem has not been possible. My central theme
underperformed dramatically—growing an average
is that the financial crisis is sufficiently broad and deep
of 1.1 percent per year versus 4.1 percent per year in
that the necessary institutional changes cannot be ini-
the previous ten years. At the same time, the country’s
tiated or implemented immediately. Nonetheless, many
financial system has fallen into disarray. Recently, the
of the ingredients of what will be required for a success-
debate over how to address the financial sector prob-
ful resolution of the problem are clear. The overarch-
lems and the role that this should play in Japan’s eco-
ing principle is that Japan’s banks, insurance companies,
nomic policy have come to the fore. For instance, the
and government financial agencies all suffer from dif-
International Monetary Fund’s (IMF) 2002 Japan coun-
ferent problems and require different solutions. But
try report proposes a four-part program to address the
all three sectors are connected, and a failure to tackle
decade long economic slump and to end the current
concurrently the problems of all three promises to
deflation. The first pillar of the program is to “deal
doom any reform plan.
decisively with financial sector weaknesses.”
In the first section, I review the macroeconomic
In September, the Bank of Japan (2002a) announced
factors that have caused the problems that are now
an unusual policy initiative, whereby it would begin
evident in the Japanese financial sector. Poor macro-
buying equities that were held by banks. In announcing
economic performance is central to the story, and in
this decision, the bank pointed to the importance of
this environment some strains on the financial system
resolving the nonperforming loan problem. It stated
were inevitable. But I show that macroeconomic con-
that “in order to resolve the overall problem, a compre-
ditions alone cannot account for the problems. Instead,
hensive and tenacious approach is needed, centering
one must also account for a host of sector-specific con-
on a more appropriate evaluation of nonperforming
siderations. In the next three sections, I review the chal-
loans, promotion of their early disposal, and efforts
lenges facing the reform of the banks, the insurance
towards higher profitability on the part of both firms
companies, and the government financial institutions.
and financial institutions.”
For each of the three, I provide some estimates on
The debate came to head when Prime Minister
the size of the losses and then explain what will be re-
Junichiro Koizumi replaced his financial services min-
quired to stop them from continuing.
ister and promised that he would deliver a plan for the
Two primary conclusions emerge. First, the likely
accelerated disposal of banks’ bad loans. The new finan-
cost of the financial problems to the taxpayer is huge:
cial services minister, Heizo Takenaka, promptly formed
My rough estimate of the lower bound for the full
the Financial Sector Emergency Response Project Team
cost is approximately 24 percent of Japanese gross
to study the bad debt problem, with a promise that the
domestic product (GDP). Second, the interaction of a
task force would issue an interim report within several
number of factors contributes to delaying the resolu-
weeks and a full report within a month. Yet, when the
tion of the problems. This delay could easily raise the
interim report was circulated in advance of its formal
costs of resolution.
release, the report’s analysis and recommendations were
heavily criticized by a number of politicians, and the re-
1
Role of macroeconomics in the
FIGURE 1
financial crisis
Japanese GDP growth 1956–2001
The combination of slow growth and
millions
the decline of the aggregate price level
15
have each contributed to Japan’s financial
crisis. The single most important problem
12 1956–73 average
for the financial sector has been the ane-
(9.2%)
mic growth of the Japanese economy over
9
the last decade. Figure 1 shows GDP
growth over the last 45 years to put re-
cent performance in context. After aver- 6
aging more than 3.8 percent between
1974–91 average
1974 and 1991, growth dropped to 1.1 3 (3.8%)
percent over the last decade. Obviously, if 1992–2001 average
there had been more growth in the 1990s, 0 (1.1%)
the financial sector would be in better
shape now. -3
The more challenging question is
how much the financial sector problems
-6
themselves independently contributed to 1956 ’61 ’66 ’71 ’76 ’81 ’86 ’91 ’96 2001
the growth slowdown. A full answer to
this question is beyond the scope of this
article, but even without resolving it, it is
financial institutions are undercapitalized. This is im-
safe to conclude two things about the interplay be-
portant because it suggests that merely throwing money
tween the financial sectors problems and growth.
at the banks will not resolve the crisis.
First, it is implausible to argue that the decline in
Determining the appropriate policies to address
stock and land prices at the beginning of the 1990s
the problems is difficult. Bank of Japan officials have
can be blamed for the financial sector problems today.
often alleged that monetary policy is impotent because
This simple explanation fails because the banks and
of the banking problems (see, for example, Hayami,
government financial institutions continue to make
2002). While it is true that standard open market op-
losses on new loans today. Therefore, the crisis cannot
erations will not be stimulative if banks will not lend,
accurately be described as merely delaying the recog-
this by no means impairs other types of monetary
nition of bad news. While the asset price collapse may
policy actions. For instance, the proposal by Svensson
have triggered the problems, it cannot be blamed for
(2001) for the Bank of Japan to stimulate the economy
their continuation at this point. This is an important
through foreign exchange intervention is in no way
conclusion because it suggests that ending the crisis
compromised by the banking problems.
will require substantial changes in the financial insti-
On the other hand, without a functioning system
tutions’ operating practices.
of financial intermediation, there are limits as to how
Second, recapitalizing the banks (and insurance
successful nontraditional monetary policy actions will
companies) would not be a sufficient step to restore
be. As growth resumes, government money will be
growth. The banking problems reflect the poor
needed to combat some of the insolvencies that are
conditions of their borrowers. Putting capital into banks
hampering normal financial intermediation. There is
to make up for past losses would be pointless if the
a wide range of estimates of the degree of insolvency
underlying corporate problems are not addressed. As
in the banking industry. But, even without settling the
Caballero, Hoshi, and Kashyap (2002) emphasize, the
issue of how much it would cost to rehabilitate the
growth problems today cannot be due solely to a lack
banks, it is possible to identify many rescue arrange-
of solvent financial institutions. There have always
ments that would be counterproductive in virtually
been international banks (and insurance companies)
all potential scenarios. Later in this article, I highlight
operating in Japan, and the number rose substantially
many of these poor choices and give some loose bounds
as a result of the so-called “Big Bang” deregulation
on the costs of better alternatives.
that was completed in April of last year. These foreign
The second major macroeconomic problem has
firms are solvent but are choosing not to lend much
been the deflation that has accompanied the slow growth.
in Japan. So the problem is not just that the domestic
2
As I explain below, the deflation has played a central these losses by recognizing capital gains on long-held
role in the problems of the insurance companies. stocks and land. But at this point, there is little more that
Besides this well-documented and widely discussed can be squeezed from these sources. As table 1, row I
effect, the deflation independently has had three per- shows, since 1995 the banks have recorded net losses
nicious effects on the banking sector. in more years than not. Cumulating the loan loss fig-
First, as stressed by Fukao (2003), the deflation ures in table 1 (row F) shows that the banks have re-
squeezes banks profitability. Since nominal interest rates corded losses of roughly ¥83 trillion (16.5 percent of
cannot go below zero, there is a floor on the cost of the current Japanese GDP) since 1992.1 According to Ja-
banks’ funds. Even with zero interest rates, depositors pan’s Financial Services Agency (FSA), this includes
may be getting higher real returns than the banks would over ¥32 trillion in outright write-offs! Yet the losses
like to pay. But the banks face competition in lending are expected to continue for the foreseeable future.
and, consequently, limits on how much they can charge As noted earlier, these losses are too large and per-
their customers. With falling prices, banks find it dif- sistent to be blamed solely on the rapid decline in asset
ficult to charge more than 1 percent or 2 percent inter- prices at the beginning of the 1990s. Indeed, as the Bank
est on their loans (since the inflation-adjusted interest of Japan (2002b) has pointed out, since 1990 the banks
burden is much higher). With deflation, the gap between have disposed of more than ¥90 trillion, which amounts
funding costs and lending rates is not sufficient for to 80 percent of the increase in loans between 1986 and
the banks to make money. If the inflation rate were pos- 1990. Thus, it is implausible to suggest that the contin-
itive, the banks would have more room to maneuver. ued losses can be attributed to misguided lending de-
The low nominal rates that are charged to bank cisions during the late 1980s. Rather, they are indicative
borrowers also complicate the problem of regulating of deeper underlying problems facing the financial
the banks. With near-zero interest rates, almost all bor- services industry.
rowers can make their required interest payments. Only There are two complementary ways to analyze
when a loan matures, and the principal is due, can one the banks’ current problems that ultimately lead to
gauge the health of the borrower. Since regulators are similar solutions about what might be done to reverse
not necessarily privy to the negotiations that accom- their decline. One focuses on the banks’ current costs
pany a loan renewal, it can be difficult for them to spot and revenue structure, while the other looks at the
the problem borrowers. Japanese lenders often allow economic forces operating in the industry.
borrowers with no hope of repayment to continue to
Flow profitability problems
operate (see Peek and Rosengren, 2002). If interest rates
The first approach puts the emphasis on the fail-
were 3 percent or 4 percent higher, then many of these
ure of the banks to generate enough revenue on their
“zombie” borrowers would soon be unable to service
loans and other assets to cover their funding and operat-
their debts. The regulators would then be able to easily
ing costs. To put this in perspective, the second panel
spot the deadbeat borrowers and pressure the banks
of table 1 reports U.S. data that are roughly comparable
to cut them off, before more money is lost.
to Fukao’s data for Japan.2 Despite the data limitations,
Finally, the deflation has meant that borrowers who
the comparison clearly shows that the Japanese banks
took out long-term loans at historically low rates of
suffer from several structural problems. One is the
interest (3 percent or 4 percent) have seen the inflation-
lack of profitability of their lending operations. The
adjusted burden of their debt grow. This is the converse
Japanese banks’ interest margin relative to assets has
of the more typical phenomenon, whereby borrowers
hovered around 120 basis points. The U.S. figures
benefit from unexpected jumps in inflation at the
(which include both fees associated with the loans and
expense of lenders. One of the clear benefits from a
interest revenue) are roughly three times as high—far
more expansionary monetary policy would be to re-
too big a difference to be attributable to the differences
verse the increasing debt burdens.
in measurement.
Banking sector problems Fukao notes that if the deflation were to stop, then
the banks could raise nominal interest rates without
I begin the sector-specific analysis by analyzing
raising the real interest burden for borrowers. But there
the condition of the Japanese commercial banks. The
are limits to how much this could be expected to help.
most thorough, up-to-date analysis of banks available
For instance, assuming, optimistically, that when the
in English is Fukao (2003). Panel A in table 1 reproduces
deflation ends the banks could raise their interest mar-
his key figures. As he stresses, the banking industry has
gin by 1 percentage point (say by increasing lending
not had a net operating profit since fiscal year 1993
rates by 2 percent and deposit rates by 1 percent), this
(table 1, row G). Until late in the decade, the banks offset
would add only another ¥5 trillion in interest margin.
3
1 8102945490066 7 7 1462981453790 6 3
200 9.3.7.3.5.9.–3.–2.–5.772.465.0.0070.4 0.012 0.759 10,8053,7318,7091,8645,8241,0004,824,4309,2554,5491,140.0160.420 0.032 0.578
– 212 1 1 145
6,3,
2000 9.43.07.13.45.36.6–1.31.40.1804.3 456.90.00010.48 0.0117 0.7581 200,814149,501212,72887,817137,58727,796109,791(2,293)107,498152,551704,6860.01750.4128 0.0333 0.5732
6,3,
9 7535934832418 2 7 5837082913024 3 4
199 9.2.7.3.4.6.–1.3.2.737.463.0.0030.4 0.013 0.801 89,6542,2301,8884,8730,0120,7509,251709,4390,1998,030.0190.420 0.033 0.571
112 1 1 163
5,3,
8 6156253497608 6 9 1823789983106 4 2
199 9.3.7.3.5.13.–8.1.–6.759.472.0.0090.4 0.012 0.755 80,6021,8092,2278,5310,1821,2188,963,1192,0810,9256,860.0170.408 0.033 0.597
– 111 1 41
5,3,
7 0600659620900 8 3 7695431672217 6 5
199 10.3.8.4.5.13.–7.3.–4.848.477.0.0050.5 0.011 0.735 72,6602,9468,3371,3207,2718,9188,361,8390,1989,6495,080.0180.423 0.034 0.626
– 111 1 98
4,2, H).
w
nks 1996 10.73.78.04.06.47.3–1.01.20.2856.0482.30.00020.50 0.0125 0.7406 161,17292,515159,24166,65994,44615,48378,9631,10880,0714,554,2342,736,6150.01760.4186 0.0354 0.6353 hich are in ro
TABLE 1 Profitability of Japanese and U.S. ba A. Japan (trillion yen, except last three rows) 199019911992199319941995 A.Interest income – interest expense7.18.99.89.29.710.8a2.62.22.52.82.13.3B.Other revenueC.Operating costs7.17.57.77.77.87.8D.Salaries and wages3.73.94.04.04.04.0E.Gross profit = A + B – C2.63.54.54.34.06.3F.Loan losses0.81.02.04.66.213.3G.Net operating profit = E – F1.82.52.5–0.4–2.2–7.0b2.00.70.02.03.24.4H.Realized capital gainsI.Net profit = G + H3.83.32.51.71.0–2.6J.Assets927.6914.4859.5849.8845.0848.2c424.3445.8460.3472.3477.8482.7Outstanding loansReturn on assets (I/J)0.00410.003600.00290.00200.0012–0.0031Labor costs/operating costs (D/C)0.520.520.520.520.510.51(Interest income – interest expense)/ assets (A/J)0.00760.00970.01140.01080.01150.0127(Interest income – interest expense)/ total income = A/(A + B)0.73200.80180.79670.76670.82200.7660 B. U.S. (millions of dollars, except last three rows) A.Interest income – interest expense114,948121,288132,872138,785145,999153,483B.Other revenue54,75959,48265,41174,70675,95281,956a C.Operating costs115,295124,233130,455139,204143,637148,936D.Salaries and benefits expenses51,55852,86154,58857,97760,36063,129E.Gross profit = A + B – C54,41256,53767,82874,28778,31486,503F.Loan losses (provisions)31,95334,15826,06116,75310,89212,411G.Net operating profit = E – F22,45922,37941,76757,53467,42274,092H.Realized capital gains4832,9714,0013,055(558)530I.Net profit (before taxes) = G + H22,94225,35045,76860,58966,86474,622J.Assets3,378,8593,420,4813,496,1203,695,8383,999,3544,299,278Outstanding loans2,045,8221,989,2291,969,9202,088,6262,296,9442,539,682Pre-tax return on assets (I/J)0.00680.00740.01310.01640.01670.0174Labor costs/operating costs (D/C)0.44720.42550.41840.41650.42020.4239(Interest income – interest expense)/ assets = A/J0.03400.03550.03800.03760.03650.0357(Interest income – interest expense)/ total income = A/(A + B)0.67730.67100.67010.65010.65780.6519 aIncludes all other profit, such as trading for own account and fees, but excludes capital gains realized from stock and real estate sales (wFrom sale of stocks and real estate.b Domestic banks only.c Notes: Financial statements of all commercial banks. Data are for fiscal years, which end in March of following calendar year.Sources: Panel A, Fukao (2003); panel B, call reports, and author’s calculations.
4
While this might be enough to stop the banks’ losses, that the Mizuho Group and Mitsubishi Tokyo Finan-
they would still be far less profitable than their U.S. cial Group are the first and third largest in the world,
counterparts. respectively, and that 19 of the largest 100 banks in
Another problem is the Japanese banks’ high labor the world are Japanese. Yet, there are few if any prod-
costs. The banks have made some progress in reduc- uct lines for which the Japanese banks are world
ing salary and wage expenses from roughly 52 percent leaders. I find no examples where Japanese banks and
of operating costs to 46 percent. Although anecdotal their global rivals have competed for business on a
reports of overpaid and underutilized bank staff still level playing field and the Japanese banks have emerged
abound, the Japanese banks likely will have to increase as market leaders. Instead, the recurring pattern is that
pay to some workers if they want to upgrade compe- Japanese banks are later to enter markets or offer new
tency levels in order to increase fee- and commission- products and, consequently, their profitability lags.
based income. It is doubtful therefore that the Japanese The low levels of fee income alluded to earlier are
banks can push their salary expenses all the way down a particularly important reflection of this problem. As
to the U.S. level of about 42 percent of operating costs. Hoshi and Kashyap (2001) note, for the Japanese banks
Finally, while not evident in the table, it is also well in aggregate, fee and commission income as a percent-
known that the Japanese banks underinvested in tech- age of total income was essentially identical in 1976
nology during the last half of the 1990s. This has long and 1996; the U.S. banks during this period increased
been recognized as a problem. For example, although their percentage of fee and commission income by two-
a condition of government-provided funds offered to and-a-half times. This disparity partially was attributable
the banks in 1999 was that the banks had to improve to regulation that handicapped the Japanese banks. For
efficiency and reduce costs, the general cutbacks in in- instance, until 1998 the banks were simply barred from
vestment were not to be extended to investment in com- many activities, such as over-the-counter derivatives
puting and automation. Still, more than three years later, transactions, brokerage activities, and underwriting.
the concerns about poor computing operations persist. But even after the full deregulation that was com-
The failure of the Mizuho Group’s computers that pleted on April 1, 2001, the gap persists. The last row
occurred on the first day that the bank began operating in panel A of table 1 shows that the Japanese banks
could hardly have been more symbolic. Due to poor continue to make roughly 76 percent of their income
integration of the three merging banks’ antiquated (excluding capital gains) from their lending operations.
systems, the new bank’s computers failed. As a result, In contrast, U.S. banks make only 58 percent of their
the ATM network was unavailable, a number of auto- income from this low margin activity; instead they
matic payments were not made, and many customers bring in a much higher percentage of high margin fee
were double-billed for credit card transactions.3 The and commission businesses.4 Since these nontradition-
Bank of Japan subsequently had to order Mizuho to al products and the associated revenue streams are
upgrade its computing systems. central to the business strategies of most global banks,
Fukao reports that the main funds payment system this deficiency is a huge problem for the Japanese banks.
used by Japanese banks (zengin) is unable to handle two- Without making comparable profits in these areas, it
byte codes, and hence cannot transmit customer names is hard to see how the Japanese banks could ever
and messages in kanji (characters). This is one of the reach the same rates of return as their competitors.
reasons why convenience stores (that have typically One way to address this problem would be for
installed more sophisticated technology) have won Japan’s major banks to scale back on their operations
customers that would like to make an occasional and to focus on niche needs of Japanese customers
electronic payment at the banks’ expense. The zengin (mostly small and medium-sized businesses). Japanese
system is scheduled for an upgrade in April 2003, but banks might arguably be better than foreign banks
the banks will have to do much more if they want to operating in Japan in this product line. The loan demand
match the technological efficiency of many of their of these customers, however, is much lower than the
global competitors. assets of the current banking system; therefore, shift-
ing in this direction in order to raise profitability would
Japanese banks’ limited comparative advantage
imply considerable downsizing. But downsizing would
The alternative (and complementary) approach to
involve the release of many mid-career and upper level
analyzing the banks’ profitability problems is to look
managers, who might face significant hurdles in be-
at their product mix and ask which lines of business
coming reemployed.
can be expected to earn normal rates of return? The
A final, further impediment to the banks’ profit-
Japanese banks are among the largest in the world in
ability is the difficult competition that they face from
terms of assets. For instance, Agosta (2002) reports
5
subsidized government financial institutions. The postal much would it cost to make the banks solvent? I review
savings system poses a particularly big problem. As first the three main problems that plague attempts to
Fukao asks, how can the private banks make profits arrive at an estimate, before reporting the range of
when Japan’s government-sponsored postal savings estimates currently made by market participants.
system has 40 times the number of offices of the The first problem with this type of exercise is de-
largest banking group, pays roughly the same rate on termining the current level of losses associated with
deposits as the banks, and charges no maintenance fees? existing loans. The banks in Japan are known for their
The extra convenience of the postal accounts, combined propensity to under-reserve against recognized bad loans.
with the government guarantee of deposits, represents For instance, they have set aside reserves sufficient
a major challenge for the banks. to cover between 40 percent and 60 percent of bad
The government-subsidized Housing Loan Corpora- loans over the last few years, whereas U.S. banks tend
tion (HLC) also compromises the banks’ ability to make to hold closer to 160 percent in reserves (Fukao, 2003).
money through home mortgage lending. The HLC re- By Fukao’s estimate, the banks are currently short at
ceives subsidies (as described below) from the govern- least ¥7 trillion in loan loss provisions.
ment and passes these savings on to their customers. The Then there is the larger problem of deciding how
HLC makes about 40 percent of all home mortgages. many additional loans are in fact already bad, but have
Fukao (2003, table 8) shows that the HLC loans have rates not been revealed as such. Almost all analysts agree
that are substantially lower than those offered by pri- that there are many more bad loans than the banks have
vate banks, despite typically having longer maturities. acknowledged. But there is considerable disagreement
Moreover, the HLC loans come with no prepayment over the size of the under-reporting. For instance, Credit
penalties (unlike typical Japanese bank mortgages). Suisse First Boston analysts estimate the ratio of prob-
These kinds of government-sponsored financial lems loans for the seven major banks to total loans to
institutions will have to be reined in if Japanese banks be just about 27 percent, roughly four times the dis-
are to regain profitability. This is widely recognized closed figure.5 Meanwhile, Goldman Sachs estimates
outside Japan. For instance, the Bank for International that all bad debts (for the entire banking system) are
Settlements in its 2001 annual report (2002, p. 133) three times as high, ¥236.6 trillion (38.1 percent of
notes that one of the contributing factors to the banks’ all system loans)!6
profitability problems is the “strong competition from Translating the figures on nonperforming loans
government sponsored financial institutions.” The IMF into estimates of taxpayer exposure requires a further
2002 country report goes further and says that the (p. step of netting out collateral and other bank reserves.
3) “exit of non-viable banks and a scaled down role But carrying out this netting is challenging when the
of government financial intermediation are necessary underlying environment is still unstable and the re-
to improve bank profitability.” ported levels of problem loans keep rising. The ratio
Yet, despite making it a priority to privatize the post- of nonperforming to total loans has been steadily ris-
al savings system and otherwise reform many govern- ing among the smaller banks in Japan. A first sign that
ment agencies, the Japanese government has encountered disclosed losses are catching up to actual bad loans will
strong resistance to its efforts to address this problem. The be when the ratio of nonperforming loans to total loans
postal savings system and the government’s home lend- levels off. In the meantime, much of the discrepancies
ing program are popular with the public. Furthermore, in estimates across analysts arise because of different
the public has not been convinced that these programs assumptions about under-reporting (and the methods
in fact are contributing to the banking troubles. Given used to net the losses against other assets).
the public support, and the role that the postal savings A second issue is the quality of the other parts of the
system plays in the Fiscal Investment Loan Program banks’ balance sheets. Two items in particular are treat-
(described below), it is not too surprising that many ed in ways that overstate the apparent health of the banks.
politicians have fought the Koizumi administration’s One is that bank capital is permitted to include tax
reform efforts, delaying a full-fledged attack on the credits against future profits. The figures for the largest
banking problems. However, without some adjustments banks suggest that about 35 percent of shareholders’ eq-
to these reform programs, the banks’ problems are like- uity is made up of these deferred tax credits for loan
ly to reappear even if they were to regain solvency. losses.7 But for these credits to be of any value, the banks
must quickly regain profitability once the loan losses are
How much would recapitalization cost?
recognized: Tax loss credits expire five years after the
Assuming that the banks could figure out how to
bad loans are actually worked out, so many of the ex-
resume making profits, the next obvious question is how
isting credits will expire before they can be claimed.8
6
Another problem is that the banks hold a signifi- lier). The cost to the U.S. taxpayers of the U.S. bank-
cant amount of insurance company debt (usually in ing crisis in the early 1990s turned out to be well less
the form of subordinated loans or surplus notes). As than 1 percent of (then current) GDP, because of the
I discuss in the next section, the life insurance compa- phenomenal growth of the economy over the 1990s.
nies also tend to hold large amounts of subordinated It is very unlikely that Japan will experience anything
bank debt and stock. Many of the life insurance com- like that during its recovery, but differences of opinion
panies are also in a very precarious financial position. over the likely path of the economy over the near term
This “double gearing” makes the banks and the in- further contribute to the dispersion of estimates.
surance companies each look to be better capitalized Given all these caveats, it should come as no sur-
than is in fact the case.9 prise that different observers reach fairly different as-
The ownership of life insurance securities is also sessments about the amount of funding that would be
part of the broader tendency for Japanese banks to own required to make the banks solvent. Table 2 shows the
corporate equities. Fukao estimates that as of March estimates of many of the leading economists and bank
2002, the banks held equities worth roughly ¥34.4 analysts as of August 2002, collected by direct corre-
trillion, which was substantially larger than their true spondence with the experts. They were each asked to
capital (by a factor of seven if one accepts Fukao’s report their estimates of the difference in the market val-
adjustments to correct for the overstated value of the ue of assets and liabilities of the Japanese banks (as
deferred tax credits, the under-reserving of bad loans, of August 1, 2002); as indicated in the table, several
and the preferred shares loans from the last public in- of the responses cited previously published estimates
jection of capital in March 1999). Thus, the banking of slightly different quantities (for example, the value
sector’s value is quite sensitive to changes in share of all problem loans or losses at major banks only).
prices; based on Fukao’s figures, the decline of the The most optimistic figure would suggest losses of
Nikkei from 11,025 on March 31 to 9,383 at the close less than ¥12 trillion (2.4 percent of Japanese GDP);
of September 30 would have wiped out all the banks’ this would be the case if the baseline ING Securities
private equity (assuming they had not bought or sold estimate were adjusted to take care of the phantom tax
any in the interim). Accordingly, the size of the mis- credits that overstate capital by roughly 35 percent.
match between the value of banks’ assets and liabili- The Goldman Sachs and Lehman Brothers estimates
ties at any point in time depends importantly on the suggest losses that are roughly three times as high.
level of stock prices at the time. Regardless of which numbers one believes, it is clear
The Bank of Japan recently announced that it was that the losses for the taxpayers will be substantial.
prepared to buy securities from the banks at market These figures and the foregoing discussion also ex-
prices. If the banks do accept this offer and sell at pre- plain why Takenaka’s Financial Sector Emergency Re-
vailing market prices, this policy would have very little sponse Project Team posed such a threat to the opponents
short-run impact. The banks would still have to accept of reform. The task force’s initial recommendations
any losses that were embedded in their portfolios and were reported to have centered on reducing the length
doing so would erase their capital by the amount of of time that could be used to claim tax credits as part
the losses. The only advantage for the banks would of banks’ capital, tightening loan assessment standards,
be that they could opt to significantly reduce their equi- and forcing increased provisioning for losses. Signif-
ty holdings without necessarily pushing prices down. icant changes in any of these directions would severe-
Conversely, if the Bank of Japan were to pay a ly impact banks’ capital and likely could push some
premium for any securities bought from the banks, (or nearly all) of the major banks below the mandated
then the premium would increase the banks’ capital. level of capital. It is not surprising, therefore, that this
But, the outline for the stock purchasing plan announced possibility triggered intense criticism of Mr. Takenaka
by the Bank of Japan (2002c) states that the prices and his plan.
will be at the market prices defined as “the lesser of the But, as the estimates in table 2 show, regardless
volume-weighted average price or the day’s closing of whether the capital deficiency is recognized by the
price.” More importantly, the total amount purchased regulators and acknowledged to the public, the private
will be limited to ¥2 trillion. Therefore, even if the sector analysts are unanimously of the view that the
prices were substantially above the market price, the banks are bankrupt—by a significant amount. This sug-
potential transfer to the banks would be quite limited. gests that barring a miraculous economic recovery that
Finally, the amount of the funding needed to elimi- no one is forecasting at this time, the banks will even-
nate the banking sector’s insolvency will depend on tually be forced either to close or to raise more capital.
the macroeconomy (for all the reasons discussed ear-
7
TABLE 2
Experts’ estimates of the insolvency of the Japanese banking system
Analyst Firm Estimate Comments
(date of estimate)
David Atkinson Goldman Sachs ¥70 trillion of net loan losses Large bank losses represent
(October 31, 2001) based on March 2001 loans 161% of capital adjusted for
(¥18.7 trillion for the major tax loss carry forwards and
banks) public money.
Robert Feldman Morgan Stanley ¥22 trillion Intended to be a lower bound
(August 2002) for additional taxpayer exposure.
James Fiorillo ING Securities (Japan) ¥19.9 trillion in net loan losses, Capital (as reported without
(August 2002) –¥2 trillion in unrealized capital adjustments) ¥l6.2 trillion
gains
Yukiko Ohara Credit Suisse First Boston ¥21.8 trillion in required credit Estimated non-performing loans
Securities (Japan) Limited costs for the major banks for the major banks ¥121.9
(July 2002) trillion
Paul Sheard Lehman Brothers “To restore the balance sheet Notes that the deposit insurance
(August 2002) health and credibility of the fund has ¥49 trillion of untapped
banking system would probably capacity. Thus, infrastructure and
require ¥30 to ¥50 trillion.” budgeting are in place to act if
there were political will.
Reiko Toritani Fitch Ratings ¥23 trillion for the major banks Adjusting the stated value of equity
(August 2002) for the major banks as of March
2002 to account for fictitious
tax credits, public funds, and
unrealized gains implies a market
value of essentially zero.
This conclusion leads to two criteria that can resulting banking sector would be more efficient at
be used to judge policy proposals regarding bank re- directing funds to deserving borrowers.
capitalization. First, it may be helpful to distinguish
Problems with the life insurance sector
between proposals that do and do not facilitate the
downsizing and consolidation of the banking sector. The life insurance companies comprise the second
If one accepts the earlier analysis, it is quite likely largest part of the financial system. As of March 2002,
that the road to profitability will come through focus- the ten major private insurance companies had assets
ing on more profitable activities and shedding assets. of roughly ¥150 trillion (30 percent of GDP). Most
Under this view, the total level of capital to be com- insurers are mutual companies so that their shares are
mitted to the industry should be determined by the not traded on exchanges, but as explained earlier their
level needed to support the long-run size of the in- financial linkages with the rest of the financial system
dustry, not necessarily its current size. are extensive. For instance, at least 10 percent of the
Second, since money to bail out the banks is limited, equity of each of the major Japanese “city banks” (that
any refinancing proposed should be done in a focused is, those that are large and globally active) is owned
fashion. In particular, if exit of some banks is inevitable, by insurance companies; as of March 2001, insurance
then it is poor policy to prop up banks that will soon go companies owned ¥5.4 trillion of bank equity and
out of business. Past recapitalizations in Japan did not ¥5.1 trillion of subordinated bank debt. Thus, it is
adhere to this rule, but featured across-the-board rescues, necessary to recognize that the health of the insurers
whereby some of the money was wasted on dying banks. is intimately connected with that of the banks.
These mistakes could be avoided if more market
Similarities with the banks
signals were used to decide which banks merited fund-
The problems of the life insurance companies re-
ing. Banks that cannot attract private financing as part
semble those of the banks in three respects. First, they
of their recapitalization might be given lower priority
too have made bad loans. However, the scale of the
than those that can. This type of selective rehabilita-
insurers’ lending mistakes is quite different. As of March
tion would lead to the best banks being rebuilt. The
2002, the ten majors had disclosed ¥568 billion in
8